journal of technical analysis (jota). issue 25 (1986, november)

TECHNICIAN-S ASSOCIATION

N Issue 25 November 1986

lWRU.lP !lECHVICB AsslDczATIoW .XX?UWL Issue 25 November 1986

Editor: Henry 0. Pruden, Ph.D. Adjunct Professor Golden Gate University San Francisco, CA 94105

Minuscript laz?lri-: Arthur T. Dietz, Ph.D. Professor of Finance Graduate School of Business Administration, mry University Atlanta, Georgia

Frederick Dickson Portfolio Manager Millburn Corporation New York, New York

Richard Ox-r, Ph.D. Vice President for Research John Gutman Investment Corporation New Britian, Cmnecticut

David Dpshaw;C.F.A. Director of Rxtfolio Strategy Research Waddell and Reed Investment Management Kansas City, Missouri

Anthony W. Tabell Technical Analyst Delafield, Harvey, Tabell Princeton, New Jersey

Robert T. Wood, Ph.D. Associate Professor of Finance Pennsylvania State University State College, Pennsylvania

printer: Golden Gate University 536 Mission Street San Francisco, CA 94105

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IT PAYS 'l'U BE CONTRARY JamesL.Fraser.................

CCXi%ARY OPINIW R.EarlHa&dy..................

'SENTIMENT'AL JOVRtGY: OLD EaVORI!l!ESAREHEZPFUL, BUl'CXNALSOBEDXEPTIVETRAPSFORTHEUNWARY

JamesB. Stack. . . . . . . . . . . . . . . . . .

THFi "AT RISK" SHORT INlZFUZZ RATIO Philip B. Erlanger. . . . . . . . . . . . . . . .

FUNDSNET pITRcIL9sE INDEX ArthurA.Merrill................

NIB: ANEWBONDMARKET INDICXIUR BruceM.Kmich.................

SENTIMENr- THE-LINE John R. MzGinley. . . . . . . . . . . . . . . . .

BOOKREI'VIEW: JOHN MURPHY, TEG9JICAL At@&YSIS OF THl3 FUIURFSM?U?KETbyRobertB.Rit&r.........

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Cartoons were made available by James L. Fraser and Malcolm S. M. Watts.

A Gall For Papers On The International Aspects of

Technical Analysis

With the founding of the International Federation of Technical Analysts UFTA) in 1986, technical analysis tookitsfirstfirm footing toward becoming a legitimate and serious-tool for international financial management. Already there are charting services which monitor U.S. Government bond action around theclock andaround the world. Surely additional products and services will arise creating an attendant demand for new knowledge and new skills by tomorrow's technicians. To help point the direction, set the priorities and present the challenges and review the techniques of technical analysis on the international level, the MTAJOURNALis setting aside the Fall 1987 issue.

Mr. Ralph Acampora, Chief Technical Analyst of Kidder Peabody of New York, has agreed to collaborate with the current editorial staff as a Special Edition Editor. Ralph was instrumental in the creation of IETA and is probably one of the best known, most knowledgeable market technicians on the in- temational scene, so I enmurage all authors who believe that they may have something pertinent on the international aspects of technical analysis to contact either Ralph Acaqora or thank Pruden.

Thank you.

Henry C%Pruden, Ph.D. Editor, MEA Journal

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l'BRKET~C~AsswsI;ATIc)N 1986 - 87

President Gail M. Dudack

Pershing, Division DLJ, Inc. 212/312-3322

VicePresident-LoqRinge Plauning Robert J. Sinpkins, Jr. Delafield, Harvey, Tabell

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-tter Robert Prechter New Classics Library 404/536-0309

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Comnittee Chairpersons

lHll&ae Frederic H. Dickson Millburn Corporation 212/398-8489

Plaoanent Anthony W. Tabell Delafield, Harvey, Tabell 609/98 7-2300

EthiCSandS- Donald E. Benson Endowment Mgt. & Research 617/357-8480

Library Dennis Jarrett Kidder Peabody&Co. 212/510-3751

Computer~InterestGroup John McGinley, Jr. Technical Trends Inc. 203/762-0229

Ewxzms~In~tGraup Bruce Kamisch KM, Inc. 212/509-5800

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MTA Editorial Policy

The MAUKETllXX%KICIA&ISASSOCIATIOYVJORIWAL is published by the Market Tech- nicians Association, 70 Pine Street, New York, New York 10005 to promote the investigation and analysis of price and volume activities of the world's financial markets. The MTA Journal is distributed to individuals (both academic and practitioner) and libraries in the United States, Canada, Europe and several other countries. The Journal is copyrighted by the Market Technicians Association and registered with the Library of Congress. All rights are reserved. P{ublication dates are February, May, and November.

Style for theMl!A&nunal

All papers submitted to the MTA Journal are requested to have the following items as prerequisites to consideration for publication:

1.

2.

3.

4.

5.

Short (one paragraph) biographical presentation for inclusion at the end of the accepted article upon publication. Name and affiliation will be shown under the title.

All charts should be provided in camera-ready form and be properly labeled for text reference.

Paper should be submitted typewritten, double-spaced in completed form on 8 l/2 by 11 inch paper. If both sides are used, care should be taken to use sufficiently heavy paper to avoid reverse side images. Footnotes and references should be put at the end of the article.

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Mail your manuscripts to Henry 0. Pruden, Ph.D., Editor, MTA JOURNAL, P.O. Box 1348, Ross, California 94957.

Km-1986

473Tl- ~JRK ‘XA-‘.- THE RECESi W?riC-r?c~~~ ON &E nGC,R ,,F THE STOCK ESCHAXGE AT TEE CL= GF

THE EKcITEmT.

IT PAYS To BE CONTRARY

bY

James L. Fraser

There has been a steadily-growing interest in Contrary Opinion theory over the past few years. Beginning in the 194Os, Humphrey B. Neill, who died in the mid 1970s at his homestead in Saxton's River, Vermont, wrote about Contrary Opinion in his now retired Neil1 Letter of Contrary Opinion. I joined him in furthering the essence of the theory in 1962 with The Contrary Investor, a newsletter on investment implications of Contrary Opinion which I continue to write today. Moreover, I began to reprint old books that deal with human behavior and the stock market while slowly moving into money management utilizing a Contrarian strategy.

Today, Contrary Opinion is accepted as an investment tool and, in fact, has become part of conventional wisdom. Whereas for years the uses of Contrary Opinion were always in the back room, now the mainstream has recognized that to make money you buy the downtrodden, the misunderstood and the overlooked. Also, there are numerous investment letters, books, and practicing managers who seek lesser recognized or secondary growth stocks which do have growth characteristics but not growth multiples. New investment books have contrary or contrarian in their titles and institutions, now responsible for perhaps 85% of stock market trading, nod sagely at committee meetings when a manager says he uses Contrary Opinion.

However, reality is not that pure. Many people use the words but not the strategy. Long-term Contrarian investors, which means value players, include Warren Buffet, John Templeton, John Neff, Dean LeBaron, Phil Carret, Irving Kahn, and David Dreman. They all manage significant sums of money and have done so for a numberofyears. Of course there are others,but at least this gives you an idea of what I mean.

Phil Carret said years ago in his book, The Art of Speculation, published in 1930 (he is still alive today managing money in New York at the age of 89) that the road to success in speculation is the study of values. "The successful speculator must purchase or hold securities which are selling for less than their real value, avoid or sell securities which are selling for more than their real value. The successful investor must pursue exactly the same po1icy.l' Of course, the time requisite for prices to move up is more important to a speculator than an investor. "A security may be undervalued, but if it is also out of style it is of little interest to the speculator." So, one has to study the psychology of the stock market as well as the elements of real value. When real value is out of favor, a Contrarian moves in. A Contrarian investor waits patiently. A Contrarian speculator, on the other hand, tries to judge thepsychologicalclimate with other tools, as charts and technical indicators, that will allow him not to wait too long. Let me give you an example. The chart below from M. C. Horsey & Company shows Sears, Roebuck, a major American corporation. Just before the August 1982 rise began, Sears was our company's largest holding. How did we get that way? Sears was a nifty-fifty stock back in 1972 and early 1973 and then declined with the bear market of 1973-74. It recovered in 1975 and early 1976 and then sank into its own tedius bear market.

8 m-1986

SEARS. ROEBUCK 8 COMPANY During this time, the news was largely negative in that mer- chandising was not doing well, other firms were taking market share away from Sears and as each year went by the financial press reported more and more negative news. The price kept coming down until finally negative news no longer pushed it down. The stock began the bottoming process in 1980 and, as long-term investors, we began buying in late 1980 right up to late May in 1982. We felt we had value which was then not being recognized.

As long-term investors, we bought too soon but that was not very material once the stock moved up strongly in 1982 and 1983. However, a speculator would have timed the movement better and perhaps bought after a breakout above 21 in 1982. The main Contrarian point is that once negative news no longer pushed the price down to new lows, the price fairly represented all possible disappointments. Of course the chart looked terrible at that time as past history for ten years was downhill but the unexpected income of positive change, which takes a long time in a corporation as large as Sears, was about tobe the next major factor which coincided with a market move that began in August 1982.

Take another example of a recent out of favor company with the-chart of Halliburton below. Everybody is aware of the great move which took place in energy related securitiesduring the 1970s that, in most cases, peaked out in late 1980. We then had a sharp fall back, a rise that participated with a 1982-83 bull market, then a continuing downturn based on negative fundamentals for major industries within the energy area. Oil field services represent a volatile sector.

Finally a Contrarian is at- tracted to the stock price after seeing it decline significantly from a high level, keeping in mind that the high price represents an extremely optimistic scenario and one that would not last. The question becomes where is value and in relation to what level of oil prices. An investor might begin buying in the low 20s and certainly participates below 20. A speculator or trader would wait for more price confirmation, that is of the price stabilizing where bad news is

HALLIBURTON COMPANY nT-

PuIhd o&r s449,ooo.olm 6h.r~. Pr.f’d . . . None sture, cca’a 108,660.ooo

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no longer a factor and where perhaps the next level of news is likely to be favorable.

Predictions and Forecasting

Fred C. Kelly, a writer for the Saturday Evening Post back in the 1930s first published Why You Win or Lose in 1930 with a forward, interestingly enough, by John B. Watson, the founder of behavioral psychology at Harvard. Thisbook is a favorite reprint of ours and in my preface I say we have difficulty struggling against crowd behavior patterns. We don't compel thinking and observation. We don't work at contesting the popular view. We are mislead by financial propaganda which makes us untimely in our opinions ard often wrong in our actions.

Kelly understands that human gullibilities are a constant contributory force to speculation. Theonlychangebetween Kelly's days and our own time is that crowd reactions occur faster, thus opinions shift quicker, and jumping to conclusions becomes an unprofitable pastime.

Every natural human impulse seems to be a foe to success in the market. We all want to.conform, to congregate as a herd. And yet we win by understanding human psychology and by thinking ahead in creating possible courses of action to today's conformity. You don't have to be a highly competitive mental person to succeed, you only have to watch and study the crowd in order to pick up useful clues as to what the intelligent minority are not doing.

To succeed in the market one must not do what most others are doing. He who does the opposite has a good chance to be right. We may not know what insiders are doing until after they have done it, but by watching and studying the investing crowd we pick up clues as to what they are not doing. I do not mean that you want to avoid a major current when it is strongly flowing because the uses of Contrary Opinion are most valuable at turning points. To get aboard a major move at the right time, it is cnly necessary to disagree with the opinion of most investors you know who follow logical reasoning processes fostered upon us by print and TV financial media.

It is not the stock market which beats us. It is our own unreasoning instincts and inborn tendencies which we do not master and which, when we give in to them, lead to disaster. Natural instincts govern action which means that fear and greed are at the opposite end of the investment spectrum. I know, we all think times have changed, which they have, but human nature has not changed and that is the point of wisdom regarding Contrarian investing strategies.

Another way to look at this is to say that money may be managed profitably or conventionally but not both. Of course, stock prices represent consensus expectations. But to profit, the expectations have to be both correct and different from what is current conventional wisdom. A significant human problem is to withstand group forces that seek to modify and distort individual judgments.

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The business of investing is an actual study of social influence. Personal investing is so widespread that a social group has been formed and we, as individual investors, are no longer indifferent to this group. When we visit brokers' offices we are alert to the group. If we hang around long enough we tend to reach an agreement with the prevailing opinion since this is the dynamic requirement of a group situation. Otherwise, our personali- ties would suffer. Even watching business news on television puts us in the position to accept prevailing opinion. The anti-social solution is to turn off the set.

Trend is Not Destiny -- Character is Destiny

We tend to modify our judgment in response to the pressure of majority and expert opinion. Majority beliefs and convictions are reinforced by most financial media. Investment practices are adopted on the basis of reasons that appear valid. But each investor comes under the sway of an already existing system of practices and values so he cannot judge independently, and he is affected the most when he is least able to exercise his own judgment. Inother words,character andtemperamentare more important than charts and systems. We want to endow investing with specific guides that can be counted on. This is good. But we should realize that our emotions and unconscious behavior patterns, as the tides of the Bay of Fundy, often overrun these guides and just as often leave them stranded.

Independence and basic confidence in your ability to control doubts is a primary requisite for successful investing. Take the case of Xerox as represented in the chart below. Obviously, when Xerox was above 150 in 1972 and 1973, there was little independent thinking regarding the idea that the stock deserved such a high price. This was group behavior in all its splendor. Then came the market drop of 1973-74 with a bit of a recovery thereafter, but not much when you consider the market bottom in recent times was year 1974 at 570 on the Bow and the market has moved higher since then. Whathappenedis that the majority belief and conviction that Xerox was a special company, deserving of high multiples and all good things was dashed through the rest of the 1970s and into the 1980s. To be sure, the higher you were in 1973, the easier it

Anyway, right through 1982 and into 1984 the majority belief become one of Japanese com- petition winning the day with copiers, first at the cheap end of the line and then finally across the board. Xerox management was perceived to be incompetent and not paying attention to what was going on. We bought the stock in 1982 and again in 1984 on the basis that management, though a bit thick,

was to fall down and hurt yourself. XEROX CORPORATION

was slowly responding to the global changes influencing its business. These changes take time. Finally, by 1984, negative articles no longer influenced thepriceof the stock. That was the safe time to buy in what technicians might call a saucer bottom. The stock then became our largest holding.

11 mJl.986

Interestingly, as you might suspect, as the stock rose up, we finally began to see a few nice words about Xerox. News follows the price. As the price moves higher the financial media speaks sweetly.

Pride of Opinion Precedes a Fall

I have been saying that a practicing Contrarian observes the psychological status of the crowd in question and then takes an opposite approach. Of course, there are more than one opposite approaches. Normally, if the crowd has decided upon a conventional future, then the successful opposite approach is either more positive or more negative, at the extremes, until cne of the extremes becomes the conventional view and then the Contrarian again must take a different road from the conventional view. The theory is based upon estimating the prevailing crowd emotion and not on forecasting the future. We make 123 attempt to predict the future and we keep an open mind. Any definite forecast of the future leaves one at the mercy of that forecast because pride of opinion will tend to tie us down to that forecast.

Take a look at a medium-sized stock chart which is Ransburg below. This company is not followed by Wall Street very closely, is located in Indian- apolis, Indiana which people may come frombutrarelygoto, and reflects future forecasting in price moves. Not of the company itself but of fields of activity that the company represents. Basically, Ransburg is a leader in industrial equipment and is associated with robots. Not surprisingly, the all time high price of above 37 was made in April 1981 when Time magazine had on its cover robots and the tremendous future they represented. This cover journalism forecast of the future left investors at the mercy of brokers who were pushing robotic stocks. Anybody who read Time wanted such items and Ransburg, normally a quiet stock, topped out at the peak of enthusiasm for robots. Obviously, this enthusiasm was not limited to the month of April but had been building up since the second half of 1980.

Again, the high technology boom in 1983 which maximized in June of that year also saw Ransburg peak out on the basis of high technology ax-d robots. The

RANSBURG CORPORATION iii price came &wn again only to rise a bit in 1986 on the basis of industrial expan- sion and the improvinq of American pro- ductivity. Now the stock is back down

Pref’d . . . N

- 7.9M. once more to below the 15 area and is a Contrary Opinion buy since we can choose it with an open mind that is notinflu- enced by delightful future forecasts. These forecasts will come to life but not when anticipated and so far we have had three false moves which undoubtedly will keep investors away until they miss the real move that takes place one of these days.

Oh, I realize that it is easy to make points from charts that back me up. And yet, investing is not a science and one must enjoy it to do it well. However, we should stick to what we understand,have some guts,and never become too overconfident. Again, PhilCarretonce said something to the

12 m-1986

effect that an investor who so lacks confidence in his an judgment that he won't buy any security until it is favored by the consensus of the investment community, will buy few bargains and is unlikely to achieve superior results. Of course, a security favored among professional investors is good but that is not the same as being undervalued in price. If unpopular, or generally unrecognized, some investigation is required to estimate basic value. That is where security analysis comes in. Once assured the basic value is there, then unpopularity will not deter the investor who is looking for long-term results.

A good trader, speculator or market technician is trying to do the same thing though using somewhat different tools that offer insights into value. We are all trying to buy things where the future is rr& already discounted. We want stocks with merit and we should buy them when they are weak. But usually we buy stocks with merit when they are strong and thereby do not build gocd performance over time.

Patience is Sustained Courage

Another way to look at this is at perspective and patience of the essential requirements. We all want to own shares of successful companies in areas of activity that have particularly promising future prospects. However, the Contrary lesson is that we all tend to be influenced by whatever feelings .are sweeping over the investment community at the moment and that true investing, to be successful, requires fighting these feelings. Neverthe- less, it is not that simple for the inexperienced investor to be contrary since inexperience breeds a certain contempt for long-term solutions.

Subscribers to advisory services aim at quick results, feeling that the game is not worth the candle unless a system or technique works immediately. An individual, fortunate enough to have an intuitive sense of values, should be able to achieve reasonable profits with some degree of consistency. The key words here are reasonable and consistency--words not in the vocabulary of those who do not yet have market experience.

R.W. McNeel, Financial Editor of the Boston Herald from 1912-1922 wrote Beating the Stock Market, published in 1921 on the human side of speculation - which means attitudes, beliefs, hopes, and fears -- the emotions and characteristics that any of us associate with human beings. Now studying people may not seem rewarding. But if you subscribe to the thesis that confidence makes business you study people. Writers tend to emphasize their statistical figures but people give these figures meaning.

My point is that character is as essential as knowledge, even more so tcday when basic statistical knowledge is readily available. In McNeel's day balance sheet figures were less reliable and yet they were relied upon. In our day statistical analysis is clearly stated and asset values are known yet the same stock swings take place. The constant element is the human side of finance -- that has not changed. Natural instincts willunques- tionably govern action.

To illustrate, fear is probably the oldest timan instinct. It is universal and deep rooted. It is the outgrowth of self-preservation whereby we have

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been able to survive over time. To quote McNeel: 'Because of its ancient origin and its great strength, man is at times exposed to the absolute breaking down of his courage under certain conditions and frequently without cause."

The other side of fear is greed or from the instinctpointof view that of companionship or gregariousness. Investors tend to flock together. We have an inborn tendency to do what we see someone else doing. Investors become excited and tend to act like lemmings as they enter into the active or emotional states of others.

Consider how basic instincts cause us to act in the stock market. We are told to buy low and sell high. Yet stocks are never low unless the head- lines are such as to cause the greatmajorityof active investors to sell. Selling is usually a creation of financial necessity, needing money, or more largely through fear of pending developments in the world that make you feel that prospect of financial loss is certain. Stock market bottoms are created when we sell stocks atridiculouslylowprices without conscious reason. Whatever that price level is at, it will look low in retrospect. Recent examples are Dow 570 in 1974, 770 in 1982, and 1079 in 1984. This may be a pattern of rising bottoms but each one offered exceptional oppor- tunities for the purchase of stocks. The opportunity is only there because most of us are unable to turn our instincts or emotions upside down and buy while others sell.

McNeel said: "In order to avoid selling, and on the other hand to buy, he must put his natural inclinations to the test of reason and determine whether they are sound QT unsound." Every investor tries to do this and I find from my own personal experience that it is easier to do this if you are physically divorced from the financial black holes of enthusiasm or despair which means the major metropolitan centers. I am in Burlington, Vermont because it is just enough off the beaten path to make it a Contrarian's delight. Hopefully, this keeps us abit away from the inborn tendency to act in common with others.

A few axioms to the uncertain art of economic prophesy follow, I will create a baker's dozen guidelines.

1. The system is there is none. I know this sounds strange but successful techniques are counterproductive when widely followed. Systems that work usually come to your dinner table as food for the future when actually they are the result of previous activity which is now so popular the system is not worth buying. What ane needs is systems at the breakfast table, for sustenance over the coming day. Usually, one receives a system too late.

2. Consensus hopes or fears are embodied in current valuation levels. The corollaries to this are that realization of expectations results in no price change while realization of unexpected outcomes moves prices. The chart of Aetna illustrates this point of view which is represented by "The Trader" column by Floyd Norris in the 18 June 1984 issue of Barron's [see Exhibit No. 11. Norris had attended the seminar on Value Investing sponsored by the New York Society of Security Analysts where I was a speaker. His attention was drawn to my mention that property/casualty insurance companies appear cheap in the marketplace.

14 MI% m 1986

The letter to the Editor is from the 25 June issue of Barron's and concerns our mentioning of bottom fishing for property/casualty insurance companies [Exhibit No. 11. The point of Mr. Swift's comments is that the entire industry is so bad off that our timing is nowhere near correct and investors should continue to avoid the entire area.

Of course, Mr. Swift's letter represents good thinking and its inclusion in Barron's reflects a certain style of consensus wisdom. The question comes down tothatonce your worst investment fears are realized, there is only upside potential left. But what are the worst fears? Is there a real crisis in the property/casualty insurance group or is it a case of the negative atmosphere being so strong that this is not the time for selling but rather the time for buying? Needless to say, the stock prices of both Aetna and Continental were both within 30 days of lows that have not been seen since.

3. The ability to sense what is going on in the economy is more important than organizing facts. The result is that indicators are IXI substitute for judgment. Besides, a simple yardstick of value can beat exhaustive consideration of all relevant facts. When you have tco many facts there is the question of selection. To illustrate, low price-earnings ratio investing is an extremely simple strategy which works over time, probably because of its simplicity. '.

4. There is a failure to perceive any new reality. In other words, it is difficult to see the significance of outside events which produce new watersheds. A recent example is the climbof energy prices into 1980 and their subsequent decline into 1986. Mostofus act like generals who are fighting the last battle in a new arena where we carry our experiences forward without taking into consideration the changing environment. The future is not always a continuation of the past. Be skeptical of past trends being stretched far beyond the present. The elastic may break or snap back when least expected.

5. There is a cultural-psychological lag in experience over expectations. We all have a tremendous capacity to believe anything until it is no longer worth believing. The human factor tells us that we see things according to our preconceptions which then paralyze perceptions. Indeed, when the market operates correctly, each investor reports a slightly different version of what is going on in the market and what signals he feels the market is sending us.

6. Trend is not destiny. The future is never clear and one pays a high price for a cheery consensus. The result is that uncertainty is a friend of the long-term buyer and we need to take a position when most lonely. Easy to say, but not easy to do. Be suspicious of widely held views. Educate yourself for ambiguity instead of certainty and you have a chance for success.

7. Character is destiny. Do not put your trust in those who are trying to hustle you but rather believe in your own common sense. Remember that our behavior patterns are restless anddynamic, withemotions often making for strange statistical measurements. For a Contrarian it is better to be right by oneself than be wrong in good company.

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8. The bedrock of reality is a world of disequilibrium. Instability is a fundamental characteristic of transition. As Le Bon, the French writer of The Crowd says, a crowd yields to instincts which individuals suppress. Rational outside perspective tends to remove you from current investment climates.

9. The art of forecasting is in the choosing. One has to decide what is imnortant ar-d what is not. We need time to reach conclusions. We react to each new piece of information as concrete evidence of a new trend that supports some exciting premise. The rise of gold and silver in 1980 was a wonderful popular delusion. The Hunt family of Texas was then worth over $5 billion and now, after some years of adversity, the family fortune seems to be well under $1 billion. Still, a nice piece of change but not exactly what they were used to in 1980.

10. The future is both promising and threatening. This is always the case whether or not perceived to be. So, how you look at the future is largely dependent upon your own psychological makeup. Every human is anxious. We want to hear answers we agree with.

11. It is better to know some of the questions than all of the answers. That is because the answers don't work out. To be sure, things are more like they are today than they ever were, but most of us worry over answers to an extent that worry consumes the spirit of action.

12. Complacency breeds surprises while fear breeds opportunity. We have a few dozen buttons with sayings on them, some of which are part of this article in various sentences. In this regard, patience is sustained courage and without curiosity conviction is stubbornness.

13. Take not thyself too seriously. Take your work seriously but don't confuse brains with a bull market.

This is a good place to say that it is of major importance in using the Theory of Contrary Opinion to be contrary to words and opinions, not to facts. It is words that mislead, distort, and delude. To paraphrase Gustave Le Bon, one of the great writers on the crowd mind, we see how words are used as a mechanism of persuasion. The four requisites are:

Affirmation - affirm the word as truth

Repetition - repeat over and over

Contagion - finally it catches

Prestige - and imitation results

Contrary thinking cannot advise you - it can only suggest contrary trends. We are creatures of habitandprone to recessionor prosperity mentality. The irony is that widely followed forecasts bring about their own demise.

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Furthermore, one does rot get by in being contrary along, one must also be curious. Nobody can afford to jump to conclusions since we have to look at the whole picture. The Contrarian can clarify thought so that recommendations fall into place. But don't force them. Think first. Don't expect the market to conform to your own preconceived opinions. It won't. Flexi- bility plus thought plus work equals a chance for success. Rigidity of mind does not.

Object, Purpose, Method, Premise

Let us review a bit and put more pieces together. Theobjectof contrary thinking is to challenge generally accepted viewpoints on the prevailing trends in politics, socio-economics, business, and the stock market. Opinions react sharply as people's emotions -- their hopes, fears, and passions -- sway back and forth.

The contrarian's purpose is to contest the Popular View because the view is usually untimely, misled by propagarda, or plain wrong.

The method is to compel thinking and observation in place of conclusion- hopping and snap-guessing. "Think prodding" or the necessary concentrated reflection takes practice.

The premise is that alternative ideas make for a clearer, better defined judgment. Taking a contrary position frequently will suggest what is NCrr coming next, When thinking through opposites, one is led to sound thoughts as to what miuht come next.

Is the public always wrong? Is the Crowd never correct? After all, we live in the most enlightened democracy of contemporary times, and individuals - acting in mass - pull the voting levers.

For a correct answer we must rephrase the question. Is the public wrong all the time? No. The public is probably right more of the time than not. But the public is right only during the trends ar-d wrong at both ends -- usually wr&g when it pays to be contrary (I feel we may include institutions as acting nublic-like in their investment activities. The market sheep are not all individuals. The fatter flocks just trample more grand.)

Professor H.F. Harding of Ohio State once wrote me that "the-odds are always good that the exceptional man is well ahead of the crowd. When they catch up he is off in another direction." The modern problem is that the speed of change influences the process and tends to compress all movements. Remember Voltaire who said: "It is only charlatans who are certain. Doubt is not a very agreeable state, but certainty is a ridiculous cne."

Contrary Opinion theory is being discussed more and more in the financial media as both professional managers and amateur individuals tend to use the expressian when it fits them. Accordingly, everybody is becoming aware that to do the opposite of what most people are doing is the way to win. Simply, you win by being contrary.

Most of us should act as true investors. Forgetting about market liguidity and the speedier ticker tape, while relying on our judgments of what an

17

investment will bring us over longer periods of time than a trading cycle.

There are different approaches to the problem. The specific investment need of many Contrary Opinion readers is to tailor a program around undervalua- tion. This means you establish that securities purchased are worth more than they are selling. Characteristics and criteria are set up. The following fundamental guidelines serve as a beginning:

1. Past records give a point of departure for analysis. Average earnings, dividends, asset values and their trends should be examined. Tangible value is the secret, either in a turnaround situation or a special asset stock.

2. New and relevant facts that expect to have an influence may be present. These facts should not yet be fully realized and appreciated by a majority of the financial community. (Clearly, technical analysis offers portraits of sentiment which aid the decision making process.)

3. A lower speculative component is essential. The measurement and delimitation of securities into investment and speculative areas is desir- able. The method is largely to ignore popular trends and to buy ex-public participation.

4. After basic principles, the distinction is still one of personal imagination and ingenuity. Confidence in market level factors influence price-earnings multiples. But a strict ladder analysis, where you try to escalate your stock over comparative choices, is not good practice.

5. Try to purchase under favorable conditions. A clear-cut demonstra- tion of superior attractiveness is still subjective judgment. Facts and ideas favorable to purchase are remembered , while negative factors are forgotten.

Do not adhere to any formula or system. Keep no idols, but rather stoke your noggin with antidotes for the temptation of conformity. Rely not on a consensus indicator approach as a substitute for common sense. Then you will not be short-circuited. In fact, you may even win.

James L. Fraser, president and founder of Fraser Management (309 S. Williard St., Burlington, Vermont 05401), is responsible for overall investment guidance as well as fundamental economic research and portfolio management. He is a Chartered Financial Analyst and has been an investment counselor and financial publisher since 1962. He is also a member of the MarketTech- nicians Association.

18

ONE sign of how the market is doing came in midweek when more than

200 analysts packed a seminar on “Value Investing.” sponsored by the New York Society of Security Analysts. “There’s a bear market psychology.” said James P. Holmes of ValueQuesl Ltd., who organized the affair. Back when the session was first announced, and the Dow was trading near its high. there was little response; he explained, but every bad week in the market brought more registrations.

You might think analysts would always be seeking value, but it can be more fun to look for exciting concepts and to chase the latest market darlings, a category occupied a year ago by little high-tech operations that kept shooting up even when investors couldn’t figure out exactly what a company did.

One way to look for value is to find what is totally out of favor in the market, on the assumption that just as enthusiasm can send stocks far too high, bad news can send them too low. James Fraser, whose Fraser Management in Burlington, VI., has compiled an admi- rable record with such a strategy. told the group he was starting IO nibble at the property and casualty insurance companies, buying Continental Corp. and Aetna.

Those companies certainly have had their share of bad news, as well as a few run-ups on the theory that finally the underwriting cycle was due to turn and they would be able to raise prices enough to cover losses. So far, all such runs have been premature, but Fraser says he thinks the downside risk is mini- mal. One way to tell when the bottom has been passed, he says, is when more bad news does not provoke price declines.

Norris 18 June 1984 in Barron's

PERILOUSPURSUIR To the Editor:

The June 18 Trader column mentioned that Frazer Manage- ment was nibbling at the property and casualty insurance companies. True, the prices look attractive, but then so do the prices of. a zillion stocks right now.

These companies have a lot of problems. A large proportion of the assets of -Aetna, Cigna and Continental Corp. are tied up in bonds that have been taking a real beating lately, and stocks that have, too.

Earnings of these companies bave come way down since 1979, ‘81 and ‘78 and there are I

respectively) rea ly few signs

that ‘the direction will change soon. Long-term natural disas- ters, like floods and tomados, seem to be in high gear. If the Ion -awaited California ‘and MI west quakes ever come, 1 3 pity the insurance industry, and its stockholders.

Aetna still faces possible bil-

booing ayouts in the A.H.

b alkon Shield suits. With 3,700 cases pending, Robins and Aetna already have paid $179 million, out of court..

With more than half of therr s(o& owned by institutions, these companies pose erils. Many more can bar1 out & fore the price slide ends.

Bottom fishing has to be done at the right time and J don’t believe we are even near it with these stocks. The casualty stocks are just that . . . casual- ties.

RICHARD A. SWIFT New Canaan, Conn.

Swift 25 June 1984 in Barron's

19 MIA m 1986

CONTRARY OPINION

by R. Earl Hadady*

"The facts are unimportant! It's what they are perceived to be that datermines the course of events."

The principles of Contrary Opinion are applicable to various forms of human activity, particularly markets. Contrary Opinion refers to an opinion which is opposite to what the vast majority of people think the course of events will be. For example, the principles of Contrary Opinion indicate that if practically everyone believes there is going to be a shortage of crude oil and acts accordingly by buying small cars, restricting their travel, and similar measures, an oil glut will occur. That's obvious you say! If that's your comment, perhaps you've forgotten the oil crisis that we experienced in 1978 and 1979 here in the United States. Perhaps you weren't lined up at the pump trying to buy a few gallons of gas for your car. In those dire days, the experts were predicting that the real crunch was yet to occur. In the early 8Os, a very knowledgeable oil geologist friend of mine told me that the oil industry had projected 1985 to be the crisis year of short supply and high prices. Contrarily, it was the year in which we began to experience an oil glut and a drop in prices!

The principles of Contrary Opinion are equally applicable to the stock and futures markets, real estate, the economy, inflation, and other similar forms of human activity. History is strewn with numerous examples of Con- trary Opinion situations. Two of the more widely known and often quoted instances are "The Mississippi Scheme" and "Tulip Mania" which are briefly covered in'the following paragraphs.

THE MISSISSIPPI SCHDlE

In France in the early 18th century, John Law, the sari of a Scottish banker, formed and sold stock in the Mississippi Company--a venture to develop the Mississippi in North America.

At that time, it was generally believed that there was an abundance of gold, silver and precious stones to be found in Mississippi, which was part of the French Louisiana Territory. The initial stock offering was at 400 livres in 1716. So frenzied was the buying that by 1720 the stock had appreciated 40 times from the original offering price.

People poured in from the countrysides to buy the stock an3 then watch the market as the price catapulted upward day-by-day, creating paper profits that were mind-boggling. Eventually, of course, there were no more buyers

*Mr. Hadady is President of Hadady Corporation, publisher of the market advisory letter, The Bullish Consensus. He is also the author of a just released book, How Sick is Uncle Sam, from which much of this article has been taken.

20

left to enter the market, and investors began to realize that the fundamental value of the stock could actually be far below its current market price. An uneasiness set in which eventually turned to panic. In short order the market collapsed, and thousands of individuals were left holding the bag.

TULIP MANIA

The tulip--believed to have been named from a Turkish word signifying a turban--was introduced into western Europe in the mid 1500s. Tulips were much sought after, especially by the wealthyin Holland andGermany. The demand for tulips kept steadily increasing and by 1634, it was thought to be in bad taste if a man of means was without a collection of various tulips. The rage for tulips finally spread to the middle class and the demand became so great that preposterous prices were paid, e.g., 6000 florins (about 560 pounds sterling) for a single bulb. By 1636, regular marts for the purchase and sale of tulips were established on the stock exchanges in Amsterdam and other cities. People of all levels sold their property and invested the proceeds in tulips. Finally, the prudent began to recognize that this folly could not last forever and began to liquidate their holdings. The trickle of sellers who did not reinvest in tulips soon became a stream, and then, almost overnight, a river swept away the wealth of the majority into the hands of a few.

OTHER EXAME'LES OF CONTRARY OPINION

You might be inclined to think that such public follies as The Mississippi Scheme and Tulip Mania are rare. Not so! Literally hundreds of such instances have been documented. The above, and many other public delusions, are covered in detail in Charles Mackay's delightful book, Extraordinary Popular Delusions and Madness of Crowds,' first published in 1841. This book is a classic. A major public delusion of more recent vintage, of course, is the "Crash of 29."

In ach of these examples, prices rose spectacularly as eager and unthinking buyers were caught up inthetemporary madness of the time. In each and every case, the end result was always the same. When practically everyone had bought, who was left to buy? With tha absence of buyers, there was only one way for prices to go--down! And once prices started down, the rush of former buyers to sell created a panic ard crash in prices.

AContrary Opinion2 approach to a given market is said to be taken if you are selling when the vast majority of participants are buying and thinking that the market will move higher . . . or vice versa. In short, the Contrary Opinion approach will be one which is opposite to the crowd. Since the vast majority of market participants are only infrequently of the same opinion about a given market, a Contrary Opinion situation does not occur often. For example, in the stock market it might average cnce about every two years; in a futures market, perhaps twice a year.

Before delving into the principles of Contrary Opinion, it is worthwhile to review some market basics which everyone knows but seems to promptly forget when one becomes involved in a market. For purposes of this discussion, we'll use the stock market.

21 m-1986

MARKET ANALYSIS

Although participants in a given market are quick to agree that price moves are the result of the action of the participants, they often forget ati lose sight of this basic and very important fact. Stated another way, the action of the participants is the only reason that prices move! Participants buy and sell based upon where they think prices are headed . . . which may or may not be in accord with the related facts in the real world. However, if enough market participants believe the market is going to move higher and begin to position themselves accordingly, the market will move higher, regardless of what the real world facts are, and vice versa.

Some very astute market analysts have been involved in forecasting over the last hundred years or so, but they have failed to fully recognize the significance of what the above paragraph implies. Their approach to decipher- ing the markets has always boiled down to either Fundamental Analysis or Technical Analysis. In the stock market, the Fundamentals refer to the economy, a company's earnings, sales, dividends, return on capital and dozens of other financial parameters involved in a company's operations. With respect to the other approach, Technical tools simply deal with the parameters that are involved in the trading activity of the stock, i.e., the price, volume, etc. The theory behind the Technical approach is that all Fundamental factors are automatically integrated into the price action, trading volume, etc., of the commodity or stock being traded.

Analysts have overlooked and failed to come up with a forecasting tool that directly deciphers the activity of the participants, the real motive power in the market. Prior to this time, analysts have based their analysis on trying to decipher why the participants are doing what they are--a very chancy occupation at best and an indirect approach. The direct approach would be to simply poll the participants and find out what they plan to do and are doing.

ASIMIIE

The use of a simile often helps to clarify a tenet so perhaps this one will help.

Assume you are in an auditorium filled with people and that this group constitutes everyone in the country who trades stock in the XYZ company. If you were able to poll these people and obtain their thoughts in connection with XYZ, would you need any other information to profitably trade the stock? The answer of course is no! You can forget the conventional fundamental and technical tools used by tba analysts. The price of XYZ will move in the direction as viewed by the majority, whether they be bullish or bearish, and for whatever reason until essentially everyone is fully positioned. At that point, the fuel that powered the move has been ex- hausted and we have a Contrary Opinion situation. At this juncture, there is only one way prices can move--in the opposite direction.

Consider a pre-election poll of voters. They have become so accurate that the results are generally accepted as gospel. The vital question in such polls is, "who are you going tovote for?" The reasons for casting a vote for A rather than B are of secondary interest and the rationale for the

22 MPA Jv 1986

decision is typically not all that easy to define. Rather than being a yes/no, black/white type of answer all kinds of subjective thinking may enter the picture. As so often occurs in news stories, the rationale given for an occurrence seems logical but in actuality it may or may not have been the real underlying reason. In short, one's accuracy in forecasting is likely to be much better working at the primary level, i.e., what are you going to do, rather than at the secondary level , i.e., why are you going to do it.

Figure 1 illustrates the proper hierarchy of the analytical tools available for forecasting markets.

CoNVENrIoN?& ANALYSIS

Conventional analytical approaches to the market, both Fundamental and Technical, are indirect methods of forecasting. For an investor or speculator to trade profitably using either or both of these approaches, these conditions must be satisfied:

1. The analysts rrrust lead to a correct forecast of prices, and

2. The correct forecast must be arrived at before the anticipated price move fully develops, and

3. The majority of market participants must subsequently arrive at the same forecast, by whatever means, to power the market in the predicted direction.

Stated another way, an investor or speculator must anticipate what the crowd is going to do, regardless of whether they are right or wrong, and be ahead of them. It is important to differentiate between where you think the market is going ard where the crowd thinks the market is headed. What th=e crowd thinks should be your anly consideration.

23

HADADYH- OF THE WAYS OF FORIEASTINGMARKFT PRICES

E'ORECASTING MARKET PRICES

Direct Approach POLLJNG

What market participants are doing

1 I Why market participants

FUND-AL TECHNICAL are doing what ANXGYSIS ANALYSIS they are doing

Indirect Approaches

Figure 1

24

Many of the legendary stock and commodity traders have referred to the psychological aspects of the markets and some analysts include market psychology in their analyses. However, this area has always played a minor roleand hasbeen relegated to simply one of a number of Technical tools. It is another case in point of how far afield and misdirected one can be led by conventional wisdom.

THEi MR. WIZARD SCENARIO

This is a make-believe scenario involving Mr. Wizard, the dean of market advisors serving speculators and investors in the stock and futures markets. I believe it will create a mental image that can serve as a refresher of how the market really works when you get sidetracked, as we are all apt to do at times.

Mr. Wizard, a market analyst and confirmed numerologist, through a fortunate series of profitable market recommendations on the stock indexes, began to develop a significant number of followers. Mr. Thomas, a speculator in the stock indexes, had a friend, Mr. Follower, who was very high on Mr. Wizard. Mr. Thomas was frequently urged by his friend, who had been making money hand over fist, to subscribe to Mr. Wizard's service and trade his recommendations.

Mr.Thomas had been considering buying the S b P 500 Stock Index when he bumped into his friend, Mr. Follower, who advised him to wait until the 13th of the month; the buy date Mr. Wizard had recommended to his clients. Mr. Thomas, being conservative by nature and from the doubt- ing side of the family, didn't place much faith in numerology. However, he decided not to buy now but to wait until the 13th, the buy date Mr. Wizard had recommended . . . it wasn't that far off anyway. Further, he'd sit on the sidelines and check out Mr. Wizard's recommendation!

As the 13th approached, prices of the stock indexes began to drop which made Mr. Thomas glad he had waited. The 13th came and sure enough, prices rallied strongly. Well, it could have been a fluke, Mr. Thomas reasoned, but then again, maybe, just maybe, there was something in Mr. Wizard's system. He'd contact his friend and get him togive him Mr. Wizard's recommendation on when to liquidate his long position and go short.

Mr. Follower called Mr. Thomas a week later and said he had just checked Mr. Wizard's phone recording which recommended the 29th as the date to liquidate the position he'd taken on the 13th, and to go short. Mr. Thomas still doubted Mr. Wizard's ability but his previous recommendation had been right on the money so he was willing to be con- vinced. As the 29th approached, Mr. Thomas kept a watchful eye on prices which began to move up significantly . . . apparently there were relatively few sellers in the market. Finally, the morning of the 29th arrived. Prices opened down somewhat and then began to fall off sharply. "By gosh," Mr. Thomas murmured under his breath, "there must be something in Mr. Wizard's system." He made up his mind right then and there that he'd subscribe to the servioa and follow the next recommendation.

25 m-1986

Here are the conclusions that can be deciphered from the preceding little scenario:

1. Mr. Thomas postponed his buying before the 13th of the month to see if Mr. Wizard's prediction would materialize. His absence, others like him, and confirmed followers of Mr. Wizard's recommendations re- duced the number of would-be buyers in the market. As a result of the shortage of buyers, sellers had to reduce their prices in order to attract new buyers.

2. On the 13th, the confirmed followers of Mr. Wizard had buy orders in on the opening, consequently prices rose. As prices rallied, other followers of Mr. Wizard who were willing to buy on strength and wanted to have an indication that Mr. Wizard's call was on the money, jumped into the market and the rally was off and running. It was further fueled by locals on the floor of the exchange who were short and had to cover their positions.

3. On the 29th, the reverse of the foregoing occurred. The absence of sellers in the market immediately prior to the 29th resulted in prices rallying sharply. A heavy preponderance of sellers entering on the 29th, of course, drove prices down rapidly.

In short, these two key conclusions can be drawn from the Mr. Wizard scenario:

1. Mr. Wizard's success was an exercise in self-fulfillment.

2. Mr. Wizard's system , whatever itmighthave been, was incorrectly given credit for his success. It was a case of doing the right thing for the wrong reason, which was led to the demise of many market analysts and big traders.

3. The secret indicator, which accurately forecasts market prices, and that one dreams of having for his personal use only, is so obvious, that it is inobvious. Contrarily, the secret indicator is not secret at all, but rather, it is the indicator that is best known and most widely used by the majority of participants who are currently trading in the market. The indicator may also be a group of indicators which are in coincidence.

With the preceding workings of the market in mind, let's turn our attention to Contrary Opinion and see how it relates. Experience has revealed that when around 70% of the participants in a given market are of the same mind, bearish or bullish, a Contrary Opinion situation has developed. As the number increases above 70%, the effect of the Contrary Opinion situation on the market will be more pronounced.

WHY A CONTRARY OPINION SITUATION CAUSS PRICES I0 CRASH

The reason for the precipitous fall in prices in a Contrary Opinion situation can most easily seen by using an example in the specifically structured futures markets.

26

A Contrary Opinion situation can only occur when practically all market participants are of the same mind, i.e., either very bearish or very bullish on the market. For example, let's take a case where 80% of the stock index traders are bullish ard expecting prices to rise. Stated another way, this represents a Bullish Consensus of 80%. Since there is a winning contract for every losing contract in a futures market , some very simple mathematics can tell us why prices drop so precipitously once the decline starts.

Let:

T = Total number of Traders in the Market

% = Average Number of Contracts held by a trader who is long (has bought) --he is a member of the crowd that constitutes 80% of the market participants and is expecting prices to rise.

N, = Average Number of Contracts held by a trader who is short (has sold).

For this stock index example, where there is a Bullish Consensus of 80%, i.e., 8 out of 10 market participants are expecting prices to rise, the re- lationship is:

80% T x NL = Total number of all outstanding contracts held by longs who are expecting prices to rise.

20% T x N, = Total number of all outstanding contracts held by shorts who are expecting prices to decline.

Because the futures market is a zero-sum game, the total number of winning contracts must be exactly equal to the total number of losing contracts. It therefore follows that:

80% T x NL = 20% T x N,

Thus, in this case where 80% of the traders are buyers (long):

20% T x N, 1

%= ------------------- = -A-

N, 80% T 4

27

In other words, the average trader who is a buyer (one who is long) only holds l/4 as many contracts as the average seller (one who is short). The following tabulation shows the ratio of the average number of contracts held by a Bull versus a Bear for various Bullish Consensus figures:

Bullish Consensus

-----------

Ratio of Average Number of Contracts Held

---------------------- Bull versus Bear

5% 19 to 1 10% 9 to 1 15% 5.6 to 1 20% 4 to 1

50% 1 to 1

80% 1 to 4 85% 1 to 5.6 90% 1 to 9 95% 1 to 19

In brief, the average participant who takes the unpopular side of the market holds more contracts than the average participant who goes with the crowd. It follows, that he therefore must be better financed and thus has more market staying power. An obvious fact when you begin to analyze the futures markets and get their workings clearly in focus. And what is the significance?

When practically all of the participants who are taking the popular side of the market get fully positioned, there is no one left to fuel a further move in prices. A signal that this has occurred is the failure of prices to move in correspondence with news supporting the popular view. For example if the Bullish Consensus for the S & P 500 Stock Index was 80% and prices failed to move higher on bullish news, such as an unexpected drop in interest rates, then there is reasonable assurance that all of the bulls are fully positioned. At this juncture, prices can only move one way - down! Once a few of the crowd begin to exit from the market, in order to take their profits, prices drop precipitously because the only potential buyers left are the well-financed participants on the other side of the market. These well-financed participants will only become buyers when they want to exit from the market . . . and that will only occur when they have sizeable profits which correspond to a large drop in prices. Once prices begin to decline, the crowd begins to head for the exit, hopefully to save some of their profits or avert margin calls. Selling begets selling and in less time than it takes to tell, the stampede is on and prices drop precipitously!

ANEWANALYTICALAPPROACH- POLLING

In taking a Contrary Opinion position, the reason why the majority of participants in a particular market are bullish or bearish is of no conse- quence, i.e., fundamental and technical analyses are not involved. Taking a Contrary Opinion position is based solely upon knowing that the vast

28 M!rAml986

majority of market participants are of one mind and that they are fully positioned. The consensus of the market participants is determined by polling, which represents a unique approach and a third way, vis-a-vis fundamental or technical, to analyzing a market. As a result of my efforts, polling is now beginning to become recognized as a separate and distinct "third" approach. The fact that polling has not been previously recognized as such is surprising, particularly since Contrary Opinion, which depends upon polling, has been around for over a hundred years. Even today, many analysts refer to a consensus of market participants and an associated Con- trary Opinion situation, as a psychological attribute of technical analysis. Further, many of the early investigators of Contrary Opinion did not view it as a means of forecasting at all, but rather as a method of working toward thought-out conclusions.

THJ3 PRINCIPLES OF CONTRARY OPINION

It is axiomatic that market prices move as a result of the action of the market participants, regardless of what the facts may be! When practically everyone is bullish on a particular market and has sopositioned himself, then there is no one left to buy and prices can only go one way from this juncture--down! The reverse would have been true if practically everyone was bearish on a market--prices would have to move higher. The principle here is self-evident in that if practically all of the buyers, or sellers as the case may be, have fully positioned themselves; there is no one of the same opinion left to participate in the market ati drive prices further, regardless of what fundamental or technical analysis indicates. The question frequently is asked, "but what will precipitate a price move in a direction opposite to what was expected." In short, among the vast majority of market participants who were of one mind, bullish or bearish, there are many weak hands in the market, i.e., those with relatively limited financing. Fur- Zther, psychologically they tend to be followers rather than leaders - sub- scribing subconsciously to the herd instinct. Any adverse move in prices, which could be caused by only a few market participants attempting to take profits or an adverse news event, etc., produces a rush for the exit by these weak hands. A precipitous move in prices occurs in this situation because there are practically no new or old participants who are willing to take over the positions held by the weak hands at current prices.

The principles of Contrary Opinion can be stated as follows:

1.

2.

3.

4.

Contrary Opinion refers to taking a position in a particular market that is opposite to what the vast majority of participants believe the course of the market will be.

Taking a Contrary Opinion position is based on polling of market participants and is unrelated to other methods of market analysis.

A Contrary Opinion position is based on the number of individual market participants, and is not related to the size of the position that an individual participant has in the market.

When approximately 70% or more participants are of like mind, and get fully positioned in a given market , a Contrary Opinion situation

29 Km m I986

5.

6.

exists. Hence, a move contrary to the expected direction is imminent.

A fully positioned condition by the majority of participants can be identified when a news event, supporting their position, fails to move prices.

The precipitousness of the contrary move is a function of the percentage of participants who are of the same mind.

ALADDIN'S TRADING IAMP

Keeping in mind the preceding analysis, a very important conclusion can be drawn which will enable cne to trade a particular market much more success- fully!

Everyone who has ever been involved in a market, whether it is real estate, the stock market, the futures markets, or whatever, has at one time or another dreamt of the secret market indicator or tool that tells you when to buy and sell... and that only you are privy to! Contrarily, this elusive wonder is not secret at all, but rather, it is the indicator or tool most widely used by the majority of participants who are currently involved in that particular market. It may also be a group of indicators or tools that are in coincidence. It can't be anything else, because the market moves in concert with the action of the participants. If the majority believes the market is going to move higher, they are buyers; and as a result of their action, prices move higher. It is so obvious that it is inobvious.

Prices will continue to move in the direction favored by the majority of market participants and can seesaw through a number of cycles without a Con- trarian situatia developing. However, once approximately 70% of the market participants are of like mind, either bearish or bullish, a Contrarian situ- ationispresent. As the majority rises above 70%, a change in the direction of prices becomes more imminent and the probability increases that the change in prices will be large.

R Earl Hadady is an author and publisher. He has written Contr and he is responsible for the publication of the newsletter sus".

30 mAJouRNALFI(NEMBwlJ86

1. Mackay, Charles, Extraordinary Popular Delusions and the Madness of Crowds, London: Richard Bentley Publisher, 1841. (Republished by Farrar, Straus, and Giroux, New York: 1932 -- rights, etc. subsequently acquired and the book is now available from by Fraser Publishing, Box 4941, Burlington, Vermont, 95402)

2. Hadady, R.Earl, Contrary Opinion, Key Books Press,1983,Pasadena,CA 91101. Ph. (818) 793-2645

3. Hadady, R. Earl, How Sick is Uncle Sam?, Key Books Press, 1986, Pasadena, CA 91101. Ph. (818) 793-2645

31 Km-1986

'SENTIMENT'AL,JOtJRNEY THESE OLD FAVORITES ARE HELPFUL,

BDTCANAISOBEDECEPTIVETRAPSFORTHE~

by James B. Stack

It's impossible to know WHEN investors FIRST realized that "acting against the crowd" was profitable on Wall Street, but odds are that it wasn't long after Charles Henry Dow compiled the first market average in 1884.

And today, it would be difficult to find a single FUNDAMENTALIST who isn't aware of the fact that Bull Markets are born in the depths of despair, and die in a sea of euphoria when optimism is rampant. However the quantifying of investor sentiment has always been an arduous, if not downright subjective task: "Just what is 'frothiness'?" "How do we know when it's present?" and "What levels should be considered dangerous?"

Through the years, a number of technical tools have been developed for this specific purpose of monitoring sentiment or speculation: the volume ratio of Low-Priced Stocks to Blue Chips, the Short Interest Ratio, the Public/ Specialist Short Ratio, the number of New Issue Offerings, and Secondary Offerings. Then with the advent of options, came the Put/Call Premium Ratio and well-known Wysong Put/Call Ratio developed by Perry Wysong from Consensus of Insiders.

It see pr the

the sentiment stampede. They were invariably bullisn at tne peaK, ana

!med that NO ONE, from the novice investor to the experienced trader to rofessional investment advisor, was immune from being swept along in . . - . - - . . . . . 3

almost uniformly bearish right at the bottom. So in the 1960's, Investor's Intelligence developed and began publishing their own Advisory Sentiment Index which tracked these excessive swings in pessimism ard optimism among the investment advisors. The outgrowth has been one of the most respected ard widely followed indexes of market sentiment.

But just how useful are the various sentiment indicators? Place ten market technicians in one room, and you'll get 10 different answers. In any case, there is little question that the surging volume of trading in Stock Index Options and Futures, has certainly shot a few holes in the technicians' once formidable array of indicators based on market sentiment. It's rot that the market was ever serene, nor that institutions used to stand quietly on the sidelines. But without the ability to separate institutional arbitrage from normal market activity, the reliability of Short Interest Ratios and many Put/Call Ratios has fallen into doubt.

Shown in Figure 1, is the NYSEAnnualized Short Interest Ratio which continues to soar to record heights... at least partially distorted by the surge in arbitrage-related short sales. The lack of regulation and controls have made it impossible to determine the extent that these arbitrage pro- grams are being used, or the serious effect they're having on these once reliable indicators. But with almost half (48%) of reported short interest concentrated in fewer than 120 of the most widely held option stocks, the odds are very high that investors waiting for the Short-Interest Ratio to

32 HJ!A Jm 1986

drop out of Bullish territory before exiting their stocks, will likely find themselves riding the next Bear Market all the way down.

PAST CYCLES

Let's take a 'Sentimental Journey' through several past market peaks with several key technical indicators, and cne of the sentiment indicators which HASN'T become distorted from the increasing levels of institutional arbitrage: Advisory Sentiment.

As mentioned earlier, Investor's Intelligence has monitored and ranked advisory services for well over 20 years using just three separate categories: % Bulls, % Bears, and the % expecting a (temporary) Correction. Various calculation methods or ratios have then been used to track these somewhat subjective measurements: %Bulls/(Bulls+Bears), %Bears+l/2 Correction, or just the %Bears. The advantage of utilizing the latter (only the percentage of outright BEARS) is that it eliminates both the 'perma-bulls' and the fence-sitters... those two groups of advisors, who are either PERMANENTLY bullish or can NEVERdecide where the market's heading next. (SeeFigure 2) l

From the technical side, we've selected three of InvesTech's key indicators: the Monetary Exposure Profile, the Continuous Disparity Index, ard the Lead- ership Index. The Monetary Exposure Profile or MEP, measures important changes and pressures behid the Federal Reserve: banking liquidity, loan demand, and the trend/momentum of short-term interest rates. As shown in Figure 3, it ranges between a very favorable +lOO an3 a bearish -100.

The CDI, on the other hand, monitors market breadth (Advances vs. Declines) which has historically proven to be one of the best indicators of a probable market top; but can be coincident or even lagging in signaling an important bottom. The most prominent measurement of 'breadth' through the years, has been the cumulative Advance-Decline line which is usuallyoverlayed on a major average to search for divergences. Although the computations used in the CD1 are quite complex, this index merely reduces the subjectivity of

33

overlaying the two charts. If the CD1 is heading upward, it means that market breadth is improving. If it's flat, breadth is holding it's own against the market. But if it is declining sharply, it signals that investors are becoming increasingly selective. . .and in this case, it's almost a sure sign of trouble ahead.

The Leadership Index, as its rame implies, quantifies the relative number of stocks hitting new yearly highs versus those that are bouncing to new lows. Ranging between a very bullish +lOO, and a bearish -100, it often acts as a confirming indicator for intermediate market reversals.

'II-E 1969-70 MAJOR BEAR MARKET

The "Go-Go" Funds of the late 60's brought the decade to a close with an almost universal confidence among investors - confidence that stocks in general (and these growth funds in particular) had very little downside risk. Advisory Sentiment had fallen to less than 25% BEARS by February of 1969. And along the technical side of the market, the MER Monetary Model had already dropped into bearish ground (below 0) just a month earlier. When both Leadership turned negative and market breadth (the CDI) began falling, vir- tually all blocks were in place for a major Bear Market.

Throughout the 69-70 Bear, monetary conditions, leadership, and breadth remained outright bearish except for brief forays upward. But notice that Ad- visory Sentiment (which had faithfully warned of the impending top), started turning more favorable even before the Bear Market began in earnest. And by the time the 69-70 Bear was half over in August, 50% of advisors had turned into QEARS.. .a level whi& had signaled 2 important bottoms in the previous three years. This time it was not to be, as the DJIA fell another 200pts before the Bear Market finally ended. Advisory Sentiment was right in turning bullish, but it's "early" signal occurred almost 10 months before confirmation came from the MEP Monetary Model along with other technical WeaS. (Figure 4)

THE 1972-73 MAJOR BEAR MARKET

Typical of analysts thoughts during late 1972, was a quote in a November issue of the Wall Street Journal, where the president of a leading brokerage firm stated: "I think you have the basis for a sustained advance, after maybe some milling around, on the basis of both positive business and earnings factors. This coincides with a stock market that doesn't show any sign of speculation. The public is still basically out of the market."

Although confidence had reached extreme levels, the froth and speculation was NCYI evident to most market watchers, as sentiment indicators (including

34 m-l.986

Advisory Sentiment) had been in or near the bearish region for more than 6- 12 months. But along the technical front, breadth (01) locked onto a solid downtrend just prior to the January peak; and the MEP Monetary Model dropped into the favorable region below 0 for the first time in almost 1 l/2 years. Within a month, Leadership had also confirmed that 1973 wasn't going to be the superbull that so many analysts had hoped for.

As this two-year Bear Market unfolded, investors had to again face the per- plexing problem that is characteristic of most sentiment indicators. Before the Bear was even l/3 over (in both price and time), Advisory Sentiment had moved to an outright bullish level... for the FIRST time since mid-1970.

"TO Buy, or not To Buy?" That was the question. Those that relied too heavily on the sentiment indicators and jumped into the market, were treated to another 12 months and 400 DJIApoints of plummeting stock prices. In fact, after the first couple months of the 73-74 Bear Market, Advisory Sen- timent never approached a bearish reading again until well into the next Bull Market. (Figure 5)

THE 1982-86 SUPERBULL

Few analysts could deny that the 1982-86 Bull Market has been hard on investors' nerves. Thebirth followed a relatively calm summer, and was trig- gered by a dramatic shift by the Federal Reserve as the MEP Monetary Model roared upward to a very bullish +75. Once again, Advisory Sentiment had indicated the potential of a bottom as it bounced around bullish readings for 12 months prior to the 'lift-off'. Confirmation came from both Leadership (as it soared to +lOO), and market breadth (the CDI) which had been in a general uptrend since January.

Along with the sudden economic revival, came a resurgence in consumer and investor optimism. And this time, the percent of Advisory Bears fell to the lowest level in six years. Unfortunately, it dropped to this bearish zone before the DJIA had reached 1100. And then in late 1984, following the high-tech wash out, Advisory Sentiment remained calmly near the bearish region as Leadership, breadth, and Monetary Conditions all confirmed that the Bull was about to re-awaken.

Although investor confidence had again reached an extreme by middle of 1986 itwasn'treadily apparent to market participants. Many analysts had developed a false sense of security. And Advisory Sentiment wasn't considered particularly alarming as it had bounced down to 'bearish' levels a surprising number of times during this Bull Market. Will monetary conditions finally deteriorate ax-d the MEP Monetary Model finally turn down to confirm a major Bear Market? Or will the Federal Reserve's stimulation reverse the Leadership and breadth upward for yet another leg in this aging Bull Market? The jury's still out cn this one! (Figure 6)

35

CONCLUSIONS

While Avisory Sentiment is but one of a multitude of sentiment indicators tracked by technicians tcday, its characteristics are quite representative of this family of indices: The measurement is somewhat subjective. It will almost never peak at the same level twice. It's usually early in signaling a market turn. And unlike both monetary conditions and other technical areas which continue to deteriorate as a new Bear Market progresses, sentiment indicators usually begin looking better and better from the 1st day that the Bear Market begins.

. This last idiosyncrasy often causes confusion or an error in judgment by technicians relying too heavily on one or two sentiment gauges. And the average investor patiently waiting and watching for a particular 'trigger- level' in a sentiment indicator, could very well be left behind in the dust.

The strength from an indicator such as Advisory Sentiment, comes in the early identification of a POSSIBLE market turning area. And once known, it's usually best to step to other key indicators along the monetary or technical front for the actual 'trigger' to take action in one's investment portfolio.

Perhaps the mostwidelyknowntechnicalcompositeis the 'ELVES' on "Wall Street Week with Louis Rukeyser," This is actually a group of 10 individual indicators originally assembled by Bob Nurock of The Astute Investor. Of the Elves' 10 components, four are related to market sentiment:

1. Put/Call Premium Ratio. 2. Advisory Sentiment (Investors Intelligence). 3. Volume Ratio of low-priced stocks to the DJIA stocks. 4. Insider Sell/Buy Ratio.

36

And after being revised in late 1974, theElves have chalked up a very re- spectable track record of signaling market turns (Figure 7). However, being heavily weighted in sentiment indicators, it will often display the general characteristics of a sentiment index: peaking early and then reversing sharply in the opposite direction in the very early stages of a new market trend. So an investor religiously following the +5/-5 Buy & Sell signals COULD have been left cn the sidelines cx even short during the past 2 years, had it not been for the single weekly bounce to trigger a +5 'Buy' in the late spring of 1984.

In closing, the various sentiment indicators are indeed valuable in rounding out a technician's arsenal of tils for market timing. And those discussed here are among the best, and the most reliable. But as with any group of indicators: momentum, monetary, breadth, cyclical, or oscillators, it's critical for investors to recognize and remember that they DO have inherent weaknesses as well as strengths in guiding the way to profits on Wall street.

James B.Stack isthepresidentand founder of InvesTech and editor of the "InvesTech Market Letter," best known for its analysis of the effects of monetary policy on the stock market. Jim has developed sophisticated market timing indicators through extensive computer research.

37

I I NYSE ANNUALIZED SHORT INTEREST RATIO

- - - - y -J . .

-m-s -w-s- - . -

, Few Shorts (8earlsh)

0.

*loo a

l 75 % 40

I++-

= l 25 9

0 .,..,.....A.

‘b

-25 -SO

-100 I

3

-79 L 8

1900-

1900 -

1700 -

1900-

1900,-

1400-

1300,-

1200,-

1100 -

1000 -

.-- -- .

M w--------.

II J.. . . . . ..~.~.~...‘y.,::.. r &:.:~.: w f; ,

67 66 69 71

ADVISORY SENTIMENT

NED DAVIS RESt3RCH P.O. Box 2089 Venke, FL 34284.2089

I

MONETARY EXPdSJRE PROFILE

WW

DJIA

I

71 72 73 74 75 76 77 76

w Bears (unfavorable)

I

79 60 61 62 63 &I 65 66

+

.F . . . . . ‘ : : .$ , : : :? ‘.‘.;g

j ‘::

38 m m 1986

60 r ADVISORY SENTIMENT

TOO IbBny Bears (favorable, 50 a-&-z 6% - - - - - - -

% Bearish Advisors

40 1Owk moving average

ho--------------------------------------

TOO Few Bears (unfavorable1 INVESTORS INTELLIGENCE Larchmont IW 10538

10; : : : : : : : : : : : ; : : i

MEP

MONETARY MODEL

LEADERSHIP INDEX

so

I

ADVISORY SENTIMENT . Too I&y Bears (favorable)

50 ------------------

% Bearish Advisors

40 1Owk moving average

+100r MEP l 75 l 50 1

MONETARY MODEL

*IO .7 +5 .1

-2 -5 -7

-10

LEADERSHIP INDEX

MI’A Jv 1986

ADVISORY SENTIMENT

Too Rmy Bears (favorable) ----------------------------------------------------------

MEP

MONETARY MODEL

+100- LEADERSHIP INDEX

.7s -

CDI

(BREADTH)

lODO - DJIA

so0 -

i700 -

1600.-

1300.-

1200 -

1 loo.-

1000 -

41

THE "AT RISK" SHORT INTEREST RATIO

by Philip B. Erlanger

It has become common knowledge that for the past three years or so short interest analysis has progressively lost its effectiveness as a baro- meter of stock market sentiment. Responsible for this impairment is the proliferation of complicated strategies such as 'arbitrage' and 'reverse conversion', which generate essentially riskless short positions. The underlying merits of short interest analysis will be discussed in this article, and a solution to the current deficiencies of the short interest ratio offered.

Short selling is the speculative process of selling a stock, which is not owned, with the hopeful expectation of buying it back (covering) at a lower price. Normally the short seller is at risk, as any advance of a shorted stock means a loss in closing out the position. Short interest is the total number of shares sold short as reported by a stock exchange. The short interest ratio relates monthly short interest to average daily volume; thus a ratio of 1 means that it would require a whole days trading volume to cover all shorts. The merits of the short interest ratio are two-fold . . . it is both a measure of investor sentiment and a measure of specific demand for stock.

Equity prices reflect investor perception of events, fundamentals, trends, risks, and potential rewards . . . the trend of investor psychology often dictates the trend of market prices. In terms of sentiment, one can define an extreme as a moment in time when a vast majority of investors con- cur with either a bullish or bearish view . . . and have committed their funds according to that view. The minority at an extreme will be very re- sistant to an opinion change. As Diagram l.depicts, a majority of bulls long the market must rely on the chance that prices will be bid higher by an unwilling minority - a moment of extreme risk. Diagram 2. represents the opposite extreme when bearish sentiment is prevalent ard there are very few bulls left long the market - as cash levels are high this represents a moment of extreme potential. On balance, the path of the market is fueled by the shift from one extreme of sentiment to the other. As the market climbs, that path or trend represents the dissolution of a bearish majority, gradually creating a reciprocal consensus of bulls . . . market declines can be contemplated as the swing from bullish to bearish extremes. Sentiment indicators plot these relationships by uncovering the extremes and the trends of fear vs. greed! The shortinterestratio is designed to be just such an indicator, plotting the path from heavy short selling (l.7 - 2.0) to light short selling (1 - 1.3).

The short interest ratio serves as a measure of demand by representing the flow of funds. Measuring the relative capacity for buying or selling, a higher ratio means there is a greater relative demand for stock . . . buying is buying, even if it is to close out a short position, which a short seller mst eventually do.

Over the past few years , institutions have enjoyed evergrowing participation in strategies that entail sufficient return for little risk. The ex-

42 l!frA~l986

pansion of the options market and the creation of index futures are the primary events that enabled reverse conversions and index fund hedging to "spread." The esoteric technique of arbitrage has also become increasingly popular as a modern vehicle of speculation. All of these use shortselling in ways that negate the usual risks . . . i.e., significant short selling exists that doesn't represent a negative bet. This tends to dampen the analysis of short interest as a measure of sentiment. When the NYSE reports monthly short interest figures for stocks, issues possibly involved in arbitrage (or other strategies) are specified. The exchange terms the short positions of these issues as potentially "effected by arbitrage transactions resulting from any one a more of the following: a) proposed or pending ac- quisitions; b) convertible securities of the same company; c) rights offerings; d) stock splits QT distributions; e) tenders; f) other special situations. In addition, short interest may be affected by options positions." As Chart 1. shows, in June of 1982, only 20% of reported issues were effected, whereas by June of 1985 half of all issues were implicated. This has had a devastating effect on the short interest ratio, as the gross tally of short interest has been on a steady rise for years, while average daily volume has only risen sporadically (see Table 2.). Many have inter- preted this as a consistently bullish development . . . a very pernicious assumption!

In order to factor out the debilitating influences, it is necessary to go back and reconstruct the monthly short interest ratio on a stock by stock basis, eliminating from consideration any issue that might be involved in the above strategies. The result is the "At Risk" short interest ratio, which theoretically should behave like the ratio of old. In compiling this new statistic, only common stocks are selected that had 5000 or more short shares reported and have an average daily volume of 14,500 or more shares. In a given month, newly listed issues are eliminated. Comparisons of the "At Risk" ratio and the old short interest ratio can be found in Tables 1 and 2 and in the accompanying charts. The following is exactly how the "At Risk" short interest ratio is derived QI a monthly basis:

= NYSE common issues included in the exchange monthly short interest report (preferreds, warrants, rights, etc. not included)

Issues with less than 5000 short shares reported.

Issues with less than 14,500 shares of average daily volume reported.

Any newly listed issue.

Tagged by the exchange as possibly involved in arbitrage.

Qualifying issue = A - B - C - D - E.

Total short interest of all Q's for a given month.

Total average daily volume of all Q's for a given month.

At Risk Short Interest Ratio = X/Y.

43

Charts 2., 3., and 4. show the "At Risk" short interest ratio, the Value Line index, and the standard short interest ratio. One immediately striking difference between the two is that the "At Risk" ratio, until the 2nd quarter of 1986, had basically been in a declining path (suggesting the expected trend towards bullishness usually coincident with secular market uptrends). The standard short interest ratio in contrast rose steadily from the 1982 period . . . that trend would imply increasing bearishness with an uptrending market. Of course, as arbitrage has skewed this ratio, its measure as a reflection of the trend of sentiment is suspect. Chart 5. shows the disparity between the two ratios - somewhat of a measure of the growth of arbitrage.

Chart 6. shows some points of market vulnerability from a sentiment point of view as expressed by the "At Risk" short interest ratio. It's one thing to determine a light level of shorting . . . that in itself doesn't necessarily imply an imminent market decline - hOwever, a subsequent rise in the ratio does imply that shift in sentiment associated with market declines. Points A, B, C, and D highlight these moments. Trendlines W, X, Y, and Z, show those moments when sentiment trended to bullishness as the market advanced.

Short interest analysis is valuable in judging the shifts of sentiment of the various industry groups. Charts 7., 8., and 9. are related to the copper industry group, showing its index, relative strength to the S & P 500, and its "AtRisk" short.interestratio. When one finds low levels of shorting (Chart 9.,pointA) and a downturn in relative strength (Chart 8., point B), price vulnerability can be contemplated (Chart 7., point C). When short interest is high (Chart 9., point X) and the trend of relative strength turns positive (Chart 8., point Y), the potential for a "short squeeze" exists.

The analysis of short interest continues to be a valuable technical tool, and while the problems of skewed data cannot be perfectly overcome, the "AtRisk" shortinterestratio strivestobe a truer measure of sentiment.

44

BICGRAPHY

Philip B. Erlanger is a Vice President of Advest, Inc. and holds the position of Chief Technical Analyst. In this capacity, Mr.Erlanger pub- lishes-the "Technically Speaking" and "Speaking of Industry Groupsll market letters. His wAt Risk" short interest ratio is reported every month with the short interest figures in the Wall Street Journal. He is a member of the Market Technicians Association.

45

I

Diagram 1. Sentiment At Market Top

u = BULLS = BEARS

Diagram 2. Sentiment At Market Bottom I ii

46

NYSE Issues Reporting

Short Interest

June, 1982 CHART 1. June, 1985 80%

Issues Not Influenced

by Arbitrage

20?4l ISSUeS

Influenced by Arbitrage

50% Issues

Not Influenced by Arbitrage

50?6 Issues

Influenced by Arbitrage

47

TABLE 1.

DATE DOW -------__ -------- -------a --------

6/08/82 802.23 7/08/82 804.98 8/06/82 784.34 g/08/82 915.75

10/07/82 965.97 11/05/82 1051.78 12/08/82 1047.09

l/07/83 1076.07 2/08/83 1075.33 3/08/83 1119.78 4/08/83 1124.71 5/06/83 1232.59 6/08/83 1185.50 7/08/83 1207.23 8/08/83 1163.06 g/08/83 1246.14

10/06/83 1268.80 11/04/83 1218.29 12/08/83 1261.89

l/06/84 1286.64 2/07/84 1180.49 3/08/84 1147.09 4/06/84 1132.22 S/08/84 1176.30 6/08/84 1131.25 7/06/84 1122.57 8/08/84 1196.11 g/08/84 1207.38

10/05/84 1182.53 11/07/84 1233.22 12/07/84 1163.21

l/08/85 1191.70 2/07/85 1290.08 3/08/85 1269.66 4/08/85 1252.98 S/08/85 1249.78 6/07/85 1316.42 7/08/85 1328.41 8/08/85 1329.86 g/06/85 1335.69

10/07/85 1324.37 11/07/85 1399.54 12/06/85 1477.18

l/08/86 1526.61 2/07/86 1613.42 3/13/86 1753.71 4/08/86 1769.76 5/08/86 1786.21 6/06/86 1885.90 7/08/86 1820.73 8/08/86 1782.62 g/08/86 1888.64

AT RISK STANDARD SHORT SHORT

INTEREST INTEREST RATIO RATIO

------__ ----_-__ -------- -----_-- 1.82 2.07 1.49 1.87 1.73* 1.73 1.25 1.44 1.68 1.92 1.17 1.33 1.36 1.61 1.25 1.65 1.16 1.47 1.26 1.59 1.56 1.94 1.15 1.58 1.14 1.66 1.29 1.91 1.26 1.99. 1.45 2.28 1.03 2.11 1.11 2.33 1.10 2.29 1.03 2.20 0.95 1.82 1.01 2.01 1.33 2.37 1.10 2.39 1.11 2.38 1.23 2.45 0.95 2.06 1.14 2.54 1.02 2.31 1.02 2.40 1.36 2.73 1.33 2.37 1.10 1.88 1.08 2.25 1.08 2.32 1.08 2.29 1.02 2.25 1.07 2.53 1.07 2.19 1.32 2.95 1.03 2.11 1.19 2.38 1.12 2.40 0.98 2.02 1.10 2.16 1.06 2605 1.03 2.02 1.16 2.34 1.71 2.81 1.84 2.77 1.98 2.81 1.72 2.80

RATIO DISPARITY ----- -----====

0.25 0.38 0.00 0.19 0.24 0.16 0.25 0.40 0.31 0.33 0.38 0.43 0.52 0.62 0.73 0.83 1.08 1.22 1.19 1.17 0.87 1.00 1.04 1.29 1.27 1.22 1.11 1.40 1.29 1.38 1.37 1.04 0.78 1.17 1.24 1.21 1.23 1.46 1.12 1.63 1.08 1.19 1.28 1.04 1.06 0.99 0.99 1.18 1.10 0.93 0.83 1.08

.* NYSE failed to report the average daily volume of individual issues, therefore the standard ratio is substituted.

48 M!m m I986

TABLE 2.

DATE ------mm ---------

6/08/82 7/08/82 8/06/82 g/08/82

10/07/82 11/05/82 12/08/82

l/07/83 2/08/83 3/08/83 4/08/83 S/06/83 6/08/83 7/08/83 8/08/83 g/08/83

10/06/83 11/04/83 12/08/83

l/06/84 2/07/84 3/08/84 4/06/84 S/08/84 6/08/84 7/06/84 8/08/84 g/08/84

lo/OS/84 11/07/84 12/07/84

l/08/85 2/07/85 3/08/85 4/08/85 S/08/85 6/07/85 7/08/85 8/08/85 g/06/85

10/07/85 11/07/85 12/06/85

l/08/86 2/07/86 3/13/86 4/08/86 S/08/86 6/06/86 7/08/86 8/08/86 g/08/86

MONTHLY AVERAGE NYSE SHORT DAILY NYSE

INTEREST VOLUME (millions) (millions) __-------- --------- ---------a ---------

98.919 47.745 95.579 51.518 96.431 55.699

120.059 83.514 141.426 73.504 139.682 104.706 135.280 83.898 127.318 77.093 124.497 84.521 143.625 90.115 147.605 76.087 153.705 97.543 148.574 89.455 166.189 86.935 159.350 80.037 168.682 74.112 182.886 86.562 194.185 83.042 205.579 89.507 203.176 92.083 188.664 103.560 182.660 90.623 202.457 85.499 208.102 86.909 204.473 85.825 201.622 82.343 212.963 103.496 223.313 87.885 216.983 93.835 229.175 95.413 220.673 80.881 207.257 87.559 249.404 132.583 250.206 111.130 223.534 96.230 220.607 96.330 253.004 112.390 251.333 99.341 248.557 113.350 248.675 84.178 222.011 105.290 262.795 110.578 301.850 125.812 266.578 131.827 294.019 135.817 318.624 155.115 318.299 157.368 331.382 141.738 349.768 124.473 368.579 133.034 374.943 133.283 387.124 138.041

Ian-1986

MONTHLY AT RISK

SHORT INTEREST

(millions) =====z===

45.698 47.370

58.892 72.189 75.447 67.229 62.337 55.419 62.863 67.865 63.021 56.909 63.718 59.327 60.597 27.635 26.061 26.492 27.541 25.553 22.322 31.269 27.310 27.616 29.190 28.553 25.612 27.810 27.400 30.608 31.068 35.252 29.093 28.267 28.572 32.640 27.855 29.971 28.480 31.560 34.073 34.339 33.414 36.730 40.795 41.603 43.077 59.874 69.506 63.773 65.851

49

2.0

t

CHART 2.

Al RISK SHORl IlllERESl

UIlLt!K LIXK IXDKX

260.00 - 150 .Ob -

110.00 - t30.00 - tto.00 - 210.00 - t00.00 - 13D.00 - 100.00 - 170.00 - l$O.OO -

CHART 3.

I’ ,I

It 150.00

/

I

110 .oo 130.00 I

1tO.00 ’ I llO.OO 100.00

w ‘83 ‘OV ‘OS ‘b#

3.0 - CHART 4.

s 1MDMB 51011 Illlfml HIID

50

-

I 2

1 .s

1

0.5

8

-8.5

CHART 5.

YC)RT XNTEEST RATXO DISPARITY

: 0 4 : t

51

-

-

-

-

-

-

-

-

-

-

-

I -

-

-

-

-

-

52 11TA JOURNAL7NOVEYBER 1986

FuNDSNFzrPuRCHASESINDEx

by Arthur A. Merrill

In almost every trade there is conflict of opinion; the purchaser is usually optimistic about the future of a stock; the seller is pessimistic. John K. Galbraith puts it "All forecasts in the market are equally divided between the right and the wrong."

Which side is right? Editor Henry Pruden reminds us that we should watch sentiment for some guidance.

The investment funds are certainly managed by astute analysts. They. should be classified in the "smart money" category. The Investment Company Institute, which represents more than 90% of the funds, reports monthly. You can subscribe to their detailed report (A), or note the summary reported in Barron's. It's on the page facing the "MarketLaboratory", in a table headed "Monthly Mutual Fund Indicators." New figures usually appear about a month late. For example, the July statistics were reported in the September 1 issue of Barron's.

Tne statistics that are most often quoted are the sales, redemptions, ar-d cash. I've just finished an analysis of two more statistics in the report: "Sales of Common Stock" and "Purchases of Common Stock", and can report some goad news. These two numbers appear to be a fine indicator of sentiment. This makes sense; the funds reveal their inclinations by their actions.(B)

Tb develop an indicator, I first subtracted sales from purchases to get net purchases. The fund assets are now more than five times the assets of ten years ago. To correct for this, net purchases were calculated as a percent of assets. The assets used were the "stock, bond and income funds." The resulting figures were erratic, so a 33% exponential was applied. This is about the equivalent of a five month moving average. To simplify inter- pretation of the magnitude, the data was normalized by dividing by the standard deviation. For example, if the curve is at 1.2, it is 1.2 standard deviations above the mean; if it is at-0.6, it is 0.6 standard deviations below the mean.(C)

For forecasting benchmarks, tests were applied to cne standard deviation and two thirds of the standard deviation. The latter seemed prefer- able. The reports are late, so, as expected, the index wasn't helpful for the short term. However, in a test using ten years of data, success in forecasting the direction of the market in the next13 weeks yielded a chi squared of 25; for 26 weeks it was 69; for 51 weeks it was 36. All three rate "highly significant." These results put performance fifth best of the forty indicators that were put to the test.

Conclusion: this is a sentiment indicator that deserves attention.

54

(A) For subscription rates, write to:

The Investment Company Institute 1600 M Street NW Washington, DC 20036

@) If you would like 10 years of historical data, a tabulation is available on request.

(C) If the term "standard deviation" isn't familiar to you, a brief description is available on request.

Arthur A. Merrill is the Editor of Technical Trends, a publication of Merrill Analysis, Inc., and he is a member of the Market Technicians Association.

55

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56

NIB: ANEWBOND

By: Bruce

MARKET INDICATOR

M. Kamich

In 1976, Alan Shawls course cn Technical Analysis at the New York Institute of Finance exposed me to the Secondary Offerings Gauge or Secondary Syndrome. This stock market indicator is constructed by collecting a moving average or moving total of the number of secondary offerings that are conveniently listed in the Market Laboratory section of Barrons. The indicator canbe plotted against the Dow Jones Industrial Average to see how it peaks and bottoms with prices. It is not a precise technical tool but is still used by many technicians.

The logic behind the indicator is relatively straightforward. A high level of secondaries is usually seen at market tops, and few such offerings at important bottoms. One line of thinking argues that secondaries contribute directly to the supply of stock available. With more supply, everything else equal, prices should weaken. Others reason that a large number of secondaries may indicate a shift away from stocks and into cash. This move into cash decreases demand for equities. Some have expressed this a little dif- ferently by saying that this shows that corporate insiders or "big money" have &cided that it is time to distribute stock to the hngry public.

Some users of this indicator follow a three-month moving average and use cut points to give signals. As an example, the +24 level of secondaries in a month would be a "sell" and a +8 reading a "buy". Stan Weinstein uses a ten- week total, with 40 or more issues QI a lo-week basis being bearish and zero being bullish. One technician who optimized the data suggests following secondaries cn a 13-week basis.

Though the Secondary Offerings Indicator is easy enough to construct, its history is not so clear. I contacted several M.T.A. members around the country in an attempt to find out who should be credited with the indicator's design. Alan Shaw informed me that this indicator has been on the wall in the Smith, Barney chart room going back to 1960. NedDavis and Stan Wein- stein referred me to an article in Barrons in 1971. Unfortunately, this article by Robert Koehler does not appear to be totally original work nor does it indicate who may have created the indicator. Mr. Koehler did try looking at the total value of secondaries and concluded that the average number of secondaries consistently proved to be a more reliable indicator. Searching for clues in the M.T.A. library, I found a difference between earlier books published, in the 1950's, and those published in the late 1960's and early 1970's. Several books from the 1950's discussed the question of whether tobuy an individual stock whena secondary issue was mar- keted. The idea of cumulating the market value of the shares or just the number of issues regardless of size, had not been put forward yet. On the other hand, some books in the late 1960's and early 1970's had pages describing the basic concept of the secondaries indicator as we kncxJ it today.

My primary concern as atechnicalanalystis with the debt market. I won- dered whether a lO-week moving average total indicator could be constructed to track smart money or corporate treasurers and/or their investment bankers'

57 m-1986 e.

decisions to come to market. Debt issued by the United States government and other non-interest rate sensitive entities were excluded. Using our own in- house source of information, CORJXXATEWATCH, I collected the weekly numbers for issuance of new straight (non-covertible) corporate debt (see the attached sample of the CORPORATEWATCH Calendar: Fixed Income Summary). Starting with 1982 (the beginning of our data) I generated a lo-week moving totalandplotted itagainstthe nearest Bond futures contract on a weekly basis. The results showed that Treasury Bond futures move with the indicator.

We have named this new bard market indicator the NIB, or New Issuance Barome- ter. We have found the results of using this NIB both enlightening and helpful in formulating an intermediate term outlook (2-3 month time frame) for bond prices. The nearest T-Bond futures contract moves up and down quite positively with the NIB, as seen in the attached chart.

Obviously a rally in the bond market makes it cheaper to borrow and we have always known that it is easier to sell into strength. As the bonds rallied and interest rates eased since 1982, more and more corporations issued debt. As seen in the attached &arts, the futures prices move more in tandem due to the increasing use of the futures market to cross-hedge new corporate debt sales (and many other debt instruments). Also, the futures market reflects a much greater level of volume and worldwide input of opinions about interest rates. Moreover, short sales are probably more easily effected and unwound in the future's market than in the corporate debt market.

How does one make use of the new indicator? One can measure the average length of time for upswings and downswings for the moving total and use this as an additional tool to help time peaks and troughs for T-Bond futures. Though our series only starts in 1982, we have found our NIB indicator has risen for twelve consecutive weeks, or roughly three months, before each pea. Periods of declining prices and lesser debt issuance have lasted about eleven weeks. Buyers of debt could defer purchases while the series is falling, and issuers of debt that want to follow the "smart money people" could consider issuing debt when the series has risen about the average number of weeks.

Conclusion--On the average, looking at the eight clearly defined rallies in the last four years, the lo-week moving total climbed for 12 weeks before reversing. This is approximately the mid-point of the 21-week cycle we follow. Declining phases have lasted 11 weeks on average. Using this four-year history as a base, one can use it on the buy side or sell side for timing purchases or sales of various (but probably not all) fixed incane securities.

58

I want to acknaJledge the following who helped in the preparation of this article:

Lindley B. Richert, Michael H. Bassett, and Anthony Napolitano of CORPORA'IE- WATCH, an on-line video produce of M3M, Inc.

Alan R. Shaw and Robert Colby of Smith Barney, Harris Upham

Steve Nison of E. F. Hutton

Nathan E. Davis of Ned Davis Research Inc.

Rita Berg and Stan Weinstein of The Professional Tape Reader

Sources:

Robert Koehler, "Surge of Secondaries, Smart Money is Still Swapping Stock for Cash," Barrons, November 29, 1971.

McCarthy, Crisanti & Maffei, Inc. Calendar: Fixed Income Summary, 1982-1986, from MOM's CO~RATEWATCH Video Service.

Bruce Kamich is a senior technical analyst for MOM, Inc., a Xerox Financial Services Company, which specializes in providing fixed income research and consulting services. Bruce contributes his technical views to MONEYWATCH, the Money Market Critique, and is responsible for their new technical video product called YIELDWATCH. As a member of the MTA, Bruce chairs the Futures Special Interest Group committee this year.

59

Rating Offering Amt. MCM Moody's SLP Date Hil.

Ia7 A3

Nri Bl

A- Al

BBB+ A3

A Aa

BBB Baa1

A Al

NR A3

NR

A-

B-

A+

BBB+

w

AA-

BBB

A+

A

09/29/86 S

09/30/86 N

09/30/06 N

09/30/86 S

09/30/06 c

09/30/86 N

10/01/86 S

10/01/86 N

lO/Ol/t36 N

100.0

550.0

200.0

175.0

125.0

100.0

225.0

100.0

70.0

source: HQ4'e "CorpgrateWatch" Video.Service

Issue Coupon

PORTLAND CENWAL ELECTRIC 8.00 -DEBS

Maturity

10/01/91

Price

100.0

COLT INDUSTRIES 12.50 SR SUB DEBS

10/15/01 99.50

PACIFIC G6E 1ST & REF MTGE BONDS

9.125 10/01h9 95.625

DEERE 6 CO. 8.50 NOTES

10/01/91 99.797

GENERAL TEL-CALIFORNIA 8.125 1ST MTGE BONDS

10/01/96 98.959

NIAGARA MORAWK POWER 9.125 1ST WTGE BONDS

10/01/96 99. a37

BANK OF NEW YORK (165) VARIABLE COUPONRENEWABLE NOTES

(165) (165) (165) GOLDMAN (165)

FEDDAL-MOGUL 4.375 NOTES

10/01/93

TEMPLE-INLAND NOTES

8.375 10/01/96

100.0

99.75

WEEK OF SEPTEMBER 29, 1986

(OVEN

FIXED INCOME SUMMARY

Yield/Spread from

Nearby Treas. Manager

8.00 +96BP

FBC

12.574 MORGAN --

9.56 GOLDMAN +165BP

8.55 +153BP

MERRILL

8.28 t80BP

DAIWA

9.15 t170BP

SAIAMON

8.375 Pw

8.412 t102BP

SALOHON

Current Del'd Call/ Sinking Call 1st Ref Fund X/ Avg. Price DATE/PRICE 1st Date Life

NC --

NC 5

NRF 5

NC

NC 5

NRF 5

NC --

0 lSS6. McCwlhy, Ctlunll C Mallel. Inc. Th. inlormallon conlalned henln haa been obblned from rource, which we bolkv. lo be rellabb bul II not guaranteed a, lo accuracy 0, complelene~s. II Is 01 l conlldenllal nature and Is intended lor the ercluslve use 01 lhe penon or lirm lo whom il Is lurnlshed by us. All l rpresrlonr of opinlonr are subject lo change wllhoul nollce. II Is nol l cornprehensIve waluallon ol Ihe InduW-y. lha compm-~les or debt rccurlller mcnlloned. and docinol consUl~le an oiler. a rollcllalion c-i an ollw or a recommcndallon lo buy or sell any secuflll~r. Addlllonal ,malcflal II wallable on request. MCM rallngr are based on dellnillons developed by MCM.

/page 2/

Yield/Spread from

Maturity Price Nearby Treas. Manager

10/01/01 100.0 12.75 BSC --

10/01/16 100.0 9.50 SLB +162BP

10/15/98 97.00 12.74 LFRUT

ccc+ 10/01/86 70.0 KANE INDUSTRIES N SR SUB DEBS

AA 10/01/86 50.0 INDIANAPOLIS P6L N 1ST MTCE BONDS

215.0 NEW WORLD PICTURES SUB S.F.DEBS

Rating Offering Amt. WCM Moody's SbP Date Mil. Ia sue

NR 83

A Aa

NR B3 CCC+ 10/02/86 N

NB Baa2 BBB+ 10/02/86 150.0 TRANS WORLD N DEBS

NR ' Baa2 BBB+ 10/02/86 100.0 TRANS WORLD N NOTE

A+ Aa AA- 10/02/86 125.0 FLORIDA P&L S 1ST MTCE BONDS

BBB+ A2 A+ 10/02/86 N

NR Bl 10/02/86 65.0 CONSECO N SR SUB NOTES

BB- Baa3 BBB 10/03/86 N

100.0 EL PASO NATURAL GAS DEBS

175.0 CONTINENTAL ILLINOIS NOTES

source: Molts "CorporateWatch" Video Service

Coupon

12.75

9.50

12.25

9.85

8.75

9.00

9.625

12.50

9.125

10/01/16 100.0 9.85 FBC +2OOBP VS 9 l/48

10/01/93 100.0 8.75 FBC +lSOBP

10/01/16 96.0 9.40 SALOMON +153BP

lO/Ol/ll 99.50 9.68 MORGAN +185BP

10/01/96 100.0 12.50 DWR -

10/15/93 99.45 9.23 GOLDMAN +195BP

(MORE)

Current Del'd Call/ Sinking Call 1st Ref Fund Xl Avg. Price DATE/PRICE let Date Life

NC 5 74% --/--I93

NRF 5

NC 3 NRFS

NC 20

NC --

NRF 5

56%X(D) 20.0 NRF 5 --/--I97

NC 5

NC --

/page 31

Yield/Spread Current from Cell

Coupon Maturity Price Nearby Treas. Manager Price Rating Offering Amt.

wcu Moody's S6P Date Hil.

NR Baa1 BBB+ 10/03/86 100.0 N

Issue

FIRST NATIONWIDE BANK SUB DEBS

AA- Aa AA- 10/03/86 100.0 ANHEUSER-BUSCH S NOTES

NR B2 ccc+ 10/03/86 50.0 N

ALPINE dROUP SR SUB DEBS

tat NR NR 10/03/86 25.0 N

M/I SCHOTTENSTEIN HOMES SR SUB NTES

NR 83 B 09125186 180.0 N

NR 83 B 09/25/86 500.00 N

NR B2 B 09/26/86 60.00 N

10.00 10/01/06 100.0 10.00 +200BP

FBC NC

8.00 10/01/96 99.32 a.10 DILLON NC 7 t79BP

13.50 10/01/96 100.0 13.50 MERRILL --

13.25 10/01/96 98.641 13.50 MERRILL --

MISSING FROM LAST WEEK'S &JMMAR'!

JSC-MS HOLDINGS SR SUB DEBS

12.375 09/30/98 100.0 12.375 MORGAN NC 5 --

JSC-MS HOLDINGS (163) a 09/30/06 45.00 (163) MORGAN -- SUB DISOUNT DEBS --

FORSTMANN (164) 04/01/98 99.577 (164) MERRILL NC SEC SR EXT NOTES t SIX WARRANTS --

(163)zero coupon until 1991, then 16 3/4X. (164)units include 8 warrahts. 11 3/4X coupon with stripped yld of 12%. priced at 99.577 per unit.

$1.40 warrant value. reset by company and put at par in 5 l/2 yrs.

(OVER)

source: MQl's "CorporateWatch" Video Servic‘e

Del'd Call/ Sinking 1st Ref Fund %/ Avg. DATE/PRICE 1st Date Life

--

--

/page 41

RatinR Offering Amt. MCM Moody's S&F Date Mil. Issue Coupon Maturity

PREFERRED

BBB+ aal At 10/01/86 75.0 CITICORP 4.35 (166) S AUCTION PFQ, SERIES 6A

BBB+ aal At 10/01/86 75.0 CITICORP 4.35 (166) S AUCTION PFD, SERIES 6B

NR a.48 AAA 10/02/86 75.0 .SEAMEN'S FINANCE II 4.45 (167) N DARTS PFD kl

NR aaa AAt! 10/02/86 75.0 SEAMEN'S FUNDING N DARTS PFD

4.45 (167)

Yield/Spread Current Del'd Call/ Sinking from Call 1st Ref Fund X/ Avg.

Price Nearby Treas. Manager Price DATE/PRICE 1st Date Life

~100,000 GOLDMAN

$100,000 GOLDMAN

~100,000 SAIDMON

$100,000 SALOHON

(165)matures 10/7/87 unless extended. floats +68bp va 3-0 treasury. (166)resets each 49 days via Dutch auction. series a starts on 12/l, series on 1218. (167)resets each 49 days via Dutch auction. first reset on seamen's finance 1215. first reset on seamen's funding 12110.

source: HCX's "CorporateWatch" Video Service

TEN WEEK MOVING TOTAL OF DEBT OFFERINGS VERSUS WEEKLY (FRIDAYS) NEAREST T-BOND FUTURES 400

480 T-BOND FUTURES

360

340

320

3w

280

260

240

220

zoo

180

100

140

120

loo

80

60

40

20

0

105

IO0

95

90

15

10

75

70

65

0

5

100.00

95.00

moo

60.00

79

76

n

76

15.00

74

13

I2

II

70.06

68

69

61

66

65.00

64

63

62

6,

60.00

66

66

51

66

55.04

54

53

52

51

50.00

DOW JONES 20 BOND AVERAGE

low Jones 20

100.00

95.00

94

93

92

91

90.00

66

66

67

66

65.00

66

62

62

61

60.00

79

76

17

76

76.00

I.

73

70.00

66.00

60.00

55.00

54

53

52

51

50.00

******** -m _ m m - ********

by John R. McGinley

Why does technical analysis work? Does it add anything missing in the usual, fundamental type analysis? What does it look for in its analysis, and why? Source materials in the study of technical analysis often include books, courses, seat-of-the-pants intuition, practical experience, word of mouth, and the like. Unfortunately in their studies, like running before learning to walk, many investors miss the most important lesson: the real reason why technical analysis works. To point to a chart pattern is too simplistic. Required is a thorough knowledge of the underlying principle/ factor involved; that principle has been broadly called sentiment.

This paper will detail the all-important principle of fear and greed, will apply the principle to a proof/justification of technical analysis' existence, and finally suggest a framework for disciplined implementation of the analysis of multiple, the real arena in which technical analysis operates.

The price of a stock has been defined in many ways: the end of a dividend or earnings stream, some multiple of book or other value, a func- tim of interest rates, the meeting place of the least optimistic holder and the most optimistic buyer, a linking to some historical precedent, or more usually a combination of all of these. None is right. The answer is simpler than that; so simple in fact, it is often all but forgotten in the detail of the analysis process.

The price of stock is only what people think. It's as simple as that. Important is not whether earnings (or dividends) expectations are too high, too low, whether they're looking long or short term, what interest rates are, or anything else. Those are inputs, not the drivers of prices. What drives prices is investors thinking that others willbeinfluencedby the inputs - for whatever reason. If those others believe the inputs more than the current holders do, they'11 bid for the stock until someone sells it to them. The inputs can be anything, as we will see - even fundamentals! Simply stated, prices of stocks are driven by the hslman emotions of fear and greed.

This fear-to-greed spectrum , of course does notoperatein avacuum. It is itself driven by a profit (or fear of loss) motive. Psychiatrists rank this motive up there with love and hate as an important mover of the masses. In the course of human events, the individual inputs (causes?) vary - transistor technology, gambling, sexy drugs, biogenetics, tulips; all have qualified. Unchanged over time are tba emotions of fear and greed. As long as there is a perceived profit to be made or the fear of loss, investors will trade - anything.

66 EEA-l.986

Stocks are not the only medium influenced by fear and greed. Land, beaver hats, gold, and numerous other "valuables" have all been subject to speculation at one time or another. (When you think of it, one way of defining investing is mild speculation.) In the end, it matters not what is being traded, or why the trading seems to be going on. What matters is profit and loss, because fear and greed are driven by perception of loss (or lack thereof), not earnings, dividends, or the like. They are secondary.

That it is the profit/loss psychology which drives stocks ard not primarily the so-called fundamentals is intuitively obvious, but by way of example, I can point to the case of a new issue in 1983 going from 10 to 60 with no earnings - ever - no product, and no one in management over 20 years of age. .Whatpart did conventional fundamentals play in that rise? Many profitable stocks have never paid a dividend and don't anticipate ever doing so. So much for dividend models. The reverse is a stock whose divi-dends and earnings rise uninterrupted for two years while its stock declines steadily for the same period (throw a dart at the stock page in January 1973). Something frightened investors enough in 1973-4 to sell wildly in the face of rising fundamentals. I submit part of the explanation for these anomalies is the profit/loss psychology, and the following:

The final step in understanding why technical analysis works is the Bigger Fool Theory. Anything but a joke, the practical application of this theory is probably the most important input technical analysts can provide to their clients. The theory's main idea is this: in buying a stock, one expects to sell it - at a profit - to a willing buyer, a fool who thinks the stock will go cn up when you think it will drop.

The prospect of earnings is the usual reason people buy stocks - these days. It has not always been so; tulip bulbs in1636 produced no earnings and worse yet had a limited shelf-life! But each buyer though the next would value them more highly. Hadn't it always been the case, they ra- tionalized? Said another way, if you think something is fully valued in your terms (whatever your terms may be), you'll sell it happily to someone else, no matter what his reasons for buying. If he wants your stock that bad,.you'll take your profit without question. From this, it should be clear why the investor must always ask himself why someone in the future would be willing to pay a higher price for his stock or, alternatively, whether there are strong reasons why there might be no one there when he goes to sell.

What if it did happen, if there were no buyer? It seems too obvious to state, but how important to ask! Buyers of the one-decision, nifty-fifty stocks in early 1973 didn't ask: at that time, investors both institutional and individual, owned - ard overowned - all the IBM they could possibly afford, to mention only one stock. Did they ever wonder who was left to bid up the stock? And after it had been bid up, to whom did they intend to sell? Everyone who could possibly justify a purchase of IBM had already done so! These.buyers had forgotten the basics of the bigger fool theory: when you go to sell, you need a buyer, someone who thinks it is right to buy when you think it's right to sell. Those early 1973 buyers turned out to be bigger fools for someone else; in fact, the biggest fools because early 1973

67 Km Jv 1986

was the exact top!

Moving ahead with this logic, it now becomes clear why the analyst must forecastnotone, but two periods ahead. The first period is the one over which you envision holding the stock. The second is that over which your future buyer envisions holding the stock. The reason is this: at that point of buying from you, your buyer must think HIS future is rosy - or he'll pass. For example, youbuya stock in March,hoping to sell as year- end earnings come out in January. You forecast a good report and think investors will anticipate it; but your calculations indicate the following year the stock will disappoint. Therefore, you want to get out just before this is realized. To pull this off, to insure there would be someone to buy your stock at a higher price, you have had to forecast for the following year as well; two years in advance, not one.

To recap the argument, investors invest to make a profit. To make a profit, they need someone to buy their stock at a higher price. To buy, that someone must believe yet another buyer will not only be there for him in the future, but will pay him a higher price. Finally, the reasons (inputs) why either of these people will pay higher prices can be anything, it doesn't have to be earnings; it varies from era to era, from person to person, from instrument to instrument. In the vernacular, it's anything which pushes their greed button. What really matters is a future atmosphere - of any description - where a buyer will happily buy expensive stock from YOU, mistakenly you think. The buyer always thinks he knows something the seller doesn't; if he doesn't, he won't buy and you might have to sell at a loss. As technical analysts , our job is to monitor this process.

Where does the fear to greed principle fit into the actual discipline of technical analysis? To understand that - and to discover a mathematical proofofthe existence of technical analysis - I turn to a basic tenet of our fundamental brethren, the P/E equation - but with a twist.

I believe the usual P/E equation (multiple equals price divided by earnings) is wrongly stated. It maintains that multiple is the dependent variable, dependent on price and earnings (or proxy). But where can one look up what earnings investors anticipate, what multiple they'll pay? Those are judgments. Price is not; you can look it up in the paper every day. A moment's reflection will confirm price is the dependent variable here. Price is dependent on a collective perception of earnings potential (sic.), and on a second , certainly emotional, possibly unconscious, decision over how much to pay for such potential. The equaticn should be rearranged as follows:

P = MxE

68

Here now, at long last is the mathematical proof of the necessary existence of technical analysis. I submit the analysis of E (earnings, or proxy) is the natural province of the fundamental analyst. The analysis of M is that of the technician. M is the amount investors are willing to pay for their perception of E; it's where psychology enters the picture. Clearly, the balance between the earnings perception and the multiple to be paid depends on the amount of fear or greed in the picture at the moment. If there's little emotion in prices, then E weighs more heavily, and vice versa. Here's the best part: neither M nor E can go to zero. This means both must have an influence as long as there is a price. Therefore, by definition, the rationale for technical analysis cannot drop out.

EEARANDGRE3BINPRMXICE

Now that we've reminded ourselves of what makes technical analysis work, the easy part is over. Harder is to keep these principles in mind when investing, analyzing. To know how they effect our analysis procedure, how they effect our charts, our indicators, requires deep understanding and careful application. In other words, how will I know fear or greed when I see it?

One of the great virtures of Edwards and MaGee's book on technical analysis is the description of the emotional story unfolding as each of the chart patterns is formed. These patterns reflect a chain of events dupli- cated over and over in ways which reflectnaturalcourses of human reactions, driven inevitably by fear and greed. (I recommend their description of head and shoulders'as a wonderful case in point.) Learning not just what the various chart patterns look like, but what they tell us of the emotional story unfolding is vital totechnicalanalysis and to making accurate as- sessments of a given situation. The analyst should ask hard questions. Is this a real head and shoulders? Is the pattern unfolding properly, does the volume behave correctly? Do I know what it says about the emotional balance when a given chart pattern varies? Is it crucial, minor? Would people really act that way? Have they? In this type of situation?

Trendlines are another clear manifestation of emotion's progressions unfolding. In an uptrend (reflecting on-going bullishness), whenever prices retreat toward the trendline, bullish - and greedy - investors buy early, anticipating prices turning at each previous low. Such "outsmarting" activity is typical of greed at work. Haven't we all at one time or another been on a long line at the bank and anticipated a new teller opening? And wanted to jump over? You either make a big profit (in time), or lose your place in line. It's natural. And investors do it all the time.

To prevent being outsmarted, we must train ourselves to look for proper evidence before making conclusions ; evidence of profitable emotional behavior. For instance, a line can be drawn between any two points on a chart but it does not necessarily create a valid trendline, one which reflects emotion, bearish or bullish. Such a line is only geometrical (a line which requires but two points); after all, a line can be drawn between ANY two points. Valid, emotional trendlines require a minimum of three points: the

69

creation of the line (the first two points) and then a test. The test gives it credibility, evidence that investors are bullishly (or bearishly) anticipating turning points. (In fact, one really needs four points for probable statistical significance, a Chi* of 4.0). How many "trendlines" have we seen over the years drawn with only twopoints? Such lines would seem to betray a forgetfulness of the basics. How much money could be lost selling when one of these incorrect trendlines is breached? Remembering what it is that creates trendlines is vital.

It is not my purpose here to go over every chart pattern or technique describing the emotional pattern whidn underlies it. Suffice to say what drives these patterns, what makes these techniques work must be clearly understood before reasonably accurate conclusions can be made. Without such knowledge, we risk taking a giant step back to the random walk we all abhor. I refer the reader to Edwards and Magee for further examples of emotional natterns. An additional reference is one of the finest works on the emo- iional component of stock market prices, Peter Wyckoff's e Psychology of Stock Market Timing. (Prentice Hall, 1963)

In suggesting technical analysis falls under the broad area of multiple, I have opened an academic can of worms for students: there are shelves of books on the analysis of E in the P/E equation, but where are all the books on multiple? It's common knowledge how many pages Wall St. historically writes on the analysis of a given company's earnings prospects. Typicaily however, this same report will contain only a sentenoa or two on the stock's multiple! This is the point: if dead right on the earnings, but dead wrong on the multiple, the analyst's stock could be a loser! It seems so obvious, yet it continues.

I am now going to suggest an outline for analysts to follow in their pursuit of multiple analysis. It will be the subject of a more detailed work in the future. First, it must be understood I am discussing a very subjective area of analysis, one quite open to criticism for inexactitude. There is frequently a seat-of-the-pants aspect to parts of this analysis. In brief defense - by way of attack! - S&P found earnings estimates made by the Street in the first quarter of the year were within 5% of the year-end mark less than 25% of the time! So much for exactitude. Then there's the fact that, at anyone time, there are up to 30 estimates of IBM's earnings on the Street. So much for the "science" of earnings estimates. To put the final nail in the coffin, what if all the estimates were identical and right? Who'd believe them? And what multiple would they draw?

I will discuss eight concepts involved in the analysis of multiple. These broad areas for analysis are discussed not necessarily in order of importance. Also, they are by no means the sly concepts involved, simply the major factors identified to date.

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IMAGE. What is the company's image in the minds of investors? Blue chip, dog, speculative, emerging quality? Do they regularly favorably surprise investors with, say, stock splits or dramatic new products? Or were they just caught lying at a NYSSA meeting? Some judgment on how the company is seen by investors clearly must be included.

NEED TO OWN. Is this kind of stock money managers feel must be in their stables, either ti help establish the quality or nature of their portofolio, or simply to look "good" (either to investors or to their boss!)? Has the company just done something investors cannot resist buying it for?

PERCEIVEDVALUE. Is there some innate worth to this company not appreciated by investors? Is it the kind of stock everyone "knows" will go up eventually? Or down? Or does it sell buggywhips? (On that subject, there is more natural ice sold now than there ever was before the inventionof the refrigerator; one should not too quickly jump to conclusions.)

PSYCH. Are investors/analysts generally "down" on the stock? Or if not, are they bored with it, badmouthing it in meetings, moving on to something else? Has it risen so far the stock evokes universal blind greed? Or the reverse? Has there been any subtle movement of feeling about the stock in investors' minds? Arguably, psych is the most important of any area in the analysis of multiple. This concept is closely allied with the next.

GET ANY WORSE/GETANY BETTER. This is best described by the story of the investor who asked the company president, "how are things?" "Couldn'tbe better," came the reply. So, naturally the investor went out and sold the stock! What had the stock to look forward to if things couldn't get any better? Another question: what has it done for me lately? What could it do? Can the news get any worse? If the bad news is all out, maybe it's time to buy?

SUPPLY/DEMAND. As indicated earlier, one should determine whether the stock is over or under-owned, and by whom. Strong hands or weak? How likely is the stock to come out, on one side or the other? What could change the present holding situation? Secondaries? New stock? Options?

BDY AREA/SELL AREA. Maybe a part of the above, it is rravertheless important to assess where one is in the fear-to-greed spectrum of prices. Is the stock in a buy area? If the chart says close enough to support to warrant a purchase, it's one thing. If it is very extended, it's quite another. There is a large grey area, of course.

OVERRIDING FACTORS - FOR OR AGAINST. In the future, other concepts will no doubt be identified. However many there are, this item should be last. In some situations, one or two factors are so important in the overall picture, be they fundamental or other, they override all other considerations. In- flation in 1983-4, IBM winning the government's lawsuit, ATT's loss of a similar suit, the sudden death of a key executive, a cure for AIDS, an elec- tronic technological breakthrough, etc.

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Practically, at the outset the analyst can make a first pass on these items simply marking each one good (blue), bad (red), or who knows (black). A mostly red checkoff sheet for a certain stock would suggest looking else- where for purchases, etc. A less clear finding would require going into each category's subdivisions and then making judgments. The details of these sub-divisions will be discussed in a future paper.

For the present I submit that a formal multiple analysis discipline, in the home court of fear and greed, is basic to investment decision making - an3 the natural province of the technical analyst.

John R. McGinley is Associate Editor of TECHNICAL TRENDS, published by Merrill Analysis. He is a member and past officer of the Market Technicians Association. Before starting with Arthur Merrill in 1982, he worked on both sides of the street, but was unable to get them together.

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Book Review: John Murphy: "TECHNICAL ANALYSIS OF THE FUTURES MARKETS"

By Robert B. Ritter

It is said that there is a time and a place for everything. And that may be an apt description for "Technical Analysis of the Futures" by John J. Murphy (New York Institute of Finance, 566 pp., $39.95). As the impact of futures--for years, the important factor in commodities--expands even further to the point where their influence at times dominates both the equity and debt markets, more needs to be known about the technical motivation behind this influence. Mr. Murphy's work will serve not cnly as an introduction to the aspiring futures trader, but also as a major source of information for the stock market technician seeking to understand the complexities of trading new classes of financial instruments simultaneously, and the effect each has on the other.

This book, in essence, presents a broad panoply of technical tools. There is hardly a facet or exercise of the craft not touched upon, from the techniques of Charles Dow, W.D. Gann and RN. Elliott to the newly emerging calculations of momentum and oscillators characterized by the newly popular fields of RSI and Stochastics. Among the subjects discussed in separate chapters.are Trends, Reversal Patterns, Continuation Patterns, Volume and Open Interest, Long-Term Charts and Commodity Indices, Moving Averages, Os- cillators andcontraryopinion, Intra Day and Point and Figure, Three Box Reversal and Optimized Point and Figure and Time Cycles. There are also chapters on Computers and Trading Systems and, Money Management and Trading Tactics, while special appendices discuss Spread Trading and Relative Strength, and the Trading of Options. In such a sweeping effort, there is a limit to the depth with which each subject dealt, but the author supplements his text by quoting experts on key points and adds an excellent bibliography for those who want to delve further into particular topics. Among the references are those to Welles Wilder, George Lane, Larry Williams, J.M. Hurst, Edward Dewey, Robert Prechter, Walt Bressert and Jake Bernstein.

The text itself has great clarity and is backed by the author's 15 years of experience as teacher, market letter writer and practitioner. The narrative is precise and informative, replete with examples, the most important of which are italicized. The excellent illustrative material is composed of well chosen charts and pertinent examples, as Mr. Murphy draws upon his experience as Senior Technical Editor for the Commodity Research Bureau's CRB Futures Chart Service.

About the only thing the text lacks is greater detail on general market data, but this is an area,in which equity technicians have ample at their disposal. Even the sophisticated market technician, however, will find that not only does the book serve as a compendium of much he has either missed or forgotten, but it enables him to develop insight into the relative importanoa of various techniques that can be applied to the equity markets. The author at times, points out the subtle differences between the effects of patterns on futures an3 equity charts, most notably in his discussion of Elliott Wave Theory.

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The book covers a tremendous amount of ground, certainly not to be digested in one sitting. It is text, encyclopedia and referral all in one package, and it belongs on the shelf of the practicing technician alongside Edwards and Magee, Pring, Frost and Prechter and Bernstein.

Robert B. Ritter is aprincipalof L.F. Rothschild, Unterberg, Towbin, and is also the Director of Equity Technical Analysis for that firm. Mr. Ritter is a member of the Market Technicians Association.

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THOSE LAMBS WERE GETTING TOO “CHESTY” 75

MTA JOURNAL/NOVEMBER 1986

journal of technical analysis (jota). issue 25 (1986, november)

Economy & Finance