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Modified VWAP Methodologies

New Research: Essay Six (continued)

Essay on MIDAS/AC Fourth Generation (Gen-4) Curves (continued)

© Andrew Coles

MIDAS/AC Gen-4 RS Curves (continued)

Prior to looking at specific chart illustrations of Gen-4 curves applied to Relative Strength (RS) lines, I’ll start with a brief introduction to RS and Spread Lines which some readers new to intermarket technical analysis will find helpful.

Background to Relative Strength Lines and Spread Lines

Construction and interpretation of RS lines

To begin, R/S lines are created by dividing one market entity by another. For example, in sector rotation and stock selection, the numerator would be a stock or a stock sector or industry group while the denominator would be a broader industry benchmark such as the S&P 500. When the numerator is rising it means that the stock, stock sector, or industry group is outperforming the broader benchmark and vice versa. Importantly, a rising numerator does not mean that the market entity in question is increasing in price but merely that, on a relative basis, it is performing better than the broader index it is being measured against. For example, if Apple (AAPL) in the Nasdaq 100 had fallen 3 percent and its sector (Consumer Goods) and industry group (Electronic Equipment) had fallen 5 percent and 4 percent respectively, all three would have declined in value but relative to the latter two the RS line would be rising because Apple’s value declined the least.  

As John Murphy discusses, it’s possible to take RS analysis to a further level by subsequently ranking individual stocks or sectors to establish more clearly leader/laggard relationships. This is easy if we normalize the RS lines to a common starting benchmark such as 0 or 100 to create a form of chart known as a Ratio Chart or Relative Performance chart. This topic is covered by Phil Doyle in the May 2001 issue of Technical Analysis of STOCKS & COMMODITIES. Gen-4 curves can also be applied to these Relative Performance charts.

Technical Analysis of RS Lines

At its most basic level, RS analysis is about moving money into a numerator that has just started to move up while closing positions in assets whose RS lines are just starting to turn down. If the numerator itself (that is, an asset such as a stock, sector, or industry group) is charted below the RS line, a comparison of the two will highlight divergences between the asset and the RS line, providing the first early warning that the intermarket dynamic is about to change.

However, John Murphy and Martin Pring have also advocated the application to RS lines of charting methods such as trendlines, support and resistance analysis, and the identification of reversal patterns and continuation patterns. Both authors have also advocated the application to RS lines of more sophisticated techniques, including moving averages and momentum oscillators such as the MACD, RSI, and Stochastics. Such techniques are meant to provide even earlier warnings that intermarket relationships are changing.

Applications of RS analysis #1: Group rotation

Group rotation is commonplace in portfolio management. Managers move money into those industry groups expected to advance in value relative to the next phase of the stock market cycle. In other words, the aim of group rotation is to establish continual outperformance as measured against the general market. This topic is the primary focus of Martin Pring’s contribution to Relative Strength analysis in his book Technical Analysis Explained.

Applications of RS analysis #2: Intermarket Analysis and the Business Cycle

Broadly speaking, intermarket analysts such as John Murphy see the business cycle as providing an economic framework for RS analysis on the basis that at the main peaks and troughs of the economic cycle there is a chronological sequence between the main asset classes, with bonds turning first, followed by stocks, and then commodities. Currencies too are integrated, depending in part on commodity prices and the interest rate cycle, with gold and sometimes copper providing the first early warning of inflation pressures.

This sequence obviously bears on the issue of group rotation and asset allocation, since the early stages of recovery favour bonds and other financial assets while the latter stages favour industrial stocks and inflation hedges and related strategies such as the short-selling of interest rate-sensitive assets.

To facilitate this analysis, one might divide the Thomson Reuters/Jefferies CRB Global Commodities Index by the 30 year T Bond futures or 10 year T Note futures. The inverse relationship between commodity prices and bonds is very important for intermarket analysts so particular attention is paid to the RS line monitoring the two. When the RS line is rising, asset allocation would again be directed at futures commodity markets; when it is falling, futures traders would be shorting commodities while stock and Exchange Traded Funds (ETFs) traders would be buying utilities, financials, and consumer staples.

Applications of RS analysis #3: Spread Trading in the Futures Markets

Spread trading is a technique in the futures markets that exploits various forms of price distortion in otherwise normal price relationships. These distortions are usually short-term and caused by fundamental factors influencing the markets. Spread lines are frequently constructed using subtraction rather than division, and although analysts such as Pring prefer division the method of subtraction doesn’t make too much difference when the time period is less than six months. In Technical Analysis Explained, Pring lists six areas where spread lines can be applied but the three I find most interesting include:

Although I won’t be illustrating Gen-4 curves on Spread Lines here, Gen-4 curves work extremely well on this type of line, as they do on other forms of analysis such as the yield curve.

Applying MIDAS/AC Gen-4 curves to Relative Strength (RS) Lines

Where Gen-4 applications to RS lines diverge from the more familiar forms of technical analysis outlined above is in how RS lines and Spread lines are interpreted in relation to the Gen-4 curves. In particular, a key emphasis is placed on the search for HIPs (Hidden Inflection Points) and RIPs (Out of Reach Inflection Points). To aid this search, I chart the RS or Spread line in the upper pane of the chart and the instrument itself in the lower pane. The HIPs and RIPs then provide market timing signals not available on the instrument itself and thus hidden from other technical analysis indicators as well as from other generations of MIDAS curve applied solely to the instrument.

At this stage, let’s illustrate Gen-4 curves applied to RS lines recommended by intermarket analysts such as John Murphy and Martin Pring.

First illustration: Applying Gen 4 curves to Sectors and Sector Exchange Traded Funds (ETFs)

To create a framework for RS analysis in the commodities markets, John Murphy uses the Thomson Reuters/Jefferies CRB Global Commodities Index as the broad objective benchmark and then illustrates this framework with various commodity groups and individual commodities. It’s possible to do this using futures, ETFs, or raw price data. In his early books, Murphy uses the seven commodity sub-sector indices provided by the Commodity Research Bureau. The purpose of this framework is obviously to establish which commodity sectors are outperforming the others. A trader can then purchase the relevant commodity sector ETF to buy into strength. However, once the best sectors have been identified, it’s possible to extend the RS analysis into the sector itself so that the best performing individual commodities can be isolated for futures trading or again ETF participation.

As noted in the previous section, the application of Gen-4 curves goes beyond this methodology because the idea is to establish HIPs and RIPs not identifiable on the sector or the individual commodity. Once identified by the Gen-4 curves, these HIPs and RIPs provide market timing signals unavailable elsewhere and hence are serviceable in highly individualised trading systems that cannot be duplicated.

Figure 5 below follows one of John Murphy’s techniques of dividing one commodity sector – here the CRB Precious Metals sector – by the CRB Index. Here I have replaced the CRB Precious Metals index with the ETFS Physical Precious Metals Basket (GLTR). In the upper pane GLTR is divided by the TR/J CRB Commodities Index. In the lower pane, according to the Gen-4 methodology, GLTR is plotted in isolation. If we now look at the swing highs (1), (2) and (3) we’ll see immediately that all of them are out of reach (ie, RIPs) on the actual price plot of GLTR in the lower pane. Thus, the signals provide excellent entry points into the Primary trend starting in mid-2011.   

Figure 5: Textbook examples of three out of reach inflection points (RIPs) which are a product of Gen-4 curves and an RS Line of GLTR divided by the CRB Index

My next illustration in Figure 6 replaces GLTR with the actual TR/J CRB Precious Metals Index. As before, the RS Line (the CRB Precious Metals Index divided by the CRB Commodity Index) is in the upper pane while the Precious Metals Index is in the lower pane. This time we can see that as the numerator weakens I’m able to anchor the Gen-4 curve to the start of a Primary trend between 2006 and 2008. This Primary trend is rising on the Precious Metals Index but because the Metals Index isn’t outperforming the Commodity Index, I can attach the Gen-4 to the top of the price series. This results in our ability  to catch the actual top in the Primary trend. See the highlighted circle. This again is another example of an out-of-reach inflection point or RIP.

Figure 6: A Gen-4 captures the actual top in the Primary trend in Precious Metals because the latter under-performs the CRB Index, thus inverting the RS Line relative to the actual price trend in Precious Metals. This is another example of a RIP.

On the next page I’ll continue this survey with a number of charts and ongoing commentary while also looking at gold, silver and currencies.

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