Crude Oil Roundtable - The Technical Analyst · Outlook for Japanese Yen ... Ichimoku Charts by...

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.technicalanalyst.co.uk wwwThe publication for trading and investment professionals

Markets InterviewMark Meyrick at EDF Trading:

Key drivers in the carbon market

SoftwareReuters NewsScope for automated trading

Yen carry trades unwind -evidence from the COT report

Tom DeMark on indicators and market timing

Behavioural finance in asset management

Fibonacci Revisited

Crude Oil Roundtable

© 2007 Global Markets Media Limited. All rights reserved. Neither this publication nor any part of it may bereproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical,photocopying, recording or otherwise, without the prior permission of Global Markets Media Limited. While thepublisher believes that all information contained in this publication was correct at the time of going to press, theycannot accept liability for any errors or omissions that may appear or loss suffered directly or indirectly by any reader as a result of any advertisement, editorial, photographs or othermaterial published in The Technical Analyst. No statement in this publication is to be considered as a recommendation or solicitation to buy or sell securities or to provide investment, tax or legal advice. Readersshould be aware that this publication is not intended to replace the need to obtain professional advice inrelation to any topic discussed.

CONTENTS 1 FEATURES

DeMark on DeMark Tom DeMark talks about his indicators, market

timing and his work with SAC Capital.

Crude Oil Roundtable In our new section, four market experts

discuss the crucial technical and fundamentalissues affecting the market.

Outlook for Japanese YenNicole Elliott from Mizuho Corporate Bank

explains her view for the Japanese yen for 2007.

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WELCOMEIn this issue we are very pleased to introduce a regular new section - theRoundtable. We begin by looking at the outlook for the crude oil market,

always a topical issue, and attempt to assess the major technical and fundamental factors to watch out for. Future issues will look at specific

markets, new products and issues in automated trading. This month we alsoget to talk to Tom DeMark about the growing interest across Europe in

his market timing indicators.

We hope you enjoy this issue of the magazine

Matthew Clements, Editor.

March/April 2007 THE TECHNICAL ANALYST 1

Editor: Matthew ClementsManaging Editor: Jim BissConsultant Editor: Trevor Neil Advertising & subscriptions:Louiza Charalambous Marketing: Vanessa GreenEvents: Adam CooleDesign & Production:Paul Simpson & Thomas Prior

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ISSN(1742-8718)

INDUSTRY NEWS AND RESEARCH UPDATE

MARKET VIEWS Outlook for JPYThe carry trade and COT Report

ROUNDTABLEOutlook for crude oil

TECHNIQUES DeMark on DeMark Behavioural finance and asset management Elliott Waves, Fibonacci and statistics

INTERVIEWMark Meyrick, EDF Trading

SOFTWAREReuters’ NewsScope

BOOKSIchimoku Charts by Nicole Elliott

AUTOMATED TRADING SYSTEMSDetrended price oscillatorsMarket timing versus hedge fund indices

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CONTENTS 2 REGULARS>


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4 THE TECHNICAL ANALYST March/April 2007

Industry News

PANEL DISCUSSION HIGHLIGHTS TA EXAM DEBATE

TA Question Time (L to R): Robin Wilkin, Jordan Kotick, Adam Sorab, Robin Griffiths and Alan Johnson.

Trading platform provider,Patsystems, has released Pro-Mark3.9, the latest version of its frontend system for professional traders.The new version now includesupgraded chart and technical analysisfunctions such as Market Profilealong with backtesting and program-ming functions for the developmentof automated trading systems.

Patsystems upgradePro-Mark 3.9 withadvanced charting

The Technical Analyst magazine'sEuropean Conference 2007 tookplace at the Waldorf Hilton inLondon on February 7th. The dayended with a panel discussionchaired by Adam Sorab, chairman ofthe UK Society of TechnicalAnalysts. On the panel was a crosssection of City analysts: RobinGriffiths (Rathbones), Alan Johnson

(Macquarie), Robin Wilkin (JPMorgan) and Jordan Kotick (BarclaysCapital).

Jordan Kotick took the opportuni-ty to highlight the continued splitbetween the Market TechnicansAssociation (MTA) and theInternational Federation ofTechnical Analysts (IFTA) qualifica-tions, which means there is still not a

single internationally recognisedqualification in technical analysis. Atpresent, traders and analysts canbecome IFTA qualified (CFT andMFTA) or MTA qualified (CMT).Kotick stressed that the continuedexistence of two exams, which are ineffect in competition with eachother, is doing the TA communityno favours.

TradeStation opens London office Tradestation, the Florida based bro-ker and charting systems provider,has opened a new London office.Based in Mayfair, the UK operationis being run by Jeremy Davies, for-merly at Panmure Gordon, who isresponsible for developing the com-pany's institutional and retail cus-tomer base. The move comes afterTradeStation Europe Ltd obtainedFSA authorisation to act as a securi-ties and futures firm in the UK.

Charting provider, Updata, hasreleased a new version of itsTechnical Analyst 5.1 which includesan enhanced integration toBloomberg data. 5.1 charts

Bloomberg Fundamentals datameans users can now chart value aswell as price for the first time andapply technicals to the new charts.

For more information, go toupdata.co.uk

Updata release TA5.1 Advanced forBloomberg


Industry News

CQG codes for NYBOT Softs Following the New York Board ofTrade's (NYBOT) decision to list itssoft commodity products for elec-tronic trading on ICE, CQG is nowoffering market data and order rout-ing for these markets (see adjacenttable for CQG symbols).

In August 2006, CQG completed itsconnection to ICE Futures makingthem the only platform offeringtrade routing with real-time and his-torical spread data for ICE products.CQG is also now offering orderrouting to NYMEX products includ-ing crude oil, heating oil, natural gas,platinum and palladium.

Title CQG Symbol NYBOT Symbol Sugar #11 SBE SB Sugar #14 SEE SE Cotton #2 CTE CT Coffee "C" KCE KC Cocoa CCE CC Frozen Concentrated O.J. OJE OJ

Sugar #11 SBES1, SBES2, SBES3, SBES4, SBES5, SBES6 For example, SBES1N8 represents SBEN8-SBEV8.

Sugar #14 SEES1, SEES2, SEES3, SEES4, SEES5, SEES6 For example, SEES2F8 represents SEEF8-SEEK8.

Cotton #2 CTES1, CTES2, CTES3, CTES4, CTES5, CTES6 For example, CTES3K8 represents CTEK8-CTEZ8.

Coffee "C" KCES1, KCES2, KCES3, KCES4, KCES5, KCES6 For example, KCES4H8 represents KCEH8-KCEZ8.

Cocoa CCES1, CCES2, CCES3, CCES4, CCES5, CCES6 For example, CCES5U7 represents CCEU7-CCEU8

Frozen Concentrated O.J. OJES1, OJES2, OJES3, OJES4, OJES5, OJES6 For example, OJES6N7 represents OJEN7-OJEN8.

Calendar spreads

INTERBANK FX LAUNCH PATTERNRECOGNITION TOOLInterbank FX, the US based foreignexchange trading broker, has releaseda new chart pattern recognitionproduct it calls Graphical ProductScanner (GPS). GPS, which is free toInterbank FX customers, is designedto identify patterns and trends in theFX markets including triangles,wedges, channels and head andshoulders, and detect which patternthe market is trending towards.

More information can be foundat: interbankfx.com


Research Update

LARGE HEDGERS AND SPECULATORSKEEP THEIR COOLInstitutional players are unmoved bymajor economic events. This is theconclusion of Ikhlaas Gurrib at CurtinUniversity in Western Australia. UsingCOT data, the author looked at theextent to which large hedgers andlarge speculators were influenced bythe eight major economic events of

the 1990s, including the Mexico crisis,Asian crisis, LTCM near financial col-lapse, and the Russian crisis and recov-ery. Gurrib shows that the behaviourof these informed players was stablethroughout with any deviation tendingto be short lived. He concludes thatthese institutional participants were

"hardly affected" by the major eco-nomic events of the 1990s.

Gurrib, Ikhlaas, "Do Large Hedgers andSpeculators React to Events? A Stabilityand Events Analysis" (January 17, 2007).

INTANGIBLE HERDINGThe book-to-market ratio is thoughtto predict returns because it proxiesfor intangible returns, which may cap-ture market overreaction to intangibleinformation that is not reflected inaccounting-based growth measures.National University of Singapore'sHao Jing investigates whether institu-tional investors' trading behavior isrelated to market overreaction tointangible information. The resultsshow that institutional investors tendto buy (sell) stocks in herds in

response to positive (negative) intangi-ble information, exacerbating overre-action. The author builds a profitablestrategy based upon this indicator, theresults of which he says reveal animportant link between institutionaltrading, herding and the book-to-mar-ket effect.

Jiang, Hao, "Institutional Investors,Intangible Information and the Book-to-Market Effect" (February 18, 2007).

What explains the observation thatdomestic currencies tend to appreciateduring foreign working hours anddepreciate during domestic workinghours? Angelo Ranaldo of the SwissNational Bank thinks that this effect,which is statistically and economically"highly significant" and which persistseven after accounting for calendaraffects, is due to domestic-currencybias: "The prevalence of domestic

(foreign) traders demanding the coun-terpart currency during domestic (for-eign) working hours leads to a cyclicalnet positive (negative) imbalance indealers' inventories which results inselling (buying) pressure on thedomestic currency."

Ranaldo, Angelo, "Segmentation and Time-of-Day Patterns in Foreign ExchangeMarkets" (January 1, 2007).

TIME OF DAY PATTERNS IN FX

Two German researchers have studiedSentix data (www.sentix.de) - a weeklysentiment survey that includes 700participants, of which 25% are institu-tional and 75% private - and foundthat professional analysts are able tosuccessfully forecast medium termprice movements (of about sixmonths in advance) in equities, espe-cially with regard to their domesticmarket. In contrast, they find that asentiment index based on privateinvestors alone may in fact offer agood contrary indicator. The newsisn't so good short-term however,since the researchers - BernhardZwergel and Christian Klein from theUniversities of Augsburg andHohenheim respectively - found thatneither institutional nor privateinvestor can correctly forecast returnsa month in advance.

Zwergel, Bernhard and Klein, Christian,"On the Predictive Power of Sentiment -Why Institutional Investors are Worth TheirPay" (December 2006).

SENTIX DATA: PRIVATEINVESTORS ONWRONG SIDE

THE MISBEHAVIOUR OF SMALL CAP STOCKS Low levels of institutional ownershipIn their paper "What is wrong withsmall stocks?" Ozgur Demirta fromBaruch College, New York and BurakGuner of Barclays Global Investorslook at why small firms tend to pro-duce risk-adjusted returns that aresuperior to those generated by largefirms. In their sample of small capNYSE firms, stocks with low pastprofitability (laggers) bring returns sig-nificantly higher than those of stockswith high past profitability (leaders)and the risk-adjusted premium tosmall stocks is generated largely by thesmall laggers. This pattern was particu-larly pronounced at earnings-announcement dates, suggesting unex-pected earnings growth explains alarge part of the abnormal returns.

To explain why this chiefly happensto small cap stocks, the authors pointto the fact that the size premiumeffect is continually driven by smallstocks that have experienced a priordecline in institutional ownership. Inother words, the effect is driven by

low levels of institutional ownershipand individual investors are "the cul-prits for suboptimal trading."

Prone to sentimentOn a similar theme, and consistentwith these findings, is the paper"Investor Sentiment in the StockMarket", in which Malcolm Baker ofHarvard Business School and JeffreyWurgler of New York University statethat, "Stocks of low capitalisation,younger, unprofitable, high volatility,non-dividend paying, growth compa-nies, or stocks of firms in financialdistress, are likely to be disproportion-ately sensitive to broad waves ofinvestor sentiment." They point outthat these are the stocks that are diffi-cult for "rational investors" to arbi-trage as to do so is often costly andrisky. Recent examples where bettingagainst sentiment would not have beena good idea include the internet bub-ble, where many contrarian arbi-trageurs had to bail out as prices con-tinued to unfathomable levels.

Poorer analytical coverageProviding further explanations for thebehaviour of small vs large cap stocksis a study by a research team at theUniversity of Bologna (Cerverllati etal) who look at the accuracy of earn-ings forecasts made by analysts inItalian brokerages. In line withresearch from other markets, theyfound that the accuracy of analysts'earnings forecasts increases with thesize of firm being analysed and theanalyst's experience of the firm, whilstthe accuracy declines with the numberof firms the analysts follows. Theyalso report that analysts are less accu-rate for technology firms in generaland that they tend to be too optimisticabout the future prospects of thefirms they cover.

Demirtas, K. Ozgur and Guner, A. Burak,"What is Wrong with Small Stocks?"(2005).

Baker, Malcolm P. and Wurgler, Jeffrey A.,"Investor Sentiment in the Stock Market"(February 12, 2007).


Research Update

M&A TRADING STRATEGY: THE ROLE OF INVESTMENT BANKSA paper investigating "The dark sideof investment banks in the market forcorporate control" argues that M&Aadvisors are privy to information thatthey directly exploit in the market byinvesting in the target. They alsodemonstrate that advisors not onlytake positions in the deals they adviseon, but also directly affect the out-come of the deal, the target premiumand the probability of success.

Of further interest, the three

researchers - Andriy Bodnaruk(University of Maastricht), MassimoMassa (INSEAD) and AndreiSimonov (Stockholm School ofEconomics) - build a trading strategythat is based upon the stake of theadvisors in the target. The strategydelivers a net-of-risk performance of4.08% per month. This result, they say,cannot be replicated with availableinformation. They then compare it toa standard merger arbitrage trading

strategy based on going long the targetand short the bidder. The results arestriking - the cases in which the advi-sors do not invest deliver the lowestreturn both if compared to other advi-sor-based strategies and if comparedto other benchmarks.

Bodnaruk, Andriy; Massa, Massimo; andSimonov, Andrei, "The Dark Role ofInvestment Banks in the Market forCorporate Control" (February 2007).

All papers are available from the Social Science Research Network, SSRN, www.ssrn.com


Market Views

OUTLOOK FOR JPY by Nicole Elliott

Nicole Elliott's outlook for JPY,written at the beginning of theyear, is proving to be on the money.Here, we publish her analysis infull to find out what lies ahead forJPY in 2007.

USD/JPY - Figure 1Yen weakness against other major cur-rencies last year was exactly what wehad expected. What has been a surpriseis that it has also remained weak againsta sagging dollar, trading above 114.50for most of the last twelve months.This hints at a bout of more persistentweakness against all and every currency,which may take it to extreme levels onany measuring rod. In this case asqueeze above 120.00 to the greenbackis a distinct possibility, something thatis likely to be accompanied by a lot ofnoise and excited traders. A briefsqueeze higher, and not above 125.00(one standard deviation from the meanof the last 12 years) is seen as most like-ly in Q1 2007 and is a selling opportu-nity for persistent US dollar weaknessfor most of the year. Again the Yenshould lag other majors, droppingbelow 114.00 in Q2 and drifting to104.00 (again one standard deviation)in Q4 2007.

A monthly close above 125.00 forcesa major review.

EUR/JPY - Figure 2Since 1995 the ultra-long term trendhas been to Yen weakness against mostcurrencies, after having strengthenedsince it was floated in the 1970's.Against the Euro the move has been

relentless since 2001 in what is a maturetrend. Late in Q1 2007 there is a goodchance of a sudden squeeze to 164.00,equivalent to where mark/yen reachedin 1998 and in turn the highest ratesince October 1992. Depending onhow much momentum is created onthe way up, there is a chance of anextension through here to 170.00. LateQ2 and Q3 2007 are likely to be domi-nated by some extremely large and vio-

lent swings roughly between 150.00 and170.00. Q4 2007 just might see a sud-den and very sharp collapse in this pairdown to 145.00 and maybe 135.00.

A monthly close below 150.00 forcesa review and suggests a long term top isin place.

GBP/JPY - Figure 3The ultra-long term trend is to astronger pound caused by Yen weak-

Figure 1.

Chart Levels: USD/JPYSupport Resistance Direction of Trade

115.50 120.00*114.50* 121.40*113.50 122.00109.00* 124.00108.00 125.00**


ness, evident since it stopped gainingagainst several currencies in 1995. It isinteresting to note that when thesewere first floated in the 1970s oneneeded 900 yen to buy one pound ster-ling. Q1 2007 should see a test of theAugust 1998 high at 241.00, abovewhich is unlikely on a first attempt. Q2is likely to be dominated by consolida-tion roughly between 230.00 and245.00. Then later in the year we shallallow for a massive 'extension' to260.00, at which point it may becomevery unstable and slip suddenly towards235.00 in Q4 2007.

A monthly close below 220.00 forcesus to review and hints that an impor-tant top is already in place.

Nicole Elliott is Senior Analyst atMizuho Corporate Bank in London.

Market Views

Figure 2.

Figure 3.

Chart Levels: EUR/JPY

Chart Levels: GBP/JPY

Support Resistance Direction of Trade 156.00 158.30154.00 160.00*150.00* 163.30/164.00**145.00 166.70140.00** 171.00*

Chart Levels: GBP/JPY Support Resistance Direction of Trade

230.00 235.00225.50* 237.00*220.00** 240.00/241.00**213.00 250.00*210.00* 260.00**

“THE YEN SHOULDLAG OTHER MAJORS,

DROPPING BELOW114.00 IN Q2 AND

DRIFTING TO 104.00IN Q4 2007.”


Market Views

YEN CARRY TRADE UNWINDING: EVIDENCE FROM THE COT REPORT by Marc Chandler

COT report There are several factors that are driv-ing the yen. The first place is with thefutures market. The IMMCommitment of Traders reportshowed that as of early February thespeculators (non-commercials) werenet short a record 173k futures con-tracts. The trade was crowded and vul-nerable to the news stream which fea-tured expectations of a BOJ rate hikeor expressions of concern about yenweakness by European finance officials.

Back in late October 2006 throughmiddle December, there was a bout ofshort-covering at the IMM. At the timethe net short speculative position was arecord 137k contracts and by the mid-dle December had fallen to 23.5K(Figure 1). This represented about a$12 billion purchase of yen. Duringthis period the market talk and mediareports were not about risk-aversion,and the yen continued to lose groundagainst the euro, sterling and theAustralian dollar. Depending on howone measures it, the dollar lost 4-5 yen.

Repatriation Yet most explanations tend to over-emphasize the role of speculators.There is another set of market partici-pants who have been larger sellers ofyen and buyers of higher yielding assetsand these are Japanese investors them-selves. In the fiscal year that began 1April 2006, Japanese investors boughtmore than $75 billion worth of foreignassets. As is their habit, Japaneseinvestors began repatriating capitalahead of the fiscal year end.

Thus, investors in Japan joined spec-

ulators in buying the yen. And the routwas on. From mid-Feb through mid-March, the yen was the strongest cur-rency against the dollar rising morethan 4%. In contrast, the high yieldingSouth African rand lost about 3% andthe Turkish lira lost about 1.7%.

There are a number of reasonsthough to expect that the market iscloser to the end of the position adjust-ment process rather than the beginning.First, the IMM Commitment ofTraders indicates that the net shortspeculative yen positions have beendramatically reduced by mid-March.For the record, the speculative commu-nity has not been net long yen (or Swissfrancs for that matter) since mid-2006.Second, the Japanese repatriation aheadof the fiscal year end appears to havelargely run its course. The amountrepatriated is very close to the amountrepatriated last year. Third, the tumul-

tuous equity markets are discouragingforeign investors from buying as muchJapanese bonds and stocks.

The US dollar fell from nearlyJPY122.20 on January 29 to a low ofJPY115.16 on March 5. The aboveanalysis does not rule out a new mar-ginal low, possibly toward the JPY114area. However, as this level isapproached, it may correspond to thedeployment of Japanese savings intoforeign markets at the beginning of thenew fiscal year. Once the market spasmended on March 5th, the yen quicklyshed nearly half of its gains. However,a "V" shaped bottom does not seem tobe the most likely scenario. Look for abase to build before the yen-carry tradetruly moves back into favor.

Marc Chandler is Global Head ofCurrency Strategy at BrownBrothers Harriman in New York.

Figure 1. Yen net speculative positions

The Japanese yen has pushed aside the US dollar as the fulcrum in the foreign exchange market. Sincethe middle of the quarter, the movement of the yen appears to have had greater influence on theoverall direction of the foreign exchange market than the US dollar itself, which is on one side ofmore than 90% of the estimated $2.5 trillion a day turnover.


TTHHEE LLOONNGG AANNDD SSHHOORRTT OOFF CCRRUUDDEE OOIILLA GLOBAL OUTLOOK

In a new addition to the magazine, the Technical Analyst's first 'Roundtable' bringstogether four industry experts to discuss the outlook for the crude oil market. By exam-ining both technical and fundamental factors, we hope to provide valuable insights intothe market for traders and fund managers interested in either the short term view, orlonger term factors that will determine crude prices in the future.

Leo DrollasChief Economist, Centre forGlobal Energy Studies CGES provides market reports on theglobal oil market to companies andfinancial institutions. Leo looks at theeconomics of the oil and gas marketsand geological factors that affect supplyand demand.

Cliff GreenCommodities Analyst, Cliff GreenConsultancy Previously a technical analyst withMerrill Lynch for 18 years, Cliff is anindependent consultant specialising inthe technical analysis of commoditiesmarkets. His clients include industrysuppliers, consumers and oil brokers.

Robin GriffithsHead of Asset Allocation,RathbonesRobin is widely recognised as one ofthe City's leading technical analysts.However, for a long term view he takesa top down approach that combinestechnicals, cyclical research and funda-mentals.

Malcolm ElderfieldLiquid Fuels Trader, SempraEnergy Europe Malcolm is a proprietary trader takingpositions on crude oil from the veryshort term out to two years. Previouslywith Shell, he has been in the oil mar-ket for 20 years.


Figure 1. Brent Crude: 2001-2007

The bull market for oil began in 2001 (see chart) but waschecked late last year. We begin by asking if this is merely ashort term correction, so high oil prices are here to stay, or ifprices are now in longer term decline.

What is the Table's short term technical outlook for oil?

Cliff Green: Let me start by saying that I approach oil verydifferently from other commodities such as copper and nat-ural gas because the market obviously has different character-istics. Looking at the Brent basis for May, we are without adoubt in an uptrend in the short term. This is probably a cor-rection within a bearish environment. This ABC type upwardmove that begin in mid January is now very close to comple-tion and various oscillators are also moving back into over-bought territory which will add to upside resistance.

The way the market has built up means there will be a lotof support on the way back down which means it may takeits time. A target of $30 a barrel is realistic over a longer timeframe - one to two years. I use a combination of cycles, pat-terns, and what I call technical measurements. For example,we have just formed a large head and shoulders type top inoil which is what I have used to give me my projections. $50and the approach to it is an important support level forcrude, not because it is a round number but because around$50 has been a previous area of congestion and has seen aperiod of extended trading. When I'm identifying supportand resistance around the $50 level then it means that tradersare stranded either short below the market or long above themarket.

Malcolm Elderfield: I support Cliff's short term viewalthough I don't think it is supported by the fundamentals -at the moment. There are key levels in oil which may beimportant in the short term: Most notable is the OPEC ref-

“THE ABC TYPE UPWARDMOVE THAT BEGIN INMID JANUARY IS NOW

VERY CLOSE TO COMPLETION.”

- CLIFF GREEN


erence price which is always at the forefront of traders' think-ing. Also, somewhere between $38 and $42 is a very impor-tant area because it was a huge stumbling block on the wayup, and the high of the first Gulf War. Should prices fall intothe high $20s then a lot of the Canadian oil shale that will becoming on stream becomes less economic. Whilst this is nottechnical, it may be a factor that could influence price levelsas the market dips.

Robin Griffiths: As far as an Elliott Wave assessment is con-cerned, we are in the down move. We currently have a pat-tern of falling highs and lows below a falling 200-day movingaverage - this is a bear market. If Brent were to rally in thevery short term to above $65 then it would break this bear-ish Elliott Wave pattern. So far, it has failed below that level.On the way down, the first support level is the January lowof $51. After that, the 50% Fibonacci retracement of theentire bull market from the October 2001 low to the 2006high gives you $47. Then the 61.8% retracement gives youclose to $40.

Leo Drollas: Our non-technical short term view is thatprices will stay at around $60, but beyond that they should befalling to the mid-$40s level. The main reason for this will beexcess spare capacity coming on stream.

What are the cyclical and fundamental factors to consider for a long termview?

Malcolm Elderfield: Fundamentals drive the oil marketlong term but ultimately high prices cure high prices becausepeople move to substitutes and supply increases. The exces-sive price of some commodities has led to recent correctionsdriven by these economic factors. There were a number oflarge macro funds who were very happy to sell copperaggressively after it reached $3,500 in the bull run. It hassince gone on to reach $8000 over a short period of time butthis is economically unsustainable; hence we have seen a fall

off in price.

Robin Griffiths: The short term downward moves we aretalking about are entirely possible within what could be calleda 'secular uptrend'. These typically have more than two legson the way up before reversing. I believe commodities in gen-eral are still in a secular uptrend that began in 2001. Youcould call this the "Jim Rogers" story. The commodities bub-ble, if it is that, hasn't burst. Instead we are seeing a cyclicalcorrection (the cycle is three years up and one year down)within a secular uptrend. I would put a low probability of themarket moving much below $40 in the correction this year. Ithink oil will remain unstable much below $50 and unstablemuch above $70 so this is the stable range we should be look-ing at with $55 as the mean.

Leo Drollas: Copper and oil can't necessary be treated thesame way as commodities. This is because copper has a sub-stitute whereas there is no substitute for oil, at least in theshort and medium term. Saudi Arabia is a cartel of one, thereis little new capacity coming on stream and also, spare capac-ity is very limited. We have witnessed a demand driven pricerise since 2001 and 2002. The recent sell-off has created itsown momentum and NYMEX has done some recentresearch to show that the non-commercials have jumped offthe band wagon which has contributed to weaker prices.However, they are not driving the market but merely waitingfor a trend to develop.

Saudi Arabia needs a minimum oil price to generate enoughrevenue to pay back debt. They seem to believe that $50 is aminimum. Oil can still be profitably produced at $40 but ahigh price is needed to make significant inroads into thenational debt. As such, Saudi can (or will) manipulate supplytowards this price if it falls significantly below it; to $40 orbelow. However, just cutting production is not that easybecause they tend to sell oil via long term contracts. Rather,they attempt to re-negotiate the price that they sell oil undercontract for the next month.

What are the important inter-mmarket relationships for the oil marketand are there any leading indicators for oil prices? Can we say to whatextent the rally in prices has been due to hedge fund speculation?

Leo Drollas: Well, if I knew that I probably wouldn't be sit-ting here. Also, the important factors affecting the market arenot obviously related to economics or economic statistics. Somany other factors need to be considered most notable ofwhich is politics. What is happening in Iran and Venezuelamay also impact prices but no one knows how, or to whatextent, and short term political factors themselves cannot beforeseen. The best indicator I can think of is stock covers(inventories).

Malcolm Elderfield: Just to put this into context, going intoQ4 last year, OECD stocks were 120 million barrels higherthan they are now. That's a huge draw and if you look at theshape of the futures market, it was in very steep contango(futures price higher than spot price) in a rising price environ-ment, which is why OPEC were saying that it is speculatorsdriving prices higher. Now the market isn't flat but the con-tangos are certainly less steep and this is due to less drawfrom stocks. Lower demand has come from the very warmwinter in Europe, despite snow in the US.

The Commitments of Traders (COT) report is used by alot of proprietary oil traders who will look at it every week totry and establish if the open interest in the market at that par-ticular point in time is there for the short term, or potential-ly for the long term. This 'sentiment' could then drive intra-day trading but I wouldn't use the COT report as the solebasis for a trade.

Robin Griffiths: Hedge funds are borrowing money so weshould see a correlation between the yen carry trade and oil.For example, when copper and oil were rocketing in price lastyear it was largely down to six hedge funds, three of whichare in the same building around the corner from here. Theywere able to take these positions because they could borrowmoney so cheaply using the carry trade. Now that the yencarry trade has to some extent unravelled with a break belowY118, then a break of the Y114 level will be a significant indi-cator.

Cliff Green: When prices went to $80, a large chunk of thatwas speculative. This has meant that both up moves anddown moves have been exaggerated. Because the FX, equityand commodity markets are so now inter-connected, itmeans forecasting prices, especially for oil, has become moredifficult but also more suited to analysis of a technical nature.It's very difficult to quantify what the current price should begiven the fundamentals. Whilst the underlying trend may befundamental, the movements within this are technical andrelated to market psychology. Also, a change in market senti-ment doesn't have to be fundamentally driven which is whythe technicals are so important.


“HEDGE FUNDS ARE BORROWING

MONEY SO WE SHOULD SEE A

CORRELATION BETWEEN THE

YEN CARRY TRADE AND OIL.”

- ROBIN GRIFFITHS


Malcolm Elderfield: The fall in prices we saw at year endand the first few weeks of January was not the result of anyreal fundamental factor. Rather it was because of a sovereignhedge - a producer - who had bought a whole raft of putoptions which the market couldn't prop up. As the marketbegan to fall it gained momentum because of the short putsbut as soon as the options expired, the market snapped backdramatically to around $60. This $60 handle was at the lower

end of the high range we are talking about for last year whichsuggests the market considers around $60 to be a fair price.To take up Robin's point, since the yen broke and it wentback down to below Y119.5, the volumes that have gonethrough Globex and ICE have dropped hugely; by as muchas 40%. This says that intra-day trading activity by hedgefunds has helped support the market.

Robin Griffiths: If you look at a chart of the gold/oilspread it is quite clear that if you are trading this spread youwould go short oil and long gold. In other words, gold ischeap and oil is too expensive. The move has already begunbut it has a long way to go. A strategist should be aware ofthis relationship which is very much an intermarket, JohnMurphy type approach. If the daily or weekly volatility issuch that it contradicts the bigger macro picture, then puretechnicals will dominate.

Leo Drollas: Global GDP is obviously an indicator for totaloil demand and everyone is talking about demand from Indiaand China. The problem with these countries is that oil andpetrol is so heavily subsidised. This encourages even greaterconsumption and puts more upward pressure on prices.Prices in the domestic markets don't determine supply anddemand as they do in the West. It's an artificial market. Butthis is not confined just to China and India. In Iran, petrol is9 cents a litre!

What is the Table's view on future oil supply and demand?

Robin Griffiths: We've all heard of the Hubbert Peak; theonly recent finds of any significance are Kazakhstan and theGulf of Mexico. This means we are running out of cheap oil,but we are not running out of hydrocarbon energy. Manyother forms of hydrocarbons can be converted into oil if theprice is right. The US has thousands of years of coal suppliesand Alberta in Canada has hundreds of years of tar sands. Itis these other sources of supply that contradict the view ofothers that oil is set to go north of $100 and stay there. Itmay blip at $100 but this is not a sustainable long termprospect. In the long run, the oil age won't end because werun out of oil.

Malcolm Elderfield: There is still a premium on oil becauseof the war in Iraq and the country is a major source of sup-ply. The investment going into oil production there is huge,or could be huge, but this will not happen until engineers cango in under a period of stable government. Then, they willramp up production very quickly over a relatively short peri-od of time, maybe two to three years.

Leo Drollas: Iraq's two major fields - the Kirkuk andRumaila - have both suffered from chronic under investment.However, they have four other giant fields waiting in thewings for investment. These combined with the right invest-

“SOMEWHERE BETWEEN $38 AND

$42 IS A VERY IMPORTANT AREA

BECAUSE IT WAS A HUGE STUM-

BLING BLOCK ON THE WAY UP, AND

THE HIGH OF THE FIRST GULF

WAR.” - MALCOLM ELDERFIELD

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ment could take Iraq's capacity to 5.5 million bpd. Thismeans Iraqi production could go from 1.8 million bpd toalmost 6 million bpd in about seven years. However, despitethis optimism, Iraqi capacity has actually being going downso its not surprising what's happened to the oil price in recentyears.

Robin Griffiths: While we're on the subject of Middle Eastproduction, they now say that in Saudi Arabia, 53% of whatcomes out of the ground is the sea water they pump downthere to get the stuff out in the first place. This suggests thatSaudi production is now past its peak.

Leo Drollas: That's standard industry practice and doesn'tnecessarily mean that the fields in Saudi are past their peak.The Saudi fields were built to work that way from way back.Matthew Simmons has made quite a bit of money out ofscare mongering over Saudi's existing reserves and worriesthat they are well past their peak. Actually, his claims haveproved to be somewhat counter productive because heforced the Saudi's out of their shell to divulge a lot moreabout their reserves than they would have done otherwise.They showed that things are not as gloomy as some peoplehad been saying.

Malcolm Elderfield: Increased supply in the future could bebearish for prices but there are so many other factors that gointo the melting pot: Is this bearish for prices? Yes, if takenat face value but if the tar sands in Canada begin serious pro-duction this may substitute for other forms of oil explorationand supply that are more expensive. We will also have newbenchmarks for oil which is already starting to happen. In thenearer term, if you look at the economic cycles of the majorwestern economies you could argue that we may be enteringa recessionary period. As such, demand could drop off quitesubstantially in the next twelve months and so prices in the$50s are not going to happen.

Robin Griffiths: As far as economics and oil are concerned,in my work I look at the economic cycles of Schumpeterwhich suggest there is a low risk of a recession in the nextyear or so but a very high risk in years 2010-2012. SinceWWII the US economy has never had a recession when UScorporate profits growth has been at current levels. Profitstip first before a recession comes along.

What impact is the global warming movement likely to have on oil pricesgoing forward?

Leo Drollas: The global warming debate is not based on sci-ence and any warming that is occurring is not, for the mostpart, the result of human activity. Now, the world may wakeup to this fact in which case fossil fuel consumption willcarry on as usual. If the global warming movement persistsand gathers strength then oil may be under threat from alter-

natives. Having said that, once nuclear fusion has been mas-tered and is commercially viable, that could be the beginningof the end for oil anyway. There have been some break-throughs in the area and so commercial production could beten to twenty years away.

Robin Griffiths: On that score the latest fad is for ethanolwhich is a complete red herring. George Bush has backed itin order to pander to the Greens.

Malcolm Elderfield: The problem with ethanol is econom-ics because a producer is making a negative $2 a barrel at themoment. So much acreage is required to produce one gallonof ethanol that it's not a viable alternative. For oil consump-tion to decline, the US public has to be persuaded to walkand onto bicycles. On the global warming debate, tempera-ture and weather analysis is so much more sophisticated thanit was 100 years ago which means it is dangerous to comparecurrent temperatures with the past because you are not com-paring like with like.

Any comments on the discussion would be welcomeand can be sent to: [email protected].

TM

TM

During Tom DeMark's recent visit to Europe to promote his indicators onBloomberg, he took time out to discuss with us the interest his indicators arenow attracting from traders and investment managers outside the US.Increasing availability of DeMark™ Indicators on various software packages isplaying an important role but as he explains, word has spread because tradersare having success with the indicators in whatever market they may be trading.

DeMARK ON

TA: I have heard that the number ofpeople using DeMark indicatorsmore than five times a week onBloomberg around the world hasgone up from around 12,000 to35,000 over the past few years. Howyou account for this increase?

TD: I realise that DeMark indicatorsare relatively low key in that they don'thave the exposure that, for example,Bollinger Bands get in TA books andsuch like. I would say that many tradershave had success with my indicatorsand this has travelled by word ofmouth. Another reason is my associa-tion with Steve Cohen. During my tripto Europe we had around 600 sign upfor my talk at Bloomberg in London,1850 in Milan, 300 in Zurich and 500 inFrankfurt and Paris combined. Thisshows how much interest there is outthere.

TA: I guess Steve Cohen at SACCapital is regarded as possibly the

best hedge fund manager in theworld. What is his connection withyour work?

TD: I've worked with Steve for 10years and he runs the number one fund.He's the best trader I've ever workedwith although I have also worked withPaul Tudor Jones; Jack Schwager hasreferred to me as the wizard's wizardbecause I have advised many of themanagers cited in his books. Steve is byfar the absolute best trader, moneymanager and investor I have witnessedin my 36 years in this business and Ihave seen the best. He uses variousDeMark indicators in his trading andhis success with them is the best testi-monial one could have.

TA: Is the increased popularity ofDeMark confined mainly to the USand Europe?

TD: I would say that the increased useof them is split evenly between the two

regions. Incidentally, I may also begoing to Singapore, Tokyo and Sydneythis year and there is talk of 1000 plusattendees in these countries. I think inSouth East Asia there may be a lack offundamental news relative to what'savailable in Europe and the US and thishas led to a greater reliance on markettiming indicators.

TA: What about the availability ofDeMark Indicators on softwarepackages. They have traditionallybeen associated with Bloomberg. Isthis changing?

TD: This actually is something else thatmay have contributed to the increaseduse of my indicators. They are nowavailable with many more vendors thanbefore. CQG, Aspen and most recentlyThomson now all have DeMark.Reuters also has plans to add DeMarkbut I have no dates as yet. I should saythat Bloomberg and CQG have excel-lent packages and present my indi-


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DeMARK


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cators very well. They also have thebest programmers in the world.

TA: Is there any difference betweenDeMark on CQG and DeMark onBloomberg?

TD: There are things that are unique toeach vendor but I have worked exten-sively to ensure that as much as possi-ble is available on each platform. CQGhad a 5 year headstart but I have donea lot to bring Bloomberg up to par. Thecheapest way to use DeMark is with aThomson screen as they have loweredthe price in an attempt to make it moreaffordable to retail users as well.

Bloomberg has invested much time,resources and programming into theproduction of a technological advancein market timing services; we refer to itas 'Cursor Commentary™'. This is aunique way of getting real-time analysisof a chart using the indicators provid-ed. It will elevate the bar for what toexpect from market timers and markettechnicians as it forces a rigid, objectiveand mechanical interpretation of themarket. It does not rely upon the rear-view, after the fact, 20-20 hindsightvision and interpretation that manypractitioners are accused of using.There is a lot in store for the productwhich will revolutionize the way theDeMark Indicators are utilized andinterpreted in real-time.

TA: We'll talk more about CursorCommentary at the end of the arti-cle. What is your interest in moretraditional technical analysis?

TD: This is an interesting point for mebecause I like to refer to DeMarkIndicators as market timing indicatorsrather than as being purely technical. Iconsider DeMark Indicators a hybrid oftechnical and fundamentals becausealthough fundamentals dictate longterm moves, technical analysis is anecessity for short and longer termmarket timing. A lot of traditional fundmanagers use technical analysis typetechniques although they themselvesmay not consider it as TA, but rather as

market timing tools.

TA: Do you agree that very often themost successful traders use techni-cals and fundamentals in combina-tion?

TD: Absolutely. A few years ago I wasin London speaking to one of the toppeople in equities at a Swiss investmentbank there. He was a pure obstinatefundamentalist although he knew thatmany of the people under him used myindicators. I asked him which funda-mentalists he admired and he said LeonCooperman who runs the hedge fundOmega Advisors and was theInstitutional Investor magazine, AllAmerican Strategist for many years.When I told him I had known Leon fordecades and actually called Leon duringour presentation, Leon admonishedthis individual by saying that the usageof technical analysis for timing was crit-ical. He was embarrassed because hedidn’t think that I inhabited that worldand, at the same time, Leon did notinhabit our world so to speak. Veryoften these guys are very narrow mind-ed and will not consider anything otherthan the fundamentals. A technician onthe other hand is willing to look at any-thing that could add value. However,people like Barton Biggs and ByronWien, both formerly at Morgan Stanleyand who are overt fundamentalists,have said that so called ‘technical style’market timing techniques achieve anaccuracy that fundamentals often can-not match. This may sound like anobvious thing to say but there are plen-ty of people out there who use nothingbut fundamentals for their market tim-ing and the guy from the Swiss bank isan obvious example and a dying breed.Actually, Barton and his former cohort,

Byron Wien, are big fans of RickBensignor at Morgan Stanley who inturn is a big fan of the DeMarkIndicators.

TA: In his book "Hedge Hogging",Barton Biggs sounded scepticalabout Fibonacci numbers in partic-ular. A lot of traders I have spokento feel the same way about the num-bers although there are of courseplenty of devotees, most obviouslyamong those using Elliott Waves.What's your view on Fibonacci?

TD: The best way to answer that is togive you a few examples. In 2002, theS&P March peak of 1527 multiplied by61.8% produces 944 (Figure 1). Thiswas exactly the September 21 marketlow. If you use 50% you get 767 whichalmost exactly where the market bot-tomed in October 2002. On August 241987, the peak in the DJIA multiply by61.8% gives you the 21 October low of1610. If you look at the FTSE; whileprojecting 61.8% times the close theday after the FTSE 1999 price peakyields the March 2003 low - to the tick(Figure 2). I use Fibonacci differentlyfrom other people. My approach is sys-tematic which removes all subjectivityfrom Fibonacci retracement interpreta-tion.

TA: My experience of DeMark isthat the TD Sequential™ Indicatoris more often discussed than otherDeMark indicators. When you didthe recent seminars in Europe, didyou find that the TD Sequential wasthe main point of interest from theattendees?

TD: There are 30 indicators onBloomberg currently with more to be

“I’VE WORKED WITH STEVE [COHEN] FOR 10 YEARSAND HE RUNS THE NUMBER ONE FUND. HE’S THE

BEST TRADER I’VE EVER WORKED WITH ALTHOUGH IHAVE ALSO WORKED WITH PAUL TUDOR JONES.”

added soon and so the talk wasn'trestricted to the TD Sequential. As I'vealready mentioned, Bloomberg's newCursor Commentary™ product thatwill be released soon and much of thetalks centred on this. Otherwise, theTD Combo™ is becoming more popu-lar although it is less recognised thanthe TD Sequential. The TD Comboworks better on intra-day and dailycharts and in identifying extremes, butit also has more rigid rules which meanthe signals are less frequent. TheCombo indicator generated the rightsignal ahead of the fall of the BritishPound in 1992 (Figure 3).

TA: To what extent are you activelytrading yourself ?

TD: I am more an advisor to SteveCohen and SAC now although I havehad some money of my own in thefund. We use the TD Combo, the TDSequential and the aggressive versions.My son is actively involved and amongother tasks including research anddevelopment and serving as liaison toSAC, he monitors the various indica-tors over different time frames andscans looking for convergence. Thisproduces high probability trades. Welook at all markets and I have 7 CQGshere running continuous scans forSetups, Countdowns and various com-binations. I still spend my day lookingat screens.

TA: Do you automate any of yourtrades?

TD: Yes but not for SAC as Steve istotally in control of his business.DeMark Indicators are particularly suit-ed to automated trading however and itcan be used in a variety of differentways. For example, if you have a Setupwithin a Setup, the trader has to decidehow to deal with this and programmethe system accordingly. This is anotherreason why people can get differentresults. Incidentally, this was a motiva-tion for my TD Lines™. I realised thattrendlines were never drawn consistent-ly. After a presentation to traders at


Techniques

→→

Figure 1. S&P500 2000-2002 Fibonacci retracement

Figure 3. TD Combo sell signal for British Pound in August 1992

Figure 2. FTSE 1999-2003 Fibonacci retracement

Day 1 (May 30):

www.technicalanalyst.co.uk+44 (0)20 7833 1441

[email protected]

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30 & 31 May 2007

Cost per delegate £1790 + VAT

Techniques


the CBOT exchange some years back, Iasked 5 traders in the front row to drawa trendline on an S&P chart and they alldrew it differently. This subjectivity issomething I have tried to eliminate withmy indicators and these produce indica-tors more suitable for automation.

TA: To what extent has the TDSequential been backtested by your-self or other users in the market?

TD: People tend to think that the TDSequential is somehow a new techniquebut it's been around for more than 30years, even before electronic charting. Ithas been tested but how you testdepends on what settings you use andhow you optimise. Steve Cohen and Iuse the indicators all the time with ourown settings but I am not going todivulge what these are for obvious rea-sons. There is no definitive way ofusing DeMark Indicators and althoughthe systematic nature of the indicatorsmakes them particularly suitable forbacktesting, the exit still has to be cho-sen. I'm not really interested in gettinginto a debate about how DeMarkIndicators should be used. The indica-tors are there and it's up to every indi-vidual trader to decide how best to usethem.

TA: If we take a hypothetical situa-tion and say that someone from aLondon bank has backtested theTD Sequential for euro dollar andsays there is nothing in it, howwould you respond?

TD: I would say he probably pro-grammed it wrongly! Jason Perl at UBSin London has done a lot of work onthis over the past 10 years and he hashad success with it. Actually, TDSequential has worked well for eurodollar, perhaps better than it has forother markets. But once again, how doyou define your exits? The hypotheticaltester you mention may have bought aCountdown 13 and held it forever. Ifthat was the case then of course hewould have lost money eventually. Aswe demonstrated in Europe recently,the perfected 9 Setups have a very goodrecord. For example, one indicator pro-duced 17 of the last 18 DeMark tradesprofitably on the S&P500. There areplenty of guys in Europe who have rig-orously backtested my studies and arestill using them so these are the peopleyou should ask.

TA: Is there any evidence that yourindicators work better in some mar-kets than others or better in differ-ent time frames?

TD: No, it's universal and there is nooptimisation for any individual markets.

TA: But if you are using the TDSequential for a particular marketyou can optimise your exit strategy?

TD: Of course, but curve fitting isoften a problem. My approach is to goback 5 or so years and see how it hasworked instead of just taking the cur-rent history and optimising. All 9s and13s stay on the chart so you can see thehistory. It's all there to see.

TA: Who are the most knowledge-able DeMarkians in Europe would you say?

TD: Well of course there are Jason Perlat UBS and Trevor Neil who used to beat Bloomberg and who now has hisown consultancy and specializes intechnical analysis education includingmy work. Their knowledge of my indi-cators is exceptional. I spent a lot oftime with Trevor's successor atBloomberg, Guido Riolo, during myrecent trip and he impressed me verymuch with his knowledge, not only ofmy work but of TA in general. Alsoadept at the studies are Gordon Kollingat Commerzbank in Frankfurt, Jean-Charles Gand at Societe Generale inParis, Hugues Rialan at Robeco,Michael Rohner at LGT and TimMcCullough at BNP Paribas inLondon. They are all highly respectedthroughout Europe as technicians buttheir knowledge is not limited to oneaspect of technical analysis but coversthe full gamut. →→

“I LIKE TO REFER TODEMARK INDICATORSAS MARKET TIMINGINDICATORS RATHERTHAN AS BEINGPURELY TECHNICAL.”

Trevor Neil and Tom DeMark

Techniques


Bloomberg CursorCommentary™ for TDIndicators™

'Cursor Commentary'™ is a revolu-tionary approach to market timinganalysis. Unlike conventional tech-nical analysis that is often subjec-tive and vague, CursorCommentary provides contempora-neous interpretation of a bar chart(Figure 4) that is timely andunequivocal. The cursor alignsitself with a particular price period,whether it is daily, weekly, hourly,etc, and associated with that pricebar is commentary (Figure 5)describing the likely anticipatedprice movement based upon thevarious TD Indicators™ selected.This exchange between softwareand user is complemented by addi-tional information with more con-cise and less detail such as sum-maries for each indicator therebyenabling the user not only toacquire a thorough understandingof the indicators, but also to arriveat quick 'bottom-line' analysis ofthe indicator at any particular pointin time.

Additionally, there are 'hot but-tons' imbedded in the text thatrefer to extended explanations, def-initions, and descriptions of thespecifically highlighted indicator.Further search/scan lists of varioussecurities that come to fore basedupon proprietary and recommend-ed indicator settings are provided,as well as a special invite only chatroom that will concentrate uponspecific markets, opportunities, andother information.(Anyone wishing to learn aboutthis exciting new service shouldcontact Bloomberg.)

Figure 5. Cursor Commentary for Nasdaq chart. Chart provided by Bloomberg

Figure 4. Nasdaq 100: Sep 2006 to present with the TD SequentialIndicator™ Chart provided by Bloomberg

Techniques


It may sound like a dry, arcane aca-demic discipline, but you'd be sur-prised how mainstream some of

the concepts of behavioural finance(BF) have become. Two of the mostpopular TV shows of the past fewyears have BF right at their heart: WhoWants to be a Millionaire, and Deal orNo Deal. The premise of both shows isto play on a basic human impulseknown as hyperbolic discounting.People generally prefer smaller, soonerpayoffs to larger, later ones. They alsoprefer to take a fixed sum rather thangamble on getting a larger one and risklosing everything.

The entertainment in both theseshows is watching people attempt toovercome their natural, instinctive cau-tion and take a gamble, even when (inDeal or No Deal) the results are entire-ly random. They also play on the ideaof loss aversion, which behaviouralfinance experts calculate is far morepowerful an emotion than the urge togain. For investors and financial ana-lysts, these quirks of human behaviourare important, because they can affectmarket mechanisms and point to high-er performance for investors whounderstand them, or to lower perform-ance for people who are subject tothem.

In some cases, whole financial sectorshave been remodelled through applyingBF principles. The US pensions indus-try for example, like the UK's, has beenmoving away from defined benefitschemes and into defined contributionschemes, putting the onus of decision

making onto the individual rather thanthe company. This has led to a dramat-ic drop in overall pension savings rates.In response, Shlomo Benartzi at theUCLA Anderson School ofManagement developed a programmeknown as Save More Tomorrow, orSMarT, "a behavioural prescriptiondesigned to help participants increasetheir savings over time," as he puts it.

BF and pension schemesIn order to counter hyperbolic dis-counting, which makes people reluctantto contribute to a larger pensioninstead of enjoying their money today,he proposed a scheme where pensioncontributions would be increased atevery pay rise. Within 40 months ofthe scheme being introduced by UScompanies, savings rates had risen onaverage from 3.5 per cent to 13.6 percent. By 2004 more than 6,000 USfirms were offering the plan to 300,000employees and the proportion of firmsnow using it could be as high as 20 percent.

The scheme was carefully designed totake account of hyperbolic discountingthrough offering it to employees as faras possible ahead of their next pay rise.This worked because, if someone isoffered 50p today or £1 in a year's time,most people will take the 50p. But ifyou offer someone 50p in five years'time or £1 in six years' time, most willtake the £1, even though there is thesame time difference between the twooffers.

Benartzi's scheme also factored in

perceived loss aversion, by making theincreased contribution effective fromthe first pay cheque following the raise,rather than letting employees see theirhigher income and then see it drop. Italso included an automatic continua-tion through successive pay increasesup to a pre-set maximum, taking advan-tage of inertia and status quo bias, bothimportant issues in behaviouralfinance.

John Hawksworth, head of macro-economics at PricewaterhouseCoopers,has taken a close interest in BF issuesaround pensions. He sums up the rea-sons that people prefer not to thinkabout the question: "It's an unpleasantmixture of maths and mortality," hesays. "People don't take rational deci-sions about pensions. They have vari-ous biases, myopia, procrastination andinertia. They'd rather be spendingtoday than saving."

Having a default option of being in apension scheme results in 80 per centtake-up, Hawksworth has found, versusjust 20 or 30 per cent if the defaultoption is to be out. With the UK gov-ernment wrestling with the prospect ofa generation of poverty-stricken pen-sioners, adopting some of these behav-ioural ideas is certainly under discus-sion, according to Hawksworth."People can be persuaded to go forsomething more rational," he says.And the principles of BF that havebeen developed in the US are nowseeping into the UK and Europe, hebelieves. "People in economics andpsychology used to work in silos and

BEHAVIOURAL FINANCE IN ASSET MANAGEMENTWe look at the use of behavioural finance techniques within the assetmanagement industry to see what elements of the subject are beingapplied to investment decisions.


Techniques

not talk to one another, but things arechanging."

Although BF has been evident in aca-demic literature for the past 20 years ormore - and indeed some of the mostinteresting applications in real fundmanagement have been developed byacademics - the true roots of the sub-ject lie much further back in history,with 18th century thinkers such asJeremy Bentham and Adam Smith,whose book The Theory of MoralSentiments described psychological ele-ments of individual behaviour. In the19th century, economics graduallymoved closer to the sciences, as leadingeconomists attempted to show that thesubject could be understood and out-comes predicted by analysing purelyeconomic agents. It was not until the1960s that psychological factors beganto take a more central role again in eco-nomic study.

Today, one curious further stageunder development is neuroeconomics,where functional magnetic resonanceimaging brain scans are used to com-pare the roles of different areas of thebrain that contribute to economic deci-sion-making, extending behaviouralfinance by adding an observation ofthe nervous system.

BF and fund management As an investment tool for the majorfunds, BF has gradually edged into themainstream, partly thanks to the workof 2002 Nobel laureate DanielKahneman, recognised "for havingintegrated insights from psychologicalresearch into economic science, espe-cially concerning human judgment anddecision-making under uncertainty."His book Prospect Theory outlinesmany of the key notions of BF, such asheuristics, where people make deci-sions based on approximate rules ofthumb rather than on rational analyses,and 'framing', where decisions aremade very differently, depending onhow the information is presented. Italso explores market inefficiencies,such as mispricing and irrational deci-sionmaking.

For some economists and financial

analysts, the question of market ineffi-ciency is the most interesting elementof BF, since it opens the possibility ofprofiting, by detecting where a stockhas been mispriced and then trading tocapitalise on this. Fuller & Thaler, forexample, runs a fund which "attemptsto achieve above market returns by cap-italising on market inefficiencies causedby investors' mis-processing of infor-mation…using insights from behav-ioural finance to gain a competitiveedge over the market." As the compa-ny's president, Russell Fuller, puts it:

"Behavioural finance is the study ofhow investors make stupid mistakes. Ifyou are aware of these stupid mistakesand don't make them yourself, then itcan be very valuable."

LSV Asset Management also runs aBF fund and describes its investmentphilosophy as being "based on the fun-damental premise that superior long-term results can be achieved by system-atically exploiting the judgmental biasesand behavioural weaknesses that influ-ence the decisions of many investors.These include: the tendency to extrap-olate the past too far into the future, towrongly equate a good company with agood investment, irrespective of price,to ignore statistical evidence and todevelop a 'mindset' about a company."

Law of diminishing returnsJP Morgan has a BF fund known asIntrepid, and ABN Amro launched a

Japan BF fund in 2001. However, ifthese kinds of funds do become popu-lar, there will be less chance for them tosucceed. "It's important to rememberthe efficient markets paradox," saysMichael Mauboussin, BF expert atLegg Mason Asset Management andauthor of investment bible, More ThanYou Know. "As inefficiencies areunearthed and exploited, marketsbecome more efficient. The centralquestion is whether these strategies willlead to systematic excess returns."

Mauboussin has been called one ofthe Most Influential People on WallStreet by Smart Money magazine. Hehas studied any number of differentbehaviours, from casino gamblers toant colonies, from the mating habits ofguppies to Tiger Woods's golf swing,to formulate investment theories. LeggMason does not operate a specific BFfund, but the various investment teamshave been "versed in the core con-cepts," as Mauboussin puts it. "Weattempt to incorporate the central ideasin identifying potentially attractivesecurities, how we gather and evaluateinformation, our probability and out-come assessments, and how we incor-porate the role of time," he says.

On specific issues such as generatingbuy and sell signals, Mauboussin saysthat BF is just one of a host of factorswhich influence investment decisions."The simplest explanation is we arelooking for mispricings as a result ofundue optimism or pessimism," hesays. "We call these 'diversity break-downs' - investors all seem to head toone side of the ship."

Equally, differing financial markets,either geographical or sectoral, may besusceptible to differing degrees of BF,he believes. "In markets where intrin-sic value is more difficult to pin down(currency markets, for example),behavioural issues may be more promi-nent. Also, emerging markets tend tobe less populated and less liquid, possi-bly making some behavioural issuesmore pronounced. But as long ashumans behave as they do, behaviouralchallenges and opportunities will bewith us."

“BEHAVIOURAL FINANCEIS THE STUDY OF HOW

INVESTORS MAKE STUPID MISTAKES. IFYOU ARE AWARE OF

THESE…THEN IT CAN BEVERY VALUABLE.”

- RUSSELL FULLER,FULLER AND THALER


Techniques

Arecent academic paper(Batchelor and Ramyar, 2005)investigated the frequency of

price and time ratios attending adjacentmovements in the DJIA ("retrace-ments") as well as same-directionmovements separated by an interveningmovement ("projections"). The study isvaluable in demonstrating that price-fil-tered movements in the stock marketdo not generally relate by a Fibonaccimultiple either to price retracements orto projections. It supports an observa-tion dating from the first edition ofElliott Wave Principle (Frost andPrechter) in 1978:"In discerning the working of the GoldenRatio in the five up and three down movementof the stock market cycle, one might anticipatethat on completion of any bull phase, the ensu-ing correction would be three-fifths of the pre-vious rise in both time and amplitude. Suchsimplicity is seldom seen".

The 1998 edition expanded upon thispoint: "Retracements come in all sizes.Occasionally, a correction retraces a Fibonaccipercentage of the preceding wave. [But these]ratios…are merely tendencies. Unfortunately,that is where most analysts place an inordinatefocus because measuring retracements is easy".

We stressed this point in reaction to anincreasing tendency among some mod-elers and writers to ignore the specificobservations within the Wave Principle

and substitute a false claim that price-defined market movements in generalare commonly related by Fibonacci per-centages. Batchelor and Ramyar haveperformed a service in debunking thiswidespread, unsubstantiated belief.Their result agrees with our empiricalobservation, as quoted above.

Not applicable to Elliott WavesUnfortunately, the authors also imput-ed to R.N. Elliott a generalization aboutthe Wave Principle that he did notmake. Elliott did note repeatedly thatthe "number of waves" in his modelconforms to the Fibonacci sequence.But Batchelor and Ramyar asserted,"Elliott (1940) further claimed that theratios of price and time retracementsand projections in successive waveswere likely to conform to Fibonacciratios." This statement is inaccurate.Through two books, a dozen articlesand at least 60 periodicals, Elliott madeno such claim.

Elliott's 1940 essay and a subsequentchapter in Nature's Law pointed out asingle example of a period when foursuccessive distances within "a triangularoutline" are related in price approxi-mately by the same Fibonacci ratio.Moreover, the first distance Elliott citedis not that of a "price trend" as definedby Batchelor and Ramyar's study but anet distance of three trends, leaving justtwo ratios that the method used in the

study would discern. In a 1944 essayand a related subsequent chapter ofNature's Law, Elliott cited twoinstances in which a set of multiplewaves is related by Fibonacci to a singlewave in the same manner, a relationshipthe study is not designed to discern. In1945, Elliott used the Fibonacci ratioonce (unsuccessfully) to support a mar-ket call, but again the relationshipinvolved multiple waves, not singleprice trends. He never cited any otherpercentage retracement, or used theFibonacci ratio for forecasting.

Batchelor and Ramyar also investigateFibonacci time relationships amongprice trends. But Elliott, who was per-haps overly intrigued with durationsthat last a Fibonacci number of timeunits, nevertheless said in 1941, "Thetime element as an independentdevice…[it]continues to be bafflingwhen attempts are made to apply anyknown rule of sequence to trend dura-tion." In other words, there is no timerule with respect to Elliott waves.

ELLIOTT WAVES, FIBONACCI ANDSTATISTICS by Robert Prechter

→→

Bob Prechter

"Retracements come in all sizes." Frost and Prechter, Elliott Wave Principle

"There is no significant difference between the frequencies with which price and time ratios occur in cycles in the Dow..."

Batchelor and Ramyar, ‘Magic Numbers in the Dow’


Techniques

To conclude, the study does providea service in debunking a certain wide-spread claim made by software design-ers and technicians who are not Elliottwave theorists. But the study does notchallenge the validity of any aspect ofthe Wave Principle; rather, as shown inthe opening quotations and the follow-ing discussion, it supports wave theo-rists' observations.

Elliott waves versus pricetrendsThe primary reason that the study doesnot pertain to Elliott waves is thatElliott waves differ from what theauthors call "price trends," which aredetermined by a percentage price filter.Years ago technician Arthur Merrill(Filtered Waves, 1977) attempted toform conclusions about Elliott wavesby using such a filter. He was unsuc-cessful because waves are a function ofform, not price alone. Elliott waveforms involve both price and time.Figure 1 shows a classic Elliott wave. Inmany cases, a price filter, which ignorestime and form, would observe the latterpart of wave 2 but none of wave 4.Instead of five waves, such a filterwould discern three "price trends,"ignoring two waves.

Elliott waves are defined as begin-ning and/or ending at certain pointsthat are quite often different from thehigh and low prices within them. Suchforms include two of the three types ofcorrective waves (flat and triangle) and"truncations" (in which ending pricesdo not reach a new price extreme) ofthe other three type of waves. So thisfact either does or can pertain to all fivewave types. Although truncations arerare, flats and triangles are common.Wave 2 is a flat single wave, yet its startis different from its price high. Wave 4is a triangle - a single wave - yet its endis different from its price low. Whendetermining ratios between Elliottwaves, the start and end values are thedefining points, not the intra-patternextremes. Thus using a price filter tomeasure market movements ignoresElliott waves in two ways.

The use of Fibonacci byElliotticiansEven within a proper Elliott Wave con-text, Elliott's successors have never for-mulated or applied any general ruleabout retracements or projections norbehaved as if one were true. CharlesCollins and Richard Russell did not useFibonacci ratios at all. Hamilton Boltoncited a Fibonacci multiple just once inhis career and A.J. Frost twice. Evenamong these few instances, none ofthem is based upon either a retrace-ment or a projection of single alternatewaves, which are the only wave rela-tionships that the study's approachwould recognize. More telling,Beautiful Pictures (Prechter, 2003)presents 90 graphs, most of them con-taining multiple examples of price ortime relationships in the DJIA, andnone of them address a Fibonacci rela-tionship between adjacent waves, andalmost none of them address a projec-tion between single alternate waves.Few of them even address relationshipsbetween price trends as defined in thestudy. Indeed, the book's Chapter 13,"Testing for Data Fitting," makes a casethat when one ignores actual Elliottwaves in favor of other price lengths,Fibonacci multiples between them

almost never appear.Chapter 4 of Elliott Wave Principle

offers 14 idealized diagrams of situa-tions where the authors discernFibonacci relationships occurring moreoften than chance would allow. Themethodology used in the Batchelor andRamyar study fails to incorporate 10 ofthem which is another indication thattheir method does not address actualclaims made by wave theorists.

The same book cites one real-lifeexample of a Fibonacci retracement inthe stock market. Even this one doesnot incorporate "price trends" such asthe study uses but instead is based upontwo Elliott waves whose turning pointsdiffer from the market's price extremes.The example conforms to the observa-tion in Elliott Wave Principle thatFibonacci retracements occur "occa-sionally" among particular pairs ofwaves, in this case 1 and 2. While eventhis statement may ultimately provefalse, the paper's statistics do notaddress its validity. Also, Elliott WavePrinciple and Beautiful Pictures specifi-cally decline to suggest any reliable rela-tionship between waves 2 and 3.

Elliott's successors' inability to findany other reliable wave relationshipssuggests that (1) Elliott theorists havebeen able to make distinctions betweensituations in which a Fibonacci rela-tionship is probable relative to all oth-ers, and (2) they would agree that test-ing relationships outside these few nar-row claims would likely yield a randomresult.

The conclusion of this study sup-ports the observations of Elliott theo-rists, who say three things that wouldanticipate the overall statistical resultobtained:

There are no Fibonacci-basedretracement or projection rulesrelating generally to all waves or"price trends";Only certain combinations of wavesseem to display Fibonacci relation-ships more often than chance,whereas all others do not displaythem;Investigating which market move-

Figure 1.

1.

2.

3.

Techniques


ments, if any, tend to have a Fibonaccirelationship would require using actualElliott waves, not price trends asdefined by Batchelor and Ramyar, andthe use of such price trends would tendto give a result close to random.

Statistics and significanceWave theorists propose only a limitednumber of circumstances in which aFibonacci relationship is likely, andeven then the probability for such arelationship is quite less than 100 per-cent. If these wave theorists are cor-rect, and if Batchelor and Ramyar'sstudy is set up to discern a small por-tion of such conditions, then shouldn'ttheir statistics reflect a slight degree ofnon-randomness regarding the appear-ance of Fibonacci ratios in stock mar-ket movements? Perhaps they do.

Deepak Goel of the SocionomicsInstitute finds in Batchelor andRamyar's statistics a different messagefrom what reviewers to date have con-cluded. He observes that although thestudy's Fibonacci table does show thatoccurrence rates for individual ratiosare not always significant, it also showsthat higher-than-expected occurrence

rates are numerous to a degree that ishighly statistically significant. In otherwords, the reported results do indicatea degree of non-randomness forFibonacci ratios in retracements andprojections (see inset).

Anyone who works with Elliott waveswould be quite at home with this inter-pretation of the results. Lumping in afew legitimate wave relationships withthe majority of "retracements" and"projections" that wave theorists woulddeem inapplicable would produce justthe kind of slightly-better-than-randomresults that the authors report. The rel-evant statistics, therefore, may supportthe observation in Elliott WavePrinciple that Fibonacci relationshipsare to be expected in certain specificsituations.

TestingI sympathize with statisticians whowant to test simple trading rules, butthe Wave Principle model, like the mar-ket itself, is not simple. The WavePrinciple is fairly well defined, though,and surely testable with the right defini-tions and the right tools. Though ourresources are limited, my colleagues

and I would be happy to help in anyway we can. In the meantime, it isheartening to see statistical studieswhose results appear to be consistentwith our empirical observations.

SourcesBatchelor, Roy, and Richard Ramyar, "Magic Numbers in theDow" (2005), www.cass.city.ac.uk/magicnumbers. Presented atthe 25th International Symposium on Forecasting, San Antonio,Texas (2005).Bolton, A. Hamilton (Robert Prechter, Ed.), The CompleteElliott Wave Writings of A. Hamilton Bolton, Gainesville,Georgia: New Classics Library (1994).Elliott, Ralph N. (Robert Prechter, Ed.) R.N. Elliott'sMasterworks, 3rd edition, Gainesville, Georgia, New ClassicsLibrary (2005). [Original edition published 1980; revised1994]Elliott, Ralph N. (Robert Prechter, Ed.), R.N. Elliott'sMarket Letters, Gainesville, Georgia: New Classics Library(1993).Frost, A.J., and Russell, Richard (Robert Prechter, Ed.), TheElliott Wave Writings of A.J. Frost and Richard Russell, 2ndedition, Gainesville, Georgia: New Classics Library (1998).[Original edition published 1996]Frost, A.J. and Prechter, Robert, Elliott Wave Principle, 10thedition, Gainesville, Georgia: New Classics Library (2005).[Original edition published 1978; revised 1998]Goel, Deepak, "Another Look at Fibonacci Statistics," TheSocionomics Institute, Gainesville, GA (2006).http://www.socionomics.net/FiboStatsPark, Cheol-Ho and Irwin, Scott, "The Profitability ofTechnical Analysis: A Review," (2004) University of Illinois:SSRN_ID603481_code17745.pdf.Prechter, Robert, Beautiful Pictures, Gainesville, Georgia: NewClassics Library (2003).

Another Look at Fibonacci Statistics By Deepak Goel, the Socionomics Institute

Batchelor and Ramyar of Cass Business School in London (2005) looked for the prevalence of Fibonacci retracements andprojections in the stock market and rejected the idea that they occur more often than expected by random chance. A closerlook at their results suggests a different picture.

The authors presented their Fibonacci results showing the percentile of occurrences of Fibonacci retracements measuredagainst a bootstrap distribution. The following analysis assumes that the results for each ratio are approximately independentof each other. This is logical because the number of occurrences of a particular Fibonacci ratio includes only those that fallwithin a small 2.5% band around that ratio. This number should therefore have a very small effect on the number of occur-rences of other Fibonacci ratios.

Fibonacci retracements 0.786, 0.618 and 0.382 do occur more often than would be expected on average in a random envi-ronment (hereafter called "positive outcome"). Two of them are significant at the 1% level and one at the 5% level. So half ofthese six Fibonacci occurrence rates are significant, despite limited data, and all six have positive outcomes. Finding a positiveoutcome six out of six times is itself statistically significant at a level of 1.6%. Finding a significant outcome three out of sixtimes is also statistically significant at the 2% level. Projections also produced positive outcomes in five out of six tests, a resultthat is significant at the 11% level. So, price trends produced positive outcomes in 11 out of 12 tests for the Fibonacci ratios,38.2%, 61.8% and 78.6%. This amount is highly statistically significant.

On the whole, 71 out of 110 Fibonacci occurrence rates exceed the 50th percentile, a number greater than the 55 expectedby random chance. Similarly, 22 out of 112, more than the 11 expected, achieve the 90th percentile; 19 out of 112, more thanthe 6 expected, achieve the 95thpercentile; and fully 16 out of 112, many more than the 1 expected, achieve the 99th percentile.

Thus, either Batchelor and Ramyar's null distribution constructed from block bootstrap is unreliable, or Fibonacci ratios dooccur more often in the stock market than would be expected in a random environment. As a check against a flawed bootstrapdistribution, one could measure the occurrence rates of randomly chosen numbers and compare those against the occurrencerates of Fibonacci numbers.

Interview


TA: By way of introduction, can you give us an overview ofhow the EU Emission Trading Scheme (ETS) works?

MM: The starting point is the Kyoto Protocol under which theEuropean Union as a whole committed to reduce greenhousegas emissions by 8% compared to 1990 levels. This target wasthen distributed between member states (of the EU15) accord-ing to the Burden Sharing Agreement (BSA). Each memberstate has then to come up with an allocation plan for theirindustry, called the National Allocation Plan (NAP).

We have now, more or less, gone through the NAP negotia-tions for the second phase of EU Emissions Trading Scheme,from 2008 to 2012. The EU Commission will look at the planand say whether the member state is on target to meet theirBSA target and if they say they are, depending on whateverthat number was in the allocation plan, then that becomes theamount of EU allowances (EUAs) that the member state canissue to their covered sectors.

TA: Does the ETS start out by creating scarcity in EUAs inorder to beat emissions down and drive the EUA market?

MM: Yes. Every installation has got an allocation of EUAs,where each allowance carries the right to emit one tonne ofcarbon dioxide or carbon dioxide equivalent. So you're saying,for example, that if as a base level you emit 100 tonnes of CO2per year and you've got to get down to 80 tonnes, then we (themember state) are going to give you 75 of them free for exam-ple. The rest of them you'll have to buy on the market or cleanup your act.

That's what the big fuss has been about. Because they gaveout all these free allocations to take you to more or less 85% ofwhat you were going to have to do, they effectively created bigwindfall profits for everyone who got a free allocation.

TA: Because the companies overestimated their emissions?

MM: Partly because they overestimated their emissions but

MARK MEYRICK, EDF Trading

The European Union Greenhouse Gas EmissionTrading Scheme is the only multi-country multi-sector Greenhouse Gas emission trading schemein the world and is increasingly attracting theattention of hedge funds and trading houses. Wetalk to Mark Meyrick, manager of financial envi-ronmental products at EDF Trading, to get aninsight into how this market works and the kindsof analysis that can be used to trade it.

INTE

RVIE

W


Interview

even if they didn't, the obvious thing to do is as soon asyou've got these things for free you've got an opportunity toswitch off your plant and make a large sum of money.Having said that, there are rules to cover this: if you actuallylook like you've closed down they'll grab the allocation back.But if you decide to run at a fairly low base level it's fairly dif-ficult to say whether you've actually stopped. For the powersector, this is the dynamic that everyone looks at all the time- what is their input fuel cost, what is the power sales costs,and what is the EUA cost, and then they make a decision asto whether they're going to run or not run.

TA: Does the fine for going over your allocation come intothe equation?

MM: No, the fine is almost irrelevant because no one is evergoing to put themselves in a position where they are shortand have to pay the penalty. In February you get your alloca-tion for the following year. So for example, we would havegot our allowances for 2007 in February 2007, but we onlyhave to account for our 2006 emissions in April 2007, so wecan effectively use what we've been given in February 2007 tomeet whatever shortfall we've got for 2006. So you shouldnever get in a position where you need to pay a penalty,except may be at the end of the Kyoto phase. And even then,you'll buy up EUAs to cover the shortfall.

TA: Is the cost of the EUA effectively capped by the cost ofthe fine?

MM: No, because the fine is not a get out of jail free card.You have to pay the fine and you have to make yourself goodthe following year. The fine isn’t an alternative to coveringyour short position.

TA: With regard to EDF Trading, are you just concernedwith hedging your group positions or do you also take pro-prietary positions?

MM: Different houses have different approaches to carbontrading. At EDF our job is to optimise the group carbonposition as best we can, which will involve proprietary posi-tion taking from time to time. Other companies will have astraight compliance requirement, e.g. a power station thatdoesn't have any power trading desk, and will simply look atthe difference between the spark price and the dark price andwork out what they will need in terms of EUAs.

TA: In terms of activity, is EDF Trading buying and sellingEUAs on a daily basis? What kind of data do you have inorder to decide whether you'll be buying or selling?

MM:Yes, we trade EUAs every day. You've basically got tolook at all the fuel prices and the power prices in the marketand this spread determines our daily trading decisions.

TA: What about the demand from EDF itself ?

MM: Well, yes, if I'm talking in terms of optimising thegroup's position. An EDFT Trader will get orders from otherparts of the group saying they want to do X or Y. We will alsohave our own views about the market which we mightexpress.

TA: So do you have a pool for all the EDF companies?

MM: No, not really. Everyone keeps control of their ownallowances. But they can really only access the market placethrough us. We act like the clearing house. However, we doadminister the EDF Carbon Fund - an internal fund in whichgroup companies commit to buy certain volumes of CERs,and we manage it, according to certain buying criteria.

TA: Is the European Climate Exchange (ECX) on ICE themain exchange for EUAs?

MM: Yes, of the exchanges ECX has got the most volume,but the OTC market has also got a lot of activity. A lot ofpeople trade OTC and then give it up for clearing to the ECXbecause they don't have master agreements with each other.There are several exchanges though. It's not only ECX -there's also Nord Pool, Powernext and the EEX in Germany.

TA: How many are there on your team involved with carbontrading?

MM: We've got two people involved directly in EUA tradingand we've got six people involved in the origination of cer-tificates of emissions reduction (CERs) from CleanDevelopment Mechanism (CDM) and Joint Implementation(JI) projects. The CDM is the mechanism of the Kyoto pro-tocol for allowing clean development projects to be createdin developing countries and generate credits that can be usedin Annex 1 countries, i.e. developed countries. These creditsare saleable into Europe as certificates of emissions reduc-tion (CERs) which can be used to offset a company or coun-try's emissions abatement obligation. The amount availableto be offset by CERs varies from 8 to 25 per cent from coun-try to country.

TA: How large is the carbon trading market? To what extentare hedge funds operating in this market?

MM: The market is huge - there are over 50 carbon fundsout there at the moment that exist solely to access CDM andJI projects, including American funds. Their buying potentialis huge on its own. I've seen analysis that says it's going to bebigger than the oil market.

With regard to EUAs, anybody can trade them as long asthey can put up margin and be on the exchange. It's certain-ly a liquid enough market - the typical spread is five cents →→

Interview


for an EUA contract.

TA: Is technical analysis useful for trading EUAs?

MM: Technical analysis is a great tool for this market on ashort term tactical basis, because the actual demand and sup-ply fundamentals are very difficult to assess. This is becauseyou've got five industrial sectors covered (electricity genera-tion; paper and pulp production; glass manufacture; chemi-cals production; cement) and you have to wait for the indus-try associations for each to say how much they've been pro-ducing. There's always going to be timing problems and dataproblems, and that's just the demand side.

On the supply side, firms have been given these allocationson an annual basis but you have to consider when they areactually using them. Are they thinking "I'm just going to siton them because I may need them next year"? - and then,just to muddy the water further, you've got companies sittingon CERs who are able to feed them into the market as andwhen they see fit after 2007.

The primary demand and supply drivers are really difficultto assess. However, as the power sector has the biggest com-pliance burden it makes up the marginal buying - players lookat the fuel and power prices and these tend to act as the driv-er to the EUA price. So you may get some sense of directionfrom that. But because it's so difficult to assimilate all thesefundamentals, and because technical analysis says that all thedemand and supply information is discounted in the price (oris as near as you're going to get), technical analysis is a neces-sary tool for this market on a short term tactical basis.Strategically and over the longer term, however, you still takethe big picture view and look at political, fundamental, regu-latory risks etc.

TA: What kind of technical tools do you use?

MM: We keep charts. We generate our own data, our owncharts and our own analysis. We don't use models as such,although Matthias, our EUA trader, has all sorts of tools thathe's developed based on, for example, the spark spread (thepower price relative to the gas price) and the dark spread (thepower price relative to the coal price). He monitors thesespreads all the time and he monitors correlations between theEUA price and perhaps the gas or power price. He'll alsolook at what the oil price is doing.

TA: Why particularly look at these spreads?

MM: You've got to remember that European gas prices tendto be set off the oil price. So, given that fuel switching (fromcoal or oil to gas) is one of the main aims of the scheme,you'll be looking at how expensive gas is relative to otherfuels. Gas powered generation produces about half theamount of CO2 emissions compared to coal fired genera-tion. However, if the gas price is so expensive relative to coal,then power generation companies will be quite happy to paythe EUA price and continue with coal until the cows comehome. On the other hand, if companies switch more to gasthen they'll be less demand for EUAs. That's why the EUAprice has been so weak in last few months, because the gasprice has been dumping.

The country with the biggest fuel switching capacity, rela-tively speaking, is the UK. As the gas price goes up, coal firedgeneration becomes more economical and more attractive sogeneration companies will start turning down their gas plantsand turning up their coal plants, therefore increasing demandfor EUAs.

TA: One of the things that strikes me about the wholescheme is the potential for bureaucracy and lack of trans-parency. Is this correct?

The EDFT Team. From left to right: Mike Fulton, Portfolio Analyst; Francois Joubert, Head of EDFT Carbon; Mark Meyrick;Adrian Stott, Manager Carbon Credit Origination; Franck Bernard, Manager Structured Marketing


Interview

MM: The bureaucracy is very challenging at times. And theregulatory risk is a real concern, which causes significantcomplications in contracting, as we try to foresee possiblescenarios /outcomes, caused by this uncertainty. People arefeeling their way in this and never really know how things aregoing to work out.

TA: Do you mean in terms of the re-negotiation of thenational allocations and how that's passed down to the par-ticipants?

MM: That, and also how the CERs are going to come intothe market because they haven't actually come into the mar-ket yet because they're sitting in a temporary CDM account.

TA: So are CERs tradeable?

MM: Yes, people are secondary trading CERs. But becausethe conditions are so complex they don't lend themselves toa straight commoditisation so they tend to be negotiated.

TA: How is the value of a CER calculated?

MM: In relative value terms I would say. You know whatyour EUA is worth, so let's say your EUA is 100%. If I nowthink about contracting for say a landfill project in Chile?You think to yourself, well I've seen the landfill, I've seen alot of pipes lying around on the ground, nothing much hashappened to them, I've seen a flaring unit which is down bythe hut which isn't connected yet and you're sort of thinkingis a credit for this project as it stands worth the same as anEUA? Naturally, you're going to say no it isn't. I don't knowif all those pipes are going to get stuck in the ground. I don'tknow if it's going to collect as much gas as it says it's goingto collect in the project design document. And by the way,the project design document hasn't yet been validated by thevalidator. The host country hasn't yet approved the projectyet, and the UNFC hasn't approved the project yet. So allthese different things will lead me to say, no way am I payinga 100 for it. I'll pay, say, 60 for it. Once you've established thedifferent risks for the project vis-à-vis how much you want tosee the price discounted against the EUA, you've got yourstarting point.

So if Barclays come along, for example, and say "we've gotthese CERs to sell to you and you don't need to worry aboutwhere they're coming from because if we don't deliver themwe're going to give you EUAs instead, how much are yougoing to pay me?" You'll say I'm certainly going to pay youmore than 60 but at the end of the day, an EUA is an EUA,so I'm not going to pay you 100. I might pay you 90. This ishow the secondary CER market started out. And then peo-ple start to think there's actually a lot more regulatory risk tothis than they thought and the price dropped down to around76. Then people said "actually it's not quite so bad and it's alot of work going around the world looking for all these proj-

ects, so may be I'll pay Barclays a bit more" - so for instancenow its 84.

Barclays would have done all their due diligence andassessed the project and may be they would have bought itfor 60. Barclays can't use the CER because they're a bank, sothey need to sell it to either a government or some body witha compliance requirement and buyers are obviously going toexpect a discount. It's just a matter of how much discount itwill be.

TA: Obviously the importance of these new NationalAllocations is tremendously important to the whole carbontrading scheme. Have negotiations now been completed forthe second phase?

MM: Well not quite. There are still a lot of things thathaven't been sorted out at an installation level. And untilinstallations know what they're getting, they're unlikely tohedge.

TA: So, can you see the process by which allocations aremade? Is it completely transparent?

MM: The allocation is public knowledge although you won'tnecessarily see the process by which it was given.

TA: Can you use publicly available information about alloca-tions to help judge the EUA market - i.e. through a calcula-tion of how short the market is going to be?

MM: Not really, because you don't know a) how many EUAsa player has already bought and b) how many CERs he's gotsitting in his war chest. Which means you don't knowwhether he's short or long really.

TA: Is there an equivalent to the Commitments of Tradersreport for EUAs and CERs?

MM: One of the good reasons for being involved in theOTC market is that you can see behaviour. For instance, wewere market maker on Nord Pool in the first year of the ETSand all the Nord Pool ever did was sell. Scandinavia as awhole was selling huge amounts of EUAs and that wasbecause the hydro situation in Scandinavia was very goodthat year and they knew they weren't going to be running

“TECHNICAL ANALYSIS IS A GREATTOOL FOR THIS MARKET ON A SHORTTERM TACTICAL BASIS, BECAUSE THE

ACTUAL DEMAND AND SUPPLYFUNDAMENTALS ARE VERY

DIFFICULT TO ASSESS.”

→→


Interview

their fossil fuel plants.

TA: I read something recently on how the amount of hydro-electric power Nordic countries generate swings violentlyaccording to how dry or wet the weather is. Is Scandinaviatherefore an important region to watch with regard to EUAtrading?

MM: When I was working for ABB and started up an ener-gy trading unit in Sweden for them, I'd never seen anythingso mad. It was incredibly volatile. They're almost, in someways, the swing producer for European carbon. If you'reanalysing the general state of the carbon market, you're goingto look at the hydrological situation in the Alps, Spain and inScandinavia all the time. Because as soon as Scandinavia, forinstance, has a bad very hydro year you know they're going tobe importing a lot of fossil fuel power from Finland,Germany and Denmark, and the so the EUA price will go up.

TA: What about other new participants to the scheme?There's been talk of certain US states such as California join-ing the scheme. Will this happen and what will be the affecton the market?

MM: California can't join the scheme per se. I mean there'sa lot of talk about expanding the ETS to include others butit's not a great idea really and it amazes me that some of thetrading associations are lobbying for it. It's difficult to workout the fundamentals anyway without including a wholebunch of other people. And, CERs are effectively the com-mon currency so you don't need to have the ETS linked up.The only complication then comes with how does a Kyotonon-ratifier manage to take Kyoto credits. Well to be honestthey can set up a registry account in any one of the Europeanstates and use that to retire the credits. There are ways aroundit. So it's not to say you can't include other countries in theETS, but I can't see the point.

TA: Will CERs be tradeable on an exchange?

MM: It will happen. Once you can come up with a commonagreement. This relies on industry participants. I mean whenthe EUAs started out there wasn't a body that gave us a stan-dard agreement from above. We all got together and bashedone out. And that will ultimately happen with CERs.

TA: Is there a correlation between CERs and EUAs?

MM: There is at the moment because obviously Europe isthe only place on earth that has a trading scheme that allowsCER usage. But let's say the Japanese and the Canadiansstarted taking their Kyoto targets seriously then the CERprice would deviate more from the EUA price because they'llbe other demand drivers.

TA: Is the scheme working?

MM: That's the $64 million question. You could say is "Isthere any point in the Europeans doing what they're doingwhen emissions in China and India are growing so strongly?"But that's the whole point of the Clean DevelopmentMechanism. People speculate what and if there will be anoth-er phase of Kyoto post 2012 and that is largely dependent onthe US, China, and India. It's going to be very interesting tosee what the second phase of Kyoto will look like. But ulti-mately whether the global fund of greenhouse gases is goingto go down enough through this mechanism I think is a verymoot point.

TA: If, after all this, Kyoto collapses, will that be the end ofthe EU ETS?

MM: The European Commission has said that there will bean emissions trading scheme whether there is a son of Kyotoor not. Europe will still be out there. Personally, I can't seethere not being a son of Kyoto. The interesting thing is whatwill son of Kyoto look like.

TA: But if there isn't a follow up to the Kyoto agreement,what's the point of Europe carrying on?

MM: I know what you're saying, but Europe has got somevery strong environmental legislation in all spheres that isunilateral and I think they see themselves as a bit of a stan-dard bearer. I think they will carry on.

The next American election is going to be, for me in mylifetime, the most interesting American election there's everbeen quite apart from the fact that the democrats are goingto have a black candidate and a female candidate runningagainst each other in the interim. But what's going to be real-ly interesting is once the Republicans and Democrats comehead to head, because one of the possible Republican candi-dates is McCain. McCain is a co-sponsor of theRepublican/Democrat McCain-Liebermann cap and tradebill. This is something they are tring to do to push theAmericans into accepting targets for Greenhouse gases.Hitherto, environmental issues have tended to divide alongpolitical lines - right against environmental legislation and leftfor it. In America, we're going to see something completelydifferent - a cross-party approach. After all, the most strin-gent American measures currently have been put in place bya Republican governor in the 8th largest economy in theworld. If McCain gets in, the world will be different from anAmerican point of view. And if a democrat gets in, all theblue states are the ones behind the Regional GreenhouseGases Emissions agreement. Whichever way, America iscoming into the global warming world and it's going to bereally interesting to see what the post-Bush administrationlooks like.

Software


REUTERS NEWSSCOPE

Automated trading systems usu-ally rely, to a large degree, ontechnical analysis based tools

incorporating such things as indicators,momentum studies and moving aver-ages into their models. The mathemati-cal nature of these studies means theyare easy to programme and have theadvantage of generating unambiguousbuy and sell signals. Incorporating fun-damental information, including bothnews and statistics, into such models ismore complicated as such informationusually has to be interpreted by a traderfirst because newswire releases are nottypically machine readable.Furthermore, the nature of marketnews releases means many are non-mathematical and so not easily pro-grammable, even if a model based onnews has been developed.

With NewsScope, Reuters has effec-tively managed to leverage their hugeback catalogue of news releases into adata source product. NewsScope allowsmachine readable Reuters news to beincorporated into event and fundamen-tal news driven automated trading sys-tems. It comprises two products:"Reuters NewsScope" and "ReutersNewsScope Archive".

Reuters NewsScope ArchiveReuters NewsScope Archive is a datasource that provides historic Reutersnews for analysis and back-testingwhen building an automated tradingmodel. Used with Reuters DataScopeTick History - an archive of tick-by-tick

price data - traders can track previousnews releases and price data to searchfor correlations, patterns and relation-ships between news events and marketmovements. These can then be used toform the basis of an automated tradingmodel by generating buy and sell sig-nals when these relationships re-occurin the future. The product gives thetrader the option to filter the Archivefor different markets, news stories andevents and discover which stories, andtypes of story, have typically affectedthe markets being traded. The tradercan then quantify this impact into aprogrammable model.

Reuters NewsScope Once the trader has developed theirautomated trading model and is nowready to trade, the product then pro-duces live news content that can gener-ate buy and sell signals based on thetrader's programmed model. Reutershas emphasised that a major advantageof using NewsScope when tradingcomes down to speed. Because newsreleases are "meta tagged" to be easilyidentifiable and machine readable, atrade can be executed within millisec-onds of the release of a news story.Therefore, by anticipating how themarket will respond to a given newsrelease, the trader can execute a tradeahead of the market.

Automated trading The problems associated with usingnews stories and fundamentals in an

automated trading model are its ambi-guity and basis risk, in short, the possi-bility of false buy and sell signals beinggenerated. According to RichardBrown, NewsScope business managerat Reuters in New York, these are validfactors; "ultimately, the user needs toestablish confidence in the patterns heor she has found in historic news sto-ries." These are issues that are not typ-ically associated with technical basedmodels; either the price has gone abovethe 200-day moving average or it hasn't.

But news stories relating to corporateearnings, economic data and politicalnews can be ambiguous and interpretedin more than one way.

Brown adds, "By analysing the neteffect of a new announcement andestablishing the percentage of the timethe market reacts in a particular way,you have the basis of a trading system,or the addition to an existing system".A rise in interest rates by the US Fedcan be either positive or negative forthe dollar, depending on, among otherthings, the prevailing economic situa-

We look at Reuters’ recently launched NewsScope product and examinehow it can be used to incorporate news and fundamental data into anautomated trading system.

REUTERS HAS MANAGEDTO LEVERAGE THEIR

HUGE BACK CATALOGUEOF NEWS RELEASESINTO A DATA SOURCE

PRODUCT.


Software

tion in the US and market sentiment.The answer to this, says Brown, lies inthe balance of probabilities. "For exam-ple, if a Fed rate hike has historicallyled to a dollar rally 70% of the time,then 7 out of 10 trades done of theback of a Fed rate rise could makemoney." This is not just because the

direction of the dollar's moves is rightmore often than not; it is also becausethe trade can be executed very quickly,before the major dollar move in themarket has happened. It's also a matterof timing because an automated systemwill react much more quickly than ahuman being and execute a trade with-in milliseconds of a news story.

Reuters say the ability to use newsstories as part of an automated tradingstrategy has two uses; one is for specu-lators looking for alpha and the otherfor investors who are looking to man-age event driven risk. However, as far asautomated trading goes, the hedge fundand bank proprietary desks would seemto be the obvious end-users of theproduct.

How it worksReuters NewsScope Archive lets yousee every stage in a story's developmenttick by tick through the day, not just thefinal article. It allows the user to replaymarket behaviour, from the initial alertthat hits the wire and notifies the mar-kets of a new development, through tothe publication of the full story andsubsequent updates, clarifications and

corrections.All the data in the archive is time

stamped and tagged with an array ofmetadata fields for easy machine read-ing to the nearest millisecond to allowtraders to track the story as it unfoldedand understand the immediate effect ofeach news event as word reached the

market. Each story is also tagged withmetadata that describes the story andallows it to be pieced together overtime. As such, Reuters say, NewsScope

enables the automated system toprocess much more news, far morequickly and consistently than humanoperators. The kind of news that canbe analysed and identified ranges from

economic data releases, political news,legislation to corporate earnings andgeopolitical events. These can be com-pared against the full range of marketsand asset classes.

Content from Reuters NewsScopeArchive is supplied in CSV data files

using Unicode UTF-8. The archive canalso be loaded easily into Oracle 9i,Oracle 10g and Microsoft SQL Server2000 and 2005 databases.

Quantifying sentimentAccording to Reuters, the volume ofnews stories alone for a particular mar-ket or company can be used as a guideto market volatility. But by examiningthe stories within the Archive, usersmay analyse what Reuters calls, "keyword tonality and sentiment scoring".For example, the words "misses" and"exceeds" that appear in corporateearnings news releases can be tested asto the impact they have on the compa-ny's share price. By identifying andquantifying "positive" and "negative"news for a particular security, an indica-tor can be developed that can be usedto trigger buy and sell signals. Forexample, "buy" when the ratio of posi-tive to negative news exceeds a pre-determined ratio or moving average or"sell" when the ratio of positive to neg-ative news falls below a certain level.

More information can be found at:reuters.com/newsscopearchive

“BY ANALYSING THE NET EFFECT OF A NEW ANNOUNCEMENTAND ESTABLISHING THE PERCENTAGE OF THE TIME THE MARKET

REACTS IN A PARTICULAR WAY, YOU HAVE THE BASIS OF A TRADING SYSTEM.”

-RICHARD BROWN, REUTERS

Richard Brown

Ichimoku Charts By Nicole Elliott

Harriman House ISBN: 1-897-59784-3 139 pages£24.99

Nicole Elliott is a technical analyst at Mizuho Corporate Bank in Londonand is a well known specialist on Ichimoku charting. Much of thebank's research she produces uses Ichimoku, or Cloud Charts, as they

are also known and her book, which has been in the works for some time, is awelcome and much needed introduction to a subject that has been attractingincreasing interest from traders and analysts.

For those looking at these charts for the first time, they can seem overly com-plicated with different coloured 'clouds', price lines and moving averages.However, their construction is reasonably straightforward and, more important-ly, their interpretation is not difficult despite first impressions. In fact, Ichimokucharts remove much of the subjectivity that is especially associated with patterninterpretation and they highlight very clearly the major trend (if there is one),where the major buying and selling pressure exists, and potential turning pointsin the market.

Whilst several other banks, including Goldman Sachs, use Ichimoku in itsclient research, it is not, as yet, a widely used technique by European and UStraders although according to Elliott, the charts are used extensively at Japanesebanks both in Asia and Europe. At least in the UK, there has been some debateover whether the charts can be used in non-Japanese markets and I have spokento several analysts who maintain that the charts only work well on Japanese mar-kets such as the Nikkei and Yen. Elliott appears to dispel this claim by usingnumerous examples of Ichimoku charts being applied to US and European mar-kets across various asset classes. She also gives many examples where Ichimokuprojections have worked well - and gives assurances that these haven't been care-fully selected for the sake of the book.

Rick Bensignor, technical analyst at Morgan Stanley in New York, is perhapsthe best known advocate of Ichimoku but his much awaited book on the sub-ject has so far failed to materialise. Ichimoku charting is now available on mostof the major charting packages including Bloomberg, Reuters, CQG andUpdata, and Elliott's book provides a clear, easy to read and concise overviewfor anyone interested in using Ichimoku charting in their trading.

Ichimoku Charts is available with a 34% discount from the Technical Analystbookshop at Harriman House. To order please call 01730 233870 and quote,"The Technical Analyst magazine".

ICHIMOKU CHARTS


Books


DETRENDED PRICE OSCILLATORS

If you are looking to develop ashort-term or day trading strategythe removal of an underlying long-

term trend can be a useful exercise. Bydetrending the data, you can backtestyour strategy to see if it would still havebeen profitable without the help of alonger-term bull or bear trend. Butwhat is the best method for detrendingdata before applying a model to it?

A simple linear regression is notappropriate since the trend is likely tochange several times over its timespan.As such, traders and analysts often lookto apply filters, such as a Hodrick-Prescott filter, or other statistical analy-sis, such as a fourth order polynomialtrend function. A Hodrick-Prescott fil-ter, for example, is a method for fittinga smooth trend line to a data series. Tothen detrend the data, it's just a matterof subtracting the "trend" from theseries.

The DiNapoli DetrendedOscillatorA more simple method, often availableat the click of a button in many chart-ing packages and trading platformssuch as CQG and GFT Forex, is adetrended oscillator. This involves theidentification of a moving average thatcorresponds to the mid- to long-termtrend (whichever you're looking toeliminate) and subtracting that from theprice. One example of this is theDiNapoli Detrended Oscillator study(see Figure 1). It measures variations ofprice about a zero line that representsthe trend, hence creating a detrendedtime series. The trend is first defined asa given moving average, and then math-ematically computed to make that aver-age a constant or a zero line.

The DiNapoli Detrended Oscillatorformula is derived from the close(today), minus the seven-day simplemoving average of the close. You can

also change the parametersfrom the default setting,such that there are twoinputs: Price (select close,mid, high, low etc) andPeriod (the "N" number ofperiods for the movingaverage).

Detrended price oscilla-tors (DPO) also have otheruses. Trading platformsand charting providersdescribe other situations inwhich they can be used; namely to 1)spot situations when an instrument istrading at historical extremes relative toits average price, 2) identify turningpoints in longer cycles, 3) classifywhether a trend exists or not, 4) viewoverbought and oversold market condi-tions, and 5) as with momentum indica-tors, look for divergences between theDPO and price to identifying potentialreversals in trend. As such, this indica-tor is powerful and versatile, and canpotentially be applied in a variety ofeasy-to-use strategies for trading.

John Ehler's methodAlso of interest is the work of JohnEhlers of Mesasoftware. Ehlers hascome up with a technique borrowedfrom modern signal analysis and whichis used in radar technology, where fixedobjects are analogous to the long termtrend and moving objects are analo-gous to the cycles we're trying to keep,analyse and trade on. In essence itinvolves subtracting the price "N" barsago from the current price. This "N"bar momentum function removes thestatic, or average, price component.The methodology is more complexthan suggested here but Ehlers pro-vides full details and EasyLanguagecode in his paper, "The Joy ofDetrending”, available from his websitewww.mesasoftware.com.

In reality we have to be careful whatwe want. What is the nature of the sig-nal? Does it have a varying trend, sea-sonality, or jumps? Do you want or canyou accept a detrended series that leadsthe signal or must it be recalculatedwith each new data point?

For example, often we are actuallyconcerned with splitting the data intothree components: the high frequency"noise," the very low frequency"trend," and the signal that you want totrade on. In such cases you should usea bandpass filter because it lets throughonly the middle frequency bands. Oneway to do this is to use a givensmoother with two "smoothness" set-tings. The difference between the light-ly-smoothed data (high-frequency noiseremoved) and the heavily-smootheddata (the long-term trend) is the medi-um-term dynamics of the signal.

As a word of caution, whilst detrend-ed data can be helpful for assessing theperformance of a trading model, itwould probably not be advisable to useit in isolation, either in terms of back-testing or for actual trading. Someargue that prices are what they are,someone paid them and that detrendedprices are therefore meaningless.

Sources: GFT Forex, Aaron Brownon Wilmott Forum andwww.mesasoftware.com.

What is the best method for detrending data before applying a model to it?

Figure 1.


While the fund blow-ups and star per-formers grab all the headlines, howdoes the average fund perform? Thereare a number of hedge fund indicesthat track the performance of thesemanagers, and it is instructive to exam-ine their results. A main difficulty isthat there is no reliable snapshot of thehedge fund universe. Ongoing researchby Fung and Hseih at the LondonBusiness School [2006] reveals thatonly 3% of funds are represented in allfive major hedge fund databases.

Malkiel and Saha (2005) found thatwhen examining the CSFB/Tremontdatabase compiled by Tremont CapitalManagement from 1994-2003, backfill-ing bias overstated returns by 500 basispoints while survivorship bias inflatesreturns by 374 basis points. In anoth-er study of the CSFB/Tremont data-base from 1995 to 2004, Ibbotson andChen (2005) determined survivorshipand backfilling biases added 247 and484 basis points to returns, respectively.In response to the paper authored byMalkiel and Saha, Van and Song (2004)

present a good overview of the differ-ences between hedge fund databasesand hedge fund indices.

Hedge fund indicesHowever, before examining theseindices a careful distinction must benoted: there exists a large difference inhedge fund databases and hedge fundindices. A database is simply a collec-tion of hedge funds and their returns,and very likely will be replete with sur-vivorship and backfilling biases as evi-denced in the previous papers. Indexreturns should be calculated on agoing-forward basis, and any additionsand deletions should be reported in realtime. Investable indices, if constructedproperly, should be free from theseaforementioned biases.

Van and Song countered that theMalkiel-Saha paper was focusing on thewrong target (databases), and that acorrectly constructed index should befree from most of these biases. A fur-ther examination by GreenwichAlternative Investments (2007, pressrelease) compared the broad hedgefund indices vs. their investable coun-terparts for four hedge fund indexproviders from 2003-2006. WhileGreenwich-Van's tracking error wasless than 1%, the three other indicessuffered from over 400 basis pointsoverstatements.

Hedge Fund Research publishesindices that track the hedge fund uni-verse back to 1990, and we will examinethe relative performance here becauseit represents one of the longest histo-ries for a hedge fund index. The HedgeFund Research Weighted Composite(HFRI) is an equal weighted index of

over 1600 hedge funds, excluding fundof funds, and results in a very generalpicture of performance across thehedge fund industry. The Hedge FundResearch Fund of Fund Index (FOF) isa similar index with approximately 750fund of funds included.

A couple characteristics of the indexmethodology must be noted. Becausethe indices are equal-weighted, andthere is no required asset-size minimumfor fund inclusion, the results will bebiased to smaller fund returns. Therewill be some survivorship bias in theresults due to poorly performing man-agers electing not to report their per-formance. It is difficult to determinethe effects of this bias, but a compari-son of the HFRX indices (theinvestable version, available only since2003) and the HFRI (a financially engi-neered time series) indices could give aclear view of any tracking error. Ananalysis we conducted found the effectto be over 400 basis points for eachsub-strategy - a very material difference(But less than the 5.7% differenceGreenwich found).

Historical returnsWith the understanding that the hedgefund indices returns will likely be over-stated, we present the year-by-yearresults of the HFRI (Hedge FundResearch Fund) and FOF (fund offund) indices. As a comparison, wepresent a passive buy and hold portfo-lio that equally weighs five diverse, liq-uid, and publicly traded asset classes.They include the Standard and Poor's500 Index (S&P 500), Morgan StanleyCapital International DevelopedMarkets Index (MSCI EAFE),

COMPARING RETURNS: MARKET TIMING VERSUS HEDGE FUND INDICESby Mebane Faber

Many billions of dollarsare allocated to hedgefunds and CTAs world-

wide in the search for better risk-adjusted returns. Names such asSoros, Tudor, and Cohen generateimages of individuals who haveaccumulated vast fortunes runningfunds over the past few decades.Managers of these funds get paidlarge amounts of money to over-see client capital; generally in thevicinity of 2% of assets and 20%of performance.

1Backfilling Bias - Historical results are added, and funds are more likely to report after strong performance. Survivorship Bias - Tendency of failed funds to beexcluded from databases because they no longer exist.

→→


Goldman Sachs Commodity Index(GSCI), National Association of RealEstate Investment Trusts Index(NAREIT), and United StatesGovernment 10-Year Treasury Bonds.The portfolio is labeled ("AA") forAsset Allocation.

An active strategy is also included("TIMING"), the logic of which isdescribed in our paper [2007], "AQuantitative Approach to TacticalAsset Allocation". The leveraged ver-sion is labeled ("2X"). The simple rulesare below:

BUY RULEBuy when monthly price > 10-mmonth SMA

(simple moving average).

SELL RULESell and move to cash when monthly price <

10-mmonth SMA.

All entry and exit prices are on theday of the signal at the close.All data series are total return seriesincluding dividends, updated month-ly.Cash returns are estimated with 90-day commercial paper, and marginrates are estimated with the brokercall rate.Taxes, commissions, and slippageare excluded

Comparing the HFRIFor an apples-to-apples comparison,we have omitted any management feesto invest in either the hedge fundindices (index provider fees) or the tim-ing models (ETF, mutual fund fees).Both should be on the order of 20 to100 basis points.

Interestingly enough, even withoutmaking any adjustments for survivor-ship biases, the buy-and-hold asset allo-cation is nearly identical to the FOFIndex across all measures except forcorrelation to the S&P 500 (Table 1).The timing model beats both buy-and-hold and the FOF Index with a higherCAGR (compound annual growthrate), and lower volatility, drawdown,and worst year.

The 2X levered model likewise com-

pares very favorably with the HFRIndex, with slightly higher CAGR,higher volatility, and lower drawdown.Even more intriguing is that all of thestrategies come incredibly close to thesame number of positive months.

Figure 1 depicts the equity curves ofthe two timing models, the two hedgefund indices, and the S&P 500.

The timing models' yearly correla-tions of returns are in the .50-.60 range,

while the FOF index is .34, and theHFRI is .63. This makes intuitive sensebecause the timing model includes theS&P 500 as a 25% component of theportfolio. Removing the S&P 500 andequal-weighting the four remainingindices results in near identical risk andreturn figures with a drop in correlationto .26. Table 2 presents this evidence.

Table 1. S&P500, asset allocation, timing, leveraged timing, and hedge fund indices,1990-2005

Figure 1. S&P500, timing, leveraged timing, and hedge fund indices, 1972-2005, non-log

1.

2.

3.

4.


Comparing CSFB/TremontThe CSFB/Tremont Hedge FundIndex is asset-weighted, and all fundsmust have a minimum of $50 million inassets under management, a minimumone-year track record, and currentaudited financial statements. There areapproximately 900 funds in the index,no FOFs are included, and perform-ance is net of all fees.

The Greenwich-Van Global HedgeFund Index includes approximately2000 funds that must have a minimumone-year audited track record, open tonew investment, a minimum of $20 inassets, and a US dollar share class mustbe available.

A simple buy-and-hold of diverseasset classes would have produced nearidentical results as the CSFB/Tremonthedge fund index, although lagging theVan Index in CAGR (Table 3). Theresults of the timing model were supe-rior in every measure of risk and returnversus the CSFB-TASS Index. The

timing model outperformed the VanIndex on a risk-adjusted but not on anabsolute basis.

ConclusionsWe examine the various hedge fundindices, and find for the most part, thata simple buy and hold passive assetallocation can achieve similar returnand risk numbers. Moreover, applyinga more active strategy results in betterrisk-adjusted performance figures thanthe hedge fund indices. Additionalbenefits of investing in either a passiveasset allocation strategy (AA) or anactive strategy (TIMING) vs. the hedgefund indices are numerous:

Access - Many of the best hedgefunds are not open to new invest-ment capital, and many that are havehigh minimum requirements.Transparency - The investor con-trols and is aware of the exact hold-ings at all times. Fraud risk is elimi-nated.Liquidity - The investor can tradeout of the positions at any time, ver-sus monthly or longer lockups athedge funds.Risk targeting- The investor cancontrol the hedging and leverage tosuit his risk tolerances. Blow up riskfrom derivatives is eliminated.Tax management - Hedge funds aretypically run without regard to tax

implications, whereas the trader canmanage the positions in accordancewith the clients tax status in mind

One argument for inclusion of thehedge fund indices is diversification(which used to be an excess returnargument in the early years of theindustry). Even though the passive andactive strategies come close to thereturns of the indices, they bear littlecorrelation (< .5) in both cases. Anargument could be made that the idealportfolio would consist of some expo-sure to a passive asset class portfolioand hedge fund indices.

Mebane Faber is a portfolio manag-er at Cambria InvestmentManagement, a California-basedhedge fund.

ReferencesFaber, Mebane, 2007, "A QuantitativeApproach to Tactical Asset Allocation,"The Journal of Wealth Management,Spring 2007.

Fung, William, and David Hsieh, 2006,"Hedge Funds: An Industry in ItsAdolescence," Federal Reserve Bank ofAtlanta, Eoconomic Review, FourthQuarter.

Ibbotson, Roger G. and Chen, Peng,"The A,B,Cs of Hedge Funds: Alphas,Betas, and Costs" (September 2006).Yale ICF Working Paper No. 06-10.Malkiel, Burton G, and Atanu Saha,2005, "Hedge Funds: Risk and Return,"Financial Analysts Journal, Vol. 61,Number 6.

Van, G. and Z. Song, 2004, "Malkiel-Saha Hedge Fund Paper Flawed,"Working paper, December.

Table 2. Excluding S&P 500 from the tim-ing model.

Table 3. Additional Indices

1.

2.

3.

4.

5.

April - July 2007

25 April Introduction to Technical Analysis London, UK

22 May Introduction to Interest Rate Spread Trading London, UK

24 May Introduction to Pairs Trading London, UK

29 May Introduction to Technical Analysis Hong Kong

30/31 May Advanced Technical Analysis (2 days) Hong Kong

30/31 May Automated Trading Workshop (2 days) London, UK

13 June Advanced Candlestick Charting London, UK

14 June Introduction to Behavioural Finance London, UK

19/20 June Automated Trading Workshop (2 days) Frankfurt, Germany

02 July Introduction to Technical Analysis Moscow, Russia

09 July Introduction to Technical Analysis Milan, Italy

10 July DeMark Indicators Milan, Italy

12/13 July Advanced Technical Analysis (2 days) Dublin, Ireland

GET QUALIFIED IN TECHNICAL ANALYSIS

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The Society of Technical Analysts (STA) represents and accredits professional and private Technical Analysts operating in the UK

Originally established in the 1960s, the STA provides its members:• Education Monthly lectures and regular teaching courses in technical analysis

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