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September 01, 2006

The Technical Palette
by David Petch

The function of art is to stir an emotional response through a visual representation the artist is using as a medium. The artist that paints has a palette where primary colours are mixed to create secondary colours and other further mixed to create the desired colour. Every artist has their own style i.e. Renoir, Picassso or Munch could have a bowl of fruit put in front of them or be transported to a beautiful sunset on a beach by the ocean, yet the final canvas of each would be different. Painting has intense theory for colour, texture, etc. and above all practice, yet some people are born to paint and others have to struggle (as I do) to draw a stick man. My grandmother is a phenomenal artist but it was not on my chromosomal complement. Every artist could take the same courses, yet each has a different brush stroke and view. As Einstein said, it all is relative. When it comes to technical analysis of the markets, there are many great practitioners, yet each can capture an image of what to expect with different brush strokes.

While there are many aspects to different forms of technical indicators and approaches, I am going to focus on what I use and what picture it paints. The analysis may be one to two weeks old (by time it is released on the web), but it illustrates how conclusions were arrived at and what to expect. The components of each indicator I use will be presented in chronological order.

When performing analysis of any given sector, it is important to fundamentally examine the supply/demand dynamics, as this is the basis for any bull market. The real estate market had a stock market boom with low interest rates, which gave people an excess of money via using their homes as ATM's. This excess money allowed people to scale up to bigger homes and allow those that could not afford homes to step up to the plate. People buying up houses created a seeming shortage and the trend continued till it hit a bubble stage. A bubble stage can be defined by seeing the whites of first time investors trying to secure a house. As per a prior article, housing prices rising too high is truly linked to a combination of shortages and speculation. Smart speculators buy homes on the market early, mopping up supply, thereby creating an exacerbated shortage. When the top becomes nearer, the smart real estate folk will begin to dump their inventory on to the market to feed the demand, but not in a fast and furious manner to affect the pricing. At this point, speculation begins to take hold and everyone wants to have a portion of real estate for income. When everyone does this things will crash, not only from supply but also due to interest rates. The housing market is complex, because interest rates define the start and end of housing booms, but in areas such as BC and Alberta in Canada, it slows things down but supply/demand dynamics still rule.

Take the train of thought in the prior paragraph and apply it to the commodity bull market. Those that are purchasing gold, silver and energy stocks, bullion etc. are taking advantage of the early end of the supply demand imbalances that will exist in 3-5 years. You are in essence equivalent to the sophisticated real estate investor buying up cheap supply before a true shortage occurs. Most of the investing public will be on board when the commodity bull market has the next up leg and true shortages will exist in stock supply, which will be released at higher prices as per the real estate example.

The above paragraphs are a quick and dirty summary to describe how a supply/demand imbalance goes from a humble beginning to a boom and bust. There are many different technicals to analyze different sectors, but I will focus on the stock market, in particular the AMEX Gold BUGS Index.

When examining a given market or stock, it is important to look at daily and weekly charts to have confirmation from both different time frames.

Bollinger Bands

John Bollinger invented Bollinger Bands in the 1980's to capture the swings in volatility of a given stock/market. For an in-depth read on understanding Bollinger Bands, I would suggest purchasing his book "Bollinger on Bollinger Bands". Bollinger bands are a statistic applied to the markets. Traditionally Bollinger bands are set with a 20 day moving average (MA) and an upper and lower value multiplied by 2 x the 20 day MA standard deviation. A standard deviation is the variability in the pool of 20 data points on either side of the mean (average of all 20 data points). When the BB is increased to a value of 55, Bollinger recommends increasing the 2 value to 2.5 to take into account the increased volatility. For 34 day MA, I use 2.1. The following thread provides a suitable description of what a standard deviation is: http://coe.sdsu.edu/eet/Articles/standarddev/index.htm.

Figure 1

Bollinger bands are useful to provide an envelope around the charted data and may also be used to form Bollinger bandwidth. Bandwidth is most often used to quantify The Squeeze, a volatility-based trading opportunity. %B is used to clarify trading patterns and as an input for trading systems. With some tinkering, I found that overlaying Bollinger bands with 21, 34 and 55 settings produce interactions that can provide important signals for a topping or bottom formation. Each index or stock may exhibit a different pattern, so what I describe below is no hard fast rule but based upon the "behaviour of the HUI". As per Figure 1, every important turning point after a decline has occurred with the lower 55 MA Bollinger band curling down. Every important top has occurred with all BB's rising above the index and curling down, particularly the 55 MA BB (also, when tops occur, the lower 55 MA BB begins to curl up). When a top is put in as per the May 2006 top, notice how low the lower 55 MA BB was relative to the top. This indicates an extreme in volatility and must see a sharp contraction before the next upleg commences. The lower 55 MA BB is still low relative to the index, suggestive that any upward move is going to be a retracement of the decline. A total of 4-5 months time will be required for the lower 55 MA BB to rise to a position close enough to trigger the next upward move. The upper 55 MA BB is rising, suggestive the current upward move is not over yet.

All of this information is simply obtained from studying the interaction of Bollinger bands with the index under study. www.stockcharts.com has been revamped and beautifully handles the overlay of 21, 34 and 55 MA BB settings..........it does contain the 21, 34 and 55 MA lines, they are dashed, so it does allow for discrepancy between the upper and lower BB lines.

One important observation by astute market practitioners is that 21, 34 and 55 are all part of the Fibonacci number sequence. There is a brief section further describing what Fibonacci numbers and Fib retracements are etc. but to be brief, Fib numbers and ratios occur throughout nature and since they are the rythymn of nature, better to play with the orchestra than break out in a separate tune. In short, Bollinger bands are a simple, yet effective measure of volatility of any particular stock or index. A signaled contraction in volatility (by upper and lower lines curling down and up, respectively) indicates a correction/consolidation. Volatility does not lie and measures the rate of change in momentum. Having different time settings for BB's (21, 34 and 55) allows for market behaviour to be tracked over various time frames.

Stochastics

The best site on the web for a detailed summary of how indicators function is at www.stockcharts.com. The following thread is a direct link to the technical analysis description of all indicators, to see the description of stochastics, simply click on the stochastic link: http://stockcharts.com/education/IndicatorAnalysis/index.html. In brief, stochastics are an oscillator discovered by George C. Lane in the 1950's. The Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods. Closing levels that are consistently near the top of the range indicating accumulation (buying pressure) and those near the bottom of the range indicate distribution (selling pressure). As stated above, I prefer to use Fibonacci based numbers/ratios for most analysis. As such, the full stochastics I generally use are 8,3,5; 13,5,8; 21,8,13; 34,13,21; 55,21,34; 89,34,55 etc.etc. By having multiple plots of the full stochastics, trends can be identified at various time frames that have important underlying information. Figure 2 shows an important pattern in the full stochastics at the 34,13,21 setting. An expanding pattern occurred from August till May 2005, with a subsequent contraction. This is a formation for a diamond pattern and if the %K breaks above downtrending line of the potential diamond, it will signal an important breakout. I prefer full stochastics because of their flexibility and the importance of maintaining enough "air between the %K and %D. Crossovers of the %K below the %D at the top of the channel indicate a sell signal (overbought)., which the %K crossing above the %D at the lower portion of the channel (around 20) indicates a buy signal (oversold).

Figure 2

One other book I highly recommend is titled "Technical Analysis for the Trading Professional" by Constance Brown. Constance was taught some important tips about RSI by an expert whose name eludes me, but was in relation to positive reversals and negative reversals. To backstep for a minute, if stochastics trend upward while an index is advancing is declining further, this is a positive divergence; the market is going to be turning around soon. A negative divergence occurs when an index puts in a higher high while the stochastics have a defined upper down trend line.

Reversals are simply the opposite and have measured moves determined from the price action of the defined area they occur ( I prefer stochastics to RSI, so I took the principle of reversals and applied them to stochastics). Positive reversals occur when an index puts in a higher high, while stochastics decline further (Figure 3). Negative reversals occur when an index puts in a lower high while stochastics continue to put in a higher high. Reversals are important because they provide information for a minimal defined breakout based upon the net price action of the defined area they occurred. Referring to Figure 1, short-term stochastics (not full stochastics), are within a contracting wedge, implying consolidation. Depending upon the trend of the market, a break in direction will usually coincide with it. A break of the %K above the upper line of the wedge would signal a breakout, while a decline below the lower trend line of the wedge would be bearish. Examination of full stochastics at the mentioned settings for daily data (or shorter term if required) captures market behaviour at various time settings (the higher the values, the longer the trend is displayed).

Fibonacci Potpourri

Fibonacci was a mathematician from the 12th century who determined the value of phi, which is 0.618. This was based upon the numerical sequence 1,1,2,3,5,8,13,21,34,55,89,144 etc. etc. Fib ratios based upon this sequence revolve around phi and are 0.382, 0.50, 0.618, 0.786, 1.00 etc. etc. The sequence continues to 1.382. etc. There are smaller subdivisions of Fib ratios that can be derived, but for our purposes, the ones presented are of most interest. Fib price retracements are simply taking the lower portion of an index correction above the final spike low to the upper portion of an index below the spike high and determining the percent retracements of 38.2%, 50%, 61.8% and 78.6%. The determined values will indicate important support and resistance levels.

Figure 3

Going back to Constance Brown, her book had a very novel method of creating a map of future price advances. Rather than using Fib retracements, she explains using Fib price projections based upon the upward price action of upward trending wave price action projected off of the subsequent low. Simply, as per Figure 3, follow a clearly defined wave structure and base all future price projections off the subsequent low. I only did Fib price projections on Figure 3 for the time period between 2001 till 2003, projected off the lows of 2004 and 2005. Shorter-term Fib price projections could have been used, but I used these to show longer-term Fib based price projections. Fib price projections shown in Figure 2 are based upon shorter-term wave structures from multiple points. This creates a map that has certain areas of overlap. These overlaps form Fib clusters, which indicate important support/resistance levels. These clusters tend to act as magnets, so if an upward Fib cluster occurs in a market that has been defined as being in an upward trend, then it likely will resonate towards that target (Fib cluster at 405 on Figure 2).

Fibonacci values can also be used for time projections of indexes as per Figure 3. A defined segment of the index pattern was marked and subsequent projections of Fib points into the future are defined. There is not law that states a major event occurs on a particular Fib date, but tops and bottoms are routinely seen upon such occurrences.

I consider the type of indicators above as Primary Indicators much like a Primary Colour is used to create a Secondary Colour. The next section details what I consider to be a Secondary Indicator, based upon Fib structure, defined time points, pattern recognition etc. Many of the points mentioned along with others that are not are pooled into what is called Elliott Wave Analysis, or the most recent workings of it, "NeoWave". I will strongly suggest that individuals who seek to truly comprehend stock market action to purchase Glenn Neely's masterpiece book "Mastering Elliott Wave". There have been some additional tidbits of information added to his development of improvements to his NeoWave over the years and are mentioned towards the end of this article.

Elliott Wave

Although R.N. Elliott devised the basic frameworks of Elliott Wave Analysis in the early 1930's, Glenn Neely picked up where Elliott left off and expanded into a scientifically quantifiable tool. The basic premise of Elliott Wave is that the stock market tape dictates what the trend of the market. If people are bullish they buy stocks, if they panic, they sell. The infinite combination of greed and fear within a defined market cycle produces a defined pattern that will differ from any combination much like a snowflake, yet will posses a recognizable pattern that can be used to provide a market with a scaffolding pattern for which future price projections can be built. I am going to try and provide a few brief and simple rules, but Elliott Wave analysis is anything but simple. There are literally thousands of rules and is one of those things that requires practice to get the proper brush stroke. Below is a very compressed summary of Elliott Wave rules based upon the writings of Glenn Neely:

1. Start of new trending patterns occurs at a rapid change in the price action to the upside or downside. Sideways wave price action until that point is part of the prior pattern (also included is rule of neutrality).
2. Waves start out as a monowave, but added complexity forms a polywave, multiwave, with further complexity becomes a macrowave.
3. Wave structure of similar Degree must have similarity and balance with respect to price and time (no less than one third).
4. Construction rules: a) an impulsive segment must have 5 waves that form a trending or terminal-type of structure b) Three of the 5 segments must travel in the same direction with a correction after the first and third segments. The second segment can not retrace the first segment.
5. One of the impulsive segments of the five waves (usually but not limited to the third wave) must be either extended in time, price or complexity (greater number of subdivisions compared to the other waves): 2/3 of these must be met for a pattern to be considered impulsive, or it is not. Rules iv) and v) combined are used for determining if a pattern is impulsive or not.
6. Rule of Alternation: waves 2 and 4 (the corrective segments) must differ in time, price, severity, intricacy and construction. If there is no difference then the pattern under study is not defined as an impulsive Degree of one higher Degree.
7. Channeling: numerous rules on channeling to determine when a corrective structure or impulsive structure is complete.
8. Degree: Each wave structure when complete fits together into a higher Degree pattern (supercycle, cycle, primary, intermediate, minor, minuette, sub-minuette, micro, sub-micro).
9. Corrective structures: flats (3-3-5), zigzags ( 5-3-5), triangles in the limiting or non-limiting category (3-3-3-3-3) and also contracting and expanding varieties, Diametrics (3-3-3-3-3-3-3) which take the form of a bowtie or a diamond, and Symmetricals (nine 3's) which form a rectangular form of structure.
10. Fib relationships: Many different Fib relationships for each wave/corrective structure, the glue of Elliott Wave.
11. Pattern confirmation.
12. Construction of complex corrective structures (double combinations, triple combinations etc (small x-wave or large x-wave).
13. Trendline touchpoints.
14. Retracements based upon a power rating.
15. Emulation.

The above is an extremely condensed shorthand listing of NeoWave rules. To fully understand the art requires one to purchase the book and invest hundreds of hours to understand and correctly apply all of the concepts during analysis. The importance of understanding Elliott Wave is that counts have a certain probability of occurrence, which is why preferred and alternate counts exist. Wave counts put together must obey most of the rules and any wrong count will quickly be taken out. I generally use 10 minute data and end of day data for count construction. I have found going to the 1 minute level is like trying to kill a mouse with an elephant gun. It at times prevents seeing the forest from the trees. Shorter-term counts are required to fit into the higher Degree counts, but the short-term pattern dictates the future direction.

One item I have found to easily identify the construction of a data set that has not had an assigned pattern is to use something coined "Frame Shift Analysis" which was pioneered by the field of Biology with regards to identifying the location of genes responsible for coding proteins.

DNA is transcribed into mRNA that contains the coding of proteins through a pairing of three residues called codons. There are 64 codons, 61 of those coding for 20 amino acids, one to signal the starting point of protein translation and two to signal the termination of a translation. Consider the code, knowing that ATG is the start codon:

1  2  3
AGCCTATGACGTCCTTC. The 1, 2 and 3 represent different starting points from reading left to right, producing the following results:

Position 1 - AGC-CTA-TGA-CGT-CCT-TC etc. etc.

Position 2- GCC-TAT-GAC-GTC-CTT-C etc.

Position 3 - CCT-ATG-ACG-TCC-TTC

To determine the termination point of a template of RNA, simply repeat the process. The same form of analysis can be done for Elliott Wave analysis, knowing that impulsive segments (:5) are either strung into impulsive segments (5-3-5-3-5), flats (3-3-5) or zigzags (5-3-5). Applying the above principle can solve isolation of these patterns from a labeling scheme that seems unsolvable quickly. For example, take the pattern below of compressed patterns to: 3's and: 5's. Isolate potential patterns to see how they fit in different reading frames and if everything fits, then the chosen frame is most likely correct. Errors in labeling will become evident if no examined reading frames indicate a possible pattern. Note: all the labeling in this scheme MUST be done at the same Degree, otherwise the exercise is futile. Grouping is easy, wherever a :5 appears, if no surrounding :5's appear, group as 335 for a flat, if a 5-3-5 appears, put it as 535 to represent a zigzag. If there are a string of three 5's, put it as 53535. There should be a 3 between each 5 and should a double zigzag occur, further analysis will show this to be the case. This method is to quickly screen a pattern into some tangible count. Note that :3's can be grouped together in 3, 5, 7 or 9 in clusters so when choosing a reading frame consider the possible groupings around the :5 structures.

1  2  3
3-3-3-3-5-3-3-3-3-3-5-3-5-3-3-3-3-3-5-3-5-3-5-3-5

Position 1- 333-353-333-353-533-333-53535-35etc. The highlighted red areas indicate a nonsense pattern, as there is not such thing as a 3-5-3 or 5-3-3 pattern in Elliott Wave. This frame is the wrong frame to be viewing the count.

Position 2- 333-533-333-535-33333-53535-3-5 etc. The highlighted area indicates a nonsense pattern, so this is the wrong frame.

Position 3 - 335-33333-535-33333-53535-3-5 etc. This is a valid pattern, so the phase of the count appears to be intact.

This scheme above will require validation by applying the rules of Elliott Wave. I would highly recommend people learn the basics of Elliott Wave and to keep on practicing. Some people may catch on, while others may struggle. There has to be an innate aptitude for individuals to perform Elliott Wave, so what do I mean by that? If I were to take art lesson after art lesson, I may be able to do the rudiments of art, but I would lack the natural skill to take it to the next level. This is something people are born with or not, so if one has trouble "seeing" wave structures, accept the natural level that one has and do not go crazy.

In short, the tools of technical analysis have many indicators that I would refer to as primary indicators that help to gauge a market and provide short-term and longer-term hints of time duration, support/resistance levels etc. These primary indicators can be used to form a secondary indicator, such as Elliott Wave to take market analysis to a higher Degree of complexity for actually predicting future market activity with reasonable activity. An Elliott Wave count should not be viewed as if it were etched in stone. There must be some flexibility. The following two charts show analysis of the AMEX Gold BUGS Index on a short-term and longer-term basis.

Figure 4

The mid-term Elliott Wave count of the HUI is shown above. The count shown has all of wave [2] to date, with wave [3].III potentially underway (Figure 5 shows all the alternate counts). The triangle structure from last week has definitely broken out of the triangle, but there is a chance it could be morphing into an ascending triangle that could last for 2-4 weeks. If this pattern develops, the measured move remains 405, but it could get there in a hurry (i.e. ensure positions are owned in quality juniors that have high grade properties or are just starting production). I have labeled wave [2] as being complete based upon the wave structure..........but a move to 405 could also mark wave B.(Y).[2] of a non-limiting triangle forming. This would imply a consolidation until yes......mid December 2006 before the HUI takes off. Some simple notes to keep in mind. The HUI should reach 405, but the weekly Bollinger bands suggest it fall back within a subsequent trading range of 320-410 until December 15th, 2006.

Figure 5

The long-term Elliott Wave count of the HUI is shown above. The green line shows the thought path the HUI is going to have over the next 3-4 months. The alternate count is shown in grey, with the counts circled. Should the alternate count pan out, it implies wave III starts in mid-December and completes at some point in 2009. Wave IV would last for 2-3 years, with a final 2-3 year wave V. In either the preferred or alternate count scenario, 2009 marks an important point to consider selling stocks and switch entirely to bullion. The wave II labeling I have is compressed in time to what one would expect for wave II. Normally wave II will take the same amount of time or more than wave I before wave III starts. The alternate count would obey all normal NeoWave rules (Glenn Neely), but in a compressed market with a severely strong move, the space of time gets compressed and so too does the wave structures. Either or, the pattern that develops will be understood by 2008 as to the most likely beast unfolding. Unfortunately, the best we can do is to address the observations and allow it to bear fruit.

I hope this analysis (although a very long chew) provides further insight into the tools that are available for technical analysis and what I examine when I am looking at charts to construct a wave count. There are many many other indicators out there, so I suggest people become very knowledgeable of how to use 4-6. Excessive uses of indicators without a focus leads to the classic case of spreading oneself out too thin.

Have a good night.

David Petch
TreasureChests.info

Treasure Chests is a market timing service specializing in value based position trading in the precious metals and equity markets, with an orientation geared to identifying intermediate-term swing trading opportunities. Specific opportunities are identified utilizing a combination of fundamental, technical, and inter-market analysis. This style of investing has proven to be very successful for wealthy and sophisticated investors, as it reduces risk and enhances returns when the methodology is applied effectively. Those interested discovering more about how the strategies described above can enhance your wealth; please visit our web site at http://www.treasurechests.info.

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