THE SPECULATOR
Prepared by Berkeley Futures, Ltd.
Stuck In The Doldrums
A number of Japanese analysts were rather surprised that the equity sell-off which started in the Far East did not, initially, take a greater toll on the Nikkei index.
Japan's already fragile economy was sent reeling by the decision to raise sales tax from three percent to five percent in April of this year. For months officials denied that the slump in demand was anything other than a temporary phenomenon and resolutely adhered to their 1.9 percent growth target for the current financial year. However, as the economic news has got steadily worse, they have had to acknowledge that the problem is more deep-seated than they originally thought. Gross domestic product fell by 2.9 percent in the second quarter of the year and some economists are predicting that the third quarter will also come in as a negative figure, thereby technically putting the economy into recession.
The government's policy options are extremely limited. There is little room for manoeuvre on the fiscal front since the budget deficit is already running at seven percent of the gross domestic product and the prime minister, Ryutaro Hashimoto, is pledged to reducing this figure to three percent. A mini fiscal package was announced last week but mini this is not expected to have any significant impact on the economy. With short-term interest rates already at zero, there is little that can be done on the monetary front to stimulate demand.
The classic response to this kind of policy impasse is to devalue the currency and the Bank of Japan has allowed the yen to slip gradually against the dollar and European currencies. But the resulting increase in Japan's trade surplus has brought renewed calls for trade restrictions. Against south-east Asian countries' currencies–which account for 18 percent of Japan's exports–the yen has, however, experienced a large appreciation.
The turmoil in the equity markets has focused investors' minds on the state of the underlying economies and it is not surprising therefore that, in the second wave of selling, the Nikkei has came under heavy pressure. This fall in share prices could add a further deflationary twist to the economic vortex.
Under Japanese accounting practices, part of unrealized equity gains are included inf a bank's capital base. The move below 16,000 on the Nikkei Dow index effectively removed this equity `cushion' from a number of the major financial institutions, leaving them more exposed to bad loans. Unfortunately the financial upheaval in the region is likely to result in a rise in the overall level of nonperforming debts. It is estimated that, at a level of 14,700 on the Nikkei, the unrealized profits of the 20 largest banks would be wiped out. At this point, the risks of a systemic collapse–whereby the failure of a major institution impacts on others producing a domino effect–increases considerably.
A wide-scale banking collapse in Japan would send a shiver through the rest of the world's equity markets and so even investors not involved in this area should keep a close eye on the Nikkei.
How To Incorporate Chaos,
Fundamentals And Cycles
Chaos Theory Is Useful To Investors
The study of chaos theory is based in physics but it has quickly been found to apply to almost every discipline dealing with natural systems. The equations involved in chaos are very complex and often insoluble. However I believe that you never learn much by starting your studies on your finals. It is better to begin with basic subjects of a similar type. After the principles underlying simple structures are understood more complex systems may be soluble.
Applying this principle to markets we begin with the observation that markets are made up of bulls and bears in competition. Either side can only win temporary because both crowds are interdependent. This means the market is a classic chaotic population growth system with two species in a dynamic predator-prey relationship, rather like foxes and rabbits, cheetahs and antelopes or polar bears and seals. An important point is that the ability of bulls to change to being bears overnight adds a strong feedback feature to our predator-prey system which would not be present in natural counterparts. This makes the market a much more volatile place than the predator-prey systems, but the same broad observations apply to both.
Previous studies into these predator-prey populations have shown that natural populations (i.e., in the wild) exhibit strong oscillatory or cyclical behavior, whereas laboratory populations show strong chaotic behavior instead. It is not definite what accounts for the different characteristics of the systems but the presence of a long evolutionary back history for natural populations may be important.
Another possibility, not necessarily a substantially different one, is the multiplicity of external factors affecting the natural systems. In short the many dissipating or entropic environmental drags on natural population systems, which are of course less prevalent or entirely absent from the more insulated laboratory systems.
My own view is that these two population types (laboratory/insulated and natural/dissipated) represent the opposite extremes between which all capital markets have their existence, assuming that the markets will assume some of the characteristics of both. Therefore we expect both cycles and chaos mixed together with secular growth/decline and also a strong response to any random external stimuli.
The following of this comparison of markets with other similar (in the sense explained above) animal/plant population systems leads us to consider certain observations about the underlying structure of markets:
Universal Observations On Complex Non-Linear (Chaotic) Systems
–Population grows until first bifurcation, when fixed point stability ends and is replaced by double point equilibrium (i.e., a cycle) with changing or evolving dimensions.
–More bifurcations follow making the system a 4- cycle, 8-cycle, 16-cycle and so on. Chaos is reached at 2 cycles. New cycles have a lesser height than earlier ones and are multiples of the wavelength of earlier ones. At the onset of chaos, the system contains an infinite number of subharmonic cycles.
–The cycles provide a gyroscopic effect giving a center of gravity for the system. This generates stability about an internal point. Interestingly, as cycles increase, so does noise–in proportion.
–As soon as chaos is reached, the number of chaotic bands decreases in reverse bifurcations, until a new cyclically stable window forms...the process starts again.
–The surprising thing is that the system does not get more chaotic. Instead we observe an infinite number of timeframes for which it becomes cyclic again. Inspection of the chaos zone on ever increasing magnification reveals more and more tiny zones of cyclic order which were previously unobserved.
–The transition to and from chaos is not at a random “flick-of-a- switch” but at a fixed acceleration.
–While in the chaotic region, randomness is high but is so as a result of masking caused by many new transients, not by the disappearance of old cycles.
Market Conclusions
These natural tendencies of populations of all species justifies our having the following expectations for markets to have:
–cycles;
–tremendous stability;
–self- correction ability to absorb and dissipate shocks;
–ability to handle growth by increased complexity instead of structural change;
–recurring periods of randomness invalidating all linear analysis techniques and fooling many statistical measures (e.g. historical volatility);
–fractal order (self- similarity) across time scales;
So, amongst other things, chaos theory tells us we have a strong rationale for looking at:
1. Cyclical analysis;
2. Long and medium term fundamental growth trends (represented by moving averages);
3. Repeating similarity of fractal pattern (price patterns and technical analysis).
Since most readers will already be aware of the values of charting and technical analysis, let us look now at the linkage between trends, cycles and technical analysis.
Price Movement = Trend + Cycles + Randoms
Cycle analysts look at markets from the viewpoint that total price action is firstly a basic underlying economic trend. To this, add a large number of cycles of varying dimensions representing the periodic actions of most market players with their respective timescales. Next, price movement attributed purely to random events is added. Normally this random action represents less than 15% of total price movement.
Work by researchers at the Foundation For The Study of Cycles indicates that most markets are 80-85% cyclic, so cycles should keep us in step with the market 80- 85% of the time. Risk/money management techniques are used to protect against the 15-20% of the time when random activity produces contra cyclical moves.
Working from a systems approach it is fair to say that trend equates to fundamentals, cycles to corrections of imbalance of over/undervaluation back to the system center of gravity and semi-random technical patterns to the assimilation of randoms by the market.
Fundamental Causes Of Cycles
The cause of cycles includes all kinds of regular and recurring fundamental events capable of affecting price valuations. However, it is preferable if we can understand what causes detected cycles. Here are some fundamental models underlying cyclic activity:
Political electoral self-interest causes periodic fluctuations. This is the cause of underlying the four year presidential election cycle, the 24-month congressional cycle and the United Kingdom three and a quarter to four year politico- economic cycles.
Many analysts hold the view that fundamental events are essentially random and cannot be allowed for in advance. But most fundamentals occur periodically. Take interest rates: the Bundesbank council meets periodically. Bond actions and refunding take place periodically. Employment and inflation statistics are published at regular intervals. Corporate reports are a major fundamental driving force which are again published periodically. Very few so-called randoms are what their name suggests. Close examination reveals that they tend to enter the market periodically, strengthening the existing cycles.
The periodic roll-over of a fixed publication sequence of multi-sourced reports/stats causes major equity and bond cycles. Examples of these include the quarterly returns giving rise to a 74-day equity cycle in the U.S. and half-yearly reports producing a 25 week cycle in the United Kingdom.
The market mechanism creates cycles. Option expiry dates underlie the 20-22 day cycle. Rolling out of short dated futures to avoid delivery causes cycles.
There are seasonal tendencies. Seasonality is a prime fundamental factor. Every year we see crop gluts after harvest followed by substantial falls in price. This rolls through the economy like a wave on a still pool and produces seasonal cycles in sectors apparently far from the source. Seasonals usually have an unique shape or pattern rather than a regular sinusoidal shape.
Extremely high or low prices create price-generated cycles, the hog cycle is an example, a sharp fall in price stimulates demand but supply has a fixed time delay before it can overcome demand and reverse the cycle.
Finally once-off cycles. These are very like seasonals but only occur intermittently. An example is the El Nino weather phenomenon. Once it begins, a sequence of cyclical events starts which must then run to conclusion. The 1992-1993 bull market in grains was a direct result of the El Nino.
The knowledge that a single observable event represents just the first of a predictable sequence of events due to follow inevitably over many subsequent days, weeks or months, is valuable knowledge enabling the accurate prediction of many fundamental shocks and forces before they occur.
A cycle analysis of the market factors all of the above fundamental events into our studies. For this reason, cycle analysis can be a rewarding exercise.
Dollar Peaking?
After two and a half years of dollar appreciation against the two other major currencies in the foreign exchange market, namely the Deutschemark and yen, a view has sprung up in the market that the dollar's supremacy may be coming to an end. The currency tipped to take over from the dollar is the Deutschemark because the market considers that, out of the three major central banks, the Bundesbank will run the tightest monetary policy over the next year or so. Also Europe is perhaps better insulated from the volatility of the Asian and Latin American markets. A number of analysts, however, do not share this view and, with fundamentalist opinion divided, it is perhaps instructive to examine the outlook for these currencies from a technical perspective.
Since the dollar peaked against the Deutschemark at Dm1.8910 in August of this year, we have already seen a significant downward correction. This has taken the form of a steep downward channel whose boundaries are currently defined by the trendlines at Dm1.7660 and Dm1.6770. Looking at this channel, one would anticipate that the next trendline to be tested would be the lower one. Also, during the course of this correction, the rate has crossed down below both the 60- and 200-day moving averages at Dm1.7714 and Dm1.7430 respectively, thereby adding to the bearish sentiment. But there is some technical evidence to suggest that the correction may be close to running its course, at least for the time being.
Obviously, the lower trendline of the channel should provide good support but there are other reasons to believe we are close to a short term bottom. The first relates to a pattern which could ultimately cause the dollar to move significantly lower. There is a possibility that the dollar/Deutschemark rate is in the process of forming a head and shoulders pattern. If this is the case, the left hand shoulder and most of the head have been completed, but the right hand shoulder still needs to be formed. This would suggest that a low should be seen somewhere above the standard support level at Dm1.6665, from which a sluggish rally should ensue. If this rally does not breach the Dm1.7385 level, the long term outlook for the dollar against the Deutschemark will be poor, with an eventual long term target of Dm1.4590 once support at Dm1.6665 gives way. The other reasons for looking for a dollar rally in this region are that Dm1.6816 represents a 38.2 percent retracement of the whole move from Dm1.3430 in March 1995 to Dm1.8910 seen in August. Also the slow stochastic (not shown) is giving severely oversold readings. So, on balance, a dollar rally should be seen shortly, but for this to turn into longer term strength, the resistance at Dm1.7385 will need to be taken out, followed by a break through the upper trendline of the declining channel.
The steep dollar correction against the yen took place between March and June of this year and has been followed by another strong rally. This appears to be moving within a channel, with the support trendline currently lying at ¥119.70, very close to the 200- day moving average at ¥120.00. The rate is currently testing the upper trendline, which is at ¥126.20. This is close to the strong resistance level at ¥127.45, which could prove to be the peak of the dollar's current upmove–especially as the RSI is moving into heavily overbought levels and the slow stochastic is already registering such levels. A period of consolidation is the most likely outlook but, if the trendline were to break, the immediate target would be ¥132.70.
November 17, 1997 Berkeley Futures. Ltd.
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