- 1997: Volume 6, No. 3 International Corner: Sitting Tight and Being Right

The main theme running through the major financial markets over the past year has been the spectacular rallies in bonds and equities, especially in the U.S. The driving force has been the realization that economic growth within the important world economies has been happening at a stable rate in a low inflation environment. This has enabled interest rates to fall, with all the associated benefits to the bond markets.

Indeed, in the past month the markets have generated a momentum of their own, with sentiment almost universally bullish. This has created a frantic rush to buy bonds and pushed yields to historically low levels.

What a contrast to the picture just over a years ago. When the Federal Reserve raised interest rates in February 1994, bond prices collapsed and produced one of the sharpest bear markets in recent history. Both sentiment and prices hit rock bottom in November 1994 and the mainstream view for 1995 was extremely bearish.

Of course this view did not prevail; the long-term trend turned upwards, wrong-footing many investors and analysts. Many people are now asking why it has been so difficult to isolate these major upward moves in 1995. If it seems more difficult to identify major trends than it used to be, the fault lies less with the market and more with the players.

Many investors would agree that the past two years have been a roller-coaster ride in the bond markets. Yet the increased volatility and seemingly random price action may be a result of enormous sums of money being thrown at these markets over very short periods of time.

The proliferation of computers over the last 10 years, together with the use of sophisticated software and associated models and trading systems, has convinced many big players to operate in a short-term time frame.

In my opinion this approach is extremely difficult to implement in an effective way. Apart from the small number of professional floor operators who deal in large volumes, with negligible exchange fees, the best opportunity for consistent profits and limited risk is to isolate the important trends, and then only trade in their direction. In effect, this prevents you from being distracted by the daily market noise, and gives a much more balanced perspective on price and trend action.

These aims are best achieved by using a technical approach that concentrates on identifying major trends, rather than trend prediction, with the inevitable problem of top or bottom selection. This method however, requires much patience and discipline to wait until a key trend establishes itself, and then to remain with it while it unfolds. Markets tend to travel much further than seems possible at any point in time. A good example is the U.S. T-bond, which has moved upward in a near continuous line, defying the many opinions that it is over-valued. A sound trend-following technique, combined with good money management, would have enabled an operator to capture a large percentage of this up move, provided the approach was based on a long term view.

To achieve these long-term aims the correct technical tools are required. A good starting point is a reliable source of data that can be retrieved on a daily basis (note: intraday is not required) together with an accurate historical data base. I use a combination of CRB (formerly Knight-Ridder) CD-Rom and daily update packages.

The ability to compile and view this data on a daily/weekly/monthly form is necessary, as the longer term charts are used to isolate the major trends, while the daily charts are used to isolate minor ones. The most important point of this methodology is the accurate identification of the major trends using a simple set of rules. Once this has been achieved, the next step is to wait for a reversal in the minor trend. This reversal should carry prices back some 50 - 62 percent of the move that reversed the major trend. An entry signal is given at this point.

Initiating a trade into a Fibonacci retracement zone helps to avoid entering a position into excessive strength or weakness, which is in effect, running blindly with the crowd. All too often, buying strength or selling weakness leads to a lot of pain, as the inevitable correction begins soon after you have entered your position.

Unfortunately the single most important task of identifying the ongoing major trend using the long-term weekly/monthly continuous charts supplied by the majority of data vendors is hampered by the basic inaccuracies apparent in many of these charts. They give a very distorted view over a longer period of time for many of the financial and agricultural markets because the contract roll over, with its inevitable price differences, tends to distort continuous charts with gaps. An obvious solution in the bond markets is to plot the yield, but this is not always possible.

CRB has found a solution to this problem with its historical and daily update packages. The data is extremely comprehensive, covering virtually every global financial and commodity market. The most important facet of this package is the ability to create a synthetically adjusted continuation chart. This facility calculates a backward cumulative adjustment for the difference between the current and previous nearby contracts, on the day specified for the rollover. This allows the creation of a more accurate continuation chart by adjusting the data to remove the rollover gaps. A simple example of the benefit of using this system can be seen from the following examples:

Figure 1 shows a standard continuous weekly chart of U.K. Long Gilt futures. According to my criteria, the long-term trend turned up during the early summer of 1995 with the rally in gilts to 109.12. This was followed by a minor trend reversal and prices fell to 102.07 by the middle of June, a 68 percent retracement. A buy signal was given between 50 and 62 percent of this retracement, marked at point A on the chart. The subsequent rally from this low in June failed to break the previous pivotal high by 14 ticks. This is marked at point B on the chart. Any long-term holder would have been extremely nervous about the failure to make a new high. However, using this unadjusted weekly chart with the standard rollover points gives a false picture of the price action.

Figure 1: Long Gilt Weekly

Figure 2 shows a synthetically adjusted weekly chart, which gives a much clearer picture of what happened. In fact, a new 1995 high was made at point B, maintaining the bullish stance taken in the middle of June from point A. This allowed the position to be maintained confirming that the major trend did not fail at point B. Furthermore, the decline to point A was an exact 61.8 percent retracement of the previous up move, which turned the major trend up. It seems that Fibonnaci retracement zones can be calculated to a greater degree of accuracy using this method, thus improving the entry point for this trade. This is a major improvement in the use of long-term continuation charts in the financial and commodity futures markets.

Figure 2: Synthetic Gilt Weekly

Although this may not be the quickest or most exciting way for many investors to reap large profits, it has the potential to produce impressive results if one is prepared to stay on board for the major moves. Go back and look at the extent of the moves in the bond markets in 1995 and reflect on that timeless saying from one of Wall Street's greatest operators, J. L. Livermore: "After spending many years on Wall Street, and after making and losing millions of dollars, I want to tell you this. It was never my thinking that made the big money for me. It was my sitting. Got that? It is no trick at all to be right on the matter. You always find lots of early bulls in a bear market.

Men who can be both right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a market operator has learned this that he can make big money."

Jonathan Green is a former technical trader with Lazard Brothers in London. In conjunction with running a farming business, he spends his time analysing and trading a wide variety of financial and agricultural markets-his strategy emphasises the importance of the long-term approach.