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[Eagle Eye]

WEDNESDAY a.m.
February 26, 2003



Fractals
by David Nichols

Every time I mention fractals and chaos theory -- which I use extensively in my work -- I get a bunch of e-mails along the lines of "tell me more". Some day I'll talk about all the really cool stuff I look at -- most likely in a seminar of some sort.

Chaos Theory is the study of the output patterns of non-linear dynamic systems, like the weather. While Euclid was a smart guy, Euclidean geometry involves reducing the world into straight lines, circles, squares, and triangles. Most market technicians use these Euclidean concepts of lines and geometric shapes, trying to reduce the markets down to something understandable in a Euclidean sense.

But the natural world isn't so perfect, and doesn't really resemble this Greek ideal. It's chaotic and dynamic, filled with turbulence and jagged edges. Chaos theory and fractals try to make sense of the turbulent swirl of the natural world, and in my opinion it's the only approach that makes sense when studying the markets.

You have to think of the markets as a natural organism, and treat it just like anything else in the natural world. It just so happens that this organism is made up of the actions and impulses of tens of millions of human beings. But the key to "understanding" the markets -- as much as this is even possible -- lies in studying it with a naturalist's eye. There is order and chaos in everything in the natural world, and the markets are no exception.

One defining characteristic of something that is fractal is that it is self-similar in all time-frames. At all levels of magnification, the same structures can be observed. In the markets, if you see an unlabeled chart, there is no way of knowing whether it is a 5 minute chart, a daily chart, or a weekly chart. Without labeling, it all looks the same.

Right now there is a startling similarity between the weekly chart of the S&P 500 (SPX), and its 60 minute chart.

Here's the weekly chart, followed by the 60 minute chart.





In both instances we can plainly see an important bottom, followed by a quick initial thrust to the upside. Then it gets interesting. On the pullback from the intial thrust -- a guaranteed chaotic output pattern, by the way -- we see that in both instances the decline was interrupted by a "solar flare" up (I call it that because that's what it looks like to me) before returning to the pullback line.





I point this out because, well, it's so fascinating. But there's also much more to this story, as the markets seem to be tracing out similar patterns in these short and long-term time-frames.

What both of these patterns is saying is that we're now due for a leg up. In the short-term, the leg up should extend beyond the intial thrust. But the long-term pattern is in a different spot, so it's not likely to show that sort of strength.

The daily chart is also showing that we're due for a move up. Coming off a bottom like that seen on Feb 13th, the markets invariably due a 1-2-3 move up. With the intraday reversal yesterday, it looks like the leg 3 up is beginning, which should carry the SPX up to about 870.



It's also important to note that the first white candle seen after the bottom, on Feb 14th, held strongly yesterday. The markets made a deep foray into that candle, but it was fully rebuffed back above it. That leaves a "hammer" candle from yesterday on the daily chart, which are always important candles. That long tail down generally provides a nice spring to further gains. Yet if the market turns around and quickly closes back down into the tail, then that can spell trouble. If a hammer is going to have its usual spring effect, it has to happen immediately.

So the market should follow-through today, but as I pointed out yesterday, follow-through is a scarce commodity these days. There was certainly no follow-through to the downside off the initial gap down yesterday. Yet by recapturing that first white candle off the bottom, the markets are now in a position to make an upside run. But they have to get going quickly.

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Sentiment Dashboard
by Adam Oliensis



SENTIMENT TANK: Is there a lot of fear in the market? The tank has been more than three-quarters full for 2 1/2 weeks now. The tank drained 2 points to 79% full of negative sentiment on Tuesday. How much fear should the market discount as war approaches? Curiously there's a fairly peaceful agreement in the marketplace on the subject. The level of fear/complacency has remained non-volatile. We're one shock away from attaining a climactic level of bearishness. Likewise any good news could cause fear to wane and the tank has a long way to drain. On the tank there's actually more room for a rally than a crash. As this afternoon's stock rally may attest to, the market might have the dry heaves. All that's going to be puked up may have already been puked up.

SHORT-TERM: The market may be reaching some sort of apex from which it will make a real price break. The hourly advance and decline phases are lasting even less time than usual. Today's morning decline phase gave way to an intraday rally that sent the short-term gauge into an advance phase mid-afternoon.

MID-TERM: The mid-term gauge progressed 1 point from 8 to 9% in its embryonic advance phase. The Confidence Diffusion Index popped back onto the "green" side of 0 to a reading of 1 in the advance phase, weakly confirming the buy signal.

LONG-TERM: The weekly gauge backed up again 1 point from 51 to 50% in its decline phase. Once again despite the 1-point backup on the weekly gauge , the slope of the oscillator remains negative because the important reading here is "weekly." The gauge is lower than it was last Friday, so it remains in a decline phase. The weekly CDI is at a bearish 2 out of 7.

NOTES ON CDI'S:

First, both CDI's are near to 0. That suggests that there is not a lot of momentum in the trends' directionalities. We can also see the lack of impulse power by the small moves the needles are making. During a strong trend the mid-term gauge will move 4-6 points/day. On this buy signal the mid-term gauge has been creeping up a point at a time. Not much umph to the developing advance phase thus far.

Second, yesterday we put in some minus signs on the CDI. That had some people perplexed. The CDI is derived by looking at 7 different technical elements. When an indicator is confirming the direction of the gauge it gets a +1. When it's neutral it gets a 0. When it's diverging from the gauge it gets a -1.

So in a mid-term DECLINE phase, for example, each bearish element gets a +1 and each bullish element gets a -1. Contrariwise, in an advance phase each bullish element gets a +1 and a bearish element gets a -1. If all the members of the array of indicators were to confirm the mid-term advance phase it would get a 7 in the CDI box. Under almost all circumstances the CDI will have a preponderance of bullish technicals when it's in an advance phase and a preponderance of bearish technicals when it's in a decline phase. Early in a trend the CDI will primarily rise and late in a trend it will begin to deteriorate. What's been interesting lately has been the hodge-podgey flittering and fluttering that so many of our indicators have done. That has at times put the CDI on the OPPOSITE side of zero from its gauge. I've had to tweak the CDI in order to describe the situation.

In the future, if the CDI ends up on the opposite side of zero from its gauge, we'll give it a "minus" sign. So, for instance, in Tuesday morning's Dashboard, the mid-term gauge was moving up weakly into a bullish advance phase, but when we looked at our 7 different technical elements, and added up the +1's, the zeros, and the -1's we ended up with a -1, diverging from the gauge and indicating less than no confidence in the advance. This afternoon all that turned around a bit and the mid-term CDI now shows still-low but positive confidence.