Understanding the KST and Asset Allocation

Transcription

1 Understanding the KST and Asset Allocation 1

2 2 Understanding the KST and Asset Allocation

3 Table of Contents Introduction... 5 Chapter 1: The KST System... 7 THE MARKET CYCLE MODEL Chapter 2: Business Cycle Analysis THE BOND BAROMETER THE STOCK BAROMETER THE RULE OF THE INFLATION BAROMETER INFLATION VS. DEFLATION To order, please call or You can also FAX your order to or your name and complete shipping address, a credit card number and expiration date along with a daytime telephone number to sales@pring.com and we ll ship out your order within 48 hours of card approval! For further information on these and other products, please visit our web site at 3

4 4 Understanding the KST and Asset Allocation

5 T Introduction his booklet has been provided with your subscription or registration to provide an understanding of the principal techniques used in the InterMarket Review and Weekly Update Service, but it is also the basis for my analysis. When you grasp the concepts contained in this booklet, you will have a greater understanding of how markets relate to each other within the course of a typical business cycle. Having greater confidence in the conclusions and recommendations from your analysis, will better position you, both mentally and emotionally, to act. Unfortunately, the business cycle approach does not seem to work effectively with individual countries other than the U.S. This is probably due to the fact that external factors have a relatively smaller influence on the U.S. economy than on other countries. This booklet has been divided into two chapters. The first describes the principal technical vehicle used in the InterMarket Review and Weekly Update Services - the KST system. The second chapter deals with the business cycle approach and ends with a primer on the relationship between inflation and deflation within the business cycle and its importance for asset allocation. For additional information on the concepts in this publication and other educational materials, please visit our web site at Good luck, and good charting! Martin J. Pring 5

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7 I f you are driving a car in a strange city and need to get directions, it s easy to stop at a gas station and buy a map. Wouldn t it be great if you could also buy an investment map pinpointing the markets proximity to major tops and bottoms? There s never been such a map available - until now. My analytical approach, the KST Market Cycle Model, can help you by becoming your investment roadmap. The KST (Know Sure Thing) is a principal technique we use in all our analysis for identifying short-, intermediate- and long-term market trends. Of course, no system is perfect (hence its name) but the KST approach is dependable enough to help put the odds in your favor. The calculation of the KST assumes that prices at any one time are determined by the interaction of a number of different time cycles. Most momentum indicators or oscillators are based on a single time span and reflect only one of these cycles. It s as if you were guarding the door to a building. You could easily see The KST System anyone approaching that particular door, but would completely miss them trying to break in from the other entrances. The KST gets round this problem by including four different rate of change (ROC) time frames in its calculation. Each one is weighted according to the length of time span. The longer the span, the greater the weight. Since raw data can be very jagged and confusing, the KST is also smoothed so it has a deliberate ebb and flow. How does the KST System fit into the bull and bear cycle? Well, there are principally three trends followed by most investors. These are short, lasting about 2 to 4 weeks, intermediate, which lasts 6 weeks to as long as 9 months and the longterm, or primary trend, which encompasses an 11 month to 2 year span. Chart1-1 shows a longterm KST for the CRB Spot Raw Industrial Material Index. The swings in this indicator are slow and deliberate, but changes in direction are designed to signal trend reversals at a relatively early stage. Buy- 7

8 Understanding the KST and Asset Allocation ing opportunities typically develop when the KST is at, or usually below, zero and starting to turn up. The moving average has a 9-month time span. It is the crossovers of this average that trigger KST buy and sell signals. We can sometimes use changes in the direction of the KST itself. However, in some situations we find that the KST reverses direction and then quickly whipsaws back. In 1990, for instance, the KST started to move sideways but always remained below its average. The moving average approach filters out a lot of these whipsaw signals while retaining a good sense of timing. Not all whipsaws are filtered in this way, but most are. As an example, look at the 1993 experience. As long as the KST is above its moving average and is rising, the trend is considered to be positive. When it s below its moving average, it s considered to be negative. Obviously, the further this indicator moves away from the equilibrium or zero level, the greater the odds the trend will soon reverse. In such a situation, the trend is still CRB Spot Raw Material Index and a Long-term KST 8 Chart 1-1

9 The KST System positive, but the indicator is so overextended that the risks outweigh the rewards from the point of view of making new purchases, except for the most nimble of traders. The KST is a very useful indicator but it does suffer from some drawbacks. First, the longest time span used in its construction is 24-months. This makes it suitable for analyzing trends that revolve around the 4-year business cycle, discussed in detail later in this chapter. Most financial markets are sensitive to this time frame most of the time. However, when primary trends are truncated due to political or other random and unusual factors, price reversals develop a lot faster than is normally the case. The highly smoothed KST, on the other hand, cannot react so quickly, which means buy and sell signals develop well after the fact. Second, when bull markets are long and bear markets relatively short, the overall price movement encompassing two or more cycles appears on the chart as a linear trend which hardly undergoes a correction. The Japanese stock market in Nikkei and a Long-term KST Chart 1-2 9

10 Understanding the KST and Asset Allocation the 1980 s (shown in Chart 1-2) and the U.S. market in the late 1980 s to mid-1990 s, offer fine examples. During linear trends where there are very few cyclic rhythms, a momentum indicator such as the KST may give premature sell signals, while buy signals will be unduly late. For this reason, it s prudent to remember that KST buy and sell signals are just that - they are buy and sell signals for momentum, not price. Under normal circumstances, the price will go with the momentum, but there are many examples where this does not happen. Consequently, KST signals need to be confirmed with some kind of trend reversal signal in the indicator they are trying to monitor. We typically use a 12-month moving average as featured in Chart 1-1 for the CRB Spot RM Index. Alternatively, it is possible to combine KST signals with trendline breaks and price pattern completions in the price index itself. We also use KST indicators for identifying other types of trend changes, specifically short (2 to 6 weeks) and inter- Nikkei and a Short-term (Daily) KST 10 Chart 1-3

11 The KST System Lehman Bond Index and Two KST s Chart 1-4 mediate (6 weeks to 9 months). There are two types of shortterm KST. One is constructed from daily data, which is suitable for the timing of the futures markets, shown in Chart 1-3, and another derived from a longer time frame using weekly data, shown in Chart 1-4. The intermediateterm KST, also shown in Chart 1-4, reflects longer term price swings. The Market Cycle Model Since it s possible to construct KST indicators for short-, intermediate- and longterm trends, a useful approach is to combine them all on one chart. Figure 1-1 shows a typical market cycle. The thick line represents the primary trend, more commonly referred to as bull or bear markets. As mentioned before, they typically extend over a 1 to 2-year time frame. Primary trends are not usually straight line affairs but are interrupted by countercyclical price movements known as intermediate 11

12 Understanding the KST and Asset Allocation trends or secondary corrections. That s the thin line in the figure. These last anywhere from 6 weeks to many months and retrace between 1 /3 to 2 /3 of the previous primary movement. Secondary corrections usually develop because of a temporary change in the perceptions of investors towards the economic or financial outlook. In turn, intermediate trends are interrupted by even smaller ones lasting a couple of weeks or so. These short-term price movements are usually caused by random factors which have little or no bearing on the business cycle. They are represented in the figure by the dotted line. From an investment point of view, the best time to buy is when all three trends are bottoming. Unfortunately, this combination is rarely seen because the short- and intermediate-term KST s usually turn well ahead of the long-term series. Occasionally, it s possible to anticipate a long-term reversal. For example, if the long-term KST starts to flatten out from below zero, the short- and intermediate-term KST s trigger a buy signal and The Four-Year Business Cycle 12 Figure 1-1

13 Business Cycle Analysis the price completes a formation, crosses a moving average, or violates a moving average. The implied reversal in momentum will usually be strong enough to allow a reversal in the longterm series. The reverse set of circumstances would be true at the top of a bull market. This arrangement is also helpful once it s evident the long-term KST is in a bullish mode vis a vis its moving average, but is not unduly overextended. This arises from the principle that a rising tide lifts all boats. In other words, if the long-term KST is positive and not overbought, it s reasonable to assume the primary trend is up. Con- sequently, when the short and or the intermediate series correct and then reverse direction, this becomes a signal to buy. The KST Market Cycle Model consists of three oscillators that reflect the primary, intermediate- and short-term time frames as you can see in Chart 1-5 featuring the Swiss franc. The direction of the longterm KST tells us whether the primary trend is up or down and the level of its maturity. Market Cycle Model of the Swiss Franc Chart

14 Understanding the KST and Asset Allocation Stock/Bond Ratio and Three KST s Chart 1-6 Maximum profit opportunities occur when long-term KST reverses to the upside from below zero. When taking short-term positions, traders should first consider the prevailing position of the long-term KST. The most important thing to bear in mind is the direction and maturity of the primary trend. Short and intermediate signals that are triggered in the same direction as the main trend result in the strongest rallies, but signals that go against the main trend generally give false indications. 14 The KST Market Cycle Model can be constructed for any financial market influenced by the business cycle and also is very effective as a tool for relative strength analysis. Chart 1-6 shows the relative performance of stocks against bonds. These inter-asset relationships can be of invaluable help in the asset allocation process when combined with the business cycle barometers described later in this booklet.

15 T Chapter 2: Business Cycle Analysis he 4-year business cycle has consistently repeated itself since the beginning of the 19th century, when reliable statistics first became available. A typical cycle averages closer to 3.6 years in length and encompasses an economic expansion and contraction. The contractionary phase normally takes the form of a decline in the level of economic activity; i.e., a recession, but sometimes is limited to a slowdown in the rate of growth, known as a growth recession. When an expansion is particularly long, say six to ten years, it usually includes a growth recession where the economy pauses for breath, but doesn t actually contract. For example, the recovery that began in 1982 experienced a sharp slowdown in growth in 1984 and These double cycles are also associated with two complete mini stock and commodity cycles. This is an important point because the primary trend of the financial markets: bonds, stocks, and commodities, are determined by the business cycle. Idealized Business Cycle for the Six Stages of the Business Cycle Stage I Stage II Stage III Stage IV Stage V Stage VI Bonds Recovery Recession Stocks Commodities Bonds Stocks Commodities Figure

16 Understanding the KST and Asset Allocation Figure 2-1 shows an idealized business cycle. The sine curve represents the path of economic growth or contraction, while the horizontal line separates expansionary periods from those of contraction. History shows an economy undergoes a chronological sequence of events during a complete cycle, making it possible to identify turning points for various financial and economic indicators, as well as bonds, stocks and commodities. Figure 2-1 also shows these idealized juncture points for the three financial markets. The six stages of the business cycle can be identified. Stage 1 occurs when interest rates peak out; i.e., debt prices turn bullish, but stocks and commodities are still declining. Stage 2 is signaled when stocks join bonds in the bullish camp and Stage 3 when all three markets are in uptrends. You can make more intelligent asset allocation decisions when the prevailing stage of the cycle has been correctly identified. The chronological sequence has worked very well (with a few exceptions) over the last twohundred-years. However, the leads and lags between these various events do alter considerably from cycle to cycle. Also varying is the magnitude of price moves by specific markets. We use two techniques to identify the various stages. The first is a very simple technical approach of comparing each market with its 12-month moving average. The proxies we use are long-term government bond prices, the S&P Composite, and the CRB Raw Industrial Commodity Index. We use raw industrial prices because they better reflect changing conditions in the business cycle. Inclusion of grains and other weather driven commodities only serves to distort the overall picture. Therefore, eliminate weather as a factor. When a market is above its average it s considered to be bullish and vice versa. There is no moving average time span that can be expected to work perfectly over all markets at all times though. The 12-month span, however, seems to test better than most. Even so, this approach does trigger quite a few whipsaw signals. That s why we rely on a more rugged test of a market s primary direction. For this purpose, we 16

17 Business Cycle Analysis have created a Barometer for each market. A Barometer is a collection of economic, financial and technical indicators. Each one has a good track record of identifying bull and bear market environments for a specific market. None of these indicators are perfect, but when they are combined within the Barometer, a consensus of 51% or more of bullish components triggers a buy signal for the market in question. Even the Barometers have weak periods, but by and large, their use, along with the 12- month moving average test, works reasonably well. Figure 2-2 shows how the Barometers performed in the 1980 s and 1990 s. You can see that by and large they experienced an accurate chronological sequence as the environment swings through the various stages. Occasionally a stage is skipped, such as Stage I and Stage VI in 1989, and Stage I in Also, the Barometers have been known to retrograde as they did in mid 1993 by moving back from Stage III to Stage II and then on through Stage III again. The varying lengths of each stage is also apparent from this chart. Stage II, in , for example, was particularly lengthy. However, in 1990 it was very short. It is important to note that the barometers just paint a bullish or bearish environment for a specific market. The market itself will usually respond to that environment in the expected way, but that is not always the case. This is why they do not usually catch the turning points of markets as close as we would like. This is especially true of the stock market. The 1995 buy signal, for instance, developed well after the December 1994 low. While specific Barometers may fail from time to time for a specific cycle, this approach works very well over the long term. Table 2-1 highlights the average annualized monthly total return for each asset category for each stage of the cycle (as defined by the Barometers). For example, bonds in Stage 1 have gained 28.6% in the seven defined cycles since the early 1950 s, whereas Stage 4, when they first turn bearish, have averaged a loss of 7.3%. Stocks have gains of 24.8% in Stage 2 and a loss of 12.4% in stage 6. In Stage 3, when both stocks 17

18 18 Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6 Bonds Bullish Stocks/Inflation Bearish Bonds/Stocks Bullish Inflation Bearish All Bullish Bonds Bearish Stocks/Inflation Bullish Stocks/Bonds Bearish Inflation Bullish All Bearish Barometer Signals and the Six Stages of the Business Cycle Understanding the KST and Asset Allocation Table 2-1

19 Business Cycle Analysis Average Annualized Monthly Return for the Six Stages * Stage Bonds Stocks Cash Table 2-1: *As defined by the Barometers and bonds are positive, equities have earned 20.1% compared to a relatively small average 9.6% for bonds. Stage analysis is useful both to assess whether returns will be positive or negative and as a guide to which asset class is likely to put in the best relative performance. The Bond Barometer The Bond Barometer is shown in Chart 2-1. It has performed reasonably well because it would have kept investors out of the bond market for most of the postwar period prior to the secular, or very long-term, peak in interest rates in Since 1981, it has been able to capture most of the bull moves, although from time to time, it does experience difficulty. One such example occurred in 1980 where a sharp reversal in monetary policy caught the Barometer off guard during the early phase of a bear market. In 1995, the buy signal came well after the bull market began, while the sell signal was given at a lower price in However, when the rallies sof 1982, 1985/86, 1991/93 and 1997/98 are considered, the overall performance was quite satisfactory. At the same time, it s important to remember that most of the 1981,1984, 1987 and 1994 declines were avoided. 19

20 Understanding the KST and Asset Allocation Government Bond Prices and the Bond Barometer Government Bond Shaded areas show when the Barometer is below 50%; i.e. bearish for bonds. Chart 2-1 The Stock Barometer Because stock prices are influenced more by psychology than economic events, this has been the least accurate of our three Barometers (Chart 2-2). Also, the 1980 s and 1990 s experienced the most bullish period for equities in the 200- years of stock market history. Therefore, a conservatively designed model, such as our Stock Barometer, gave a more cautious outlook than was called for in reality. Since such a strong period is unlikely to be repeated in the future, we will probably find this Barometer will eventually give more accurate signals, along the lines of those given in the 1950 s,1960 s and 1970 s. This particular instrument is largely influenced by the rate of change of interest rates. Normally when rates rise, stocks, after a long lag, decline. The interest rate environment was particularly hostile in 1989, yet stocks rallied sharply. This was due to a large extent on an unprecedented amount of corporate stock retirement. This reduced supply and placed additional cash in the hands of investors (raised demand). These types 20

21 Business Cycle Analysis of factors are unusual and cannot be measured by normal cyclical indicators. The Rule of 12 The Rule of 12 is a very profitable, yet simple, technique for identifying positive periods for equity prices. It takes advantage of the fact that declining short-term interest rates are positive for equity prices once they start to respond. Remember, in most cycles short-term interest rates lead stock prices, but the lead varies from cycle to cycle. The trick is knowing how long the lag might be. The Rule of 12 uses two 12-month moving averages, one for the S&P Composite and one for short-term interest rates. The rule states that when the yield on 3-month Commercial Paper is below its moving average and the S&P Composite is above its average, it is a very positive environment for equities. Chart 2-3 shows this in the marketplace while figure 2-3 indicates the performance that was obtained for the period between 1948 and As you can see, the S&P Composite and the Stock Barometer S&P Composite Stock Barometer Chart 2-2 Shaded areas show when the Barometer is below 50; i.e. bearish for stocks. 21

22 Understanding the KST and Asset Allocation average annualize rate of return was just under 25%. This compares to the buy/hold approach (labeled the entire period ) of just under 10%. Also, the risk factor, measured as volatility, was very low when the Rule of 12 was in force, compared to the average period for holding stocks, which was much greater. Thus, in a period when the Rule is operating, the rewards are substantial and the risk minimal - an ideal combination. It s important to understand that when the Rule is not operating it doesn t mean that returns are negative sometimes they are and sometimes they re not. It merely states that when the Rule of 12 is in force, a well above average allocation to equities is recommended. The shaded areas in Chart 2-3 show when the S&P is above its 12-month moving average (MA) and the 3-month Commercial Paper Yield is below its 12-month MA. S&P Composite vs. 3-Month Commercial Paper Yield 22 Chart 2-3

23 Business Cycle Analysis 25 * POSITIVE ENVIRONMENT 20 REWARD ENTIRE PERIOD * NEGATIVE ENVIRONMENT * RISK Figure 2-3 The Inflation Barometer The Inflation Barometer, shown in Chart 2-4, is our most accurate model, having identified the majority of business cycle swings in industrial commodity prices since the 1950 s at a relatively early stage. Changes in commodity prices are perhaps the most important influence on bonds. Consequently, this indicator has provided us with valuable advance warnings of reversals in price swings in the bond market. Inflation vs. Deflation One of the most important aspects of business-cycle analysis from the point of view of optimum asset allocation is the relationship between inflation and deflation. During the middle to late phase of the recession and the early stages of the recovery, deflation sensitive assets outperform inflation sensitives. Examples of deflation sensitive assets would include bonds and interest sensitive stocks such as prefereds and electric utilities. Inflation sensitive assets would embrace so called earnings driven stocks 23

24 Understanding the KST and Asset Allocation Inflation Barometer and the CRB Spot Raw Material Index Chart 2-4 such as basic industries, steel, chemicals, mines, and energy. It is important to note that it s entirely possible for both inflation and deflation sensitive assets to be rallying together in the early phase of an equity bull market. What we re concerned with is the relative performance. There are a number of relationships we follow to try to get a fix, not only on emerging relative strength trends, but also to act as further confirmation for our Stage analysis. For example, if a number of ratios are indicating a superior performance for deflation-sensitive assets, this suggests we are in the early to middle stage of the business cycle. Conversely, if inflation sensitives are beginning to emerge, then we have a good idea the cycle is in a more mature inflationary phase. The relative strength relationship between bonds and industrial commodities lends itself very nicely to KST analysis because the cycle is continually moving from an inflationary to a deflationary phase. In this respect, Chart 2-5 shows the ratio between government bond prices and the CRB Raw Industrial Material Index. As a general rule, 24

25 Business Cycle Analysis the long-term KST experiences very smooth and deliberate swings between the bull and bear phases of the cycle. When both the KST and the Ratio are above their moving averages, a relative bull market favoring inflation sensitive assets is signaled and vice versa. We can also look to the position of the KST as a guide to the prevailing stage of the cycle. For instance, if the KST is overbought and starting to roll over, it s likely the inflationary part of the cycle is giving way to the deflationary part. Chart 2-6 shows another in- Government Bond Prices vs. CRB Raw Material Index Chart

26 Understanding the KST and Asset Allocation Inflation vs. Deflation Sensitive Groups and a Long-term KST Chart 2-6 flation/deflation ratio. This one is an internal stock market measurement since it pits an index of inflation sensitive-equities to deflation-sensitive ones. Inflation-sensitives embrace stock groups that do well when commodity prices are rising such as mines and energy. Deflation stocks put on a superior relative performance at the beginning of the cycle as the economy is terminating a recessionary phase. They include interest-sensitive stocks such as electric utilities and financials. If you compare this ratio to the ratio between bonds and commodities you will see the cyclical swings are reasonably consistent with each other. 26

27 Learning the KST "I'd recommend it to anyone." J. Bratkovich T he KST is a unique indicator which can be used by both traders and investors. Traders like it because it helps identify those elusive short-term swings in the futures markets. Investors like it because it helps with those time-sensitive decisions within their investment portfolios. However, the most valuable function of the KST is its ability to provide you with perspective. You ve seen market-oriented commercials which make wild claims about perfect indicators, new systems, black boxes, and so forth. The KST doesn t need to make extravagant claims. Developed more than 10 years ago, the KST system was successful in identifying the 1990 bottom in the bond market (as featured in an article in the December 10, 1990 issue of Barron s) and the 1995 peak in the Deutsche mark. In Learning the KST you will discover the concept behind this useful indicator, together with its strengths and weaknesses, all in more than a dozen full-color movies and accompanying charts and illustrations. Following the 2-hour presentation, you will find a 40-question, interactive, multimedia quiz to help you understand what you have learned. The automatic scoring system allows you to compare the results of up to three tests so you can monitor your progress. To order, please see page 3. $69.95 (S/H not included) 27

28 Understanding the KST and Asset Allocation Notes 28