From the April 01, 2008 issue of Futures Magazine • Subscribe!

Dow turning point

The Cycle Project Oscillator (CPO) is a proprietary model that identifies multiple cycle influences in a market and has proven itself on numerous occasions. The methodology is based on the theory that market prices consist of three kinds of movements: random noise, large unpredictable shocks like the 9/11 event, and cycles of numerous frequencies that combine with one another to build an overall wave pattern. The program then filters out random noise and ignores unpredictable shocks, focusing on the wave patterns embedded in price data.

While unpredictable shocks are important, our experience is that the system eventually returns to its underlying cyclical behavior. Random noise is purposely ignored as having no predictive significance. The program then goes through an initial de-trending filter that is determined by its specific time interval. The de-trending adds considerable computational stability to the analysis. The properties of the analysis are such that, in general, the time function being analyzed is converted into a discreet set of time dependent segments, which, by themselves, are adaptable to direct Fourier computations with variable evaluation lengths. Algorithms are applied, which slide forward and back to test the validity of each transforming length until minimal differences are established. Further, as these length searches are effected, another search is conducted that seeks a characteristic waveform applicable of the time segment under analysis.

In the March 2003 Futures “Tech Talk,” we noted how the CPO had accurately forecast prices since 1976 and confidently projected a major bottom in the Dow in 2003, “probably in the first half of the year.” We refined the analysis in that same article, noting that the projection forecast a double bottom configuration with an initial low anticipated in February and a final low due in late March or early April. The model hit a home run as the Dow bottomed the week of March 14.

Several months after calling the March 2003 bottom, the CPO, as described in the July 2003 “Tech Talk,” indicated that price action in the stock market was providing confirming evidence that the long-term trend in the market was up and pointed solidly higher for the next three years. The CPO did a nice job picking that low and more recently called this fall’s high. In the July 2007 “Tech Talk” we noted, “Monthly analysis of the Dow indicates a major top is near.”

So what is the CPO telling us today? “Long-term outlook” shows 40 years of weekly data giving us an indication that the Dow will drop through mid March and will then trend higher into May targeting the low 13,000 area. The medium-term outlook, which uses daily data, is more bullish short term but does indicate some weakness in mid to late March (see “A closer look”). The daily chart is more precise about the timing of the next major high, near the end of May.

The most important question is what to do with this information. What it indicates suggests that you should buy breaks in the 11,800 to 12,000 range this spring and look to exit above 12,700. But while random noise is purposely ignored as having no predictive significance, that random noise could stop out an otherwise profitable trade. With that in mind, a more conservative approach using options would allow the CPO scenario to play out. You could buy deep out-of-the-money May or June Dow futures calls at, say, 12,200 and cap your exposure. This way you can benefit from a major move to 12,700 or beyond. You could further reduce the cost of the trade by selling calls further out of the money. Your cost of buying the May/June 12,200 call and selling a 12,600 call would be approximately $1,200 with a profit potential of $4,000.

John Rawlins has been providing analysis and research to financial institutions for more than 20 years and is a former member of the Chicago Board of Trade. He can be reached at bondtrader@bellsouth.net.

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