From the November 01, 2010 issue of Futures Magazine • Subscribe!

Getting technical with economic data

Common indicator

The indicator, stochastics in this case, levels the playing field to the extent that each series of data is treated in a similar fashion. (A 50-month moving average also is used to provide reference over time.) Slow stochastics, which was developed by George Lane in the 1950s, measures price momentum. It is a well-known indicator with a respectable history.

While the traditional use of stochastics suggests that overbought and oversold readings at the extreme higher and lower edges of the indicator are relevant, movement by the indicator above or below 0.50 usually signals a trend change. Using the TradeStation platform 8.7, we entered the following inputs into the slow stochastics algorithm:

Price inputs: For DJIA; high, low and close; and industrial production, close.

Stochastic length: 25

Stochastic length 1: 10

Stochastic length 2: 25

Smoothing type: 2

Overbought: Above 80

Oversold: Below 20

"Industrial strength stocks" (below) covers the period from January 1920 through December 1966. Notice the peak in the stock market in September 1929 when the Dow Jones Industrial Average hit 386.10. The high followed a statistical peak in stochastics in January 1929 with momentum failing over the next several months. The indicator then signaled a long-term negative with a decline below 0.50 at the end of June 1930. That signal developed after the market staged a brief countertrend rally that lasted through late April 1930 when the DJIA hit 297.25.

chart

The DJIA declined until July 1932 and lost nearly 90% of its value in just under three years. The Great Depression was underway. Fortunes were lost and millions were out of work. At one point, 25% of the potential workforce was unemployed. The negative stochastics signal, following its oversold nadir in July 1932 at the market low, confirmed a positive reversal when the indicator moved above 0.50 at the end of December 1933 to signal that the worst decline in stock market history had ended.

Industrial production reached an actual and stochastics-based high a month before equity prices in July 1929. It then confirmed a negative reversal below 0.50 at the end of April 1930, a signal that remained negative until the end of August 1933 when both the market and industrial production had moved to the upside. Then things got interesting. Industrial production rallied to a new high in December 1936, stalled a bit into the 1938 lows, and began rallying without a serious look back for the next 70-plus years. On the other hand, equity market prices rallied off of the 1932 lows but did not eclipse their 1929 highs until November 1954 and 18 years after the 1929 peak.

There are other examples of industrial production leading the stock market in the post-1929 era: It rose from late 1939 until the beginning of World War II when the stock market remained in a modest downtrend. Again, during the 1961-62 bear market, industrial production remained dramatically positive while equity market prices were sinking. In late 1974, when the stock market was making new lows below the worst levels it hit in 1970 and many were calling for a new Depression, the fundamental measure failed to confirm that action and held well above its 1970 low.

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