Money and finances

Looking Deeper into Levels of the Rate of Change Indicator

The rate of change oscillator conveys a good deal of information in and of itself, but it provides more information if the time is taken to study the market action that errated the current reading.
More specifically, each day’s new rate of change indicator level actually involves two variables: the current day’s change in price level and dimction of movement, and the level and direction of the price movement of the day that is being removed from the calculation being made.
If the day being removed was a day of market decline, rate of change measurements will turn upward even if today shows no gain in price, for as long as it shows lesser loss than the day being removed. Therefore, if weaker market periods are being eliminated from rate of change calculations, rate of change levels tend to rise easily, often before price trends tum upward. If today happens to be a rising day and the day eliminated from the calculation was a falling day, rate of change measurements might rise rapidly.
Conversely, if the days being removed from your calculations were days of market advance, it will be more difficult for your rate of change indicator to gain ground. During strong market periods, rate of change indicators are likely to track sideways, but at relatively high levels. It might appear at such times that negative divergences are taking place, but if you examine the data stream carefully, you might notice that the stock market is not really weakening at all and that, in fact, the ability of its rate of change readings to remain high is a sign of strength.
Let’s go back to our data September was a period of sharply declining stock prices, so rate of change levels rose quickly in October, even prior to price gains of any significance. Not until the turn of the month into November were the days being eliminated in the calculations rising market days. Rate of change measurements remained flat, though high for several weeks. The inability of rate of change measurements to advance further was, in this instance, not a sign of market weakness, but rather simply a reflection of the ongoing strength that had been maintained over several weeks.
Relative strength readings did not seriously begin to fail until the end of 2001, when, after a dip, prices rose to new highs while rate of change measurements clearly failed to do so. Prices and rate of change measurements declined simultaneously early in 2002, the decline preceded by the negative divergence that had developed between December 2001 and January 2002.
The first dip down in early December, accompanied by declines in the rate of change indicator, was not necessarily indicative of a more negative market climate. Even the strongest market advances have periods of consolidation. You might notice that at no time did rate of change levels decline below 0 during December. However, a negative divergence, with more bearish implications, did develop at year end.
What made tlh negative divergence more significant than the flattening of the rate of change indicator during October and November? Well, for one thing, rate of change readings were no longer tracking at high levels, declining to near the zero line. For another, patterns of price movement had changed, with price trends flattening. As a third consideration, there was very little time between the time that the rate of change failed to reach new peaks that would have confirmed new highs in price, and the rapid turndown in price levels from the early January peak.
Again, declines in rate of change readings and the presence of negative divergences are more significant if they are accompanied by some weakening in price trend. Double-top formations in price (two peaks spaced a few days to a few weeks apart) accompanied by declining double top formations in rate of change measurements can be quite bearish.
Conversely, rising patterns in rate of change measurements are more significant if they are confirmed by a demonstrated ability of the stock market to turn upward. Double-bottom stock market formations, spaced a few days to a few weeks apart, accompanied by rising rate of change readmgs often provide excellent entry points.

INTERNATIONAL ACCOUNTING STANDARDS (IAS)

International accounting standards (IAS) or the latest US GAAP (generally accepted accounting principles) accounting guidelines will reform the auditing world in the post-AEW investment climate. The revised accounting drafts are of major relevance to banks, funds, insurers and all types of corporation.
In particular, the latest IAS 39 and FAS 133 spell major revisions for reporting and valuation that enforce a stricter manner of stating corporate accounts.12 These have particular significance for the statement of derivative valuations in the corporate accounts. This has a direct implication in the daily mark-to-market exercise where the company is exposed to fluctuating values of derivatives.
Similarly, FRS17, the new accounting measure for funds requires them to state an actuarial valuation of funds’ assets and liabilities that are regarded as a stricter and harsher view. All parties, investors, accountants and audited companies are arguing over the animal that is called “fair value”. Like the blind man touching different parts of a camel, it is a difficult creature to pin down.
In fact, a previous financial disaster, the US Savings and Loans collapse, led to new CAMEL regulations to bolster the banking sector. Bank regulators examine subjects and judge them on a scale of 1 (best) to 5 (worst/likely to fail). The criteria are:

• capital adequacy
• asset quality
• management quality
• earnings performance
• liquidity.

In all, the companies audited may well complain that the new accounting standards are too strict and draconian, while being costly to implement. Thus, for example, the IAS cousin in the USA, as defined by the FASB, has shown more leeway for the corporate heads than might have been allowed in Europe. US company stock options held by key staff are not normally treated as expenses and deducted from corporate profits account. The usual practice is excused by the reasoning that the valuation of the options is either too complicated or inaccurate, so firms tend to leave this entry as a footnote in the corporate accounting statements. The FASB has stated that it will review this practice. Meanwhile, the IASB has decided that the options should be treated as corporate expenses – a standard for EU auditors starting 2005.
IAS standards serve to give us better foresight of corporate illness before it hits us. Some companies will invariably slip through the net, but we should (hopefully) stand a better chance of catching a cold rather than a debilitating sickness in the pre-AEW era. The new IAS are hoped to be part of a stronger corporate AEW radar to detect errant performing or corrupt companies before they implode and cause further public damage. IAS and new FAS procedures can only be part of a risk management toolkit, not the whole answer. A wider corporate picture is needed.

Adjusting Overbought and Oversold Rate of Change Levels for Market Trend

The levels at which momentum indicators can be considered “oversold” (with the market likely to try to firm, especially during a neutral or bullish period) and “over bought” (with the market likely to at least pause in its advance, especially during i bearish or neutral period) often vary depending upon the general market climate.
During bullish market periods, rate of change readings rarely reach the negativty extremes that can exist for many weeks or even months during bear markets. Where they do decline to their lower ranges, the stock market frequently recovers rapidly During bearish market periods, rate of change readings tend not to track at levels a: high as those during better market climates; the stock market more likely decline rapidly when readings reach relatively high levels for bear market periods
When assessing whether momentum indicators suggest an imminent market reversal based on overbought or oversold levels, adjust your parameters based up the market’s current price trend, moving average direction, and rate of change parameters that are currently operative. These adjustments are, of course, somewha subjective rather than completely objective.
For the most part, significant market advances do not start when rate of chang and other momentum oscillators stand at their most negative or oversold reading! They tend to begin after momentum oscillators have already advanced from their most negatively extreme readings. The October 2002 advance did not start until the 21-day rate of change oscillator had ahead established a rising, double-bottom pattern, the second low point of which was corsiderably higher than the first.
The end of the November-December market advance did not stand until the 21-day rate of change oscillator had already retreated from its peak level with a descending double-top formation created in the process.
The summer 2002 decline did not end until rate of change measurements established a pattern of rising lows (diminishing downside momentum). A divergence developed within Area A on the chart; the price level of the Nasdaq 1 (Index fell to new lows, whereas its 21-day rate of change level did not. You can already see a minor-tern but nonetheless significant secondary positive divergence in A n B, with prices declining to a final low while rate of change measurements became less negative.
The recovery from the lows of September 2002 developed in a classical fashion. The first step was a strong leg upward that carried prices above a resistance an (the peak in August) and momentum readings to high levels, more positive than any time since March. However, the initial spike came to an end after approximately two months.
Was there a warning of the forthcoming two-month decline? Yes, indeed. Check out Area C on the chart, the area in which prices rose to new recovery peaks in November while rate of change levels declined, a classic negative divergence that foretold developing market weakness.
The dedine in the stock market in Area D appeared to be developing from a bearish-looking head and shoulders market top formation (defined as “Bottom Fishing, Top Spotting, Staying the Course: Power Tools That Combine Momentum Oscillators with Market Breadth Measurements for Improved Market Timing”), but the positive divergence (lower prices unconfirmed by rate of change patterns) that developed in January 2003 argued for a more favorable outcome, which did develop.

REPUTATIONAL RISK

What due diligence is meant to do is to protect you before you buy. Caveat emptor! Unfortunately, the banks and funds have concentrated on white-collar executives cramming themselves into a large boardroom for a long discussion, possibly punctuated by lunch and drinks. Bankers, financiers, accountants, lawyers, technical specialists and backup staff all enter into the fray. This makes the due diligence a top-heavy, unwieldy and often ineffective process. This is because there are people of the like mindset who are often intent on take-over or merger.
Ambiguous evidence and management stubbornness can override the due diligence findings, even in the face of corporate failure. Risk appetite overrides the limit for bearing risk – eventually they give up after the event failure. During 1999–2000, 11 556 US M&A cases of >51 % equity were announced. Only a tiny proportion, 383, did not complete as the project momentum carried most through.
Most M&A failed to meet their targets. Management stubbornness or self-interests against shareholder benefit (a k a “agency theory”) are attributable. One major perk could be a larger salary or bonus upon M&A; bigger workforce and more sales and revenue. Based on fulfilling sales and growth performance targets, the CEO’s stock options start to kick in. Such remunerative packages are deceptive and only lead to executive greed, further putting the company at risk.
The innate greed pattern, coupled with the short-term tenure of the CEO, lead executives to extract as much out of the company rapidly before a forced exit. CEOs have a temptation to get a percentage of an ever bigger pie – that pie becomes commensurately larger under M&A. A leader’s overambition creates an overvalued company within M&A, whose chances of success are loaded against it. This subsequently leads to a boom–bust cycle in the share price.
The case around the directors’ table may for be clear for M&A, but the damage and failure afterwards are visible for all.
How can we improve on the due diligence process? Due diligence can work, but not for every firm. We can instigate a more flexible “slimmed down” due diligence. Due diligence can be cheap and quick, a rapid detective investigation, not an expensive boardroom affair.
It can progress from simple elements such as:
Internet search on name e.g. local community website or Google.com.
Check for name in library or newspapers.
Check criminal record or court appearance in public office and legal documents.
Asset liens and tax judgements.
Real-estate holdings in property register.
Trawl companies documents for record of directorship and holdings in other companies.
Call in a private investigator.
Gathering together the findings, with the accounting experts’ input, we can track the company’s health or movements in a risk map.
Post-Andersen and Sarbanes–Oxley, there is some doubt that they will reveal the true corporate health in a timely and accurate fashion for interested investors. Both the US Sarbanes–Oxley Act and European legislative directives are designed to make CEOs and accountants more accountable when signing financial statements. These legal moves stand or fall on the crux of whether these key staff signed a financial statement knowing of any irregularities. The auditing industry is still very concentrated in the Big Four, even after corporate audit and management consultancy are split. Apart from the lack of choice, there is also the spectre of these four companies having the same type of operational procedure, more or less, from each other. Buying one company’s auditing services instead of another does not necessarily represent a qualitative improvement, nor a substantial quantitative discount in the daily rate charged.
The current legal and accounting system militates against swift justice and compensation for those who have suffered loss.
In 1998 there were nearly 2 million pending civil tort cases. The cost of the U.S. tort system for 1999 was over $200 billion. . . . The RAND Institute for Civil Justice studied transaction costs and determined that about 43 cents on the dollar goes to the plaintiff. The other 57 cents goes to transaction costs, which include attorney fees paid by the plaintiff.
All professions are policed by their own institutions to some extent. This does not mean that billed rates are reduced. There are associations of bankers, insurers, lawyers, accountants etc. There is some recourse for complaint and reporting breach of contract or trust. The lawyers, for example, have the Law Society, while accountants have the Joint Disciplinary Tribunal. A client’s complaint is not always satisfactorily resolved by any means, but it is usually an inexpensive way to whistle-blow on the professional. It is a cost-effective manner, but often not the end process, to start getting compensation. It would be better not to get ensnared in the first place, so you need an alert system.