Understanding the KST

and
Asset Allocation

Understanding the KST and Asset Allocation

Table of Contents

Introduction .......................................................... 5
Chapter 1: The KST System ................................. 7
THE MARKET CYCLE MODEL ............................. 11
Chapter 2: Business Cycle Analysis .................... 15
THE B OND BAROMETER ..................................... 19
THE STOCK BAROMETER .................................... 20
THE RULE OF 12 .............................................. 21
THE I NFLATION BAROMETER .............................. 23
INFLATION VS. DEFLATION .................................. 23

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Understanding the KST and Asset Allocation

Introduction

his booklet has been provided with your subscription or

email 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
www.pring.com.

Good luck, and good charting!

Martin J. Pring

Understanding the KST and Asset Allocation

The KST System

f you are driving a car in a

strange city and need to get
directions, its easy to stop at a
gas station and buy a map.
Wouldnt it be great if you
could also buy an investment
map pinpointing the markets
proximity to major tops and
bottoms?
Theres 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. Its as if you
were guarding the door to a
building. You could easily see

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. Buy7

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 its below its moving average, its 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

Chart 1-1

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

Understanding the KST and Asset Allocation

the 1980s (shown in Chart 12) and the U.S. market in the
late 1980s to mid-1990s, 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, its 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 11 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

Chart 1-3

10

The KST System

Lehman Bond Index and Two KSTs

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 its 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

Understanding the KST and Asset Allocation

trends or secondary corrections. Thats 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 KSTs usually turn
well ahead of the long-term series. Occasionally, its 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
KSTs trigger a buy signal and

The Four-Year Business Cycle

Figure 1-1

12

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 its 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, its 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 1-5

13

Understanding the KST and Asset Allocation

Stock/Bond Ratio and Three KSTs

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.

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
doesnt actually contract. For
example, the recovery that began in 1982 experienced a
sharp slowdown in growth in
1984 and 1985.
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

Stocks
Bonds

Commodities

Recovery
Recession

Bonds

Commodities

Stocks
Figure 2-1

15

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
16

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 its 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. Thats
why we rely on a more rugged
test of a markets primary direction. For this purpose, we

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 12month moving average test,
works reasonably well. Figure
2-2 shows how the Barometers
performed in the 1980s and
1990s. 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 1995. 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 1985-86, 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
1950s, 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
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

86
Table 2-1

87

88

89

90

91

92

93

94

95

96

97

98

Understanding the KST and Asset Allocation

Barometer Signals and the Six Stages of the Business Cycle

Business Cycle Analysis

Average Annualized Monthly Return

for the Six Stages 1953 - 1994*
Stage

Bonds

28.6

15.3

9.6

-7.3

-4.8

0.7

Stocks

-0.7

24.8

20.1

16.6

4.3

-12.4

8.6

6.8

5.2

8.2

7.7

Cash

4.91

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 1981. 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 1996.
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,
its important to remember that
most of the 1981,1984, 1987
and 1994 declines were
avoided.

19

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 1980s and 1990s experienced the most bullish
period for equities in the 200years 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 Barom20

eter will eventually give more

accurate signals, along the lines
of those given in the
1950s,1960s and 1970s. 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

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 1991. As you can see, the

S&P Composite and the Stock Barometer

S&P
Composite

Stock
Barometer

Shaded areas show when the Barometer is below 50; i.e. bearish for stocks.

Chart 2-2

21

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.
Its important to understand that when the Rule is not
operating it doesnt mean that

returns are negative sometimes they are and sometimes

theyre 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

Chart 2-3

22

Business Cycle Analysis

25

* POSITIVE ENVIRONMENT

REWARD

20
15
10

ENTIRE PERIOD

5
NEGATIVE ENVIRONMENT
0

10
RISK

12

14

*
16

Figure 2-3

The Inflation Barometer

Inflation vs. Deflation

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
1950s 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.

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

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
its entirely possible for both inflation and deflation sensitive
assets to be rallying together in
the early phase of an equity
bull market. What were 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
24

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,

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, its 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 2-5

25

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
26

will see the cyclical swings are

reasonably consistent with
each other.

Learning the KST

"I'd recommend it
to anyone." J. Bratkovich

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.
Youve seen market-oriented commercials which make wild
claims about perfect indicators, new systems, black boxes, and so
forth. The KST doesnt 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 Barrons) 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.

$69.95
To order, please see page 3.

(S/H not included)

27

Understanding the KST and Asset Allocation

Notes

28