While thinking about the patterns that prices can trace, we have to look at how prices move cyclically. Some of the cycles are obvious, such as the seasonal cycle which affects prices in commodities, and specifically agriculture, but of course the annual cycle is also reflected in the investors’ old saying of “Sell in May and go away”, meaning that in the summertime the markets are quite often in the doldrums. It is possible to discover different cycles for different types of market. Technical indicators which we’ll look at later usually have time periods associated with them, and the selection of effective time periods that are related to dominant cycles can make them more significant.
The U.S. has a four year cycle, called the Presidential cycle, because of the regularity with which elections happen in that country. It’s somewhat cynical to note that this means the stock market generally does well, creating a good feeling in the country, in the pre-election and election years, and the two post-election years tend towards weakness.
Not all of the cycles are so obvious. You may have heard of biorhythms which theory claims there are three personal cycles, affecting our emotions, physical wellbeing and our ability to work, and these are based on three different periods of 23, 28 and 33 days. Edward Dewey claimed in his book Cycles: The Mysterious Forces that Trigger Events that there was an 18.2 year cycle affecting marriages, real estate sales, immigration, construction, and other seemingly disconnected events. Nikolai Kondratieff claimed in the 1920s to have discovered a 54 year cycle which affects economic events, and he discovered this by looking at prices back to 1789.
One of the principles of cycles is that all of them are related by small numbers – for instance, Kondratieff’s 54 year cycle divided by three gives us (approximately) Dewey’s 18 year cycle. More commonly cycles are divided by two, so in trading you will see mention of 40 day, 20 day, and 10 day cycles. These are related to the 18 year cycle by generally halving except, analysts say, when you get to four and a half years when you take a third, giving the next cycle length of one and a half years.
So the cycle lengths would be 18 years, nine years, four and a half years, one and a half years (18 months), nine months, four and a half months, etc. Of course there are some rounding errors as you go down, and in any case cycles are not precise, but you are generally looking for a repeatable pattern. You can find on many charting programs that you are able to superimpose equidistant vertical lines so that you can try by eye to locate regular cycles. A common way to start this is to connect low points, as these tend to be more reliable in discovering cycles. That’s because the high points can shift, called “translation”, to the left or right – they tend to be biased to the right in a bull market, and to the left in a bear market, as prices take a little longer to go up than down.
The purpose of all this discussion is to get you thinking about the patterns and repeatability. If you can find a consistent cycle that repeats more often than not, then that gives you the edge when you are betting on the direction of the price.
The Principles of Cycles
You are now familiar with stock charts and how they look. They proceed from left to right as a series of troughs and crests, sometimes going up, sometimes down, and sometimes level. Often these can be associated with a certain period of time, and a good way to do this is to measure between troughs, looking for some regularity. The troughs are best because the peaks can vary, being subject to some distortion.
The three things that characterise a cycle in general are its size or amplitude, its time between troughs or period, and something else called the phase. The phase is a measure of where the cycle wave is in time. This is important when we consider that there is always more than one cycle working on any chart, and the phase gives the relationship between between the starting points of the different cycles.
Given these three factors for any cycles on the chart, the cycles can be extended and summed to estimate where they will go in the future.
This brings us to the rules or laws of cycles. There are six principles, and one was already mentioned, that is summing waves together to get the overall effect. It really is as simple as that, you can plot the individual cycles that seem to be affecting the stock and just add them together vertically to get the varying price movements, or so the cycle theory goes. Some people would maintain that all price movement can be broken down into the sum of several different cycles, it is just a matter of finding all the cycles that are happening. I wouldn’t go quite this far, but you can get some complicated price charts just from a few cycles with different periods and different phasing.
The second law of cycles is that of harmonicity, which was covered above. This is the law which says that the different periods of cycles are all simply related to each other, usually by a factor of two. If you have a 20 day cycle, you could well see a 10 day cycle or a 40 day cycle too, and in fact that helps you in finding cycles of other periods. If it doesn’t work out well, then you can look to see if a factor of three is needed somewhere, as in the example above of Krondratieff’s and Dewey’s cycles.
Thirdly, there is a principle of synchronicity, which says that cycles try to get in line with each other, so that they all bottom at the same moment. It is just like a natural law, as for example when people start to breath in sync with others near them.
A fourth law says that the cycles with the long periods should also have the larger amplitudes, and cycle experts say that they should be in proportion to their periods, so that a 40 day cycle would have double the amplitude of the 20 day cycle component of the chart. I can see that you wouldn’t want to have the largest amplitudes on the smallest periods, but I think you have to beware of thinking that the chart can be mechanistically determined by sticking with these laws too closely.
In fact the fifth principle of cycles addresses this. Called the principle of variation, it says that everything else that has been said about cycles is just about strong tendencies and not to be taken too literally. You should expect to have some variation in the real world. The final principle is that despite anything else, all markets have in common certain cycle lengths, such as those mentioned above, and you can start your cycle analysis by looking at them.
Cycles may or may not be directly involved in your looking at the markets, but undoubtedly they influence many other trading tools. In the next chapter, we look at moving averages, and you will see how the idea of regular periods, simply related, such as 10 and 20, can be used together to facilitate the moving average signals.