The Dow Report: A Brief Overview of Cycles
By Tim W Wood CPA, May 7, 2004
In recent weeks I have shown you how I use cycle high and low points to identify trend changes. I have recently received questions asking for more of an explanation about these methods. So, in today's Observation I will attempt to present a brief simplified explanation of just how cycles can be used as a very powerful technical tool once they are understood.
From a cyclical perspective, the trend is defined by the direction of the cycle of the next larger degree. This means that from a cyclical perspective we work in many different dimensions. The key is to isolate and study each cycle of each dimension so that the direction and expectation of these cycles can be known. The identification of these cycle lows is definitely outside of the scope of this brief overview, as it would take volumes of material to do this subject justice. All I want to do here is simply present the concept of using cycle highs and lows of various degrees to show you the concept of how we can work in the various dimensions to identify important turn points.
The first dimension that I work in is the long-term. Please see the diagram below. The red trend lines are representative of the long-term cycle. The overall trend is obviously up when this cycle is advancing and is down when this cycle is declining. These lows are identified using timing bands that have been developed through historical norms, the price action of each cycle of smaller degree and the help of price oscillators. Once a long-term cycle low is identified and confirmed, we then know that the trend is up. We can then use the declines into the lows of the cycles of smaller degree as buying opportunities.
The second dimension in this example is the intermediate-term. This is represented by the green trend lines in the diagram above. We also have timing bands or windows in which the next low should occur. These timing bands are again developed and are based on the historical averages of the previous cycles of the same degree. This in effect gives us a time target from which to expect the next low. As this intermediate term cycle advances, we then monitor the price action of the short-term cycle, represented in blue, in order to identify possible tops and bottoms.
The third dimension in this example is the short-term. This is represented by the blue trend lines in the diagram above. When working with the short-term cycles, I also have timing bands to help identify the time target for the next corrective move down. Notice that as this cycle moves up, each short-term cycle low is higher than the previous low. Also notice how each high is generally higher than the previous high. As long as this pattern holds, the trend is clearly up.
How The Three Dimensions Work Together
Notice at the first intermediate-term cycle top, labeled "A," that the last short-term cycle failed to move above the previous short-term cycle high. I marked this event with a small red line. This setup is what I call a failure. Then, once the short-term cycle began to move down, notice that the previous short-term low was violated. This violation then serves as price confirmation that the intermediate-term cycle has topped. Therefore, the intermediate-term trend then turned down.
As a cycles analyst, I then look for the price action to continue down into the timing window for the next intermediate-term low. The price action of the short-term cycle is continuously monitored as the intermediate-term cycle moves down. I then use the combination of the timing window for the intermediate-term cycle low, the price action of the short-term cycle and various oscillators to identify the next intermediate-term low.
Notice that at the intermediate-term low, labeled "B," the short-term cycle makes a low above the previous low. This is sort of a failure in reverse, as price failed to make a lower low and was then followed by a higher high. This higher high is the final price confirmation that the intermediate-term trend has turned back up. At that point one can re-enter the long side or add to existing long positions as the long-term trend continues to advance. This analytical process is then repeated for the next intermediate-term cycle.
Let's now jump to the last intermediate-term advance. Notice how the intermediate-term cycle advance, labeled "C," was brief in this example. Also, notice how the short-term cycle went parabolic into the final high. In this case, there was no warning by the formation of a failed short-term cycle. However, in this case the cycles analyst would have known that the advance was running on borrowed time as his timing bands for the cycle top would have warned that the top was near. Then when the short-term cycle went parabolic, he should have been further warned that the end was near for this cycle. However, in this example there was absolutely no cyclical deterioration until price fell below the previous short-term cycle low. This event is marked with a small red line. Once the violation of the previous short-term low occurred, the cycles analyst has seen the long-term cycle move into its timing window for a top. Additionally, the short-term cycle has violated the previous short-term cycle low indicting that the intermediate-term cycle has topped and the price oscillators should at this point be warning of imminent danger. Then, with the break of the intermediate-term cycle below the previous intermediate-term cycle low, the confirmation is given that the long-term cycle has topped. Therefore, the turn in the long-term direction of the market has just occurred and that direction is now down.
Once the long-term direction turns down, we can expect to see both the intermediate-term and the short-term cycles make lower lows and lower highs until the long term cycle low is reached. Please understand that this is a VERY simple example of how I incorporate cycles into my overall technical analysis of the markets. Also please understand that this very simple diagram is an idealized example. In the real world no technical or fundamental approach is full proof. However, this is an approach that I have found to work with a relatively high degree of accuracy.
In my work with cycles I also use statistical analysis of the long and intermediate-term cycles to develop expectations that can be applied to future cycles. For example, history may show me that 89% of all long-term cycles, that advance for 6 months or more, hold above their previous long-term low as the correction into the next long-term low occurs. Further analysis of these long-term cycles with advances of 6 months or more is then done in order to find the average advance of this group of cycles. The same is done for the declines into the lows. Analysis of the long-term cycle may also reveal that when this cycle advances for 5 months or less, the previous cycle low has an 83% probability of declining below its previous low and that the average decline may be 39%. These numbers above are all arbitrary, but I present them to you as an example of just how the quantification of cyclical behavior can be used as a guide for future cycles. The key is to identify the cycle of each degree or dimension and then apply the historical norms to the cycle. Basically, this is nothing more than cycle profiling.
Tim W. Wood
© 2004 Tim Wood