The Dow Report: A Current Application of Cycles
By Tim W Wood CPA, August 6, 2004
Recently I have been showing you charts of various markets or indexes and have talked about how we need to see moves above or below certain points in order to confirm the trend. I continue to receive questions about the mechanics of this theory. This is a very simple concept, but it can be somewhat difficult to grasp. For the May 7, 2004 Market Observation I did a piece titled A Brief Overview of Cycles. I urge you to re-read this article as it should help you to better understand this concept.
The cycles diagram from my May 7th article is presented below. I have included it in this text for your convenience. In today's Observation I want to use this application of cycles on a couple of indexes in an effort to give you a real time example of this theory. This should also help you to better understand the levels that I have recently been discussing when I have said that it would be bullish above a certain point or bearish below a certain point.
Walter Bressert taught that the direction of the trend is the direction of the next larger cycle. So, what we try to do is use the short-term cycles to help identify the turn points of the longer-term cycles. For example, you can see in the chart diagram above that the short-term, represented by the blue line, makes a series of higher highs and higher lows up until the failed advance at Point A. This was a warning that the intermediate-term trend, represented by the green line, had changed. This warning was then confirmed once the previous short-term low was violated.
At Point B a higher low was made. This was warning that the short-term decline was over. This warning was then confirmed once the last very minor high was exceeded from a couple of days earlier.
At Point C we had a bit of a different situation in that there was no failed rally. At Point C price just collapsed and once it violated the previous short-term cycle low, it served as confirmation that the intermediate, and in this case, the long-term both had topped.
Application to Sectors
Dow Jones Consumer Cyclical Index
Now, I want to apply this concept to a couple of sectors. The first chart below is the Dow Jones Consumer Cyclical Index. Notice how the September, November and February short-term cycle lows occurred at progressively higher levels. Then in March the warning that the intermediate-term cycle could have topped came when the decline into the March short-term low violated the previous low. When the rally out of the March low failed to carry above the March high, another more serious warning was sounded. This failed rally set this index up to move below the previous short-term cycle low and this is exactly what followed. This then carried the market down into the May intermediate-term cycle low. From this low the market again rallied, but also failed to move above the April short-term cycle high. This again set the stage for further weakness, which indeed followed.
At present it appears that we have recently seen another short-term cycle low. Thus far, the rally out of that low has been another failure. Worse yet, we have now violated the most recent short-term cycle low. Therefore, this is currently a strong indication that more weakness should follow for this sector.
Retail Holders Index
The next chart below is of the Retail Holders Index. I covered this index in my Market Observation on July 23rd. It's now time for a follow up. I explained the current cyclical setup as well as the meaning of a decline below the May low. The May low was then violated in the very next trading session. This violation carried this index down into its most recent short-term cycle low. It currently appears that the rally out of that low has now failed. Furthermore, we just violated the July short-term cycle low. This can only be viewed as bearish action and is indicative of more weakness for this sector as well.
AMEX Oil Index
Now let's apply this concept to a current situation that is of interest to us all. The next chart below is of the AMEX Oil Index. Notice how each of the short-term cycles have made higher cycle highs and higher lows. That is until recently. The late July low was a short-term cycle low. From that low, the market advanced and all appeared well until the rally failed. The failure to move above the July short-term cycle high is now a real time warning just as you see at Point A in the cycles diagram above and that occurred in the Retail Holders Index back in April. This is warning us that we could also very well be seeing a trend change for this index as well. Should this index violate the July short-term cycle low, the odds would then favor such a change.
Oil Services Index
Just for comparison I have also include a chart of the Oil Services Index below. As you can see, we have pretty much the same setup here as well. Could it be that these stock indexes are looking ahead and seeing a major turn for oil? Or, is this just the beginning of perhaps an intermediate-term cycle decline? Only time can answer this question. But from a cycles perspective, I can tell you that as of today we are indeed seeing the warning signs for a trend change. If we violate the July lows, it will only be the degree of the trend change that will remain in question.
Dow Jones Health Care Sector
Several months back I also looked at the Health Care Sector and warned about a top there as well. Notice that even this sector is following the same basic path as the others above. The July short-term low violated the May intermediate-term low as the decline into the July short-term cycle low unfolded. Even this index is seeing the same important cyclical points violated.
I hope that these examples will help you to better understand the meaning and importance of these cycle highs and lows. The challenge is being able to identify the cycles of the various degrees. Then, we simply use the cycle high and low points of the cycle of the next lower degree as a tool to help identify the longer term trend changes. Understand that these are indeed very simplified examples. Cycle identification also involves the use of oscillators and cycle timing bands that have been tailored for each particular cycle. I also use Dow theory and other technical tools as well. Nothing works every time, but it is the combination of all of these tools that make this approach effective. I use this approach in all of my work and specifically apply it to the stock market, gold, bonds and the dollar.
Tim W. Wood
© 2004 Tim Wood