Cycles and the Big Picture
By Tim W Wood CPA, September 25, 2009
I have recently received a few e-mails asking about cycles and their application to the market. So in today’s wrap up I will attempt to present a brief and very simplified explanation of how cycles can be used as a very powerful technical tool once they are understood. I will then apply this simplified cyclical concept to the market.
From a cyclical perspective, the trend is defined by the direction of the cycle of the next larger degree. Also, from a cyclical perspective we work in many different dimensions. In this overview I’ll keep it simple and we will only focus on 3 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 require extensive writing and study on your part 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. I will apply this concept on a very elementary basis and without the aid of indicators or statistical timing bands.
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 that have been specifically timed and developed for each cycle. 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 these lows are expected to occur. Again, these timing bands were developed 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.
When working with the short-term cycles I also have statistical 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. 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. It also sets this short-term cycle up in a left-translated manner, which means that it peaked to the left of its mid-point, which has bearish implications. Thus, when we see this setup it serves as a clue. Anyway, once the short-term cycle began to move down, notice that the previous short-term low was violated. This violation serves as preliminary evidence that the intermediate term cycle has likely topped. Then, the next step is the actual downturn and confirmation of the intermediate term trend. As a cycles analyst I then look for the price action to continue down into the statistical based 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. In addition to the timing band and indicators to identify the intermediate-term low, we will ultimately have short-term price confirmation. As an example, 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 move above the previous short-term high. This higher high is then the final price confirmation that the intermediate-term trend has turned back up. So even the confirmation process is dimensional. 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. This is called left-translation and serves as an early clue of a cyclical peak. 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. But, the fact that the intermediate-term trend was left-translated served as a serious warning of that top. Once the violation of the previous short-term low occurred, cyclically that price break served to pretty much cast the die on the left-translated intermediate-term cycle top, which in turn pretty much cast the die on the longer-term top. Thus, at this point the cycles analyst should know that a longer-term top is now in the making. Additionally, once the short-term cycle violated the previous short-term cycle low, indicting that the intermediate term cycle had likely topped, the price oscillators should have at that point been warning of immanent danger. Then, with the break of the intermediate-term cycle below the previous intermediate term cycle low the final confirmation is given that the long-term cycle has indeed 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 fool proof. However, this is an approach that I have found to work with a relatively high degree of accuracy.
In addition to cycles I also use statistical analysis and indicators that have been specifically geared toward each cycle. With equities, I also use Dow theory. As for the equity markets, there is no doubt that the rally out of the March low has been a good one. But when I apply all of my cyclical, statistical, Dow theory and other technical tools, I definitely believe that the October 2007 high coincides with Point C in the simplified cyclical diagram above. I have included a chart of the Industrials below.
I told subscribers before price moved into the March low that a low of a higher degree was due. I also told them that it would be tradable and that it would be mistaken as a new bull market. This has all proven correct. However, this is not a new bull market. It is an intermediate-term bear market rally much like is illustrated in green to the right of the longer-term peak in the diagram above. As for when this top occurs, I’ve gone back to 1896 and have discovered very specific markers that have occurred at all important market tops and these markers will help identify this counter-trend bear market rally top for my subscribers. Until such time as this top is made, the talking heads will continue to tell us that the economy is in recovery mode and that the worst is behind us. As a result, more and more people will be sucked back into the market or they will become complacent and will not understand what is taking place once the Phase II downturn begins. It will be perceived as just a healthy correction and buying opportunity. After all, we are told that the bottom is in, Right. As a result, the average person will continue to hold all the way down and the Phase II decline will ultimately be even more destructive that the Phase I decline. It is always this way and given the consensus that I’m seeing and hearing, I don’t look for this time to be any different. I also urge you to read the August 14th Observation if you have not done so, as it proves a good overview of the bear market phasing that I’m referring to in this article.
Tim W. Wood
© 2009 Tim Wood