No escaping the stockmarket cycles

Published by Peter Temple on 31 August 2010.
Last updated on 03 May 2011

Stockmarket cycles are an unavoidable part of investing

Cycles are an unavoidable part of the stockmarket and of everyday life. Research by Richard Dewey, a pioneer of this sort of analysis, identified cycles in such disparate variables as Atlantic salmon breeding, flooding in the Nile, tree growth, international battles, sunspot activity, property prices and the stockmarket. Dewey's stockmarket cycle lasted on average 9.2 years.

Stockmarket, and indeed all, cycles have two basic components: their amplitude and phase. Amplitude is the degree to which they move above or below the underlying trend line.

Most cycles have four distinct phases: an initial upswing from the cyclical low; a continued upswing from the trend line to the peak, followed by a downswing from the peak to the trend line, and then a further downswing to the cyclical trough. Cycle length is normally measured from trough to trough.

What's important to realise here, though, is that cyclical movements can occur in almost any timeframe, from a few minutes of price changes in an actively traded stock or commodity, to a century or more of broad stock, bond or commodity market movements.

The only limit to the discovery of cyclical movements in basic stockmarket, bond market and commodity indices, or indeed any other market, is the degree to which accurate and consistent price data is available over long periods of time. Dewey identified a whole raft of cycles relating to financial data showing a prevalence of 18.2-year cycles in industrial company sales, construction, real estate transaction volume and other variables in data going back to the 19th century and earlier.

However, many technical analysts of the stockmarket focus on looking at shorter term cyclical patterns.

Research on the success of different trading systems in the 1970s suggested that some of the simplest rules worked best. One example is the rule tied to the four-year US presidential election cycle. The other is so-called four-week rules, which suggest a cyclical turning point has occurred when a price exceeds the highs of the four preceding calendar weeks (a buy signal) or if it falls below the lows of the preceding four calendar weeks (a sell signal).

The four-week rule also reflects another property of cycles, namely that the length of different cycles is often tied together by simple numerical coefficients. In commodity markets at least, the four-week rule is held to be the bedrock of many trading patterns, but mention is also made of two-week cycles, eight-week cycles, one-week cycles and so on.

The four-week cycle, which normally comprises 20 trading days, is also the reason behind the choice of many key moving average calculations, with the 10-day moving average (half of a four-week cycle) and the 200-day moving average (10 four-week cycles) widely held to be key technical indicators. Forty-day and five-day moving averages are also quite often used in technical analysis, suggesting some element of harmonics in the way in which cycles are arranged.

This principle is not the only property of cycles, according to the experts. Another is the idea that all cycles are simple summations of a range of smaller cycles, something which can be seen in the ideas developed in the Elliott Wave Theory, which has a large number of passionate devotees.

One other important principle is that of synchronicity; the tendency of multiple cycles of differing length to top out and bottom out at the same time. Cycles are also expected to be proportionate. This means that there should be a proportionate relationship between a cycle's length and its amplitude. In other words, the longer a cycle's length, the greater will be the movement from peak to trough.

However uncomfortable the deterministic nature of cycles might make the average investor feel, the fact is that the accumulated data supporting their existence cannot be ignored, at least when looking at broad historical market trends.

The existence of market cycles is also important because awareness of them provides an important counterweight to the slew of opinion and economic data with which market users are bombarded and allows investors to have the confidence to take a longer-term view of the likely course of the market with the comfort of a weight of historical evidence to support it.

On the basis of Dewey's nine-year cycle, measured trough to trough, the UK stockmarket cycle that began in 2003 (nine years after the previous trough seen in 1994) should bottom out in 2012. So prepare for a little more pain in equity markets over the next 12 months.

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