THEORY OF STOCK MARKET CYCLES - Knowledge Base

College LevelIntroductionto TechnicalAnalysisTheory of stock market CyclesLecture 7Objectives• Introduction theory of stock market cycles- Quality of Cycles- Principles of Cycles• Cycle Investigators- Kitchin Wave- Juglar Cycle- Kondratieff Wave- Schumpeter’s Model- Dewey & S.I.R.E.• Elliott Wave• Seasonal CyclesThis lecture series is produced bythe Market Technicians AssociationEducational Foundationbased on the detailed class notes ofCharles D. Kirkpatrick II, CMTCopyright © 2007. All rights are reserved.M a r k e tT e c h n i c i a n sA s s o c i at i o nE d u c at i o n a lF o u n d a t i o nIdentifying and fundingeducational programs in the fieldof Technical Analysis since 1993MTA Educational FoundationPost Office Box 425127Cambridge, MA 02142-5127617/253-8959 • Fax: 617/452-2199info@mtaef.org • www.mtaef.orgReadingMaster TextbookTechnical Analysis: The Complete Resource for Financial Market TechniciansCharles D. Kirkpatrick and Julie R. DahlquistChapters 19-20; pp. 453-507Additional ReadingTechnical Analysis ExplainedPring, Martin, chapters 14-15The Wave Principle of Human Social Behavior andThe New Science of SocionomicsPrechter, Robert, page 24

Chart 1Stock Market CyclesChart 2The Amplitude of a WaveChart 3The Period of a WaveChart 4The Phase Difference Between 2 WavesIntroductionCycle analysis attempts to find recurring major and minor peaks and troughs inprice movement for better trade timing. By adding short-, medium- and long-termcycles together the actual price activity can be forecasted.In a trading range, cycle are fairly regular in that the market peaks half waythrough the cycle. However, when a market is trending, the cycle peak tends toshift left or right depending on the direction of the larger trend (called left or righttranslation). This is consistent with the notion that in rising markets, prices shouldspend more time going up and in falling markets, prices should spend more timegoing down. (Chart 1)A cycle is simply a regularly occurring sequence of events. The sun rising everymorning and setting in the evening is a cycle. The four seasons are one cycle. Infinancial and commodity markets, a cycle is loosely defined as price movementof a market from a local bottom to a local top and back again. For example, if amarket is in a 10-point trading range with a bottom of 40 and a top of 50, the pricemovement from 40 to 50 and back to 40 again is one cycle. Traders can use thisinformation to enter low-risk buys at 40 and low-risk sells at 50.Qualities of CyclesCycles are measured from trough to trough as the tops tend to take more timeto develop. Bottoms are more easily defined.The three qualities of a cycle are: amplitude, period and phase.• Amplitude measures the height of a wave (Chart 2)• The Period of a wave is the time spent between troughs (Chart 3)• The Phase is a measure of the time location of a wave trough (Chart 4)Principles of CyclesThere are four important principles to cycles: Summation, Harmonicity, Synchronicityand Proportionality.• Summation hold that all price movement is a simple addition of all activecycles. (Chart 5)• Harmonicity means that there are waves within waves and that they are usuallyrelated. (Chart 6)• Synchonicity refers to the tendency for waves of differing lengths to bottom atthe same time. (Chart 7)• Proportionality describes the relationship between cycle period and amplitude.Longer-term cycles have greater amplitude. (Chart 8)College Level Introduction to Technical AnalysisTheory of Stock Market Cycles • Lecture 7, page

Chart 5Summation of 2 WavesChart 6Lacking HarmonicityChart 7Lacking SynchronicityCycle InvestigatorsKitchin Wave – The 41-month cycle – The Kitchin Wave (4-year cycle)First thought to have been used by the Rothschilds, who had analyzed BritishConsols and had broken up the price fluctuations into a series of repeating curvesthat had been combined and used for forecasting. (Chart 9)In 1912 a NY syndicate heard of the approach and hired a mathematician todiscover the secret formula of the Rothschilds, and working with the Dow JonesRailroad Averages, he discovered a 41-month cycle, plus 3 others, which his employersused to help them invest in the market.Ten years later (1923) Professor W. L. Crum of Harvard published the resultof an analysis of monthly commercial paper rates in NY from 1866-1922. Crumshowed in the series the presence of recurring 40-month periods. The importanceof the contribution was that it established, at least for one series, the existence ofa cycle which could be observed with remarkable regularity. Simultaneously, ProfessorJoseph Kitchin, also of Harvard, showed cyclic influences in bank clearing,wholesale prices and interest rates in Great Britain and the USA for the period1890-1922. The “four-year cycle,” although at first none too favorably received,has as the years have gone by, acquired acceptance. The particular cyclic patternhas since been termed the “Kitchin Cycle.” In 1946, the cycle stumbled and wassquashed for 2 years, regaining its rhythm completely out of step with the idealcadence it had maintained since 1868. The beat has become a little longer, with thetroughs and the peaks upside down.Juglar Cycle1860: Frenchman Clemant Juglar published his book, Des Crises Commercialeset Leurs Retours Periodique en France, en Angleterre, et aux Etats Unis. Juglar hascome to the conclusion that a general economic cycle lasting 8-10 years existed.This is, he discovered the fundamental mechanism of alternation prosperities andliquidations, the latter of which he interpreted to be a reaction of the economicsystem to the events of the former. Eventually his view was adopted, which discountedcompletely the “crisis” role and focussed on the wave. Juglar’s findingswere calculated on banking figures, interest rates, stock prices, business failures,patents issued, pig-iron prices, and a variety of other phenomena. On Wall Streetit became known as the Decennial Pattern – the Juglar Wave, or a 9.255-year cyclein stock prices. (Chart 10)If stock behavior is an example of random walk, there can be no cycle exceptby chance. The 9.255-year cycle has repeated itself 16 times since 1834. Accordingto the Bartels test of probability, the 9.2 cycle could not occur by chance morethan once in 5,000 times!College Level Introduction to Technical AnalysisTheory of Stock Market Cycles • Lecture 7, page

Charts 8Harmonicity and SychronicityChart 9Kitchin WaveChart 109.2 year CycleChart 11Kondratieff WaveChart 12Schumpeter’s ModelKondratieff Wave1926: N.D. Kondratieff described the cycle in detail and thereafter it has beennamed after him. It was Kondratieff who brought the phenomenon fully beforethe scientific community and systematically analyzed all the material available tohim on the assumption of a Long Wave, characteristic of the capitalist process. Hebelieved the economy moved to a vaster rhythm. For 20 years, its basic directionwas upwards; then, after an inflationary peak, it started a 30-year slide, ending upin a depression. Kondratieff considered that this long wave is the most importantforce, reflecting not only major economic trends of the society, but all facets ofnational life - from prosperity to social unrest, war, etc. Moveover, it is the dominantwave, with the other more regular cycles – Juglar’s and Kitchin’s – acting as brakesand accelerators to the dominant wave direction. (Chart 11)Schumpeter’s Model1939: Austrian-born Harvard economist Joseph Schumpeter compiled an exhaustivetwo-volume study entitled Business Cycles: A Theoretical and StatisticalAnalysis of the Capitalist Process. Schumpeter developed a complete economicsystem of regular cyclical growth and contraction using the 3 cycles of Kondratieff(50-57 years), Juglar (10 years), and Kitchin (4 years). Schumpeter argued thatthe cyclical fluctuations were cased by waves of innovation. In this theory, boomis the expansion caused by innovation; depression is the inevitable adjustment ofvalues and cost which must follow. Reduction of costs by innovation is rough onthe less-gifted producers, who must be eliminated or reorganized on a more economicalbasis. Innovations come in spurts, and, as long as this is so, excess andadjustment cannot be avoided. (Chart 12)Dewey & S.I.R.E.Sun Spots – 28-day trading cycle for most commodities. Most commoditymarkets make a cycle low every 4 weeks. (Chart 13)Elliott WaveThe 5-wave pattern. In markets, progress ultimately takes the form of five wavesof a specific structure. Wave (1), (3) and (5) actually effect the directional movement.Waves (2) and (4) are countertrend interruptions. The two interruptions are arequisite for overall directional movement to occur. “Elliott noted three consistentaspects of the 5-wave form. They are: Wave two never moves beyond the start ofwave one, wave three is never the shortest wave, and wave four never enters the priceterritory of wave one. The stock market is always somewhere in the basic 5-wavepattern at the largest degree of trend. Because the 5-wave pattern is the overridingform of market progress, all other patterns are subsumed by it.” (Prechter)Often wave movements are related to the Fibonacci Ratio, the most commonbeing 0.618. (Chart 14)College Level Introduction to Technical AnalysisTheory of Stock Market Cycles • Lecture 7, page

Chart 13Sun SpotsChart 14Elliott WavesSeasonal CyclesAll markets are affected to some extent by an annual season cycle. The seasonalcycle refers to the tendency for markets to move in a given direction at certain timesof the year. The most obvious seasonals involve the grain markets where seasonallows usually occur around harvest time when supply is more plentiful. In soybeans,for example, most seasonal tops occur between April and June with seasonal bottomstaking place between August and October.One well-known seasonal pattern is the “February Break” where grain andsoybean prices usually drop from late December or early January into February.(Charts 15 + 16)Chart 15Seasonal CyclesChart 16Seasonal CyclesCollege Level Introduction to Technical AnalysisTheory of Stock Market Cycles • Lecture 7, page