COLLEGE LEVEL INTRODUcTiON TO TEcHNicAL ANALYSiS

Lecture 7 Objectives

THEORY OF STOcK MARKET CYcLES

Introduction theory of stock market cycles - Quality of Cycles - Principles of Cycles Cycle Investigators - Kitchin Wave - Juglar Cycle - Kondratieff Wave - Schumpeters Model - Dewey & S.I.R.E. Elliott Wave Seasonal Cycles

This lecture series is produced by the Market Technicians Association Educational Foundation based on the detailed class notes of Charles D. Kirkpatrick II, CMT Copyright 2007. All rights are reserved.

MARKET TECHNICIANS A S S O C I AT I O N E D U C AT I O N A L F O U N D AT I O N
Identifying and funding educational programs in the field of Technical Analysis since 1993 MTA Educational Foundation Post Office Box 425127 Cambridge, MA 02142-5127 617/253-8959 Fax: 617/452-2199 info@mtaef.org www.mtaef.org

Reading
Master Textbook Technical Analysis: The Complete Resource for Financial Market Technicians Charles D. Kirkpatrick and Julie R. Dahlquist Chapters 19-20; pp. 453-507 Additional Reading Technical Analysis Explained Pring, Martin, chapters 14-15 The Wave Principle of Human Social Behavior and The New Science of Socionomics Prechter, Robert, page 24

Chart 1 Stock Market Cycles

Introduction

Cycle analysis attempts to find recurring major and minor peaks and troughs in price movement for better trade timing. By adding short-, medium- and long-term cycles together the actual price activity can be forecasted. In a trading range, cycle are fairly regular in that the market peaks half way through the cycle. However, when a market is trending, the cycle peak tends to shift left or right depending on the direction of the larger trend (called left or right translation). This is consistent with the notion that in rising markets, prices should spend more time going up and in falling markets, prices should spend more time going down. (Chart 1)

Chart 2 The Amplitude of a Wave

A cycle is simply a regularly occurring sequence of events. The sun rising every morning and setting in the evening is a cycle. The four seasons are one cycle. In financial and commodity markets, a cycle is loosely defined as price movement of a market from a local bottom to a local top and back again. For example, if a market is in a 10-point trading range with a bottom of 40 and a top of 50, the price movement from 40 to 50 and back to 40 again is one cycle. Traders can use this information to enter low-risk buys at 40 and low-risk sells at 50.
Qualities of Cycles

Chart 3 The Period of a Wave

Cycles are measured from trough to trough as the tops tend to take more time to 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)
Chart 4 The Phase Difference Between 2 Waves

Principles of Cycles

There are four important principles to cycles: Summation, Harmonicity, Synchronicity and Proportionality. Summation hold that all price movement is a simple addition of all active cycles. (Chart 5) Harmonicity means that there are waves within waves and that they are usually related. (Chart 6) Synchonicity refers to the tendency for waves of differing lengths to bottom at the 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 Analysis

Theory of Stock Market Cycles Lecture 7, page 

Chart 5 Summation of 2 Waves

Cycle Investigators
Kitchin Wave The 41-month cycle The Kitchin Wave (4-year cycle)

First thought to have been used by the Rothschilds, who had analyzed British Consols and had broken up the price fluctuations into a series of repeating curves that had been combined and used for forecasting. (Chart 9) In 1912 a NY syndicate heard of the approach and hired a mathematician to discover the secret formula of the Rothschilds, and working with the Dow Jones Railroad Averages, he discovered a 41-month cycle, plus 3 others, which his employers used to help them invest in the market. Ten years later (1923) Professor W. L. Crum of Harvard published the result of an analysis of monthly commercial paper rates in NY from 1866-1922. Crum showed in the series the presence of recurring 40-month periods. The importance of the contribution was that it established, at least for one series, the existence of a cycle which could be observed with remarkable regularity. Simultaneously, Professor Joseph Kitchin, also of Harvard, showed cyclic influences in bank clearing, wholesale prices and interest rates in Great Britain and the USA for the period 1890-1922. The four-year cycle, although at first none too favorably received, has as the years have gone by, acquired acceptance. The particular cyclic pattern has since been termed the Kitchin Cycle. In 1946, the cycle stumbled and was squashed for 2 years, regaining its rhythm completely out of step with the ideal cadence it had maintained since 1868. The beat has become a little longer, with the troughs and the peaks upside down.
Juglar Cycle

Chart 6 Lacking Harmonicity

Chart 7 Lacking Synchronicity

1860: Frenchman Clemant Juglar published his book, Des Crises Commerciales et Leurs Retours Periodique en France, en Angleterre, et aux Etats Unis. Juglar has come to the conclusion that a general economic cycle lasting 8-10 years existed. This is, he discovered the fundamental mechanism of alternation prosperities and liquidations, the latter of which he interpreted to be a reaction of the economic system to the events of the former. Eventually his view was adopted, which discounted completely the crisis role and focussed on the wave. Juglars findings were calculated on banking figures, interest rates, stock prices, business failures, patents issued, pig-iron prices, and a variety of other phenomena. On Wall Street it became known as the Decennial Pattern the Juglar Wave, or a 9.255-year cycle in stock prices. (Chart 10) If stock behavior is an example of random walk, there can be no cycle except by chance. The 9.255-year cycle has repeated itself 16 times since 1834. According to the Bartels test of probability, the 9.2 cycle could not occur by chance more than once in 5,000 times!

College Level Introduction to Technical Analysis

Theory of Stock Market Cycles Lecture 7, page 

Charts 8 Harmonicity and Sychronicity

Kondratieff Wave

Chart 9 Kitchin Wave

1926: N.D. Kondratieff described the cycle in detail and thereafter it has been named after him. It was Kondratieff who brought the phenomenon fully before the scientific community and systematically analyzed all the material available to him on the assumption of a Long Wave, characteristic of the capitalist process. He believed the economy moved to a vaster rhythm. For 20 years, its basic direction was upwards; then, after an inflationary peak, it started a 30-year slide, ending up in a depression. Kondratieff considered that this long wave is the most important force, reflecting not only major economic trends of the society, but all facets of national life - from prosperity to social unrest, war, etc. Moveover, it is the dominant wave, with the other more regular cycles Juglars and Kitchins acting as brakes and accelerators to the dominant wave direction. (Chart 11)
Schumpeters Model

Chart 10 9.2 year Cycle

1939: Austrian-born Harvard economist Joseph Schumpeter compiled an exhaustive two-volume study entitled Business Cycles: A Theoretical and Statistical Analysis of the Capitalist Process. Schumpeter developed a complete economic system of regular cyclical growth and contraction using the 3 cycles of Kondratieff (50-57 years), Juglar (10 years), and Kitchin (4 years). Schumpeter argued that the cyclical fluctuations were cased by waves of innovation. In this theory, boom is the expansion caused by innovation; depression is the inevitable adjustment of values and cost which must follow. Reduction of costs by innovation is rough on the less-gifted producers, who must be eliminated or reorganized on a more economical basis. Innovations come in spurts, and, as long as this is so, excess and adjustment cannot be avoided. (Chart 12)
Dewey & S.I.R.E.

Chart 11 Kondratieff Wave

Sun Spots 28-day trading cycle for most commodities. Most commodity markets make a cycle low every 4 weeks. (Chart 13) Elliott Wave The 5-wave pattern. In markets, progress ultimately takes the form of five waves of a specific structure. Wave (1), (3) and (5) actually effect the directional movement. Waves (2) and (4) are countertrend interruptions. The two interruptions are a requisite for overall directional movement to occur. Elliott noted three consistent aspects of the 5-wave form. They are: Wave two never moves beyond the start of wave one, wave three is never the shortest wave, and wave four never enters the price territory of wave one. The stock market is always somewhere in the basic 5-wave pattern at the largest degree of trend. Because the 5-wave pattern is the overriding form of market progress, all other patterns are subsumed by it. (Prechter) Often wave movements are related to the Fibonacci Ratio, the most common being 0.618. (Chart 14)

Chart 12 Schumpeters Model

College Level Introduction to Technical Analysis

Theory of Stock Market Cycles Lecture 7, page 

Chart 13 Sun Spots

Seasonal Cycles All markets are affected to some extent by an annual season cycle. The seasonal cycle refers to the tendency for markets to move in a given direction at certain times of the year. The most obvious seasonals involve the grain markets where seasonal lows usually occur around harvest time when supply is more plentiful. In soybeans, for example, most seasonal tops occur between April and June with seasonal bottoms taking place between August and October. One well-known seasonal pattern is the February Break where grain and soybean prices usually drop from late December or early January into February. (Charts 15 + 16)

Chart 14 Elliott Waves

Chart 15 Seasonal Cycles

Chart 16 Seasonal Cycles

College Level Introduction to Technical Analysis

Theory of Stock Market Cycles Lecture 7, page