On occasion I receive e-mails about cycles and the way in which I use them with my Dow theory work. Let me begin by saying that cycles and Dow theory are two different disciplines. While they can be used to complement one another, they are very much different and for that reason I am not going to incorporate the Dow theory aspects of my work in this article.
As for cycles, I've learned that in many incidences it seems that when I talk about cycles many conjure up images of some sort of black magic, voodoo, chicken bones and the like. However, I can assure you that this is not the case and in this article I'll show you why. Cyclical analysis is simply a method of trend identification that allows one to look at various trends of like degree. In my case, I then data-mine these trends in an effort to find common traits. In doing so, probabilities can then be applied to the various trends of the various degrees and I term this technique, "trend quantification." I use technical indicators that I have developed to help me identify the various trends and their turn points. Then, I apply the applicable probabilities to current cyclical events in order to develop a forecast. These methods also have an added benefit in that they take the emotion out of the decision. What I mean is, this does not allow a belief that something is going to go up or down to taint the analysis. With this method, the probabilities are what they are and I simply follow them. My goal is just to get it right regardless of the direction.
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 statistics that have been developed over the years, the price action of each cycle of smaller degree and the help of price oscillators, mainly my Cycle Turn Indicator. 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 opposite would of course be applicable when the long-term is moving down.
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 the next low should occur. These timing bands are again developed and are 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 of the intermediate-term cycles. Plus, I use very specific indicators that I have developed to help identify these cyclical tops and bottoms.
The third dimension in this example is the short-term. This is represented by the blue trend lines in the diagram above. When working with the short-term cycles, there are also statistical based 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. The trick, which has taken years to develop, is the identification of which high and low marks THE cycle high or low and its meaning.
How The Three Dimensions Work Together
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, which may or may not always be seen and which can occur at various levels. But, within the context of failures, we also have statistical based expectation in which these cyclical tops and bottoms should occur. Together, this provides us with a road map as to what should occur. We then look for that expected setup to occur. Anyway, getting back to this example, once the short-term cycle began to move down, notice that the previous short-term low was violated. This violation then serves as structural confirmation that the intermediate-term cycle has topped. Therefore, the intermediate-term trend then turned down.
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 my Cycle Turn Indicator to identify the next intermediate-term low.
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 higher high. Plus, we also use this in conjunction with our statistical based timing bands in which the lows are due. Then, structurally, this higher high serves as price confirmation that the intermediate-term trend has turned back up. 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. Also, notice how the short-term cycle went parabolic into the final high. `Going back to the example above, there was no warning by the formation of a failed short-term cycle. However, in this case the I would know that the advance was running on borrowed time as the statistical based timing bands for the cycle top would warn that the top was near. Then, when the short-term cycle went parabolic, we would 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. Once the violation of the previous short-term low occurred, the cyclical structure tells us that the intermediate-term has topped. Additionally, the short-term cycle has violated the previous short-term cycle low indicating that the intermediate-term cycle has topped and the price oscillators, particularly my Cycle Turn Indicator, should at this point be warning of imminent danger. Then, with the break of the intermediate-term cycle below the previous intermediate-term cycle low, the confirmation is given that the long-term cycle has in fact 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 then expect to see both the intermediate-term and the short-term cycles to make lower lows and lower highs all within the context what we refer to as left-translated cycles, which is another indication of the ongoing bearish environment that will continue in force until the long-term cycle low is reached. Again, we have statistical based timing bands in which we look for these lows and then we allow the shorter-term structure to confirm the low. It is by understanding the meaning of such structural shifts at the various degrees that tells us if a decline is temporary, a buying opportunity, or if a more meaningful turn has occurred. As a result, this can keep us on the right side and prevent the mistake of trying to buy a dip that is more that a dip.
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 full proof. However, this is an approach that I have found to work. All we have to do is follow the Cycle Turn Indicator and work within the statistical based timing windows for price lows. For the benefit of new readers I will give you a couple of examples, sparing you the boring details, of how I have used these methods at longer-term market junctures. Back in 2000 I used these methods to call the stock market top and stated, based upon the probabilities, that the 4-year cycle low, which I said was due in 2002, would close below the 1998 4-year cycle low. As it turned out, this is exactly what happened. As the market continued pressing higher into October 2007 I continuously stated emphatically that we were seeing an extended 4-year cycle. Based on the statistics I maintained that neither the July 2006 low nor the low in March 2007 were 4-year cycle lows and that the decline into the 4-year cycle low was still ahead of us. In fact, I even gave a presentation on this in October 2007 at the New Orleans Investor Conference and the statistical based expectations presented there proofed out almost perfectly. Back in 2008 I used these same statistical methods to call the top seen in commodities. In fact, these methods specifically gave sell signals on the CRB, crude oil and gasoline the week of July 18, 2008, which I shared publicly in such article as this. Again, these same methods were used in anticipation and identification of the March 2009 low in equities. At present, few are aware of the dangers of the ongoing rally in equities. Yet, the statistical based work, as well as Dow theory, is warning that all is not well. Once we get the proper setup in place, the die will be cast and the decline into the Phase II low will resume. Because of the duration of the advance out of the 2009 low, most can't imagine such an occurrence is even possible. But, when cycles are properly interpreted and the appropriate indicators and statistics applied, they can be a very very important tool and they have nothing to do with black magic or voodoo. Cyclical analysis and trend quantification is simply an attempt of applying a scientific method to the markets that is non-emotional. Also understand that within the context of these longer-term trends, the same methods are used to identify intermediate and short-term trends and turn points as well.
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