Stock market cycles

Stock market cycles

A cycle or a wave represents a process that tends to repeat itself in time in a more or less regular fashion.

There are many types of business cycles. Some of the most common ones are those that impact the stock market [Channels & Cycles: A Tribute to J. M. Hurst, by Brian Millard, Traders Press (March 18, 1999)] . In his book The Next Great Bubble Boom, Harry S. Dent Jr., a Harvard graduate and Fortune 100 consultant, outlines several cycles that have specifice relevance to the stock market. [The Next Great Bubble Boom: How to Profit from the Greatest Boom in History, 2005-2009, by Harry S. Dent, Free Press (September 2004] . Some of these cycles have been quantitatively examined for statistical significance.

Some of the major cycles that have been examined by Mr. Dent and others are:

* The four-year presidential cycle in the USA.
* Annual seasonality, in the USA and other countries.
* "The Halloween indicator" (or "Sell in May and Go Away") [http://www.marketwatch.com/News/Story/Story.aspx?guid={CDFB00A7-8DAA-49A9-A2EF-83502D872CDF} For everything a season?, By Mark Hulbert, MarketWatch, Oct. 28, 2005]
* The "January effect" [http://query.nytimes.com/gst/fullpage.html?res=9C02EFDA143EF936A35751C1A96F958260 STRATEGIES; Playing the January Effect, Whatever Its Cause, By MARK HULBERT, December 5, 1999]
* The lunar cycle [ The Harvard Business Review, December 6, 2006]

Many investors and market traders take recourse to these cycles and the insights they provide when making investment decisions. For example investment advisor Mark Hulbert has tracked the long term performance of Norman Fosback’s a Seasonality Timing System that combines month-end and holiday-based buy/sell rules. According to Hulbert, this system has been able to outperform the market with significantly less risk. According to him it has the best risk-adjusted performance of any system his newsletter tracks [http://abnormalreturns.com/2005/11/03/hulbert-on-fosback-seasonality-system/ Hulbert on Fosback seasonality system (Commenting on "Barron's" article, Trading the Calendar Can Pay Off Big, By Mark Hulbert, Thursday, November 3, 2005)] .

Causes

Many have theorized as to the possible underlying causes of these statistical cycles. The four year U.S. presidential cycle for example is attributed to politics and its impact on America's economic policies and market sentiment. Either or both of these factors could be the cause for the stock markets statistically improved performance during most of the third and fourth years of a president's four year term. [http://www.hussmanfunds.com/rsi/prescycle.htm Average Gain in Year Two of Presidential Cycle Hides Important Declines, William Hester, December 2005] . The month-end seasonality on the other hand is generally attributed to the automatic purchases associated with retirement accounts. There other cycles however, for which the explanations are less clear.

Compound cycles

The presence of multiple cycles of different periods and magnitudes in conjunction with linear trends, can give rise to complex patterns, that are mathematically generated through Fourier analysis.

In order for an investor to more easily visualise a longer term cycle (or a trend), he sometimes will superimpose a shorter term cycle such as a moving average on top of it.

A common view of a stock market pattern is one that involves a specific time-frame (for example a 6-month chart with daily price intervals). In this kind of a chart one may create and observe any of the following trends or trend relationships:

*A long term trend, which may appear as linear
*Intermediate term trends and their relationship to the long term trend
*Random price movements or consolidation (sometimes referred to as 'noise') and its relationship to one of the above

However, if one looks at a longer time-frame (perhaps a 2-year chart with weekly price intervals), the current trend may appear as a part of a larger cycle (primary trend). Switching to a shorter time-frame (such as a 10-day chart using 15-minute price intervals), may reveal random price movements appearing as high frequency 'noise' in contrast to the primary trend on the chart.

Use of multiple screens

A stock market trader will often use several "screens" on thier computer (charts) with different time-frames and price intervals in order to gain valuable information for making profitable buying and selling (trading) decisions.

Some expert traders emphasize the use of multiple time-frames for succesful trading. For example, Alexander Elder suggests a Triple Screen approach [Dr. Alexander Elder, Trading For A Living” (1993)] [http://www.investopedia.com/articles/trading/03/040903.asp Triple Screen Trading System - Part 1 by Jason Van Bergen ] .

*Longer-term screen: To identify the long term trend and opportunties
*Middle screen: To identify the best time (or day) in which to locate a trading opportunity
*Finer screen: To identify the optimum intra-day price at which to buy or sell a security

Implications

Several of the stock market 'technical analysis' approaches are based on the underlying assumptions of cyclicity. These include the use of oscillators, moving averages and the Japanese Candlestick style charts. All of these indicators are different methods of analyzing and synthesizing market price and/or volume over time.

*Moving Averages: There are many types of moving average indicators. Some moving average indicators such as the exponential moving average show a slightly different version of the moving average trend by smoothing out the short term fluctuations.
*Oscillators: These illustrate the price and volume cycles thereby allowing the investor/trader to identify relevant peaks and valleys within the trend itself.
*Japanese Candlestick Charts: This is a specialized type of price chart that provides more information about price activity than the standard "mountain" style chart used by many amateur investors.

ee also

* Wave
* Technical analysis
* Market timing
* Stock market bottom
* Market trends and Trend following

References


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