In economics and finance, cycles all look alike and start with a continuous line that begins at a low, forms a semispherical bump, and returns symmetrically to the same or near the same low, over and over again, over time. A cycle is made up of waves, and the wave is modeled on the sine wave as the following figure shows. You see this pattern all the time in music and electrical energy, not to mention the ocean tides.
A sine wave.As applied to financial markets, the core concept is that human behavior forms and repeats in specific recurrent patterns. Whether the impulse for financial market prices to form cycles is inherent in the universe or arises from some unexplained aspect of crowd behavior, nobody knows.
Think of the following to differentiate between cycles and waves:
- Cycles have a repetitive character. Not only will prices surge and retreat, but they’ll also surge and retreat in a more or less orderly manner so that you can count the periods between them and use that count to project the next surge and retreat.
- Waves, on the other hand, can be big or small, short-term or long-lasting, choppy or orderly. You don’t know when a wave begins how far it will go. Market waves aren’t like the ocean tides.
Just as you try to attribute supply and demand dynamics to the shape of indicators, you can consider a bigger form of crowd behavior when looking at cycles and waves. Refer to Chapter 3 to read about George Soros’ reflexivity feedback loop. This idea postulates that expectation of a market price move causes crowd behavior that validates the very price behavior that was expected. If and when the crowd is disappointed because an intervening event has now changed conditions, a new expectation gets a grip and the crowd causes that expectation to come true, too. This causes an up-and-down pattern that can have the appearance of regularity — otherwise known as cyclicality.
Starting with economics
The economic cycle is the process by which an economy (and the businesses in it) expand, reach a peak, and then contract and go into recession. They do all this in a wave-like pattern around a growth trend. Economists have been trying to pin down the economic cycle for more than two centuries. So far there have been the following:- A super-long cycle, the Kondratiev wave of 45 to 60 years
- The infrastructure cycle of 15 to 25 years
- The business cycle of 5 to 7 or 7 to 10.5 years
- The inventory cycle (another business cycle) of about 40 months devised by Joseph Kitchin in 1927
Economic cycle theories can be based on data like the number of ships leaving a harbor each week, the unemployment rate, the rising and falling cost of commodities like cocoa, salt, and coffee, or a thousand other data points. One of the off-putting aspects of cycles is that there are so many of them. They overlap, they offset, they last too long for practical application. But hang on. Consider that in the 19th century, the Rothschilds had minions to plot many cycles from data series going back hundreds of years. They were seeking the confluence points where a preponderance of overlapping cycles hit a top or a bottom at the same time. The confluence points comprised a buy/sell indicator for the securities the Rothschilds were trading. The Rothschilds’ secret cycle technique, which clearly was working for them, sparked a small industry of cycle-seekers starting around 1912. It has never stopped. It’s interesting that at least one of the Rothschild companies still uses cycles and has still kept their exact nature a secret.
Move on to magic numbers
Looming over the cycle question is the issue of whether some giant mystical order in the universe dictates financial price movements. One of the best explanations of specific numbers that reveal the mystical order of the universe is in Tony Plummer’s The Law of Vibration: The Revelation of William D. Gann (Harriman House). This book attributes regular rhythms and recurring patterns to a “sacred geometry” that reveals the “deep structure” of the universe. Maybe there are gravitational waves from outer space affecting trading crowd behavior. Einstein predicted these cosmic ripples almost a hundred years ago and their existence was proven only in the last decade.Other number-based cycle theories include Elliott Wave, which I describe in the last section of this chapter, and a lesser known theory based on the number embedded in pi, which I don’t cover. I call these specific number “magic numbers” because the theorists who propose them consider the numbers to have magical properties that somehow determine future prices in securities markets.
Using cycles
Market cycle analysis is far more complicated — and contentious — than applying indicators. Just about every technical analyst will use an indicator for the same purpose, but put a group of cycle theorists in a room and you will get a fist-fight. Every cycle theorist can show you charts of his cycle-based predictions overlaid on actual prices to demonstrate his theory works — but with a lot of adjustments and exceptions, and each theory involves different numbers — 4 days (no, 5), or 20 days (no, 22). If the experts can’t come up with something reliable on cycles, why bother?The answer is easy: Indicators fail sometimes, so any extra help you can get from elsewhere can add to your trading edge, whether volume, market sentiment, fundamentals, seasonality, or cycles.
Opinion is divided about whether cycles are an integral part of technical analysis. Cycles fit into the technical universe because they’re couched in price terms alone without reference to fundamentals. Some technical analysts embrace a cycle theory alone, some modify a cycle theory with other indicators, and some dismiss all cycle ideas out of hand as crackpot, requiring too much effort or not useful. You don’t need to embrace a cycle theory to become a skilled technical analyst. You can safely ignore cycle theories altogether. But you should know about the existence of cyclical theories to be able to evaluate assertions and promotions. Besides, cycle theories are fun.
Cycle material is far more complex than standard indicators. You’ll have to accept (or overlook) some wild-eyed, mystical, and possibly fruitcake ideas. But don’t dismiss cycles out of hand. Several big-name traders embrace some aspects of cycle theory. You don’t have to believe in some hidden order in the universe if you are lucky enough to get a feel for cycles.