Tuesday, September 09, 2008

An Introduction to Trading: Stock Market Cycles

My initial post in this series focused on the importance of approaching the markets with a conceptual framework. In this post, I want to take a step back and explain to readers how I view movements in the stock market. This is a conceptual structure that helps me to think about how the moves in today’s market relate to those from the day before—and the day to come. This structure applies not only to daily market movement, but also movement on smaller and larger time frames. I claim no originality in this presentation; I think you’ll find related concepts from a host of technicians, from Joseph Granville to Stan Weinstein to George Lindsay. Indeed, much of technical analysis lore—from double-bottom and head-and-shoulders patterns to oscillator and indicator divergences—spring from this kind of conceptual structure.

The key idea is that markets, at any time frame, move in aperiodic cycles. A cycle is a structure that includes two or more market tops and/or bottoms. Like snowflakes, cycles have several defining features, but no two cycles are completely identical. Cycles are aperiodic in that tops and bottoms do not occur at regular, predictable time periods. These cyclical structures occur on an intraday basis, swing basis, and over longer periods of weeks and months.

The chart above is a highly idealized view of a market cycle. It begins with a sharp upward movement from a low point, with broad participation in the rise. The bull move attracts interest—and often volume—until we hit a point of maximum upward momentum and strength, which I have labeled as a momentum high. At a momentum peak, we will typically see a large number of stocks making new highs relative to new lows; we’ll also often see expanded volume; and overbought readings on many market oscillators.

The higher prices attract sellers and a decline ensues that is a more significant decline than had been seen during the prior rise. I’ve labeled this as a separating decline, adopting a term from Lindsay. During this decline, certain market sectors hold up relatively well; others dip significantly. Market indicators will typically move from overbought to more neutral levels and, we will typically see a reversal of prior action in bonds, currencies, and/or commodities. This alerts us to the possibility that something is shifting in the financial landscape.

From this separating decline, we typically get one or more subsequent rallies, often that take the broad market indexes to new price highs. At these highs, however, we frequently see fewer stocks making new highs, fewer sectors participating in the strength, and weaker upside momentum readings. Very often, we’ll also see non-confirming action in those correlated markets: interest rates, commodities, and currencies. As the market makes these fresh price highs, upside strength and momentum are waning. Divergences begin to accumulate.

With the waning upside, those shifts among asset classes lead to selling pressure in the broad indexes, taking the majority of shares lower. This decline continues until we hit a point of maximum downside momentum, at which we see stocks making new lows dramatically outnumbering those making new highs; a typical expansion of volume on panic selling; and very weak oscillator readings.

Here, too, this point of maximum downside momentum tends to be followed by a separating rise that is notably stronger than the upside reversals that occurred during the market’s downward move. Some sectors bounce very strongly off their lows; others rise only a little. This bounce is commonly accompanied by a move to more neutral momentum and strength readings in indicators. Not infrequently, we’ll also see reversal moves in interest rates, currencies, and/or commodities.

This rise is followed by one or more subsequent declines that may take the broad indexes to fresh price lows. During this latter decline, we see fewer stocks making fresh new lows, reduced downside momentum, and divergences among many market indicators. We may also see non-confirming action in those related asset classes. This waning of selling then emboldens buyers, and we start a fresh cycle.

The nesting of these cycles within one another means that any given cycle will have a shape that is partially determined by the cycles of higher-order magnitude. If the market on a longer time frame is in a rallying mode, for example, a short-term cycle will tend to have an elongated rise and a modest subsequent decline. The structural qualities of the cycles will typically be present, but their timing and shapes will vary, fooling many traders.

It takes a while to train your analytic eye to perceive these cycles. On a large time frame, for instance, we had a bottom in October, 1998, a momentum peak in the stock market in the first quarter of 2000, a price peak in the Dow during 2001, a momentum trough in October, 2002, and a price low in March, 2003. That was one big cyclical movement.

More recently, we had a momentum peak in June, 2007; a price peak in October of that year; a momentum low in January, 2008; and we—I believe—are making subsequent price lows in July and now in September of that year. If that analysis is correct, the next significant market cycle should be to the upside.

Note that this is not a precise timing tool, a mystical numerological scheme, or a mechanical trading system. It is a conceptual framework that guides thinking as to two important market issues:

1) Is the market getting stronger or weaker over time?

2) How is the market action at one time frame linked to that at other time frames?

But why would we see such structural similarities among market movements? That question will be the topic of the next post in this series and will form a second leg to our developing conceptual structure.