Microscope, Telescopes & Satellites (3)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

The last of our instruments is the satellite which gives a global perspective in distances.  In our time horizon analogy, the  satellite might cover many years, if not decades, of market action.  It is basic human nature to seek order in chaos, and investors and speculators carry this instinct over into their market moves.  They try to make some sense out of the seemingly random action that occurs each day in the market.  One of the methods many market participants use to overcome this market confusion is to ascribe a cyclical aspect to the market.  If you view the market as having cycles or "seasons" like nature, a certain level of comfort can be achieved and some sense can be made of market action.

In addition to creating the Dow Jones Industrial Average, Charles H Dow, the founder and first editor of the Wall Street Journal, wrote over two hundred editorials on the market in his financial newspaper.  After Dow's death, William Hamilton, Robert Rhea and George Schaefer collected the editorials and organized them into what they named the Dow Theory, a term Dow never used in his lifetime.  Under this theory, the market has three movements or cycles consisting of the "main movement" which may continue for anywhere from less than a year up to several years.  This would be considered the major trend of the market during this period.  The next longest period is the "medium swing" which lasts from several days to up to three months.  It consists of any secondary or intermediate reaction to the main movement.  The shortest period is the "short swing."  These minor movements may continue from several hours up to a month or more.  Many technical analysts believe that the Dow Theory is the foundation of modern technical analysis.  All three of these movements are happening in the market at the same time.

Another well known cycle was developed by a Russian economist, Nikolai Dmitriyevich Kondratieff.  It bears his name, the Kondratieff Wave.  This cycle or wave covers a period of up to 50 years from beginning to end and is meant to expose major moves in commodity prices.  It is also supposed to explain boom and bust cycles in capitalistic countries.  Some of its followers believe it also accounts for social and political events.  I mention it because it was popular in the 1990s, but I would point out that the investing careers of most individuals will not last for the duration of a complete 50 year Kondratieff Wave.

Another theory of cyclical movement was developed by an accountant, Ralph Nelson Elliott, in the 1930s.  It is a form of technical analysis.  Mr. Elliott published his book, The Wave Principle, in 1938.  He believed that market prices moved in specific patterns based on prevailing crowd psychology, alternating between optimism and pessimism.  His theory is popularly referred to as the Elliott Wave, which includes a five wave pattern and a three wave pattern.  Elliott  believed that the basis for his theory rested on the Fibonacci sequence of numbers, examples of which are found throughout nature.  Wave analysis continues to be a component of technical analysis, and its most famous proponent today is Robert R. Prechter.

If you were to look at the stock market over the past 100+ years, you would see that the overall trend is up, marked, intermittently, by severe downward cycles and sharp recoveries.  The basis for this may be nothing more than basic human nature.  As Bradbury K. Thurlow pointed out in his book, Rediscovering the Wheel: Contrary Thinking & Investment Strategy, "the generic  bias of nearly all investment approaches is positive".  He went on to point out the following:

Because of our historical indoctrination in accepting the premise of a secular uptrend in stock prices, because investors are traditionally owners rather than sellers of assets, and because in America we have been taught that the road to success is in accentuating the positive, we think habitually of the plus factors that affect stocks and tend to minimize the minus factors.*

This may be the only cycle you should keep in mind.  As to the rest of them, it becomes a matter of belief.  Norman G. Fosback reviewed several cyclical theories in his book, Stock Market Logic, A Sophisticated Approach to Profits on Wall Street.  He concluded his study as follows:

Most cycles are without doubt figments of the imagination.  Nevertheless, strange things exist in the universe, and the ultimate resolution of the truth of cyclic phenomena must await future study.  In the meantime, if cycles have a utility, it is in reminding us that "This, too, shall pass;" that no bull market or bear market lasts forever.**

* Excerpts from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, copyright ©1981, published by Fraser Publishing Company, are used by permission of the current copyright holder.

 ** Excerpt from Stock Market Logic, A Sophisticated Approach to Profits on Wall Street, Norman G. Fosback, copyright 1976, 1993, The Institute for Econometric Research, page 168.

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