Cycles—The Rhythm of the Market
There is an adage in the stock market that says, “Sell in May, and go away.” There also is the January effect, the Halloween indicator, and several other well worn terms. What these phrases have in common is they refer to certain patterns that tend to repeat with predictable regularity. We call these patterns cycles. There is the super cycle, the 17.6 year stock market cycle, the 7 year commodity cycle, the four year presidential cycle, the lunar cycle, annual cycles, and the list goes on.
Markets also have cycles. They are created by the never ending battle of buyers and sellers in the marketplace. With a bit of practice, you will be able to spot the rhythmic rise and fall of prices on a chart. Some are easy to see, some take a bit of searching, but when you spot the patterns of ups and downs, what you are looking at are cycles. This rhythm can be useful for timing a trade.
How to Identify Cycles
If we compare a market cycle to the weather, it helps us illustrate how they affect our expectations for price behavior. Coming out of winter and into spring, we expect that the temperature is going to rise rapidly. It doesn’t do so in a straight line, but the trend is clearly up. This would be similar to the early stages of a market cycle. Entering a long position in the early stages of a cycle can be very profitable. As a practice, we only look to take long positions in this part of a cycle. Attempting to short the spring part of a cycle can be very risky, as the price trend is for prices to climb.
As spring transitions into summer, the uptrend in temperature takes on a more sideways movement. Sure, there may be particularly hot or cold days, but the trend is for a consistently high temperature. This would be analogous to the top of a market cycle. This part of the cycle is difficult to trade because there is no clear up or down trend. Trading this part of a cycle can result in several whipsaws as stops get repeatedly hit. In order for us to make money, we need prices to be rising or falling. In our opinion, it is usually best to avoid the summer part of a cycle altogether. Patience is the order of the day here.
As autumn approaches, we can accurately predict that the temperature is going to drop. Finally, the dog days of summer give way to cooler temps, and as the days get shorter, the temperatures begin to drop much more rapidly. The later we are in the season, the more confident we become that cooler temps are imminent. This would be similar to the late stages of the market cycle top. Entering a short position at this stage of the market cycle can also be very profitable. In general, we are most interested in the spring and autumn, or the “sides” of the cycle, and not at all interested in trading the top of the cycle. As a rule, we only look to have a short position, or to be in cash, during this part of a cycle.
There are cycles of varying lengths of time, and each asset tends to have its own unique cycle rhythm. With our style of trading, we tend to focus on daily cycles. Each asset has its own cycle length, which will vary at times—they won’t always be perfect. Below is a chart of the HUI showing three daily cycles, with each cycle being right around five weeks in length. Notice how they tend to rise and fall at the same time?
The green arrows show the exact bottom of each cycle, and the red arrows show the top. A cycle that rises for longer than it falls is called a RIGHT TRANSLATED cycle. The first cycle in the below chart shows a right translated cycle. The peak was on the right side of the cycle. The next cycle is a LEFT TRANSLATED cycle, a cycle that rises for a shorter period than it falls, giving it a peak that is on the left side. Knowing whether a cycle is right or left translated can help us determine a price target when we enter a trade. For example if a cyclewas extremely right translated (meaning it rose a long time, deep into what we’d consider a normal cycle time period), we may expect only a very mild correction before the uptrend resumes. The first cycle below is a good example of that. The peak of the cycle was so right translated, that the drop into the cycle low lasted only 3 days.
We rely on cycles to help us with our entries and our exits. The challenge is getting into a trade in the early stages of a cycle so the reward to risk ratio exceeds our minimum 2:1 requirement, but not so early that we haven’t established a point on the chart to set a logical stop. The below chart shows the point at which opportunity to profit is greatest, and the point at which the risk becomes the greatest, in each of the two cycles. In the real world, it isn’t possible to catch the exact tops or bottoms. But with experience, and good risk management, we can catch enough of the moves to consistently make money over time.
Cycles are just one of many tools we have in our toolbox, though a very important one. We refer to them often enough that, over time, it should become clear how we utilize them in our trade analysis.