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February 10, 2006

Dow Theory and Cycle Quantifications
by Tim Wood

According to classical Dow theory, the rally out of the 2002 low is a giant "Secondary Reaction" separating Phase I from Phase II of a much larger ongoing bear market. A correction into the spring is now in the cards, but it is the following rally that is important and that will set the stage for the decline and the degree of the decline into the coming 4-cycle low. If the Dow theory is correct, the coming 4-year cycle low should also coincide with the Dow theory Phase II low. Therefore, the coming 4-year cycle low should prove to be a very important event that should serve to confirm whether or not this Dow theory phasing is correct.

Charles H. Dow once wrote "There are three movements of the averages, all of which may be in progress at one and the same time. The first, and most important, is the primary trend: the broad upward or downward movements known as bull and bear markets, which may be of several years' duration. The second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months. The third, and usually unimportant, movement is the daily fluctuation."

In my work, I use both Dow theory and cycles. Cycles are not a part of Dow theory. But, understanding cycles allows one to quantify each of the three movements that Dow spoke of above. This quantification is done by analyzing trends or cycles of short, intermediate and long-term degree. Once each of these movements have been segregated into movements of the same degree, we can then "profile" each of these movements in order to develop expectations for the outcome of the current cycle or trend that is at hand.

As an example, there is an intermediate-term cycle in the stock market. We know that since 1896, this cycle has averaged 12.39 months from low to low in the Dow Jones Industrial Average. Within this cycle is the advancing portion of the cycle and the declining portion of the cycle. This cycle last bottomed on April 20, 2005 at 10,000.50 and February 2006 marks the 10th month of the current cycle. Furthermore, we know that this cycle low should ideally occur with the coming 22-week cycle low in early spring.

As discussed in the January issue of Cycles News & Views, we also know that because of the fact that the January rally was able to better this previous cycle top, which occurred in March 2005 at 10,984.50, the expected decline into this coming annual cycle low should now be softened. Here's why. In our profiling of this annual cycle, we know that 91.5% of the entire population of these cycles that have topped out in 7 months or more have held above the previous cycle low. This statistical fact is now fully applicable and tells us that we should expect the coming annual cycle low to occur above the April 2005 low, which again occurred at 10,000.50. So, in going with the odds, this logically becomes our expected outlook for the decline into the next annual cycle low later this spring. But, there are two sides to this statistic and the flip side of this very strong statistic would obviously tell us that violation of the April 2005 low would likely be a very bearish omen. I say this because if the market fails to uphold a statistical probability of 91.5%, then obviously something is wrong. However, for now we are working with the most probable outcome.

Once the coming annual cycle low is made, the market will once again rally as the new cycle pushes up. As things are now setting up, it looks as if this will coincide with a summer rally. Since we are due to move into a 4-year cycle low, the statistics tell us that odds are against the success of summer rally. The reason for this is that in going back to 1896 there have been a total of 27 4-year cycles. 16 or 59% of these 27 4-year cycle tops were followed by a failed annual cycle advance. It was from that failed cycle that the decline into the 4-year cycle really got into gear.

Now, let's look at the 11 4-year cycles that topped without having a failed annual cycle to follow. The common denominator among these 11 cycles is simple. They were all 4-years cycles that topped in bull markets. Saying this another way, we know that in bull markets the advance into the 4-year cycle top typically occurs in conjunction with the very last annual cycle within the 4-year cycle. In other words, there is no failed annual cycle that follows the 4-year cycle top in true bull markets. So, if we are truly in a long term Primary bull market, then the coming annual cycle should exceed the current highs.

But, saying this yet another way, in true bear market periods, market history shows that failed annual cycle advances typically follow the 4-year cycle and set the market up for the drop into the 4-year cycle low. If we are truly still in a bear market and if the rally out of the 2002 low has truly been the rally separating Phase I from Phase II of an ongoing bear market, as is suggested by Dow theory, then we should expect to see a failed annual cycle advance following the 4-year cycle top. This is why the summer rally will be so important. A failure will serve as an early confirmation of where we are and what statistically should follow. At that point, the applicable 4-year cycle statistics will be important as they will be used to develop our expectation for the every so important decline into the coming 4-year cycle low. It was for this reason that the testing of the March 2005 high was so important because it served as a very important mile marker as it was a failed annual cycle advance until it bettered the March 2005 high. As a result, we now know that the timetable for the bear has likely been pushed forward, but not likely aborted.

For more information on Cycles News & Views please visit www.cyclesman.com. My service uses classical Dow theory as a back drop, but incorporates statistical analysis of long and intermediate term cycles as an aid which allows us to develop expectations for the future cycles or trends. The February issue of Cycles News & Views is now available. This issue covers the time and price expectations for the decline into the coming annual cycle low, the expected duration of the rally that is to follow as the next annual cycle moves up and the statistical expectations for the next 4-year cycle low that is looming on the horizon. I also cover gold, the dollar and bonds. My service includes the monthly newsletter and web-based updates that are published at least 3 times a week.

Tim W. Wood
Cyclesman.com

Copyright © 2004-2009 by Tim W. Wood. All rights reserved.

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