approach to technical analysis
Cycles - Structure - Price projections
"By the Law of Periodical Repetition, everything which has happened once must happen again, and again, and again -- and not capriciously, but at regular periods, and each thing in its own period, not another's, and each obeying its own law... The same Nature which delights in periodical repetition in the sky is the Nature which orders the affairs of the earth. Let us not underrate the value of that hint." -- Mark Twain
Current Position of the Market.
SPX: Long-Term Trend - The 12-year and 10-year cycles are still in their up-phases and could continue to influence the long-term trend, but a correction is probably very near.
SPX: Intermediate Trend - The uptrend from June '06 is coming to an end and could already have ended for some market indices.
Analysis of the short-term trend is done on a daily basis with the help of hourly charts. It is an important adjunct to the analysis of daily and weekly charts which determines the course of longer market trends.
In this issue:
- It's all about cycles
- The next correction, how deep?
- Market breadth still strong
- Warning signs
It's all about cycles!
Cycles are abstract phenomena of the universe. We do not know their origination or exactly how they are responsible for repetitive fluctuations in the stock market and in many other spheres in our world. Theories have been advanced that stock market cycles are caused by a shift in gravitational pull, and this has a psychological effect on human beings leading them to act alternatively out of hope and out of fear. Until scientists unravel more of the universe's mysteries, this is probably as good an explanation as any. A small shift in gravity would cause a small cycle, while a larger shift would cause a longer and deeper cycle.
However, the problem is far more complex. There are conventional cycles, those whose regular phases are measured from low to low. There are also CITs (changes in trend), reversals which appear to take place at regular intervals and which can bring about either a high or a low point in the market. The Gann cycles would fit in this category. And, some reversals are caused by Fibonacci ratios which determine the relationship between the length of a trend and that of a preceding one. These ratios seem to affect both time and price. The latter two "cyclic" rhythms probably have more to do with mathematics than gravity. Consequently, when someone talks about "cycles", it is difficult to know what is meant, and it is no wonder that a plethora of cycles or pseudo-cycles are used by analysts to make their market forecasts.
I only follow a handful of conventional cycles which have proven their value over the years. Two of these are longer cycles which are currently influencing the stock market: the 12-year cycle which made its low in 2002, and the 10-year cycle which bottomed in 2004. Because they are still in their up-phases, they are primarily responsible for the on-going bull market and in July, they received an additional boost by the 4-year cycle. There is an on-going debate about whether the 4-year cycle made its low earlier than usual this year, or if its low is still ahead of us. After some reflection, I adopted the former view. The stock market has shown exceptional strength since its Summer lows and, if I am correct, the bull market may last quite a bit longer than many expect. That does not mean that there will not be corrections along the way. In fact, one is probably right around the corner. The 9-month cycle made its last low in June, and the next one should come about mid-February. Also, the 20-week cycle last bottomed in mid-October and is scheduled to do so again in early February. The combined action of these two cycles should bring about the first significant stock market reaction since May 2006.
The following is a chart of the weekly SPX which shows the lows of the10/20week and 9-month cycles and when they are expected to make their next lows. I have also placed the 4-year cycle where I think it belongs. This year, it was not defined so much by the amount of weakness that it brought to the market in its final phase, but rather by the strength which it caused after it turned up. In this sense, it behaved similarly to the way it did in 1994.
As long as we are looking at this chart, let's look at other technical aspects. Note that the price has moved out of the top of the channel. This is usually regarded as a sign that the market is overbought, which it is, but it is also a sign of strength. The momentum oscillator at the bottom of the chart has been trading in an overbought condition for some time, with no sign of turning down.
The next correction, how deep?
Because we know that the next two important cycles will make their lows in February and that they are already past their mid-point, we can expect a decline to begin at any time and continue into that time frame. This is all the more likely because important Fibonacci projections ranging from 1423 to 1433 were reached last week. However, there is a smaller -- but very significant -- cycle which could hold things up for a while. The 6-week cycle bottomed only 3 days ago, causing a short-term rally to new highs in the SPX and other indices. This may soften the impact of the decline until we get into the New Year. I would expect most of the weakness to occur between mid-January and mid-February.
This correction will take place in the context of a strong longer-term trend, so it could be fairly mild retracing only 50 to 75 points. When the top is in place, it will be possible to make more precise projections. After that, resumption of the long-term trend is expected.
I want to show you a chart of the hourly SPX, not only to indicate the 6-week cycle lows (blue asterisks), but because it gives a clear picture of what has taken place since July and the 1225 level where the uptrend started. It is difficult to find such a well-defined uptrend channel that has lasted this long. And where is the weakness? Last week, the index went to fetch the top of the channel once again. What is exceptional about this move is that not a single short-term low has been violated since the beginning of the trend.
Market breadth is still strong.
Another validation of the market strength can be found in market breadth. In the past few weeks, the McClellan oscillator (which appears below) has made occasional dips below the zero line, but only to come right back above it. This has resulted in only a mild retracement in the summation index. What a difference with the patterns exhibited by both indices prior to last May. Since only intermediate-term cycles are about to bottom at this time, and since their lows are coming so close to the 4-year low, only a moderate retracement can be expected.
Corresponding strength is found in the new highs/new lows index.
Some warning signs.
There is no evidence that a long-term top is beginning to form, but there are signs that a multi-week decline is about to start. Let's first look at an hourly chart of the NDX and compare it to the SPX, above. The NDX has now been under-performing for several weeks. Historically, the NDX has been the early bird forecasting a correction in the SPX. The last time this took place was in the early part of 2006. At that time the divergence continued for 4 months and resulted in a 100 point decline in the SPX. The current divergence is much less pronounced, and the cycles that will be responsible for the correction are not as powerful as those that produced the summer correction. Consequently, a decline of that magnitude is not anticipated.
The next warning comes from the CBOE Volatility Index (VIX). As you can see on the next chart, last week this index reached a level which is associated with extreme complacency. This reading is the exact opposite of what it indicated in June/July of this year and can only be interpreted as a signal that a reversal is imminent.
Another warning comes from the price structure of the SPX. It appears to be completing a 5 wave pattern which could turn out to be an ending diagonal. If this is true, a reversal could carry the index all the way back to 1378.
The long term strength of the stock market is undeniable, but there are signs that a correction is about to take place. To me, this means that the 20-week and the 9-month cycle, which are scheduled to make their lows in February ‘07, are beginning to exert downward pressure. However, since the 6-week cycle made its low only 3 days ago, it could delay the beginning of the correction for a while longer.