Gerald Loeb, in his classic tome “The Battle
for investment Survival”, wrote that an investor must be proficient in
fundamental analysis and must have working knowledge of technical analysis
but in the end it is the man that can walk outside, breathe the air and know
which way the wind is blowing that will be successful.
I must admit that I never put much credence into
these wave and cycle theories but I think that it is important in this world
of high frequency, algorithmic trading that it is important that I understand
these theories but also do my bests to help my readers understand them as
Today I wanted to write about different wave
analysis theories that are becoming more and more a part of the markets
algorithmic trading that accounts for about 80% of the trading that takes
place. The wave principal incorporates cyclical and secular movements in
financial markets in an effort to capture the overall psychology of the
investors. Cycle analysis has played a significant role for investors in
determining the future direction of financial assets over the past century.
Riskier assets such as commodities have shown
cyclical tendencies over the decades and there have been a number of studies
that have explained the historical wave patterns of commodities such as the
Elliot Wave Principal, the Kondratieff cycle and the Longwave
Wave analysis, as it relates to the markets is
simply the study of supply and demand of a stock based on a specific
criterion. The Elliot Wave Principle focuses on price action, where the
Kondratieff and Longwave theories combine specific
The most coveted to these cycles is the Elliot Wave
Principle which is a form of analysis that traders use to analyze market
cycles. He underlying theme in the Elliot Wave is to identify investor
psychology and attempt to create a technique to measure this psychology and
how investors react to events.
Ralph Nelson Elliot developed the principles of the
Elliot Wave during the 1930’s and published his theory of market
behavior in a book “The Wave Principle” min 1938.The theory
analyzes specific price movements or waves which determine a point in a
cyclical trend. An example of his theory is that long term bull markets move
up in five waves while long term bear markets move down in three waves.
During the upward bull market movement each wave is accompanied by
corrections (labeled A, B and C) which are downward cycle waves.
There are three basic rules for the Elliott Wave
1. Wave 2 cannot retrace more than 100%
of wave 1.
2. Wave 3 can never be the shortest of
the three impulse waves.
3. Wave 4 can never overlap wave 1.
The second theory is called the Kondratieff Cycle.
The Kondratieff Cycle is a theory based on a study of price behavior combined
with economic data which includes wages, interest rates, raw material prices
and other factors that affect economies. Kondratieff was convinced that his
study of economic, social and cultural life proved that economic cycles
existed and could be used for the purpose of anticipating future economic
developments. The wave theory is centered on a growth and a contraction phase
of the long wave, when growth and deflation are at their peaks respectively.
The analysis differs in that it is less technically oriented and analysis
specific economic data points to determine levels of waves.
The Longwave principle is
based on the belief the Kondratieff Cycle repeats itself over time. While the
Kondratieff Cycle applies to past events, The Longwave
Cycle looks at many factors to determine where we are presently and uses that
information to forecast the future price action and economic activity. The Longwave Principle looks at the life cycle of an economy
and uses those points to project the psychology of market investors.
The concept of a commodity super cycle grabbed the
attention of the investment community after the Federal Reserve announced QE2
during the summer of 2010. With the economy reeling, many thought that a shot
of liquidity would drive inflation higher and eventually create growth and
higher inflation. The question for most analysts is whether commodity prices
could climb two or three fold despite moving higher by 70 percent since the
lows reached in March of 2009.
One analysis that can be used to forecast a super
cycle in commodities is to examine the long term price trends and apply the
Elliott Wave Principle. The pattern for price expansion or growth is depicted
as a five price swing sequence from mid 2002 to
late 2008. Five waves were completed and reversed during the financial crisis
of 2008 – 1009 which quickly ended the cycle with a crash of commodity
see chart below.
I chose this chart of the Reuters / Jefferies CRB
Index because over the years from 2002 to 2009 it is a perfect proxy chart
that illustrates the Elliott Wave. It illustrates the 5 waves perfectly.
Markets have rebounded and there are
some factors that could take commodity prices above the recent 2008 highs.
I will finish my thoughts on the wave cycles in
another post but before I take my leave I wanted to spend a bit of time
talking about the news coming out today.
U.S. equities are expected to stay steady on Friday
after sharp gains in the previous session, with futures for the S&P 500 staying flat, for
the Dow Jones gaining 0.08 percent and for the Nasdaq
100 falling 0.07 percent.
At 8:30 EST the Labor Department will
release the employment report. Economists forecast that a total of 60,000
jobs were created in September compared with no new jobs in August. The
unemployment rate is seen at 9.1 percent, a repeat of the August rate.
The Commerce Department will release
wholesale inventories for August. Economists predict inventories to rise 0.5
percent versus a 0.8 percent increase in July.
The Economic Cycle Research Institute
releases its weekly index of economic activity for Oct. 1. In the prior week
the index read 121.9.
The Federal Reserve will issue August consumer
credit. Economists in a Reuter’s survey forecast consumer credit to
raise $7.75 billion versus an $11.97 billion increase in July.
The U.S. House of Representatives and the
Senate will vote next Wednesday on three long-delayed trade deals with South Korea, Panama
The Bank of Japan kept monetary policy unchanged on
Friday, holding off from tapping its depleted policy arsenal for now although
fears of a global recession and Europe's debt crisis are clouding the outlook
for the fragile economy.
Credit agency Moody's cut its ratings on
British banks Lloyds and Royal Bank of Scotland on Friday and said it
expected the UK government would have to continue to support the country's
systemically important financial institutions.
Today the FTS Eurofirst
300 index of top European shares rose 0.7 percent after the European Central
Bank's offer on Thursday to help struggling banks. Japan's Nikkei average rose 1 percent.
In conclusion, there will be a lot of news to
digest today and it all has the potential to move the market. It
promises to be a very interesting day.