Forecasting major economic business cycles

There are two basic methods of predicting prices in financial markets. The first is that prices ultimately reflect fundamental values in the economy. Prices are determined by actual and expected developments concerning these values; therefore, forecasting prices amount to forecasting fundamentals.

The second approach argues that most fundamental values are already discounted by the market and forecasting prices become an issue of deciding what the market is “saying” about itself. It’s a matter of technically analyzing prices.

This article looks at a possible chart indicator to forecast crowd sentiment, find trends and pinpoint reversals of the major business cycle. Historically, the ratio of the Dow Jones index and Gold prices has been shown to be one such indicator.

Technical Analysis of Price

In technical analysis of a market, no account is taken of fundamental values because it is assumed investors’ expectations are already reflected in prices. The market is trying to anticipate the future, with changes in prices preceding changes in fundamental conditions.

The rationale behind technical analysis is that people indulge in group behavior. Price movements and indices of investor activity, such as the Dow, gold and crude oil, respond to information shocks and their prices oscillate rhythmically in response to cyclic crowd sentiment. These market rhythms have been modeled as fixed, periodic cycles or as dynamic systems with aperiodic cycles.

Using the Dow/Gold Ratio

The Dow/Gold ratio has been found as a useful measurement of price changes to reflect crowd activity in the business cycle. It can be interpreted as the number of ounces of gold that buys one share of the Dow.

Example:

  • With the Dow at 10,000 and gold at 500, it requires 20 ounces of gold to buy one share of the Dow, so the ratio is 20.
  • Why settle for the Dow/Gold ratio? The reason is that it shows the cyclical nature of the battle between paper assets and hard assets. When the equity growth phase ends, and the preservation of wealth becomes paramount, gold tends to excel. A simple technical analysis of the chart data can reveal when changes are likely to occur.

Dow/Gold Ratio Reveals the Business Cycle

The Dow/Gold ratio chart in figure 1 shows a time period since the 1930s. It can be seen that there are two main peaks and troughs varying from a ratio as low as 1 to as high as 42. When the ratio is on the rise, it is time to buy equities but when the ratio peaks, one needs to switch to selling equities and buying gold.

The peak in the year 2000 indicates the previous signal to start buying gold. Since then, the ratio has been in a downtrend and a bottom is in sight. By extrapolating the graph, a forecasted region of the ratio in the range of 1 – 5 would correspond to pairs of Dow and Gold values. For illustration, one could guess that a ratio of 2.5 may define Dow 5000 and gold $2000. Of course, exact values would depend on actual market conditions.

Therefore, we could be witnessing an approaching new era for equities. Time will tell but one thing is for sure, it would be wise to consult the Dow/Gold ratio to check if a bottom of the business cycle has been formed.

Rhythms of Time Cycles in Financial Markets

Market analysts of finance and economics have long been aware of the existence of market cycles.

Financial market cycles are thought to relate to the behavior patterns of individual market participants acting en masse, i.e. as a crowd. Investor sentiment continually changes in a limit cycle – moving from greed, which causes prices to rise, to fear, which causes prices to fall.

A knowledge of cycle theory can be used to measure the natural rhythm of markets, and this information may be used for timing and entering a trade.

Market Trends a Superposition of Price Cycles

Unfortunately, many market technicians in the past have searched for regular, or periodic cycles. This tradition goes back to using basic science concepts – for example, Dewey and Dakin and many others since, modeled price fluctuations as a simple superposition of waves of different frequencies (cycles).

This technique was fine for the short term but problems occurred when looking for cycles in the longer term. Edward Dewey later showed there were problems with two cycles with slightly different periodicities. They might start in phase but eventually will cancel each other out – the cycle will disappear.

In general, investigation of markets using fixed cycle theories has many drawbacks as it assumes the apparent tendency of such phenomena as price movements, weather habits, sun spots, cattle production, etc., to continue in one trend for a fixed number of weeks, months, or years, before reversing to the opposite direction.

Market Cycles Not of Fixed Length

According to Edgar Peters, there is no intuitive reason for believing that the underlying basis of market or economic cycles has anything to do with periodic cycles. Market cycles are actually aperiodic or dynamic – meaning they expand or contract over time, a feature of chaos theory and the fractal nature of markets.

One of the first cyclical theories was by Ralph N. Elliott. His Wave Principle is able to model the fractal nature of markets and can be applied to all types of long-range or short-range price charts, as long as the subject involves mass behavior. Elliott’s major contribution to cycle analysis was that each wave of similar degree must relate in both price and time.

Each Market Has Own Dynamical System

According to Elliott, markets move in price and time from highs to lows and lows to highs in minor trends, intermediate trends, and primary trends.

Each trend of similar degree is the direct effect of an underlying cause – the constant vibration of numerous cycles at work. According to Bryce Gilmore, on many occasions, market trends change with important cycle events, classified as:

  • Fundamental Cycles due to the regularity of profit reports, production reports, crop estimate report, Federal Reserve board meetings, G8 meetings, government elections, etc.
  • Natural Cycles, or seasonal cycles, as a result of the mechanical movements between the earth, the moon and the sun.
  • Planetary Cycles due to the movement of the planetary system. Gilmore believes that the relative position of planets is important but is a secondary effect on market cycles.

Tools to Measure Cycles

There are relatively few market tools or software to measure cycles and take advantage of them. Some traders use simple tools ranging from those applicable to the fixed cycle: Fibonacci time retracement tool and W.D. Gann’s tools, to those applicable to the dynamic cycle: for example, “CycleTrader”, Gilmore’s sophisticated time cycle software.

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Author: knowledge herald

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