How to profit by spotting cycles in the markets

One of the longest economic cycles in use today is the Kondratieff cycle. This lasts for 50 to 60 years (the duration is somewhat inexact). It describes the cycles of catastrophe (complete economic contraction) at one extreme, rising to recovery (maximum expansion) at its apex, then declining to catastrophe once more.

Kondratieff was a Russian economist working in the 1920s. So he was heavily influenced by the great bull market and economic expansion of that period. He had lived through the Great War, and noted that wars come in two varieties, economically speaking.

There is a ‘trough’ war which starts on the first part of the cycle. The price stimulation of wartime spending creates economic recovery and a moderate inflation in prices. ‘Peak’ wars occur when the recovery is well underway, where capacity utilisation is high, and the added government spending creates a huge increase in prices and the money supply.

After a ‘peak’ war, the government spending spigot is shut off. The resulting recession creates a disinflationary period (a steadily declining rate of price increase) of about ten years where relative prosperity and stable times return. During the last part of the cycle, deflation and depression occur as credit is too easily available, resulting in asset price bubbles inflating, then bursting with damaging consequences (sound familiar?).

The Kondratieff cycle has been studied extensively. But the major bone of contention between today’s economists seems to be: just where are we in the current cycle? That means it’s of limited use to investors. It might be an evocative description of the ups and downs of the economic lifecycle, but if we can’t agree on where we are, it’s hard to use it to make money.

Another theory with a large following, is the notion of the four-year business cycle. This maintains that the expansion and contraction of credit occurs in four-year cycles. Business expands when credit is available, and contracts when credit tightens. Forecast stock market moves would be straightforward, if this theory were reliable.

If it were only that simple!

Market cycles are more reliable and easier to spot than economic ones

So why am I telling you this at all? Well, while economic cycles can be difficult to detect, you also have cycles in markets. And we have one advantage here – we have the price charts, which show the price highs and lows at a glance. Price cycles are much easier to spot on a chart than in the economy.

And here is a great cycle I have found in the US dollar (USD) / yen (JPY) chart.

Since 2006, the USD/JPY has made a very significant low every year at around the same time of the year – usually in November. All of these lows have lead to a major advance – and a profit opportunity. Will this cycle repeat in 2010?

In summer this year, I was tracking the yen as it benefitted from the huge ‘carry trade’ (borrowing in a low-yield currency such as the yen to invest elsewhere) that banks and hedge funds were taking advantage of. The USD / JPY rate was heading for the all-time low (made 15 years ago) of 80.

Already in 2010, it had dropped from the 93 level. But, if history is any guide, I expected the 80 level to represent major support, and a large price rally to occur. And in October, it dropped below the 81 level. My feelers started twitching!

Waiting for the dollar to fight back

From mid-September to late October, I noted the momentum readings were getting stronger as the market declined – a positive sign for a turn-around.

Then on 31 October, the market came within 20 pips of the 80 level, and started to rebound, as traders recognised the significance of that round-number 80 level.

Of course, I wanted to put on a long trade. On 1 November, I pulled the trigger, expecting the 80.20 low made the previous day to hold.

• 1 Nov buy £2 rolling USD / JPY @ 80.90.

• Risk 100 pips or £200 (3% of account)

If stopped out, I was prepared to re-enter again, as I was confident my cycle theory was good. I believed I could expect a major low around this time, and that the 80 area would hold. And my account had now grown large enough to accommodate this risk without breaking my 3% rule.

Over the next few days, the market advanced on rising momentum. I was then able to raise my protective stop to break-even using my break-even rule on 9 November as it moved into new high ground.

From 16 November, the market struggled to make any progress, and on 22 November, I could draw a good pair of tramlines:

On 23 November, the market rallied right up to my upper tramline, and then retreated.

That was not good news – it should have carried on higher. But momentum was reaching into overbought territory. So I decided to raise my sell-stop to a point just under the lower tramline, and was taken out on a correction:

• 23 Nov sold £2 rolling USD / JPY @ 83.15.

• Profit 225 pips £450 vs risk of £200

The market had made a good rally from the low, Momentum was high, and a correction down was likely. Setting such a stop was a good policy.

Spotting cycles for yourself

If you go over many price charts, you will spot high/low cycles repeating at the same intervals (or very close). Don’t just look for the highs separately from the lows. There are cycles that incorporate combinations of highs and lows.

If you spot a repeated pattern going back at least three cycles, it is probably reliable. Used in conjunction with other analysis, it can give you an advantage in setting up a good trade. And even short-term charts are good hunting grounds.