Introduction to the Cyclicality of Financial Markets
Financial markets tend to follow specific cycles. In the long run, these cycles are forming time patterns. The identification of these patterns can optimize investment decisions. Knowing the potential starting year and completion year of each market cycle can prove very helpful to investors.
- Market cycles follow economic cycles, which are formed based on market liquidity conditions, inflation, and the interest-rate cycle.
- A market cycle includes two or four distinct phases. Each phase corresponds to specific trends that emerge during different economic conditions.
- Generally, a market cycle can range from six months to many years, or even decades.
The diversification between mature and emerging markets
Before moving forward, it is useful to examine the main differences between mature and emerging markets.
Volatility and the length of market cycles are the two main elements that differentiate each financial market from the rest. As shown in the following chart, mature markets follow longer cycles, are less volatile, and offer lower risk/return ratios than emerging markets.
Chart: Comparing mature and emerging markets
The chart source is my latest book “Α Game of Chess in the Global Markets”.
For example, the emerging cryptocurrency market follows a short cycle of just 4 years, while the mature commodity and equity markets follow significantly longer market cycles.
Among other things, the level of participation of large institutional investors plays a significant role here. The stronger the presence of large institutional investors in a financial market, the lower the volatility and the greater the cyclicality.
Benner’s Cycle Theory
Benner’s Cycle was published in 1872 on a business card, and it is a simple theory that aims to predict the market’s tops and bottoms. Later, in 1875, Samuel Benner published a book with commodity price forecasts for the period 1876 -1904. In the book “Benner’s Prophecies: Future Ups and Downs in Prices”, he tried to explain historical market changes and the high degree of cyclicality. Benner mentioned three commodity cycles:
- An 11-year pattern of corn and pig prices, with peaks occurring every 5-6 years
- 11-year peaks of cotton prices
- A 27-year cycle in the price of pig iron
Explaining the Benner’s Cycle Model
On Benner’s cycle chart, four main events create a full market cycle:
- The start of a market cycle
- The top of the market cycle
- The bottom of the market cycle, and the start of a mid-cycle
- The top of the mid-cycle
After the bottom of the mid-cycle, a new market cycle starts (1).
Chart: The Benner’s Cycle chart
The chart shows the years of euphoria, the hard years, and the years of panic.
Markets periodicity:
- CYCLE BEGINNING: 18/16/20 years
Starting in 1924, a new cycle begins every 18/16/20 years.
- CYCLE TOPS: 18/20/16 years
Starting in 1927, a new market cycle top occurs every 18/20/16 years.
- CYCLE BOTTOMS: 20/18/16 years
Starting in 1931, a new market cycle top occurs every 20/18/16 years.
- MID-CYCLE TOPS: 18/19/17 years
Starting in 1935, a new mid-cycle top occurs every 18/19/17 years.
Validating the Benner’s Cycle Model
Some analysts argue that Benner’s cycle successfully predicted almost all the tops and bottoms of the American stock market of the past century. Others claim that there is neither logic nor justification behind the Benner Cycle, thus, it can’t be seen as a reliable theory.
However, data is more important than opinions, and the best way to validate Benner’s forecasts is by using historical backtesting. The following chart presents all Benner’s forecasts since 1924, and the validation of these forecasts.
Note: Each market cycle starts in January, while all the tops/bottoms are calculated based on December.
Chart: Validating Benner’s Cycle forecasts since the beginning
Conclusions
These are some key conclusions regarding Benner’s Cycle model:
- Market Cycle Beginning
Benner’s Cycle seems to be very successful at the beginning of each cycle. More specifically, every entry since 1924 was profitable.
- Market Cycle Top
The model wasn’t very successful, as there were 3 good and 3 bad calls.
- Market Cycle Bottom
The model wasn’t successful, as there were 1 good and 4 bad calls.
- Mid-Cycle Top
The model wasn’t very successful, as there were 2 good and 3 bad calls.
Overall, Benner’s Cycle is very reliable at the beginning of each market cycle, and completely unreliable at the end of each market cycle. As concerns market tops and mid-cycle tops, the model is sometimes accurate, and sometimes not.
Other market theories
There are quite a few other market theories that aim to explain the cyclicality of financial markets:
- Wyckoff’s method (explained below)
- The Elliott Principle (explained below)
- The Gann's Law of Vibration (explained below)
- Fibonacci Time Cycles
- Ray Dalio Economic Cycles (» Economic & Business cycles at TradingCenter)
- The Presidential Cycle (a fixed investment cycle of 4 years)
- The Kondratiev Wave (connected to the technological life cycle of 45-60 years)
- Juglar Cycle (a fixed investment cycle of 7 to 11 years)
- Kitchin Cycle (a short business cycle of about 40 months or else 3-5 years)
The Wycoff Method
Richard Wyckoff claimed that no matter the length of a market cycle, there are four distinct phases:
- Accumulation Phase: The market moves sideways, as smart money is buying and retail investors are selling
- Mark-up Phase: The market goes up significantly
- Distribution Phase: The market moves sideways, as retail investors are buying and smart money is selling
- Downtrend: The market goes down significantly (completion)
■ Find more about the Wyckoff Method:
» https://tradingcenter.org/index.php/learn/technical-analysis/329-wyckoff-method
The Elliott Theory
Ralph Nelson Elliott supported that the stock market is moving in a recognizable pattern consisting of two phases: an impulsive and a corrective phase.
- The impulsive phase is composed of five sub-waves (1, 2, 3, 4, 5) and moves in the same direction as the main trend
- The corrective phase comprises three sub-waves (a, b, c)
■ Find more about the Elliott Principle:
» https://tradingcenter.org/index.php/learn/technical-analysis/124-elliott-wave-principle
The Gann Theory
William Delbert Gann claimed he had discovered a repeating pattern of time and price that allowed him to predict market tops and bottoms. Collective behavior creates cycles through time, and that is what Mr. Gann called the “Law of Vibration”. According to this theory, human behavior creates predictable vibrations in the whole market. Gann used circles, triangles, and squares in his work. The square of nine is a trading method that squares price and time. The first square is completed by using the number 9. Each cell in Gann’s square of nine is a point of vibration.
» https://tradingcenter.org/index.php/learn/trading-tips/346-vibration-law-gann
Sources:
- Α Game of Chess in the Global Markets (Giorgos Protonotarios)
- Benner’s Prophecies: Future Ups And Downs In Prices (Samuel Benner)
- Ray Dalio Economic Cycles (check his article on Linkedin)
■ The Cyclicality of Financial Markets and the Benner Cycle
Giorgos Protonotarios, 8th of June, 2023
for TradingCenter.org (c)
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