The Economy

A MONEYCHANGER INTERVIEW: TIM WOOD:
WHICH WAY DO MARKET CYCLES POINT?

For fifteen years CPA Tim Woods has been studying markets and technical analysis intensively. He focuses on cyclical and Dow Theory methods. In his November 2001 article in Technical Analysis of Stocks and Commodities magazine, Mr. Wood forecast that the Dow would close below the 1998 four-year cycle lows. Specifically, he called for a close below 7,400 in fall 2002. [The eventual low came October 9, 2002 when the Dow closed at 7,286.] After that article appeared he launched his newsletter, Cycles News & Views. Disgusted with mindless pro-stock propaganda masquerading as analysis, Tim wanted to offer the investing public factual, non-biased analysis. He comments on the stock market, gold, bonds and the dollar. You can visit his web site at www.cyclesman.com to sample his work.

Presently Mr. Wood expects the equity markets to decline much further. In the short term, he does not believe that stocks have already made their critical four-year cycle low. He looks for that low to occur in December or early January. That should mark the beginning of a fairly long (six months, more or less) counter-trend rally in this on-going bear market.

Mr. Wood’s Cycles News & Views is available only by e-mail. A year’s subscription (12 issues) costs $250, but until December 16, 2002 if you mention that you are a “MONEYCHANGER subscriber” you can subscribe for only $199, and Mr. Wood will send you all eight back issues. Send payment to Cycles News and Views, 1868 Forsythe Ave., PMB 305, Monroe, LA 71201. Mr. Wood kindly made time for this interview on October 22, 2002.

MONEYCHANGER Explain the concept of market cycles.

WOOD There are cycles in every aspect of our lives, even where we’re not aware of cycles. Night and day, the seasons, the sun, the moon, your heartbeat, your breathing, birds’ migration -- everything in nature moves in cycles and so do markets.

The trick for the market technician is to identify the cycle. That’s made harder because there are various cycles working within one another. For example, there is a four-year cycle in the stock markets. Within that four-year cycle there is annual cycle. Within that annual cycle there is a weekly cycle, and within that weekly cycle there is a daily cycle. You have to take a layered approach, extracting and quantifying the cycle you are looking for. Then, based on history and that quantification, you can form an expectation or probability about that cycle’s future behaviour.

MONEYCHANGER The cycles of the earth around the sun is exactly 364-1/4 days. Are you maintaining that the stock market cycles from high to low in exactly 48 months?

WOOD No, cycles in the stock market act like a living, breathing entity. One minute you might breathe 15 times and the next minute 18 times. Cycles contract and expand ever so slightly.

MONEYCHANGER Can they really be useful then? I’ve seen technical analysis systems so elastic in their interpretations that they lose all substance by the time their practitioners finish putting on the qualifications. If your cycle is so elastic that it stretches from six years to three and a half years, how can it help you time investment decisions?

WOOD It’s not that elastic. I found that from 1896 the Dow Jones Industrial Average cycle averages 47.08 months. Knowing that you can develop timing windows.

The weekly Dow cycle runs 16-25 weeks. You might say, “That’s a mighty wide window of time.” However, when you assemble a whole population of cycles with many, many instances, you find 80% of the time the weekly cycle falls within this window. That cycle averages 22 weeks. So you can develop a high probability – 80 to 90% -- that the cycle will fall within that window, based on history. I also use additional technical indicators that have been tied to the cycle. These help identify cycle lows within the timing window.

MONEYCHANGER What exactly do you call “one cycle”? I know what a sine wave looks like – a cycle that moves from zero up to its maximum positive peak, then all the way up back down to minimum negative trough, and then back up to the zero line, like a backwards S on its nose.  Is that what you mean by “one cycle”?

WOOD I measure “one cycle” from trough to trough, i.e., from bottom to bottom.

MONEYCHANGER So your cycle looks like a mound?

WOOD Right, or a half circle.

MONEYCHANGER So from trough to trough stock markets show a four-year cycle, a yearly (or seasonal) cycle, a weekly cycle, a daily (or trading) cycle, and I think you mentioned a trading cycle, too. What good does that do us?

WOOD The best answer comes from last summer. Everyone was debating whether we were in a recession or not. Armed with my background as a market technician and cycles student, I decided to do a long term study to figure it out for myself. I believe that the stock market is a barometer of things to come, not things that have happened. It forecasts the economy.

The question was, “Do long term stock market tops indeed occur before a recessionary decline?” I decided to look at the four-year cycle. First you have to quantify that cycle, so I went back to 1896 and identified every four-year cycle bottom. Then I began analysing the cycle. The main thing that popped out was this: every time the four-year cycle topped out in 20 months or less, 100% of the time it turned down and took out the previous cycle low.

MONEYCHANGER “Topped out in twenty months or less” means from beginning trough to peak?

WOOD Yes, from trough to peak in 20 months or less. Since 1896 the four-year cycle has topped five times in twenty months or less. Every time it did that, the next low moved below the previous four-year cycle low. Whenever anything happens one hundred percent of the time, you have to conclude that the odds favour repeating that performance.

When I saw this in the summer of 2001 I immediately looked at where the markets were then. Lo and behold, the Dow had topped in January 2000 at 11,723 and the S&P 500 in March 2000 at 1,535. If those were the cycle tops, then from the 1998 lows the S&P had topped in 17 months and the DJIA in 16 months. I had to conclude that if the indexes couldn’t rise over those highs, then they were headed below the 1998 low.

Next I turned my attention to the seasonal cycle.

MONEYCHANGER In 1998 the Dow made a low at 7,615 and the S&P500 at 969. Last summer (2001) when the Dow was trading between 10,600 and 9,500 the S&P between 1,283 and 1,171, long before the September panic, you were able to forecast that the Dow would drop below 7,615 at the next four-year cycle lows?

WOOD Yes, that’s what I published in a November 2001 article in Technical Analysis magazine.

If the four-year cycle had already topped, then the next smallest cycle to examine would be the seasonal cycle. Going back to 1896, 97% of the time that the seasonal topped in six months or less, the seasonal cycle declined below its previous low at its next trough.

If the market took out the previous seasonal low, that would indicate that the primary trend had changed to bearish, that is, a pattern of lower peaks and lower troughs. That would also confirm that the four-year cycle had topped in January & March 2000.

That is exactly what happened. The seasonal cycle topped in May 2001 and then melted down into the September 2001 low, taking out the previous seasonal low (March 2001). When the seasonal cycle confirmed my interpretation of the four-year cycle, I knew the four-year cycle had topped and I felt very confident about my forecast.

MONEYCHANGER Following up on the market’s subsequent performance, this year the DJIA bottomed July 23, 2002 at 7,705. By the way, you don’t follow closing lows but intraday lows, don’t you?

WOOD I measure cycles from intraday low to intraday high.

MONEYCHANGER It closed that day at 7,702.34. Whether during the day it touched 7,615 doesn’t much matter, since we had a later low on October 9, 2002 at 7,286.27

WOOD The intraday low was 7,197.49 on October 11, so we indeed took out 7,615..

MONEYCHANGER Is it worthwhile to study cycles? That answers the question,. On July 1, 2001 the DJIA closed at 10,479.86. Would this cycle study have profited an investor? From 10,479.86 you were able to forecast that a year later the market would go below 7,615. Studying cycles would have saved an investor over thirty percent.

That was a drop of about 3,280 points. Playing the DJIA futures at $10 per point, that offered a trade worth $32,800! But if we had only sold our stocks and sat on the sidelines in cash, we would still have saved ourselves thousands of dollars.

Was that just a lucky shot, or can cycles study repeat that performance over time?

WOOD Absolutely -- it will repeat that performance. The key is to extract and quantify the cycle so you can identify where you stand within the cycle.

MONEYCHANGER Right, but doesn’t that involve a great deal of interpretation?

WOOD I don’t know if I agree with the words “great deal.” Interpretation requires the knowledge and ability to extract and quantify that cycle. Yes, at times things are iffy, and you are always waiting for the next layer of confirmation. When price drops into a low for the window, you can’t identify that as the low until some time after the fact. You must have confirmation for any high or low. I suspected that we had seen the top, but I had to wait until the seasonal cycle topped and dropped broke its previous low to confirm my interpretation. So there’s always a lag time while you are waiting for your hunch to be confirmed.

MONEYCHANGER Isn’t that what Dow Theory requires? According to Dow Theory the Industrial average’s direction has to agree with the Transportation and Utilities averages. One average rising to new highs while the others drop or make new lows amounts to a non-confirmation. On the other hand, when one average makes new lows and the others later confirm, then you can say with confidence that the primary trend is down.

Okay, Tim, you’ve convinced me that studying cycles can be helpful and profitable. What do cycles tell us about the stock market’s movement from here? All the stock indexes made new closing lows on October 9, 2002. That has been followed by a reaction. This is typical – markets swing back and forth like a pendulum between oversold and overbought. The herd panics out of stocks, then panics back in. But all those optimists out there who still believe in “buy and hold” hope that this reaction marks the end of the bear market – the Big Bottom. Who is right? According to your cycles work, what does the future holds for stocks?

WOOD That buy and hold strategy is a point I cannot pass up. Anyone who actually takes the time to study history will prove to himself that buy and hold is just a bunch of baloney. If a person had listened to his broker in 1929 and held when it started to collapse, he would have had to wait twenty-five years just to break even – not taking inflation into account.

Where do stocks go from here? Right now I do not think the four-year cycle has bottomed yet.

MONEYCHANGER Let me make a distinction here to ward off confusion. When you talk about cycle highs and cycle lows, that’s not the same thing as “primary trend.” Even within the primary trends (bull or bear market) cycles are still at work.

WOOD Exactly, and I want to get to that a little bit later. I do not see the four-year cycle low in place yet. Ideally, that low ought to occur between November 15th and January 17th. I have no crystal ball, but I think that this rally will fade and then roll over, dropping into the mid-6000 range before it puts in that four-year cycle low. That should happen later this year or very early next year.

MONEYCHANGER Do you mean the Dow somewhere around 6,500?

WOOD I think it will drop to the mid-6000 range before we see the four-year low.

MONEYCHANGER That would take it all the way back to the level where Greenspan described the market as suffering from “irrational exuberance” before “insane” or “lunatic” exuberance took it to 11, 723.

WOOD Coming off that four-year cycle low stocks ought to rally strongly. It should run fast and furious like this present one, except it will show much more staying power.

MONEYCHANGER Will that mark the end of the bear market, or just a major counter-trend rally?

WOOD That won’t be the end of the bear market, but it will fool a lot of people. All the talking heads will proclaim that everything is fine because the rally will last for several months. The Dow could approach 9,000 – 10,000 again. The six-month mark is the first hurdle stocks have to pass. However, I am looking for that rally to fade in less than six months. If it does, then no doubt stocks will roll over and drop below the lows they are about to put in later this year. For the four-year cycle low due in 2006, I have a minimum downside objective of 3,000 for the Dow and 314 or so on the S&P 500.

MONEYCHANGER Yesterday the S&P 500 closed about 870. You’re projecting a 500 point drop?

WOOD Absolutely, and that’s a minimum downside objective by 2006. Yes.

MONEYCHANGER Will that mark the bear market’s end?

WOOD It could, but that’s getting so far out, we’ll just have to wait to see. It could stretch out to 2010

I have combined studying cycles with Dow Theory. I found original copies of books by William Hamilton, Robert Rhea, George Schaeffer, and others. Around the turn of the century, bull and bear markets were obvious to them. A bull market was the upside piece of a four-year cycle, and a bear market was the downside piece of a four-year market.

My theory is that stock market investing became more and more sophisticated. By the time we got to 1921, which I call the first great bull market in our country’s history, a series of two four-year cycles were strung together in a bull market running from 1921 to 1929. from the ’21 low to the ’29 high the market advanced 568%. Then it declined for three years into the 1932 low.

That offers some interesting observations. The advance was two four-year cycles strung together. The decline lasted only 37% as long as the advance.

In the next great bull market from 1942 to 1966 (24 years), the market advance 1,076%, roughly doubling the first bull market’s advance. The following decline lasted eight years (1966-1974), or 33% of the advance’s duration. From a cyclical standpoint, the next bull market began in 1974, with the bottom of the preceding bear market. From 1974 to 2000 that market lasted 26 years and advanced 2,061%.

In each succeeding bull market, the advance has roughly doubled the performance of its forerunner, and the following bear markets have lasted about one-third as long as the bull market. If this bear market follows that pattern, it will last until 2008. If it reaches the 37% example, that puts us out to 2010.

Here’s why I say the bear market might end in 2006. From a cyclical standpoint it must end with a four-year cycle low.  The earliest that can happen is 2006, and probably the latest is 2010. Since nobody has that crystal ball, we have to wait and let the market tell us, but I can’t see an end to the bear market before 2006 or 2010.

Also, common sense tells you that a market doesn’t correct a 2,061%, 26 year advance in just two years. You don’t need to be an analyst to see that. However, TV commentators are cooing that everything is fine, the bottom’s in, so everybody ought to stay invested for the long haul. That’s obviously wrong to you and me but I am not so sure it’s obvious to everyone.

MONEYCHANGER Your argument has implications far beyond the stock market. Obviously it suggests that we ought to be out of stocks completely for at least the next four-years and maybe the next six years, unless we’re short or some particular stock offers spectacularly attractive special circumstances.

WOOD Exactly.

MONEYCHANGER What about the implications for the economy?

WOOD First let me follow up on what you just said. I think being short is a wonderful idea. A person can use the Rydex Ursa Fund or the Prudent Bear Bearx Fund to profit from the downside. For the average person, though, has a problem: how do you pick low risk entry points. That is where cycles can help your timing. I started getting short back in January, added to the position all the way up into March, and rode it down into the July lows.

MONEYCHANGER And the cycles told you that was the time to get out?

WOOD Yes, because I didn’t want to be too greedy. It was an profit, if you looked at a chart from the 10,600 level down to the 7,000 range. Now I think that once the four-year cycle bottoms, a person could go long on an intermediate term basis. Rydex has a fund called the Nova Fund that leverages the upside. With someone timing that bottom for them, they could buy that Nova Fund, ride the bear market up, and then look to start accumulating short positions for the big decline. The next leg of this bear market is going to be far worse than anything we’ve seen already.

MONEYCHANGER Yes, but bear markets are notorious for very sharp, sudden, and vigorous rallies. The rally comes out of nowhere, flexes big muscles, and then just as quickly vanishes. If you are short with a margined position, the whipsaw can eat you alive. Without some way to time entering and exiting the position, short or long, you can get creamed.

WOOD Exactly. That’s why it’s imperative that a person have a timing method. If you believe a cycle is topping or bottoming, and you establish your position at the top or bottom, you’ve entered the market at the lowest risk point. That’s my whole strategy.

MONEYCHANGER Okay, so the big rally you expect in the spring is a classical sucker rally.

WOOD Yes.

MONEYCHANGER Your studies dictate we avoid stocks. What else can we invest in? What about bonds, gold, or silver?

WOOD In a bear market your first duty is to plug the leaks and try to preserve your capital. That way you have something left to re-enter stocks when they offer great value once again. However, there are other options besides just sitting in cash.

As this four-year cycle bottoms and the Dow rallies off of that low, the bond market is set up to sell off into the three-cycle bottom in the first quarter of 2003. So that puzzle piece fits.

As the stock market rallies everybody will think the good times are rolling again. That will take pressure off the bond market, so it will sell off into that cyclical low that is due. Then (I think) the stocks will come unravelled. Something fundamental will happen. I don’t know what that will be, but some big event will send the market down. That will set off a flight to safety, sending people scuttling back into bonds.

The Fed will probably lower interest rates again to try to keep things floating, so we will get one more shot up with the bond market. It’s will probably approach or make new highs. A sixty-year cycle bottom is due in interest rates in mid-2004, but sometime within the next three-year cycle interest rates should reach their ultimate peak, i.e., bonds will hit their ultimate top.

All these cycles are coming together at the same time. Some time around mid-decade the Kondratieff Wave is due to bottom. It last bottomed with interest rates in 1944. It always begins with a trough war (WW II then) in a time when the economy is depressed. War stimulates the economy. After the war came the roaring ‘50s, ‘60s, and ‘70s. The Kondratieff Wave’s upside is marked by prosperity and ultimately inflation (as we saw in the ‘70s and ‘80s in commodities and gold and silver). The Kondratieff peak usually shows somewhat stable prices and a peak war (Vietnam). Following that it spawns a great bull market about the time the peaking process is completed (late ‘70s or early ‘80s). We’ve seen that, and now we’re on the downside of the wave with deflationary times. I think we’re probably coming out of that now, or about to. That period will be marked with a depressed economy, and in the past has always started with some kind of trough war as the Kondratieff wave bottoms with low interest rates. That sixty year cycle low happens to be due mid-decade, when everything else comes together.

MONEYCHANGER What about precious metals?

WOOD To be perfectly honest, I am bullish on metals because I am bearish on the US dollar and the fundamental economic outlook. It is a good idea to own a core position in precious metals. Long term, as the Kondratieff wave rises inflationary forces will pick back up. Even if it takes another five to ten years, ultimately precious metals will soar. Also, when the sixty year cycle bottoms in interest rates there is usually some sort of debt or currency crisis.

That brings us to the next item. The average household today has credit card debt of about $7,000, and its lowest home equity ever. Twenty years ago home owner’s equity averaged some 30%; today it has dropped to a mere 16%. As the economy comes unravelled these folks swimming in debt and living from paycheck to paycheck will land in trouble. What will happen to them when suddenly one of the spouses loses his job? The stock market is in the toilet, there is no place to go, and they’ve got huge debt. There is the potential for a massive bankruptcy. Who will be left holding the bag? The banks will have to take a hit. Who will bail the banks out? This gets ugly.  That’s what the cycles tell me. It’s not a matter of opinion. It’s a matter of history and cycles and it’s all coming together mid-decade.

MONEYCHANGER What about the shorter term cycles for gold and silver?

WOOD A seasonal bottom in gold should come later this year, probably in November - December. From there the seasonal cycle turns up and we’ll have to see what the market tells us. My studies of seasonal gold cycles suggest that any seasonal cycle that tops in six months or less will take out the previous seasonal low.

MONEYCHANGER What does that say for buying gold now?

WOOD I think it’s dangerous not to have a core position in gold, but I am not real, real excited about it right at this point..

MONEYCHANGER In other words gold needs to close over the previous high at $327.80. The $325 area has been blocking gold for five years, and it must jump that hurdle.

WOOD Right, the last seasonal low occurred in December 2001 at $271.20, and so far the seasonal top came in June. That’s exactly six months. We don’t have that confirmation yet. We need to get past that six month mark and over $330.50 (intraday) to get me excited about gold.

MONEYCHANGER What about silver?

WOOD It will probably follow gold. I like silver better than gold because I think that ratio will narrow.

MONEYCHANGER The present ratio is about 72:1..

WOOD It may not go back to 16:1, but I think it has to approach that level. Therefore, I actually like silver better than gold.

MONEYCHANGER Even though it’s been disappointing since gold bottomed in 1999, even though gold has outperformed silver, you still like silver better than gold?

WOOD I still like silver better than gold, because of that ratio potential.

MONEYCHANGER So you would time silver off gold right now? If gold breaks through $330.50, then you would buy silver, too?

What form do you favour for gold and silver investments?

WOOD I believe in buying the junk silver bags, and physical gold coins.

MONEYCHANGER You commented in one of your newsletters about the divergence between gold stocks and gold. Off the June 2002 top gold has declined 33% while gold stocks have given up about 86%. Does that kind of divergence leave you as nervous as it leaves me?

WOOD Yes, it does. Gold stocks and gold did not really start to perform until after the economy hit rock bottom in early 1932. Gold stocks led the way when the market started up again.

MONEYCHANGER But there’s a danger in your presupposition.  Gold’s performance in the 1930s arose primarily from government action, specifically, Roosevelt raised gold’s official price by 69%. We would normally expect any panic (or panic followed by a depression) to send people fleeing into gold because it is the ultimate liquidity, the ultimate case. Logically the price of gold along with its purchasing power ought to rise after a panic and during a depression. But when the government gives you a 69% jump in a fixed price and depression lowers your costs, you will show a profit. That’s what makes generalising from the Great Depression a chancey business. The gold stocks led the stock market up? Well, of course they did. The government handed them a 69% jump-start.

WOOD I can’t argue that point.

MONEYCHANGER That’s not to say that the gold stocks won’t do well this time around, or that they’re a bad investment, but only to point out that sometimes there are fundamental forces at work that won’t necessarily be repeated in the next cycle. In fact, there is always something fundamentally different going on that alters the cycles.

WOOD Absolutely.

MONEYCHANGER Tim, thanks very much for a fascinating interview.

WOOD You’re quite welcome.

 Readers can visit Tim Wood’s website, www.cyclesman.com, to sample his work or subscribe to his newsletter.

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