Looking at charts, we can step back and take a very long term view of the markets. Figure 1 is an annual chart of the Dow Jones Industrial Average dating back to 1920. This chart uses a logarithmic (log) price scale instead of the more common arithmetic scale. The logarithmic scale uses percent changes to determine the distance between two numbers on the vertical axis. While traditional charts show the same distance between 10 and 20 as they do from 90 to 100 since each represents a change of 10 points. With a log scale the distance from 10 to 20 represents a doubling in price just as the distance from 50 to 100 equals a 100% gain, meaning they would be the same distance apart on the price scale.
Log charts are best suited for long-term analysis since the early action, when the Dow traded in only double digits as opposed to the five-digit values reached last year, would be completely lost on an arithmetic scale.
In Figure 1, we have added a trend line connecting the 1932 lows and the 1982 lows. Trend lines are a popular technical tool and the market generally moves above and below trend lines. This chart shows how far from average the market got in the last bull market. The market also deviated from its long-term trend in 1962 and spent 16 years trading in a relatively narrow range, as shown in Figure 2.
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Figure 1: The long-term trend line shown in this chart provides a floor for stock prices, but indicates that prices can still trade significantly lower without violating the long-term trend. (Source: Trade Navigator)
That extended trading range is shown within the box in Figure 2. This illustrates that prices may return towards the trend line by trading nearly horizontally for some time. As measured by the Dow, we are now in the tenth year of a trading range. This type of behavior is not uncommon in stocks. Stocks also showed zero progress from 1937 to 1949. These periods were then followed by long bull markets.
Figure 2: Extended trading ranges are the norm after extended bull markets. (Source: Trade Navigator)
Many technicians look at cycles to forecast turning points. Traders should be careful with this technique. There are logical reasons why cycles should be present in price movements, but they change from time to time and are frequently wrong. Figure 3 offers a potential clue as to when this bull market could begin based upon a 10-year cycle that extends back to 1932. The market shows a bottom or very small trading range occurring every 10 years, missing only once (in 1972 when the market continued lower for two more years).
Figure 3: Cycle theory predicts steady to lower prices into 2012. (Source: Trade Navigator)
While 2012 is a long ways off, there is room for optimism. The market moves up and down whether it’s a bull market or bear market. There is also a rotation of market leadership roughly aligned with the business cycle. While it is unlikely that the market will shoot straight up from this level, it is very likely that a disciplined approach to finding market leaders while respecting risk can lead to profits in a trading range or a bear market.