Industrialized economies progress through cycles of expansion, peaking, trough, and expansion again. It follows then that the major industries propelling those economies pass through four phases during their existence: introduction, growth, maturity, and decline. Those industries consist of separate companies, and of course, the securities issued by those companies tend to anticipate business cycles and move in the same direction.

When you look at a stock chart below, you can observe its price history and the cycles – or series of peaks and troughs – that it's completed so far.

Ifyou observe a monthly or weekly chart, where each bar or candlestick represents one month or one week, respectively, you may be able to look at a stock's price history for an exten,ded duration of time, such as five to ten years. Although the cycles may not be formed as uniformly as those drawn in the above figure, they will still etch a bell-curve, or cycle formation, consisting of peaks and valleys, or troughs.

These cycles take place from the macrocosm. to the microcosm. Each large cycle consists of many smaller cycles, and each small' cycle' is formed by a sequence of even tinier cycles.

Here's an analogy: This book is made of many chapters. Within each chapter are separate sections that, when strung together, \create that chapter. The sections are made of a series of paragraphs; the paragraphs are built of sentences, which are foimed by words. Each word, sentence, paragraph, and section is a complete unit in and of itself. And, when looked at as a whole, they form the complete book. Get the picture?

So, you will find complete cycles occurring on monthly, weekly, daily, and intra-day stock charts, where one bar or candlestick may represent a time frame of one month, one week, one day, or intra-day designations, such as sixty minutes, thirty minutes, five minutes, one minute, or any increment in-between.

LET'S DRAW THE CURTAIN ON STAGE ANALYSIS

A „close-up“ of a cycle, whatever the time frame, reveals that it's constructed of four different movements, or stages. We call the study of these stages „Stage Analysis.“ When you learn how to identify which of the four price stages your target stock currently inhabits, you've made the first step to keeping your losses small and your profits large!

Stage One represents the valley, or trough, of the cycle. This is when the stock prices are at their lows of the cycle. During these times-which on weekly and daily charts could last from weeks to months-the stock price moves sideways in a range between an approximate high and low price, and increments in between. You'll hear gurus and analysts talk about a stock in Stage One as „basing.“ That means the stock is forming a new price base from which it will (hopefully!) start to rise again.

What is the collective mindset of market players participating in a Stage One? Volatile vacillation! Buyers hold the price up each time it falls to the bottom of the base, and sellers push it down each time it rises to the top of the base. Equal pressure from buyers and sellers cause the stock to oscillate sideways, sort of like a snake swiveling through a drainage pipe.

When the stock bases for a period of time, market conditions, industry rotation, or good news will urge buyers to step in and start paying higher prices. Then, the price „breaks out“ of its base and shoots into an uptrend, or Stage Two. The collective mindset-greed--creates more and more demand, which drives the stock higher. Rising, then pulling back and rising again, it rockets to higher and higher prices on the wings of euphoria.

Finally, at its peak, buyers refuse to continue paying higher prices, and the uptrend slows to a halt. Euphoria and demand dissipate. So the uptrend, or Stage Two, is broken, and the stock drifts sideways into a Stage Three. Technical analysts refer to this pattern as „rolling over.“

During Stage Three, which is the peak of the cycle, ,buyers support, or „hold up,“ the price when it falls. Sellers press the price down when it rises. As you can see, the stock price seems suspended in „mid-air.“ The collective emotion in a stock experiencing Stage Three: indecision.

At some point, when a stock is in a Stage Three, fear steps to the forefront. (If it doesn't, and the stock breaks out to new highs, it resumes a Stage Two.) When fear sets in, buyers refuse to support the stock any longer. Selling pressure increases and the stock tumbles into a downtrend, into a Stage Four. Now the stock „heads south.“ In a Stage Four (which looks like a Stage Two, reversed) the stock dives to lower prices, rebounds a bit, and then dives again (think: „rubber rock“). Supply floods the market as fear goads terrified sellers into unloading their long positions.

The only happy campers who hold a Stage Four stock are short sellers. As you may remember, short-sellers sell the stock at a high price. Then, they buy it back at a lower price and pocket the difference as profit. (We'll go into selling short later.)

Stage Four is also the place where frustrated investors, watching their stocks tank and principal shrink, may „average down“ by buying more of the losing issue. Because averaging down lowers the average price paid for the stock, their fervent hope is that when the stock rebounds, losses will recoup faster. Maybe. Maybe not. Some beat-up stocks stay down for the count, or at least for weeks and months. Hanging onto these weaklings ties up money that could be spent on a strong stock that makes money. We sometimes call capital invested in such issues „dead money.“

Since we're on this subject, if you have the „averaging down“ mentality, please banish it. There's a correct way to average down that's based on sound money-management principals; then there's the desperate averaging down method that usually leads to bigger losses. In the pages that follow, you'll learn how to average down properly.

Stage Four is also when some investors, believing they're getting a „bluelight special,“ load the truck with a tanking issue. Watch them go slack-jawed when their cheap stock gets even cheaper!

As an astute trader, you won't let that happen to you. You'll stand on the sidelines, cash in hand, while others hold losers or run screaming to the door. Then, when the selling is over, you'll step in and buy high-quality bargains that are ready to recover. Sound like fun? It is!

At some point, a stock in a Stage Four will slow its descent. Hot and furious selling evaporates, and buyers start stepping up to the plate. Now the stock turns back into a sideways, basing pattern – a Stage One – and the cycle is complete.

DIFFERENT STAGES CALL FOR DIFFERENT REACTIONS

With a little practice in looking at charts, you'll start recognizing which stage of a cycle a stock is experiencing. This in turn will initiate your selection process for buying stocks.

We use Stage One to scan for stocks that are basing, preferably for four to six weeks. Again, these stocks are in the first stage of a new cycle, and usually coincide with a market or industry correction. This is when a stock is „on sale.“ Usually, we don't buy stocks in Stage One. We monitor them. When they break out of their base in synchronicity with other factors, that's when we jump in! Stage Two is where you, as a short-term trader, will spend most of your time and make most of your profits.

When you're position trading, you spot a stock breaking out of a solid Stage One base into a Stage Two uptrend. You buy it and ride it for several weeks, taking profits when it completes its entire Stage Two. If you opt to swing trade, you play Stage Two by buying the break outs and selling before the stock pulls back, taking multiple-point profits out of two-to-five day holds. With practice, you may decide to do a combination of both position trading and swing trading. I like this method for capturing optimum profits!

When a stock rolls over into a Stage Three, we stand aside. During this stage, price patterns tend toward the volatile and unpredictable, and a stock may lurch sideways in a haphazard pattern. It's particularly unwise to hold a Stage Three stock overnight.

Again, stocks that fall into a Stage Four are doomed to suffer lower and lower prices. There are two ways to treat a stock in a Stage Four downtrend.

First, if you are relatively new to the stock market and have no prejudices against selling short-that's good news! Or, perhaps you've been in the market for a while and already realize the profit potential in selling high and buying low. You may even hedge your account by selling short.

The second way to approach a stock in a Stage Four downtrend is to avoid it completely! If shorting a stock-or even the thought of it-makes you break into a sweat, then sidestep stocks in a crash and burn mode. During times when major market indexes plummet to new lows (read Bear Market), as they did in the fall of 2000 and spring of 2001, you can keep your assets in cash and take a vacation. Or, spend the your time off to read up on advanced trading techniques.

Remember, one of the most important lessons any trader or any investor can learn is when to stay out of the market altogether!

ADDITIONAL CYCLE COMPONENTS

Now that we've identified the stages inherent in cycles, let's zoom in even closer to analyze the action.

In the illustration that follows, you can see motivating factors in each stage. (Keep in mind that many small stages form the larger stages.) It's interesting to note that while a stock experiencing a Stage Two uptrend on a daily chart may be soaring on the wings of optimism, greed, and euphoria, a glance at an intra-day chart may reveal intervals-not apparent on a daily chart-where apprehension and outright panic prevail.

Aside from emotions, figure also shows notations referring to supply and demand. Greed and fear act as precursors to these two economic factors.

In Stage One, indecision causes supply and demand for a stock to alternate in the short-term, pushing it sideways. When optimism (mild greed) triggers a stock to break out of a Stage One into a Stage Two, greed for the stock at that price causes increasing demand. The· greed amplifies as more and more buyers absorb all available stock (supply) at each higher price level.

When the price gets „frothy,“ or „toppy,“ at the height of a Stage Two, demand will shrink as increased supply, provided by sellers taking profits, arrives in the marketplace.

As the stock rolls over into a Stage Three, indecision reigns again. Just as in Stage One, supply and demand remain in relative balance, although volatile swings are the norm.

Sooner or later, buyers will tum their backs on a Stage Three stock and decide to take profits. Supply floods the market. When no one steps in to buy, these buyers-turned-sellers must lower their prices to attract buyers. This initiates a Stage Four. Now, apprehension turns to fear, causing even more sellers to join the ranks, which pushes more and more supply onto the market at each lower price level. Just as greed initiates demand, so does fear initiate supply. It becomes a self-perpetuating action and reaction.

Finally, when the falling price reaches a support area established weeks, months, or even years ago (as seen on a weekly or daily chart), supply begins to be absorbed by tentative buyers. As they continue to soak up the supply, the stock ceases making lower lows. Selling volume dries up, and buyers start to step in. Supply and demand even out, and the stock reverts to a Stage One to begin a new cycle.

The below figures show two weekly charts (each bar equals one week) and two daily charts (each bar equals one day) of stocks that have made complete cycles. Check out how fear and greed incite supply and demand to drive stock prices up and down.

October, 2007
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