First off, thank you to all of those who attended OASIS 2005 in San Diego last week.  It was great to see a lot of familiar faces from the prior year and to meet a lot of new faces this time around. During one of the general sessions on the Main Stage, Tom Gentile detailed a system that he had originally unveiled at OASIS 2004.  This year, he added a filter that involved using a cycle that I started following about 15 years ago—better known as the 40-week cycle. I say I have been following it for “about” 15 years because I know that I read about it somewhere in the very early 1990s, but truly cannot recall the source. At the time it seemed kind of ridiculous, but being a good little market analyst I made a note to follow it and see if the performance continued.  Lo and behold, 15 years later it is still performing and I am still following it.  In fact, I am doing more than following it.  I have incorporated it into my overall approach  to investing in the market.  When you see the results you will better understand why.  

THE THEORY
For some inexplicable reason (and don’t ask me to explain why because I can’t), since April 21^st, 1967 the stock market has been moving in 40 week waves.  The first 20-weeks represent the “bullish phase” and the second 20 weeks represent the “bearish phase.”  At first blush, there is no real reason for anyone to put any stock in this theory.  However, the results have been—at least for me—too compelling to resist.  So let’s take a look.

THE RESULTS
Let’s start with the relatively boring numbers:

Through 49 completed 40-week cycles since 1967, the Dow Jones Industrial Average has:

• Advanced 76% of the times during bullish phases 
• Advanced 51% of the time during bearish phases  

Likewise, the Dow has averaged:

• A gain of +6.1% during the bullish phases 
• A loss of –0.3% during the bearish phases.  

Now these numbers are interesting but not really enough to make one say "wow!”  However, the long-term effect of compounding money does a funny thing over time.  If we do the same numbers above on a cumulative basis, we get a much more interesting result.  It goes like this:

• Had an investor invested in the Dow only during each 20-week bullish phase (and assuming no interest was earned during each bearish phase),  he would have seen his capital grow +1,718%.  
• Conversely, had an investor invested in the Dow only during each 20-week bearish phase (and assuming no interest was earned during each bullish phase), he or she would have seen their capital decline (yes that’s right, decline) by –33%.  

Now one can quibble with 76% winners versus 51% winners, and while an average of +6.3% is a lot better than an average of -0.3%, still it doesn’t seem like that much of a difference.  However, a total return of +1,718% versus a total return of –33%, well there’s not much room for argument there.  And as compelling as the numbers are, the age-old adage of “a picture is worth a thousand words” definitely hold true in this case.

THE BULLISH PHASE
Chart 1 shows the growth of $1,000 invested in the Dow Industrial Average only during the 20-week bullish phases.  In other words, starting on 4/21/67, this hypothetical account was long the Dow for exactly 140 calendar days, then was out of the market for 140 calendar days (20 weeks times 7 days a week equals 140 days).  For this illustration, it is assumed that no interest was earned while out of the market.  The trend and slope of the chart is fairly remarkable.  While there is some volatility and some down periods along the way, the long-term trend is unmistakable.  


Chart 1 – Growth of $1,000 invested in Dow Industrial only during each 20-week bullish phase since 1967

THE BEARISH PHASE
Chart 2 shows the growth of $1,000 invested in the Dow Industrial Average only during the 20-week bearish phases.  In other words, starting on 4/21/67, this hypothetical account was out of the market for exactly 140 calendar days, then was long the Dow for the next 140 calendar days (i.e., it is long during the second 20 weeks of each full 40-week cycle).  It is assumed that no interest was earned while out of the market.  The chart is quite a hodgepodge of performance.  The 1970’s were a disaster, with $1,000 invested only during the 20-week bearish phase losing over 60%.  The 1980’s were very good right up until the Crash of ’87 when the Dow lost 22% in a single day.  Likewise, the 90’s were very good thanks to the great bull market.  However, the bearish phase clearly suffered the brunt of the 2000-2002 bear market.  



Chart 2 – Growth of $1,000 invested in Dow Industrial only during each 20-week bearish phase since 1967

All in all, the bullish phase has clearly been the best time to be long the stock market.

ROLLING RATES OF RETURN
To get a better perspective on the relative performance of the market during bullish and bearish phases, let’s take a look at rolling 5-year rates of return for the bullish and bearish phases compared to a buy-and-hold approach.  Basically, we are doping the following: At the close of each trading day we will look back over the last 5 years of data and measure the net percentage rate of return over that time.  What we are looking for is to see how consistently the market performs during each phase compared to each other as well as how each performs compared to a buy-and-hold approach.  Here are the results:

• Buy and Hold Approach: 5-Year period shows a gain 80% of time.
• Bearish Phase of 40-Week Cycle: 5-Year period shows a gain 47% of time.
• Bullish Phase of 40-Week Cycle: 5-Year period shows a gain 100% of time.

Here we clearly see one of the most compelling results of the 40-week cycle.  To date, the bullish phase has yet to witness a decline in equity over any 5-year period.  The buy-and-hold approach suffered 5-year declines 20%, or 1/5^th of the time.  Conversely, the bearish cycle shows a gain during less than half of all rolling 5-year periods. 


Chart 3 - Displays the rolling 5-year return for the 20-week bullish phase since 1972.

SUMMARY
Given the results displayed above, there cannot be much debate that for the last 38 years, the 20-week bullish phase has vastly outperformed the 20-week bearish phase.  Still, there remains reason to be skeptical.  Can anyone explain this phenomenon?  No. Can anyone guarantee us that this trend will continue ad infinitum into the future?  No. The last two “bullish” phases have witnessed the Dow decline by –2.1% and –1.3%, respectively.  The last two completed bearish phases have seen the Dow advance by +9.7% and +1.6%, respectively.  Likewise, the latest bearish phase – which started at the close on 4/1/05, has seen the Dow move up by about +2% so far.  

So is this 40-week cycle beginning to lose effectiveness?  The bottom line is that it is simply too soon to tell.  The next real test will come between 8/19/05 and 1/6/06.  The next bullish phase is due to begin after the close on 8/19/05.  Since 1967, the bullish phase has not experienced three declining periods in a row.  So with the last two bullish phases posting losses, if this cycle persists we should (look for/hope for/expect) to see the market rise in the final third of 2005.  I can hardly wait.  

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

• Email This Article
• View Full HTML
• Digg This
• Delicious
• Subscribe

Recent Articles by Jay Kaeppel, Optionetics.com

• November 4, 2009
  Kaeppel's Corner: What's Your Plan?
• October 28, 2009
  Kaeppel's Corner: "Energize" Your Portfolio
• October 21, 2009
  Kaeppel's Corner: Spotting Opportunity (That the Masses Are Sure to Miss)
• October 14, 2009
  Kaeppel's Corner: Three Strategies You Probably Have Not Considered
• October 7, 2009
  Kaeppel's Corner: The Creative Bull