Four-Year Cycles by James G. Arnold
I developed the "form" of a long-term up/down cycle of the stock market, as shown in Figure 1a. This form shows that all market trends continue to excess. The up market phase drives prices far above value and the down market phase carries prices well below value. Strangely, the extent of these excess movements has demonstrated great consistency in past markets.
The measure of price relative to value is reflected in the price/earnings ratio (P/E) of the average and in the dividend yield of the average. The typical movement of P/E and yield over the long-term cycle is shown in Figure 1b, and Figure 1c. When the average P/E rises above 20 and the average dividend yield dips to the 3% neighborhood, the market phase is ready to shift from up to down. Similarly, when the dividend yield rises above 6% and the average P/E settles down toward 6 or 7, the long-term down market is about to turn into an up market.
A similar consistency of extremes is found with the four year cycle, but the limits of these extremes are more psychological than real. A market trend feeds upon itself. A rising market generates enthusiasm. This attracts more buyers and more buyers cause the market to rise further. In a similar manner, a falling
market generates fear. The fear produces more sellers, which, in turn, drives the decline further. In the physical technologies, this situation would be described as a system with positive feedback. Such systems are noted for their tendency to become unstable. The market certainly follows this analogy.