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I assume that the midpoints of these cycles approximates value. This is the long straight line drawn through the cycles in Figure 1, part c. The line demonstrates an annual growth rate of 1.6%. This is the rate of real value growth of stocks.

Such a basic number should be confirmable. Figure 2 is a plot of the Standard & Poor's 500 earnings over the most recent up-down cycle (1949-82). Now, earnings, or nominal earnings, or earnings capability are the most commonly accepted gauges of value. To use real earnings growth as a measure of value growth cannot be a major error. In this figure I plotted earnings and real earnings and then imposed regression lines over the two market phases. During the down market, the dollar growth is greatest, but when this is translated into real earnings, the growth rate becomes very small (0.7%). During inflationary periods, prices increase and profits do as well, but not enough to make up for the inflation. The real annualized earnings increase is 2.3% during the up market phase and 0.7% during the down market phase. Over the complete market cycle, the average growth rate is 1.6%— exactly the growth rate shown in the 100-year plot shown in Figure 1, part c.

Of major importance in the long-term market is a second cycle pattern, known as the four-year cycle. Attempts have been made to tie this cycle to many other events such as the Presidential term or the business cycle, but none of these seems satisfactory. Figure 3 shows the four-year cycle during the up phase of the most recent 33-year cycle (1949-82). The genera trend is that of a series of upward steps—usually three advancing years and then about one year of correction. This pattern gives stability and order to the progression of prices. When the pattern is not completed by the downward correction, it is time to become concerned. This is always the signal for a major disruption.

The stock market model I've developed is primarily based on these three characteristics: the value line, the 33-year cycle and the four-year staircase. These are shown in simplistic form in Figure 4.

The shape of the four-year "step" is important. As we go up the staircase, corrections become deeper with each step on an inflation-adjusted basis. Eventually, the correction exceeds the rise. This, of course, causes the trendline to turn downward, beginning the down phase.

In addition, note in Figure 4 that the preceding down phase has pressed prices far below the value line. The series of stairsteps eventually brings prices far above value. This is the market's trademark. Eventually, all movements become excessive. Likewise, the resulting down phase will carry prices to the undervalued extreme.

Our next task will be to assemble past market data sufficient to describe the parameters of Figure 4. In the process, we will develop techniques for applying the model to answer those questions that daily confront any participant in the market.

James G. Arnold is a retired aerospace engineer who combines engineering with 35 years of investing experience in his financial analyses.