May 31st, 2007

Life Cycle Investing: Introduction

There are all sorts of philosophies in the stock market with nearly equal numbers of staunch advocates and sharp critics. There’s the buy-and-hold, swing trading, momentum plays and day-trading. There’s classical value investing elucidated by Graham & Dodd/Buffett or practiced as IBD’s CANSLIM. There’s technical analysis employing a variety of technical analysis tools and indicators such as moving averages, Bollinger Bands, stochastics, MACD and many more.

Finally, there’s Elliot Wave (for a comprehensive overview, click on the link to Wikipedia). Ralph Nelson Elliot said, during the depths of the Great Depression that “because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable.” When it came to the stock market, Elliot said:

“collective investor psychology (or crowd psychology) moves from optimism to pessimism and back again. These swings create patterns, as evidenced in the price movements of a market at every degree of trend. Elliott’s model proposes that market prices alternate between five waves and three waves at all degrees of trend, as the illustration shows. As these waves develop, the larger price patterns unfold in a self-similar fractal geometry. Within the dominant trend, waves 1, 3, and 5 are called “motive” waves, and each motive wave itself subdivides in five waves. Waves 2 and 4 are “corrective” waves, and subdivide in three waves. In a bear market the dominant trend is downward, so the pattern is reversed—five waves down and three up. Motive waves always move with the trend, while corrective waves move against it.”

The Elliot Wave philosophy can be illustrated in these charts:

The Elliot Wave principals leave me cold because, while they start at the premise of human nature, they appear sterile and too mechanical. I prefer to think of business and the stock market as something more dynamic, something that combines economic cycles, business strategy and execution, financial performance and momentum or the lack thereof (the movement of share prices as reflected in the supply and demand for individual stocks, that is). That’s why I chose the term “Life Cycle Investing” for this series of posts.

The more I study the long-term history of a stock (beginning with it’s IPO, if possible), the more I come to realize that success in the stock market depends on recognizing that stocks, along with almost anything else in nature, go through Life Cycles. The products and businesses represented by those stocks go through life cycles and those life cycles are amplified or augmented, on the one hand, by the life cycle of the economy and, on the other hand, by the life cycle of interest in the momentum of the companies’ stocks. Success will come to those who discern where stocks are in their life cycle.

(Product) Life Cycle, according to Wikipedia goes through 5 stages: Development, Introduction, Growth, Maturity and Decline. They represent those stages in the following graph:

Using the some charts relatively new IPO’s and some classics pulled from the DJ-30 like Apple (AAPL), Microsoft (MSFT), Pfizer (PFE), IBM, Walmart (WMT), AT&T (T), MMM, MacDonalds (MCD) and Coca-Cola (KO) to demonstrate the power and effectiveness of Life Cycle Investing.

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