Do markets move in predictable cycles? (Part 2)

Have a prosperous Christmas!

You should because since 1950 the Australian stock market has enjoyed a Santa Rally for three out of every four Decembers. Over the month the share index has risen on average by 2.1%.

The sweet spot is between mid-December and early January when for the past 37 years, 31 years averaged a gain of 4.2%.

Since 1950, the share index has fallen just twice during this Santa season (2007-08 and 2010-11).

And it gets better. In the eight trading days leading up to New Year’s Eve, the All Ords index has risen an astounding 86% of the time from 1980 to 2016.

No one knows why the Santa Rally happens. But enjoy it if it happens again and have a happy 2018 from your MarketTiming team at The Constant Investor.


In Part 1 of this editorial (https://theconstantinvestor.com/markets-move-predictable-cycles-part-1/), I gave you a broad brush overview of early thinkers on business and market cycles.

In Part 2 below, I examine the works of more recent cycle advocates and draw overall conclusions about the value of cycle analysis as a market timing tool.

Harry Dent’s Cycles

Harry Dent is a demographer who applied his craft to market cycle analysis. He has written a dozen books and runs Dent Research, which publishes a monthly US investment newsletter called Boom and Bust.

You will recall Harry Dent found a close relationship between sunspot cycles and stock market cycles, yet so far things are not working out as he foresaw back in 2014. Let’s examine the other cycles he has postulated as these too are meant to drive stock markets.

His most noteworthy is a 39 year Generational Spending Cycle based on data that the heads of households reach a spending peak in their mid-40s. By projecting the number of households that each year reach their peak spending age it is possible to trace a future cycle of peak and trough spending years.

In December 2008 Dent produced the chart below which showed that the US Dow Jones share index adjusted for price inflation had moved in tandem with projected immigration adjusted births lagged for peak spending.

Source: Dent Research

If this relationship had held then the stock market crash of 2008 should have continued until 2026 except for a dead cat bounce in 2017. So far this scenario has not unfolded. Instead the US market has rallied without a correction since March 2009.

Dent’s other two cycles are a 26 year Geopolitical Cycle and a 45 year Innovation Cycle.

The Geopolitical Cycle like Edelson’s War Cycle tracks global conflicts whereas the Innovation Cycle like the Kondratieff Wave reflects technological progress. Here is a depiction of each of Dent’s four cycles including his 10 year Sunspot (Boom/Bust) Cycle.

Source: Dent Research

The important point to note is that each of Dent’s cycles don’t trough before 2020. Indeed the innovation cycle doesn’t do so until 2030. He believes the pressure of these cycles will overwhelm any central bank monetary stimulus to cause an economic and share market rout comparable to the 1930s and 1970s. 

Dent has recently come up with three more cycles that also show downturns between 2008 and 2023.  He calls these a 28 year Financial Crisis Cycle, an 84 year Populist Movement Cycle and a 250 year Revolutionary Cycle. His latest book Zero Hour and his previous books The Demographic Cliff (2014) and The Great Depression Ahead (2009) explain these cycles in more depth. They are all available online from Amazon Books.

Source: Dent Research

Note that all of Dent’s cycles (both the earlier 4 and the latest 3) are in a downwards phase. He sees no economic or market turnaround until after 2023.

Only time will tell if Dent is right or wrong. His book in 1999 titled The Roaring 2000s proved widely off the mark since the US share market crashed in 2000-2003 and again in 2007-2009 and ended the decade much lower than it started. So far his prediction of The Great Depression Ahead (2009) has not materialised. Instead the US economy has been growing and its stock market has enjoyed a massive boom.

Elliott Waves

The cycle proponents reviewed so far were concerned with their duration not their shape. Indeed they assumed cycles are just smooth rolling waves. Two cycle analysts who took a different view were Charles Dow and R.N. Elliott.  

Over a hundred years ago Charles Dow theorised on the shape of a typical share market cycle whether long or short. His views got refined by William Hamilton and articulated by Robert Rhea. Here is a modern depiction of it. The different phases speak for themselves.

The Dow Cycle Pattern

R.N. Elliott was an accountant in the 1920’s and 1930’s who while recovering from a serious illness spent time researching the pattern of stock market cycles and concluded they were not symmetrical as Dow assumed, but lopsided; longer on the upside and shorter on the downside. In his view they typically moved in eight waves; five waves in an uptrend (coined ‘impulse’ waves), and three waves in a downtrend (‘corrective’ waves’).

Each cycles ranged in duration from just a few hours (subminuette waves) to many decades (grand super-cycles), yet they each resembled each other in design. Here is a depiction of a complete eight wave Elliott Cycle.

The Elliott Wave Cycle Pattern

Robert Prechter in the 1970s revived Elliott Wave theory and founded a newsletter company, Elliott Wave International that exists to this day. Prechter wrote many books both refining Elliott’s work and forecasting the stock market’s direction. His success in 1979 in accurately foreseeing a new secular bull market and then calling the crash of 1987, won him an enthusiastic following. The Financial News Network (now CNBC) named him “Guru of the Decade” for the 1980s.

But Prechter’s forecasts thereafter went amiss. He urged his clients to pull out of the stock market in 1995 with the result they missed the huge price run-up to the dot.com bust of 2000.

In his 2002 book, Conquer the Crash, Prechter argued that by 2000 the stock market had completed five impulse waves of a Grand Super-Cycle that started around 1784. The economy would now descend into a long deflationary depression that would be reflected in three corrective stock market waves that would “impact on your financial health dramatically.”

By November 2008, Prechter’s Chief Market Analyst interpreted the US share index since 1933 in Elliott Wave terms as shown in the following chart.                             

Source: Steve Hochberg, Chief Market Analyst, Elliott Wave International, Is the Bear Market Nearing an End?, Live Webinar, November 20th 2008

Because he saw the market after August 2000 undergoing three (a, b, c) corrective waves he expected the post-2007 crash (wave c) to rival that of 1929-1932. For the Dow Jones share index that didn’t happen in nominal terms, though by March 2009 it had done so in real terms. Yet America has not descended into a deflationary depression as predicted by Prechter in 2002.

Also his postulation in The Elliott Wave Theorist of May 8th 2010 that the US stock index possibly by 2016 would fall to its previous level of 1960 (in an ideal Grand Super-Cycle scenario) or 1980 (in a flat such scenario) proved wrong.  By December 30th 2016, the S&P 500 share index was double its value of May 7th 2010, the last trading day before Prechter issued his chart projections.

Perhaps America would have suffered a great depression and a stock market wipe-out but for the Federal Reserve’s quantitative easing program (QE). But if government intervention can interrupt market cycles then they are not inevitable as Elliott and Prechter contend.

Applying the Elliott Wave principle to the US bull market since March 2009 might suggest that it had exhausted itself by 2015, yet that that did not happen.  See chart below. The bull market refused to morph into a three wave (a, b and c) bear market.

Application of Elliott Wave Cycle Formation to the US Stock Market, 2008-2017

Because in Elliot Wave theory wave 3 can’t be the shortest of the impulse waves and wave 4 can’t overlap wave 1, the above interpretation must be wrong suggesting that wave 1 might not yet be over.

This demonstrates the difficulty of applying Elliott Wave principles to trace out a market’s past cycle let alone know its next move.  Also because Elliott waves don’t have fixed amplitudes or durations it’s hard to know when an impulse or corrective wave has completed its dash. For these reasons the Elliott Wave Cycle is a poor guide for timing the share market.

Conclusion

My view on cycle theory is that it’s largely in the eye of the beholder. As a result even enthusiasts for the same cycle theory have difficulty agreeing on how to apply it for market forecasting purposes. To quote Investopedia:

             “Market cycles are often hard to pinpoint until after the fact and rarely have a    specific beginning or ending point.”

            Source: https://www.investopedia.com/terms/m/market_cycles.asp

That’s not to say there are no business and market cycles. There clearly are, but their shape, amplitude and duration vary greatly making it impossible to discern a fixed pattern and period for predicting their future course.

Examine the following chart that traces the share price index based first on British and then US stock exchange data. I have updated the chart to 2017. You may discern patterns in this chart, but I defy you to apply them to foresee the next move in the market.

Stock Market Price Index since 1700

Source: Robert Prechter, The Elliott Wave Theorist, January 22nd 2009

Likewise here is a chart of secular bull and bear markets since 1871 based on adjusting the S&P500 share index for inflation so that it is expressed in real terms (i.e. constant prices).

It’s clear from the above two charts that the stock market moves in cycles, but it’s also obvious that they do not have a regularity or pattern that can foretell future turning points. That’s why at MarketTiming we prefer to let the share market tell us what it is doing rather than us saying what it should be doing.

We use long term trend and momentum indicators to establish the actual direction and speed of share indices at the end of each week’s trading. When these measurements turn positive, we recommend buying and holding a listed share fund to reflect the share index. And when they turn negative we recommend selling that fund and staying in cash until the situation reverses.

When the market is trendless it can undergo whipsaws (repeated changes in direction) that involve modest losses or opportunity costs. Such drawdowns are part and parcel of any trend-trading system and should be viewed as insurance premiums for avoiding much larger losses from market crashes.

Over time respecting the market’s trend and momentum has delivered high returns with much less price volatility and investor trauma than buying a share portfolio and holding it regardless of market conditions.

Incidentally, Harry Dent after predicting a further and deeper crash in 2009, eventually changed his mind. In his 2016 book, The Sale of a Lifetime, he not only accepted that US shares were in a bull market, but insisted they were in a price bubble that would burst between 2017 and 2019.

Source: Dent Research                                                                                                                                                                                                                                                                                                                          

I agree with Dent that the current US bull market will crash, though unlike him I refuse to put a date on it. I expect a crash for five reasons:

  1. Every secular bull market in history has ended badly;
  2. The bull market is already in its 104th month without a correction;
  3. The S&P500 index is extremely overvalued on any measure;
  4. The bond yield curve is flattening as it usually does before a crash; and
  5. The stock market exhibits the extreme calm that precedes a storm.

I’ve written before about the first four points (https://theconstantinvestor.com/why-america-needs-a-crash-to-restore-value-to-its-shares/). On the last point, look at this chart showing that share volatility now matches the historic low that preceded the stock market crash of 2008.

But I must qualify this; such an historic low was also reached in 1994 and the stock market after dipping slightly rallied for another seven years. Yet in 1994 the S&P500 registered a cyclically adjusted Price/Earnings Ratio of 20 whereas now it’s 32, making it much more top heavy.

Notwithstanding this, the US market may continue melting-up as long as the 2017 rebound in economic growth and corporate earnings continues, interest rates remain low and investors think nothing can go wrong. For this possible scenario read my article of a month ago (https://theconstantinvestor.com/high-stock-market-melt/).

But the more overvalued US shares become, the greater the adjustment required to restore their fair value. And history suggests such price shocks overshoot on the downside.

I don’t know whether the crash will occur in 2018 or 2019, but when it does it will shake share markets around the world even though most countries (like Australia) are not as overheated as America.

At that point I will be relying on MarketTiming’s strategies, various unlisted investments and select market neutral hedge funds to mitigate the market meltdown.