Saturday, 11 May 2013

This Time It’s Different.


"The four most dangerous words in investing are: 'this time it's different.'" Sir John Templeton.

Readers of my book and articles will know that I track the secular 17.6 year stock market cycle and in particular the specific 2.2/4.4 year cyclical turning points.  Awareness of this long term Balenthiran Cycle is essential for understanding where markets are headed and being positioned accordingly.

The Balenthiran Cycle diagram, below, shows the secular bull market cycle from 1982 to 2000 and the secular bear market from 2000 to 2018.  By studying price data from the Dow Jones Industrial Average going back 100 years, I have demonstrated that this cycle works from 1929 to 1947, 1947 to 1965 and 1965 to 1982. I have then been able to extrapolate the cycle forwards to provide a market roadmap stretching out to 2053, which outlines the changing character of the stock market through the different phases of the 17.6 year stock market cycle.

Balenthiran Cycle

The green segments are cyclical bull markets that typically last for 4.4 years and the red segments are cyclical bear markets that last for 2.2 years. Although significant progress is made during bull markets, bear markets can result in either a sizable drop or a period of sideways movement.

The Balenthiran Cycle forecasts that the current secular bear market won’t end until 2018. However when I was a guest on CNBC, as well as in comments to my articles, the response that I keep hearing is that a new secular bull market has already begun, central bankers have won. QE has triumphed over a cycle that has survived the Great Depression, two world wars and both the US and UK abandoning the gold standard. Basically “this time it’s different!”

However this time is not different and as well as the 17.6 year stock market cycle forecasting a significant low in 2013, another shorter term cycle is as well.

The 17.6 Week Stock Market Cycle

In order to trade effectively, it is useful to monitor shorter timeframe cycles in addition to longer term cycles.  One in particular is very informative, the 17.6 week cycle, and it is flashing red right now!

As can be seen from the chart above, the third harmonic of the 17.6 week cycle has coincided almost exactly with interim highs during the cyclical bull market. The dates given by the cycle are shown in the following table, along with the actual market highs:
The chart above also shows that a typical correction following a high is completed during the next 17.6 week cycle, which put us at 13th September 2013, one day before St. Leger Day!

Sell in May? The famous saying began in Britain as "Sell in May and go away, stay away till St. Leger Day." St. Leger Day is the final horse race of the British equivalent of the Triple Crown.

A remarkable coincidence, or is it?

To Understand The Future You Must Know The Past

Now that both the Dow Jones Industrial Average and S&P 500 have surpassed their previous highs, a debate had begun about whether we are in a new secular bull market or whether we are still in the secular bear market that began in 2000. The discussion goes something like this:

Bulls: "Who cares, markets are going up and we are making money."

Bears: "Yes, but only because the Fed is pumping money into the system."

Bulls: "Who cares, stocks are going up."

Nothing is going to get in the way of bulls at this time - spending cuts, Italian elections, Cyprus, continued economic malaise. The "great rotation" has most people believing that equities will stay high as bond money finds its way into the stock markets. What can go wrong?

Historic Stock Market Cycles

Boom and busts occur much more frequently than many imagine and by studying historic stock market cycles we can learn a lot about their expected duration and also what to expect along the way.

In the late 1800s/early 1900s business men and scientists such as Joseph Kitchin, William Stanley Jevons, John Mills, Clement Juglar and Nikolai Kondratieff, to name a few, started to formulate theories about recurring business cycles of various lengths and established the concept of the business cycle.

A cycle doesn't mean that the same exact thing will happen over and over again. A cycle is a sequence of events that repeat over time. The outcome won't necessarily be the same each time, but the underlying characteristics are the same. A good example is the seasonal cycle. Each year we have spring, summer, autumn and winter, and after winter we have spring again. But the weather can, and does, vary a great deal from one year to another. And so it is with the stock market.

General interest in cycles wanes during the boom times ("who cares I am making money") only to resurface during prolonged corrections, as economists and investors seek to understand why the usual short sharp recession has not been followed by a recovery. This was true in the 1930s and is the case once again.

Business Cycles

In the 1930s economists Joseph Schumpeter and Simon Kuznet did much to progress the concepts of cycles in innovation and economic development. In his book Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, Schumpeter suggests a model in which the four main cycles (Juglar, Kitchin, Kuznets and Kondratieff) are multiples of each other and can be added together to form a composite cycle.

Schumpeter wrote: "But there is no rational justification that the writer can see for assuming that the integral number of Kitchins in a Jugular or of Juglars in a Kondratieff should always be the same. Yet from the study of our time series we derive a rough impression that this is so. Barring very few cases in which difficulties arise, it is possible to count off, historically as well as statistically, six Juglars to a Kondratieff and three Kitchins to a Juglar-not as an average but in every individual case."

Source: Joseph A. Schumpeter, Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process

Analysis of world GDP growth rates by Andrey V Korotayev, and Sergey V Tsirel identifies cycles of approximately 4 years, 9 years 18 years and 53 years that correspond with Kitchin, Juglar, Kuznet and Kondratieff cycles respectively.

Source: Andrey V Korotayev, and Sergey V Tsirel, A Spectral Analysis of World GDP Dynamics: Kondratieff Waves, Kuznets Swings, Juglar and Kitchin Cycles in Global Economic Development, and the 2008-2009 Economic Crisis

Stock Market Cycles

We can see that there is good evidence for regular business cycles of fixed durations but how does this apply to the stock market? JM Hurst was a former NASA engineer who used frequency analysis to identify stock market cycles. The longer term cycles that Hurst identified were 18 years, 9 years, 4.5 years and 3 years. These are described in his book The Profit Magic of Stock Transaction Timing. Hurst set out a number of principles of cycle theory and also believed that the larger cycles are multiples of the small cycles.

Well known investors such as Warren Buffett and Jim Rogers have both written about 17/18 year stock market cycles and numerous analysts have constructed charts showing 18 year bull and bear market cycles. Cycles of approximately 18 years have been documented by many stock market commentators.

The 17.6 Year Stock Market Cycle

Art Cashin was, as far as I am aware, the first person to mention the 17.6 year stock market cycle. In an interview on CNBC he mentioned why the bear market would last until 2017. Steven Williams from CyclePro Outlook has also written about the 17.6 year stock market.

Source: Kerry Balenthiran, The 17.6 Years Stock Market Cycle: Connecting the Panics of 1929, 1987, 2000 and 2000/

My own research, without knowing about Art Cashin and Steven Williams, also identified the existence of a 17.6 year stock market cycle. When I read about Cashin and Williams I found it incredible that three people could independently identify such a specific cycle. However I have gone a step further, crucially I have discovered a regular 17.6 year stock market cycle consisting of increments of 2.2 years that correspond to major cyclical stock market turning points such as 1929, 1987, 2000 and 2007 and beyond. I have called this cycle, rather modestly (and, after all, if has to be called something), the Balenthiran Cycle.

Balenthiran Cycle

Source: Kerry Balenthiran, The 17.6 Years Stock Market Cycle: Connecting the Panics of 1929, 1987, 2000 and 2007.

The diagram above shows how the Balenthiran Cycle looks for the bull market from 1982 to 2000 and the current bear market from 2000 to 2018. In general cyclical bull markets last 4.4 years and cyclical bear markets last 2.2 years. By studying price data from the Dow Jones Industrial Average going back 100 years, I have demonstrated that this cycle works from 1929 to 1947, 1947 to 1965 and 1965 to 1982. I have then been able to extrapolate the cycle forwards to provide a market roadmap stretching out to 2053, which outlines the changing character of the stock market through the different phases of the 17.6 year stock market cycle.

Using the Balenthiran Cycle I forecast that 2013 is likely to see a significant stock market correction that will provide a fantastic opportunity to buy into equity markets ahead of the next great bull market. The current long term bear market in stocks is likely to continue until 2018, but after that we should see another period where equity investment comes back in vogue and buy and hold rules again, just like from 1982 to 2000.

As major world wide stock markets hover around multi-year highs and the media is full of articles stating that a new bull market is underway, it is worth remembering that, as we are all aware, stock markets do not go up in a straight line. Investors tend to forget that big falls occur when we least expect them. The tendency to expect outsized returns to continue, aka greed, means that people tend to ignore the warning signs and are unprepared for the inevitable change in trend that occurs. This happens on the way down as well as up. By being aware of long term secular cycles as well as the intermediate cyclical turning points investors will be better equipped to ensure that they have the right strategy for the prevailing stock market conditions.

Secular Bear Market Vs. Cyclical Bull Market

The big argument on twitter, among many, is focused on whether we are in a bull market or a bear market. Both sides are equally vociferous and committed to their position. What they don't realize is that they are both right in their own way. But understanding the difference in the way they are right is critical to successfully navigating the current market.

Marketwatch published the chart below showing the current market uptrend compared to the last market uptrend. The similarity is remarkable.

The 2009 to 2013 move up has displayed similar behavior to the 2002/3 to 2007 bear market rally (cyclical bull market), and based on the chart above you may well conclude that it hasn't got much further to run.

But how can we determine whether 2009 to 2013 is a bear market rally or the beginning of a new secular bull market?

Barry Ritholtz's blog discussed the top ten S&P 500 bull markets of 20% or more, see table below. The current bull run comes in at number 6 and the table shows that it could continue on much further, based on past experience.

However one thing that is not immediately obvious from the table above is this; of the ten bull markets, six of these have been cyclical bull markets within secular bear markets, only the first three have been during secular bull markets. So the chances are that this is also a cyclical bull market within a secular bear market.

But hold on, the bulls cry, "the markets are making new all-time highs, that's bullish!" Well not necessarily. During the bear market of 1965 to 1982 the Dow made new all-time highs in 1972 and then promptly fell 45%. So new highs are not necessarily an indication of a new bull market.

How do we know where we are in the current stock market cycle? Are we in the midst of a new long term stock bull market or a market rally within an ongoing bear market?

These are the questions that I set out to answer when I started to study historic stock market cycles. It comes as a surprise to most people to find out that booms and busts occur surprisingly regularly and that there is a repeating cycle in the stock markets.

My research has identified that a 17.6 year stock market exists within the markets consisting of downtrends lasting 2.2 years and uptrends lasting 4.4 years (2 x 2.2 years), with a combined cycle length of 17.6 years. I have called this cycle the Balenthiran Cycle and demonstrate how the intermediate turning points match stock market behavior going back to the early 1900s and extrapolate the cycle forwards to provide a market roadmap of the next secular bull market to 2035 and subsequent secular bear market to 2053.

Using the Balenthiran Cycle I forecast that we are in a secular bear market that will last from 2000 to 2018, and the current uptrend will end in 2013 and that we will have a low at the end of 2013 (not lower than the 2009 low). Following this low I forecast (using historic cycles) that we are likely to see a bounce in the markets with higher lows in 2015 and 2018 before the new secular bull market begins in 2018.

Bulls and bears can both therefore claim to be right, but it's only by taking a historical viewpoint and looking at the bigger picture that investors can ensure that they position themselves correctly for the future.