Saturday, 11 May 2013

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.