Saturday, October 31, 2009

Cycles

I have been meaning for some time to write a blog on cycles within the stock market. I think it is extremely important at this point in our current market advance to shine some light on where I think we are going and why.

Firstly, once again I reiterate that stock market technical analysis is not a crystal ball. It is merely a pictorial charted reflection of the "movements of the masses" expressed by way of how they "vote" with their billions of investment dollars each and every day.

In order to be successful in the markets you need to ride on the tails of the masses (the general public investment "sheep") yet keep a firm eye on a well defined exit strategy to avoid following those sheep over the cliff when the canyon edge becomes apparent (as I have shown with the use of the 13 week vs 34 week exponential moving average crossovers previous). Using simple technical analysis techniques such as these keep you on the right side of the trade when the markets are advancing and either in cash or short the market when markets are declining.

One of the areas that is somewhat outside pure technical analysis is the study of cycles. As we all know, cycles are part of everything around us (24 hour time cycle, monthly lunar cycles, 12 month calendar cycle, 4 season cycle, etc). What many do not know is there are cycles in investment as well.

Most people are familiar with the term "business cycle". It is perceived by most to be a period of economic expansion followed by a period of economic retraction (commonly known as a recession). The common perception is these "business cycles" are controlled or can be manipulated by the Federal Reserve and U.S. Treasury (through the setting of interest rates, the control of the money supply and government "stimulus" policies such as the recent "cash for clunkers" fiasco).

What is interesting (and alarming) to me is that this commonly accepted rational that the government can control long term economic cycles is a recent phenomenon (the past 60 years). The key is this acceptance of government omnipotence has occurred during a time of rather benign (bullish) longer term economic cycles. As such, I believe we have become much too complacent in assuming the government can control our economic future and steer (manipulate) a clear path forward. They have had an "easy go" of it over the past 60 years but that is about to change.

There have been numerous studies over the years looking at cycle theory. Three of the most prominent cycle theorists were Edward Dewey (who discovered the 19 year stock market/real estate cycle), Nikolai Kondratieff (who developed the Kondratieff Long Wave Cycle, which I have written about previous) and Ralph Elliott (who was the father of the Elliott Wave Theory). All 3 confirmed the presence of specific economic cycles that reoccur time and again within a Capitalist economic system operating within a Democratic political system.

In addition to the fore mentioned cycle specialists, two authors who have attempted to put some "science" behind the cycle theory are Harry S. Dent Jr and Stephen J. Puetz. While their approaches to the question of cycles is unique, it is interesting to note their conclusions are remarkably similar.

Mr. Dent uses demographic analysis in combination with well established cycle theory to predict future economic forecasting. His predictions over the years have been somewhat "extreme" (direction and timing correct but magnitude incorrect) but the science behind his theories is relevant and cannot be ignored.

Stephen J. Puetz attempts to quantify various cycle theories previously discovered by others and compress them into one neat package he calls the Extra-Universal Wave Series. While I disagree with some of his assumptions, the core thesis he comes to works well in explaining various cycles previously identified by numerous individuals, including the following:

-a 2.12 year stock cycle
-a 6.36 year stock cycle
-a 19.08 year stock and real estate cycle
-a 57.24 year war and commodity price cycle
-a 171.72 year civil war cycle
-a 515.16 year civil war cycle

I will not bore you with the details (for more Google Dewey, Kondratieff, Elliott or buy Puetz's or Dent's books) but suffice it to say there is fairly good indications taken from the work done by all I have quoted above that we have past the "prime" period of economic expansion in the western world (Especially the U.S.). As such, there is a very real chance we are now going to experience an extended period (2020-2023 bottom for Dent, 2026 bottom for Puetz, 2025 bottom for Kondratieff) of severe economic strife, crushing depressions/recessions, extreme levels of unemployment, violent civil unrest (especially in the U.S.) and the chance of a World War conflict.

Within this we need to consider from a Technical Analysis point of view how to view this potentially extreme event and how to prepare for it. Elliott wave theory does a good job of it for us.

In it's most basic form, Elliott Wave theory takes the form of a 5 wave "up" pattern (3 waves up with each up wave countered by a down wave in between) followed by a counter wave "down" pattern of 3 waves (2 down waves with an up wave pattern in between). The "up" pattern is labelled 1-5 and the "down" pattern is labelled an A-B-C correction.


Basic Elliott Wave formation:




Elliott wave is used down to the smallest time frame by some technicians but I find it most useful in identifying larger term patterns to give us something of a "crystal ball" look at what might be coming.

The problem with Elliott Wave is it is difficult to determine the "correct count" until the event has passed. As such, there are various scenarios that fit the current situation we are in.

Using the Oct/2007 top to Mar/2009 bottom, there are 3 possible Elliott wave scenarios:


Elliott Wave Scenario 1:



This is the most widely accepted scenario. It states we experienced a 5 wave advance from the early 1970's with a Wave 3 top in 2000, a Wave 4 down in 2003, and a Wave 5 top in Oct/2007.

From Oct/2007 to Mar/2009 we experienced Wave A down followed by Wave B up (to our current level). Once Wave B ends we can anticipate a Wave C decline to our final stock market low.


Elliott Wave Scenario 2:



Under scenario 2 it is assumed Wave 5 topped in 2000 with Wave A the decline into 2003, Wave B the rise into Oct/2007 and wave C the fall into Mar/2009.

If this is the case we have begun a new bull market and we would never again see a price below that achieved in Mar/2009 and we would begin a new multi-decade price advance in the next bull market.


Elliott Wave Scenario 3:



The 3rd scenario suggests the same as scenario 2 but instead of a 3 wave A-B-C decline we are in the midst of a 5 wave pattern within an expanding triangle.

In order for this to be valid we would need to exceed the Oct/2007 top followed by a massive decline slightly below the Mar/2009 low, followed by another climb ultimately out of the pattern through the top to commence the new bull market.

Unto themselves, each pattern is possible and plausible. However, given the cycle patterns I mentioned previous, it it highly unlikely the most bullish outcome (scenario 2) would be correct. It would have been the best case scenario 15 year's ago but not now given our current economic climate and this point in the longer term economic cycles (IMHO).

Given this, I think scenario 1 or 3 is in play. I favor scenario 1 (the most pessimistic outcome unfortunately) but cannot rule out scenario 3. The price action over the next 6-12 months will tell us which is correct.

In order to examine these in more detail, I have used the Dow Jones Industrial Average in the following charts to illustrate where I think we are going (click all charts to enlarge):


Elliott Wave Scenario 1:



This scenario is the most bearish yet most closely fits with the pattern of cycles we are currently in. I have yet to see anything on a fundamental level (debt levels, house foreclosures, unemployment rates, realistic stock valuations, etc) that indicates this is not the correct road map forward.

In this scenario we are currently in Wave B of an A-B-C correction. As indicated, wave B normally extends to either the 50% or 61.8% Fibonacci retracement level before beginning it's next decline. NOTE WE HAVE MET THE REQUIREMENTS OF HAVING REACHED THE 50% FIB LEVEL AND HAVE STARTED A DECLINE FROM THIS LEVEL.

From this point (or up to the 61.8% level at 11242 should prices reverse and commence a new upswing) prices should rapidly decline in wave C.

Normally in an A-B-C correction, the length of wave A equals the length of wave C. Should this be the case I have put some estimated price targets on the chart.

Irrespective of how you look at it, this scenario will result in a top to bottom decline of 75-82% from the late 2007 highs. This will be in line with the 1929-1932 "Great Depression" in terms of magnitude. However, during that time the U.S. was the worlds most powerful "Creditor Nation" with huge excess capacity and industrial production. Debt (either at the government or the individual level) was almost non existent. Today is not the case and the U.S. is NOT prepared for what is to come this time around should scenario 1 unfold. With this will come massive unemployment, unprecedented civil unrest and a Teutonic shift in power from the U.S. to the more affluent and developing nations (ie. China).


Elliott Wave Scenario 3:



Under scenario 3 (I've labeled it scenario 2 on the chart; disregard that typo) we go through a period of boom and bust over the next several years with a stock market that exceeds it's 2007 high (slightly) followed by a bust that exceeds it's 2009 low (slightly) followed by the 1st leg of a new bull market.


The question that must be asked is "how do we know what we are going to face"? In my mind, the key to watch is the Fibonacci levels of 38.2% (9416) and 61.8% (11242). A significant rise above the 61.8% level and it is safe to assume scenario 1 is off the table (and a rise above the previous top at 14198 would confirm it without a doubt and set up either scenario 3 or scenario 1).

Alternately a price break below 9416 and it is safe to assume scenario 1 is unfolding (confirmed by a price break below the Mar/2009 low at 6469). Should that occur I expect the worst.

How to play this from an investment viewpoint is difficult as there is no clear direction. For now the best is to time the market and wait. If scenario 1 confirms it would result in a severe deflationary collapse. During these conditions "cash is king" and, believe it or not, the best place to hide would be in currencies (the USD as long as it can maintain it's reserve status; otherwise whatever currency replaces it as the world's reserve currency). Interesting enough, gold tends to do well at both extremes of deflation and inflation (it is the "run to" currency when no one knows what to expect in the future) but not when things are going well. As such, I think it is a currency (as opposed to a commodity) that everyone should consider.

Under scenario 3, I would have to assume unlimited fiscal stimulus worldwide would have altered the "correct path". Given this, I would expect very high to hyperinflation in most developed markets. Once again, gold would do well, as would the stock market, real estate, commodities, etc. The dollar (and other currencies) would be trash and would be held for as short of time as possible; only as long as it takes to take them and convert them into "something else".


Conclusion


It is my opinion we have transitioned into a "new normal". The common thought process is that we are in for "more of the same" with respect to the type of economic progress and stock market advances that we have experienced for the past 60 years. I do not agree.

Those who have their eyes open will see it coming and react accordingly; unfortunately the masses will be blind and the coming economic blight will decimate the balance sheets of most of the majority.

Fortunately out of a firestorm comes new growth. Those that can preserve their capital and survive the coming blaze will face prospects unheard of over the past 40 years. Stock valuations will be at obscenely cheap levels, homes will be again affordable, and people will have learned to live within their means for the 1st time in 40 years.

As much as it will hurt, I don't think that is necessarily a bad thing. This reset is long overdue.

Keep your head up and your eyes open. Protect yourselves and your families. I'll see you on the other side.


There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.

Donald Rumsfeld



Dwayne Malone


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