Stock Market Update 30 Dec 2012

It is traditional at the end of the year to look forward into the next with “forecasts” and “predictions”.  It has been proven the ability of market analysts to forecast future price trends is extremely limited and frankly quite useless but none the less human nature compels us to attempt to gain insights into the future.

Given such, my year end look forward into 2013 will not be an attempt to predict the future but an attempt to “wrap” economic, cycle, technical and fundamental indictors around current asset prices in order to game the odds of price increases in equities going into 2013.


Overview:

In 2012 world equities (as measured by the iShares MSCI ACWI Index ETF) gained 14.9%.  It was an exceptionally volatile year with 1 significant decline occurring during March-June (-13.5% decline) and a lesser decline occurring in Sept-Nov (-6.5% decline).  Both declines were halted by unprecedented central bank intervention worldwide.  Indeed, the story for 2012 was the ongoing central bank manipulation of money supply and interest rates in an attempt to forestall the needed conclusion to a debt super cycle top which they refuse to allow to deflate.

The Kondratiev (also spelled Kondratieff by some) long wave cycle (known as a K-wave) has been spoken about before.  To refresh memories, it is a 4-phase cyclical period of 50-60 years that occurs in Capitalist economic systems associated with the creation and destruction of debt.  It is marked by four clearly distinct periods during which certain asset classes perform better than others

The Kondratiev Cycle is broken down into four "seasons." As described by Jim Richter, they are as follows:

1) Spring: A time marked by economic expansion. Savings are at fairly high levels, and interest rates are low. Stocks and real estate are the most successful investments.

Most recent Spring: 1949-1966. Prior Kondratiev Springs: 1794-1800, 1844-1858, 1896-1907.


2) Summer: A time marked by high inflation, high interest rates and by volatility. Commodities, gold, and real estate do well during the summer.

Most recent Summer: 1966-1982. Prior Kondratiev Summers: 1800-1816, 1858-1864, 1907-1920.


3) Autumn: The happiest phase of the K-Cycle. Paper financial investments like stocks and bonds always do best. Autumn is characterized by speculative bubbles or manias in stocks, bonds, real estate, and collectibles. On the other hand, gold, silver, and commodities collapse. Autumn is also marked by a serious decrease in savings, and a dangerous and reckless increase in debt. The imbalances build up to the point where they cannot continue.

Most recent Autumn: 1982-2000. Prior Kondratiev Autumns: 1816-1835, 1864-1874, 1920-1929.


4) Winter: The insane excesses of the Autumn are purged or cleansed. The ultimate result is a deflationary recession or depression. Debt is repudiated. There is usually a banking crisis. Bankruptcies and foreclosures increase, as does social discontent. During the Kondratiev Winter, GOLD and CASH are the best investments.

Most recent Winter: 2000-? Prior Kondratiev Winters: 1835-1844, 1875-1896, 1929-1949.

We are now in the “winter” phase of the 4 phase process and can expect a period of 15-20 years (the last 2 Winter phases lasted 21 and 20 years respectively so realistically the end of this Winter will not occur until 2020) of broad based deflation until the levels of debt have been reduced to extraordinary low levels.  In Capitalism, it is this winter “debt destruction” economic depression that sets the stage for the “spring” phase which is the ideal time to invest in risk assets such as equities.

It is my belief the Kondratieff “winter” phase began in 2000 with the tech bubble top and had central banks allowed the normal flow of Capitalism to take its course we would now be nearing the end of the “winter” phase.  This would have been a very difficult period for most countries worldwide as both government and corporate debt would have been reduced to exceptionally low levels (government debt through austerity and balancing of budgets; corporate debt through bankruptcy).  Unfortunately, central banks (led by the U.S. Federal Reserve) believe they have the power to eliminate K-wave “economic debt gravity” by a litany of novel new quantitative easing, bond repurchase, and untried money printing programs.  It is obvious these programs do nothing to eliminate the ongoing excess debt built up in our current system and merely extend the “winter” phase well beyond that which would normally occur should the excessive meddling not take place.

Given our current backdrop, it is very difficult to expect significant rises in equity markets in 2013.  During 2012 each successive central bank infusion/intervention has become less and less effective in boosting asset prices during declines.  At best, during 2013 we should expect more of a ‘muddle through” environment with the probability of increased volatility and the risk of substantial market declines.  However, given central bank manipulation of interest rates and excessive pumping of liquidity into markets, a case can also be made that money has to go somewhere and on a risk basis equities offer a potential greater rate of return than fixed income products.  As such, it will be possible to make money in equities in 2013 but being nimble will be key.

If this sounds like a “fence sitting” position, it is so only because in the history of economics we have never seen such attempts to manipulate markets by central banks and therefore the outcome is difficult to gauge given the lack of historical backdrop.  As such, it will be key in 2013 to continually monitor real time economic and technical indicators on a continuous and ongoing basis to determine the correct exposure to risk assets as the current K-wave drama continues to unfold. 


Economic Analysis:

In 2013 the U.S. will be the key market to watch to monitor world economic activity.  As the worlds largest economy and the largest consumer of goods, any indication the U.S. is slipping into recession would be a very worrying event.  A reduction in consumer demand in the U.S. would lead to reduced production in China, Japan, Korea and Germany with follow through reduction in demand for raw materials in Australia, Canada and OPEC producing countries.

It appears Europe will continue 2013 in recession and there is no indication of a turn around any time soon given the still high levels of debt and reluctance for a number of European countries to restructure their labor markets, eliminate socialist government programs and make significant reductions in debt levels through voluntary participation in austerity programs.  In 2013 I believe a return of the “bond vigilantes” to not only the PIIGS (Portugal, Italy, Ireland, Greece, Spain), but also France will result in significant volatility returning to those countries bond markets (which have been quite quiet the past few months as focus has shifted to the U.S. and the current "fiscal cliff" issue).

When assessing the economic indicators to judge the risk of recession in the U.S., I center on those indicators believed to be those used by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee in dating recessions in the U.S. (they have never publicly announced which specific indicators they use in their assessment).

These indicators are:

-Industrial Production
-Real Personal Income (excluding transfer payments)
-Employment
-Real Retail Sales

It is the NBER that is tasked with the responsibility of officially dating recessions in the U.S., which they do in a “rear view mirror” process so by the time they announce the recession it is already been some time within the recession.

I rely on data provided by Doug Short; an analyst who provides excellent updates on key indicators as they are made available by the U.S. government.  Historical back testing of his indicators reveals a high probability should his indicators indicate recession as a probability in subsequent months the NBER confirms the same dates.  As such, they are indicators that I monitor closely.

As of published data the end of Nov, 2012, the good news is his indicators appear to show a low probability we are currently in recession in the U.S. (unlike claims from others that the U.S. has been in recession for months).  All economic data is subject to later revision so must be taken with a grain of salt but as of the end of Nov 2012 it appears the U.S. is not in recession.

The bad news is for the past number of months the U.S. has stalled economically (note the "Big 4 Average" on his chart has stalled out the past 12 months) and it would not take much to tip it over into recession (the "Fiscal Cliff" issue may do so).

The 1st few months of 2013 will be critical to assess how the fiscal cliff outcome affects the key economic indicators into the spring.


Cycle Analysis:

From a top-down perspective here is a breakdown of the cyclical influences affecting equity markets into 2013.

50-60 Year Kondratieff Cycle:

We are going into year 13 of the 15-20 year “winter” deflationary cycle (some would argue the cycle top was 2006 associated with the housing bubble in the U.S. but my belief is the top occurred in 2000 with the tech bubble and the housing bubble was a “side show” engineered by Alan Greenspan/the U.S. FED in an attempt to counteract that start of the K-wave "winter” deflationary phase).

Had central banks allowed “economic debt gravity” to take its course we would be nearing an end to the debt destruction cycle in the next year or two.  My belief is the ongoing monetary manipulation will extend the length of time to exit the “winter” phase and, until we do so, the overriding economic cycle will be one of deflation and debt destruction.

This overriding deflationary environment will preclude substantial gains in equities under a “buy and hold” strategy for many years to come.  Equity gains will be possible as we cycle through the normal capitalist business cycle within this deflationary period but tactical movement into cash as cyclical bear market conditions become increasing probable will be essential to preclude large account drawdown’s associated with cyclical bear market business cycle declines combining with secular bear market pressures associated with the debt deflation “winter” cycle.


10 Year Decennial Cycle:

In general terms there is a recurring 10 year pattern in stock patterns.  A typical decade consists of 3 cycles, each lasting approximately 40 months.  Generally in a given decade years ending in 5 and 8 tend to be strong years with weakness in years 1, 7  and 0.

Since 1833 the Dow Jones Industrial Index has returned the following average return in each year of the Decennial Cycle:

Years ending in:

0) -1.11%
1)   -0.64%
2)   +5.11%
3)   +7.28%
4)   +5.42%
5)   +21.47%
6)   +3.75%
7)   -4.09%
8)   +12.68%
9)   +9.61%

We are entering year 3 of the 10 year Decennial Cycle.  Since 1833 there have been 11 "up" years and 7 "down" years during year 3 but interestingly when year 3 is the 1st year of the new president (as it is this year) the record is 2 years up (1933 and 1993) and 7 years down (1833, 1853, 1873, 1893, 1913, 1953, 1973).

THIS ARTICLE UPDATED FROM W.D. GANN’S 1935 FORECASTING COURSE


Taken from http://www.schoolofgann.com/

W.D. Gann is credited with discovering the 10-year cycle, or decennial pattern.

No. 1 in a new decade is a year in which a bear market ends and a bull market begins. Look up 1901, 1911, 1921, 1931, 1941, 1951, 1961, 1971, 1981, 1991, 2001, and watch for 2011, and 2021. So far this year we are in a bearish trend. It’s important to note that yearly cycles within the overall scheme of Gann cycles are not a big factor, and you need to do further analysis. You don’t want to buy into October if major Gann angles or supports have been broken, and I stress the importance of considering many factors in making your decisions.

No. 2 or the second year is a year of a minor bull market, or a year in which a rally in a bear market will start at some time. See 1902, 1912, 1922, 1932, 1942, 1952, 1962, 1972, 1982, 1992, 2002, and watch for 2012, and 2022

No. 3 starts a bear year, but the rally from the second year may run to March or April before culmination, or a decline from the second year may run down and make bottom in February or March, like 1933. Look up 1903, 1913, 1923, 1933, 1943, 1953, 1963, 1973, 1983, 1993, 2003, and watch for 2013, and 2023.

No. 4 or the fourth year, is a bear year, but ends the bear cycle and lays the foundation for a bull market. Compare 1904, 1914, 1924, 1934, 1944, 1954, 1964, 1974, 1984, 1994, 2004, and watch for 2014, and 2024.

No. 5 or the fifth year is the year of Ascension, and a very strong year for a bull market. It can be a new bull market or a big correction in an existing uptrend. See 1905, 1915, 1925, 1935, 1945, 1955, 1965, 1975, 1985, 1995, 2005, and watch for 2015, and 2025.

No. 6 or the sixth year is a bull year, in which a bull campaign which started in the 4th year ends in the fall of the year and a fast decline starts. See 1896, 1906, 1916, 1926, 1936, 1946, 1956, 1966, 1976, 1986, 1996, and watch for 2006, 2016, and 2026..

No. 7 or the seventh year is a bear number, and the seventh year is a bear year because 84 months or 84 degrees is 7/8 of 90. See 1897, 1907, 1917, but note 1927 was the end of a 60-year cycle, so there was not much decline. Also see 1937, 1947, 1957, 1967, 1977, 1987, 1997, and watch for 2007, 2017, and 2027.

No. 8 or the eighth year is a bull year. Prices start advancing in the seventh year and reach the 90th month in the eighth year. This is very strong and a big advance usually takes place. Review 1898, 1908, 1918, 1928, 1938, 1948, 1958, 1968, 1978, 1988, 1998, and watch for 2008, 2018, 2028.

No. 9 the highest digit and the ninth year, is the strongest of all for bull markets. Final bull campaigns culminate in this year after extreme advances and prices start to decline. Bear markets usually start in September or November at the end of the ninth year and a sharp decline takes place. See 1869, 1879, 1889, 1899, 1909, 1919, and 1929 – the year of the greatest advances, culminating in the fall of the year, followed by a sharp decline. Also see 1939, 1949, 1959, 1969, 1979, 1989, 1999, and watch for 2009, and 2019.

No. 10 the tenth year, is a bear year. A rally often runs until March and April; then a severe decline runs to November and December, when a new cycle begins and another rally starts. See 1910, 1920, 1930, 1940, 1950, 1960, 1970, 1980, 1990, 2000, and watch for 2010, 2020, and 2030.

In referring to these numbers and years, we mean the calendar years. To understand this, study 1891 to 1900, 1901 to 1910, 1911 to 1920, 1921 to 1930, 1931 to 1940, 1941 to 1950, 1951 to 1960, 1961 to 1970, 1971 to 1980, 1981 to 1990, 1991 to 2000, 2001 to 2010, 2011 to 2020.

Given the above, the Decennial cycle projects an end to the current cyclical bull market in early 2013 with a new bear market decline into late 2014-early 2015.


4 Year Presidential Cycle:

We are entering year 1 of the 4 year Presidential Cycle.  Theory holds the economic stimulus injected into the economy as the party in power seeks re-election in year 4 leads to strong markets but once re-elected the stimulus is removed in the subsequent year.  As such, year 1 of the 4 year Presidential Cycle tends to be the weakest of the 4 years.

Since 1833 the Dow Jones Industrial Index has returned the following average return in each year of the Presidential Cycle:

Post Election Year:  +2.0%/Years up 20/Years down 24
Mid-Term Year:  +4.2%/Years up 27/Years down 18
Pre-Election Year:  +10.4%/Years up 34/Years down 11
Election Year:  +5.8%/Years up 29/Years down 15

As can be seen, historically year 1 has been the weakest of the 4 year cycle both in terms of average return and up vs. down years.  It is interesting to note the weakest period in the 4 year cycle is the last quarter of year 4 into the 1st quarter of year 1 (where we are currently).


Seasonal Cycle:

We are currently within the bullish 6 month seasonal cycle (Nov-Apr yearly).

Historically this 6 month period is the time when the greatest returns are made in equities yearly.  From 1950 to 2011 the S&P 500 Index has returned the following broken down by month:

Clearly stock market performance is typically strongest in the Nov-Apr period and weakest in the May-Oct period.

In summary, the long term cycles (K-wave and Decennial) are down into 2013, the medium cycle (Presidential) is down into 2013 and the seasonal is up until April 2013 (with Year 4 4th quarter-Year 1 1st quarter weak).  As such, cycles suggest it is a time to be very cautious.


Technical Analysis:

As we end 2012 the MSCI World Index continues on its bullish path from the start of the year (up 15%). 
All technical indicators on the chart are bullish with excellent buy volume occurring into year end.

Price is currently in the middle of the blue uptrend channel and finished last week between resistance at 48.38-48.67 and support at 47.01-47.23 (weekly close 47.36; down 1.15% on the week).

Until a new weekly sell signal occurs it must be assumed the medium term trend technically is up.  However, very strong resistance must be overcome early in 2013 to allow a push into new highs in the spring.  Key resistance at 48.38-48.67 must be broken on a weekly closing basis in order to get me feeling more bullish about the outcome into early 2013.


Fundamental Analysis:

In terms of value based upon historic data equity markets remain quite expensive.  Once again, an excellent chart from Doug Short highlights the levels of over-valuation based upon a number of metrics:

Based on the latest S&P 500 monthly data as of the end of Nov, 2012, the market is historically overvalued somewhere in the range of 31% to 45%, depending on the indicator you use.

This does not mean the markets cannot go higher but it puts into context the fact markets are not a great "bargain" at current levels.


Sentiment Analysis:

Generally it is accepted prices peak when the most participants are bullish and fully invested in the markets.  Conversely, when there is a fair amount of skepticism in the markets they tend to rise on a "wall of worry".

There are many composite sentiment indexes available.  Here are several I monitor:


Citigroup Panic/Euphoria Model:

Barrons Sentiment Roundup:

Consensus Index:
Consensus Bullish Sentiment 49%

AAII Index: 
Bullish:  44.4%
Bearish:  30.2%
Neutral:  25.4%

Market Vane:
Bullish Consenus:  63%

TIM Group Market Sentiment:  54.9%


CNN Money Fear & Greed Index:

St. Louis Fed Financial Stress Index:

Overall sentiment can be described as neutral; neither too bullish nor too bearish.  As such, not too much information is currently being provided but there appears to be enough "concern" in the market to support a gradual rise in equity prices.



Bottom Line:

Going into 2013 it is apparent there will be a number of headwinds in terms of cycles, recession possibilities and technical levels.

I expect there will be some watered down solution to the "fiscal cliff" and we will get a rise in the markets as a result.  The key will be to see if they can overcome key resistance and hit new highs for this cyclical bull market or pull back into the upcoming bear market.

We are currently sitting right on the edge either way so it is difficult to judge.  My current asset allocation model (as of today) sits at a 45% equity/55% Bonds/Cash weighting.  Until I see a breakout above key technical levels it is wise to remain cautious.

As of today I remain in a 50% Equity/50% USD Cash position as I indicated in my last post:


-Russell Global 90 Fund: 40%


-Fidelity International Fund: 10%


-Russell USD Liquidity II Fund: 50%



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