Long-Term Cycles vs Short-Term Market Potential
Cliff DrokeA reader has asked the following question, which addresses a problem confronting many investors right now:
7 November 2011
"I always appreciate the Kress Cycle analysis. Yet, I must say that I am confused. For quite some time, you have talked about the 'hard down' phase and the topping of most of the important cycles that was supposed to be taking place now through 2013/2014. And yet, now it seems the [weekly] cycles are calling for a rally through the end of the year. The Elliott Wave folks have been talking that the sky is about to fall in as well and yet there is great divergence in that camp with some still calling for that while others say that it may now have been pushed into 2012. I keep looking for a retest of the bottoms that holds at which point I would pick up more shares, but so far, no retest has occurred."
This reader went on to question how the yearly cycles can be suggesting one market outcome (namely a bearish one) while other factors seem to be pointing to a recovery. This is a valid question in view of the activity in the financial market since the early October bottom. While it's true that the 120-year cycle, along with its component cycles, are in decline between now and late 2014, there are other factors at work and this is at the heart of the matter we'll be discussing in this latest installment.
At any given time the position of the weekly cycles must be taken into account when evaluating the stock market. These cycles have a greater impact on the near-term direction of the stock market than the yearly cycles unless the yearly cycles happen to be bottoming (as with the 6-year cycle bottom in late 2008). As the "hard down" phase of any cycle is the final 10% of the cycle's duration, the 120-year cycle has been in its final "hard down" phase since 2002. Yet this fact didn't negate the upside potential of stocks in the years between 2003-2007 as well as the periodic rallies we've witnessed in the intervening years. This is because a number of yearly cycle components of the 120-year cycle have been rising in the intervening years, including: the 12-year cycle (until late 2008), the 10-year cycle (until late 2009), the 6-year cycle (until 2011) and the 4-year cycle (until late 2012).
Another factor that investors sometimes fail to account for is central bank policy. When Federal Reserve policy is aggressively "loose", as it was in the years 2001-2003 and again in 2009-2011, any yearly or even intermediate-term weekly cycle that happens to be in the ascending phase will tend to exert a bullish impulse on stocks. The liquidity factor is extremely important and should never be discounted when evaluating the yearly cycles.
Investors are also starting to question the outlook for 2012 in view of the fact that the 4-year cycle is peaking next October. The question is whether the 4-year cycle is strong enough by itself to stabilize the stock market when every other components of the 120-year cycle is in its final descent. A superficial examination of this question would lead to a negative answer. But if central bank policy is aggressive enough to counteract the deflationary impulse created by these cycles heading into 2012, it's possible that the rising 4-year cycle could single-handedly provide support and prevent a repeat of the credit crash until the cycle peaks in October 2012.
Doing so would require something along the lines of a coordinated monetary stimulus, a global QE3 if you will. If the world's major central banks all combined to provide ample liquidity in the coming months it's possible that the peaking 4-year cycle could "rescue" the U.S. economy and financial market for one more year until the irresistible deflationary force of the other, declining yearly cycles in the 120-year series hits hard in 2013-2014.
Long-term cycles can be used for long-term investment planning but aren't the best tools for short- and intermediate-term trading and investing. The lesson I had to learn many years ago -- one which all too many cycle analysts/traders seem not to have learned -- is that while cycles can be useful guidelines as to the overall direction in which stocks are headed in the longer term, they can't be relied upon with any consistency when it comes to making short-term timing decisions. And the short-term is where most of the trading profits come from. (As the cycle analyst Bud Kress once said, the short-term leads to the intermediate-term, which leads to the long-term, i.e. all profitable trading positions must begin with the short-term outlook). Cycles can often be used to identify a turning point in the market, but just as often these turning points fail to materialize due to short-term factors in liquidity or market psychology. The short-term cycles can sometimes be whipsawed by these factors.
I believe we'll see some potentially heavy downside in the years 2013 and 2014 while the 120-year cycle is in its final descent. But also keep in mind that along the way there will be tradable rallies since markets rarely go straight down for any length of time. Indeed, markets never take a straight path -- whether up or down. There will definitely be rallies along the path to 2014 and depending on what the Fed is doing, those rallies could at times be fierce. This is where having a reliable trading discipline comes in. And a reliable trading discipline should be based mainly on proven technical market tools instead of an unbalanced reliance on cycles only.
New Economy Index
As addressed in the previous commentary, the New Economy Index (NEI) has been confirming that the U.S. retail sales and economic outlook is positive for the near term outlook. Below is the latest update of the NEI chart.
The interpretation of this chart is straightforward: when the indicator itself is in a rising trend above its 12-week (black line) and 20-week (red line) moving averages, the U.S. retail spending economy for consumers and businesses is considered to be improving (or at least holding steady). If the two moving averages are in a confirmed decline, then the short-term retail economic outlook is bearish. To date this indicator has reflected a buoyant economic outlook in terms of retail spending as we head into the critical Christmas shopping season. Thus, the economy will probably be able to end the year on a relatively positive note in spite of the fact that the middle class is still in a wage and balance sheet recession and the jobless rate is still high.
Confirming the positive economic bias that the NEI has been reflecting in recent months is the latest U.S. unemployment report. On Friday, Nov. 4, it was announced that the unemployment rate dipped to 9% in October, a slight improvement from recent months. The report showed that 80,000 net new jobs were created last month with the professional and business service sector showing the strong gains. Health care, education, and leisure and hospitality sectors also added jobs last month.
As the Neil Irwin of the Washington Post observed in his reporting of the unemployment numbers, "The latest job figures point to a labor market frozen in place, neither adding enough jobs to put the vast armies of unemployed - 13.9 million people - back to work, nor falling into an outright contraction or shedding jobs." He added that the report "at least offers relief from the fear of double-dip recession, pointing instead to slow-and-steady economic growth."
The present economic climate is less than stellar and for many Americans job prospects are dismal. This isn't your father's economic recovery. But it's finally starting to look like the Fed's QE1 and QE2 loose money programs were mildly successful, at least in terms of keeping the economy from continual contraction in the face of overwhelming deflationary pressure. Operation Twist, the Fed's current program of buying long-dated Treasuries to keep interest rates low, could provide additional support for a while.
The Fed faces a major stumbling black in its ongoing attempt at fighting deflation, however. It's the hedge fund factor. Each time the Fed ramps up liquidity, hedge funds take advantage of this by bidding up commodity prices, which in turn puts upward pressure on consumer prices and undermines the chances for a significant job market recovery. It's a classic catch-22 situation, for if the Fed does nothing then deflation will eventually wipe away all the progress made since 2009. Yet if the Fed aggressively pursues a loose money policy (and only an aggressive approach can succeed against long wave deflation), it risks pushing up commodity prices even further. Perhaps this is why Fed Chairman Bernanke is content with pursuing a less aggressive policy in Operation Twist.
Along with selling short-term Treasuries and purchasing longer-dated Treasuries, the Fed will also reinvest maturing agency bonds and mortgage assets in agency backed mortgage debt with the goal of lowering interest rates on home mortgages, car loans and other big-ticket items. The Fed hopes this will stimulate demand for consumer credit as well as increased business investment and therefore rescue the economy. The Fed has an outside chance of maintaining the current level of unemployment in 2012 while the 4-year cycle peaks if the eurozone debt crisis doesn't blow up between now and then. This will be an exceedingly difficult balancing act on Bernanke's part but with coordination from other central banks it's very possible that the economy can see one more year of relative stability before the expected Kress Cycle Tsunami hits in 2013-2014.
As we talked about in last week's commentary, the intensity of the recent breakout in the SPDR Gold Trust ETF (GLD), our gold proxy, up suggested that the move was more than just short covering or reactionary buying due to the news coming out of Europe. It further suggested that this could be the start of an interim recovery for gold. This recovery is now under way and as the daily chart shows, GLD has established a pattern of higher highs and higher lows, which is the basis of an incipient recovery. Ironically, gold stands to benefit from both the uncertainty surrounding the European sovereign debt situation as well as any jubilation resulting from makeshift plans for dealing with the debt (as this entails dollar weakness).
Over the years I've been asked by many readers what I consider to be the best books on stock market cycles that I can recommend. While there are many excellent works out there on the subject of technical and fundamental analysis, chart reading, etc., precious few have addressed the subject of market cycles. Of the relatively few books on cycles that are available, most don't even merit mentioning. I've read only one book in the genre that I can recommend - The K Wave by David Knox Barker - but even that one doesn't deal directly with stock market cycles but instead with the economic long wave. I'm pleased to announce, however, that after nearly 10 years of research and one year of writing, I've completed a book on the subject that I believe will meet the critical demands of most cycle students. It's entitled, The Stock Market Cycles, and is available for sale at:
Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment. He is also the author of numerous books, including most recently "The Stock Market Cycles." For more information visit www.clifdroke.com
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