Stockmarket Cycles

December 17, 2002
The Cycles

The history of the four-year presidential election cycle in the stock market suggests that the year 2003 will be an up year in the stock market if not a big up year. If you or anyone else suggest otherwise, you had better have some darned good reasons. We suggest otherwise, and we will give you several reasons. Let's begin, however, by giving you an idea historically how important the bottom seen in a midterm presidential election cycle tends to be. Don Hays, in his well written daily Internet commentary concerning the stock market, presented a table in his December 9th edition which catalogued the percentage changes from the mid-year election year low to the following election year high since 1918. There have been 21 previous mid-year election years followed by 21 election years since 1918. The average gain from the mid year election cycle low to the following election year high has been 56.8 percent. In every single election cycle since 1918, the stock market has seen an increase in prices from the mid election cycle year low to the following election year high-every election cycle save one. The 1930 mid-year low was 157.51. The 1932 election year high was 88.78, down an amazing 43.6 percent. Mind you, we are measuring from a preceding low to the following high, not from low to low or high to high.

That election cycle was truly remarkable in its difference between preceding and subsequent election cycles. It was so remarkable and so different that it begs to be researched. Recall that in our November newsletter, we showed a long-term pattern of four year cycle bottoms which occurred in October of the mid election cycle year. That pattern went back over 75 years and showed that there was only one dramatic departure from the general pattern which showed very little risk over at least the next year below the October low of the mid election cycle year. Because two very bullish historic patterns were completely disrupted by the pattern in 1930, that pattern invites us to seek reasons for the departure. Consider this--since the formation of the Federal Reserve in the early 20th century, there had been 19 occasions when the Federal Reserve initially lowered discount rates twice consecutively prior to 2001. On every occasion, save one, the stock market was up one year after the initial lowering of the discount rate. The exception to that rule occurred in 1930. The reason we say prior to 2001 is that that very rare market failure has occurred once again. The Federal Reserve began lowering rates in early 2001 and has continued to do so in almost unprecedented fashion since then. Unfortunately, something has gone terribly awry. One year after they began lowering rates, and for the only time since the sole prior occasion in 1930, the stock market was down despite the lowering of rates. We hope you see our point. We believe there is a very strong suggestion that what caused the failure in 1930 is also causing the failure here, and we believe that theory is confirmed by the market's failure for the first time since 1930 to conform to prior cyclic and four year presidential election patterns. That is the first argument that leads us to believe the market will not conform to its election cycle pattern and produce a rising market in 2003.

TradeStation Chart Analysis - $INX Weekly S&P 500 Index

Created with TradeStation

Let's move on to the second argument. The chart depicts the symmetrical pattern that has been playing out on the S&P 500 since its all-time high in March 2000. The pattern was discovered by Roger Hirst of Goldman Sachs and we have reported on it in our newsletters of December 2001, March 2002, and June 2002. First, let us caution you as we always do with patterns of this type that the pattern will obviously not continue ad infinitum. It has been playing out, however, for a long period of time and we will respect it until it is obvious the symmetry has ended. Let's point out some of the patterns on the chart. Moving out in both directions from the all-time high, we can see that the important lows in October 1998 and in September 2001 were both exactly 77 weeks away from the high. On the chart, we have placed the vertical lines 79 weeks away from the all-time high so that they would not cover the obvious bottoms that occurred two periods away. The next symmetrical time sequence is interesting because it occurred from 88-103 weeks on either side of the all-time high and was a topping pattern which led to the start of significant declines on both sides of the symmetry exactly after 103 weeks. The period between 88-103 weeks is depicted on both sides by dashed lines between which we have enclosed a square box covering that complete time period. By August 2002, it appeared as if the symmetry might be ending. The August 2002 high corresponded closely on the symmetrical pattern with the October 1997 low. Now, however, the pattern has held up nicely on both sides of the symmetry and we have two arrows pointing to our current location on either side. If the pattern continues in even a general way, the market is faced with almost three months of straight down price activity. In fact, although the chart on the left-hand side of the symmetry does not show the results for the next 52 weeks, the left-hand side of the pattern continues almost straight down for the next year with a relief rally of only around two months scheduled to begin in March 2003. How close will the market conform to the symmetry over the next year? There is no way to know, of course, but we prefer to face the market with a cautionary outlook based on this continuing pattern rather than a rosy outlook based on the election cycle. We will continue to update the pattern as long as it continues to be relevant. Incidentally, based on the analysis of this pattern, we discovered a 77 week turning point pattern with turns occurring in the weeks ending April 18th, 1997 (low), October 9th, 1998 (low), March 24-31, 2000 (high), and September 21st, 2001 (low). The next turn is due March 14th, 2003. That would conform exactly with the low of April 18, 1997 on the left side of the symmetrical pattern if it turns out to be a low.

The final argument contending that the year 2003 will be a down year comes from the world of academia. As a general rule, we would caution you to steer clear of any stock market forecast issued from those quarters. Professors, whether in economics or in more arcane subjects, have a terrible forecasting record when it comes to the stock market. Perhaps the most celebrated forecast from academia was issued by Irving Fisher, a professor at Yale, who intoned within weeks of the bubble top in 1929 there was no way the market would crash. He forecast further that the market had reached a permanent plateau and that downside risk was negligible. Fisher, an economics professor at Yale, was an acknowledged stock-market expert, at least until 1929. By the time the market had bottomed in 1932 with the Dow down some 90 percent, it would be kind to say his reputation had been tarnished.

Fast-forward 72 years! Two young geophysicist professors from UCLA, Didier Sornette and Wei-Zing Zhou, have authored a paper entitled "The U.S. 2000-2002 Market Descent: How Much Longer And Deeper." It was written for a statistical mechanics class under the category of quantitative finance. The paper begins by stating, "A remarkable similarity in the behavior of the U.S. S&P 500 index from 1996 to August 2002 and of the Japanese Nikkei index from 1985 to 1992 (11 year shift) is presented, with particular emphasis on the structure of the bearish phases." The abstract of the paper goes on to state, "... we demonstrate the existence of a clear signature of herding in the decay of the S&P 500 index since August 2000 with high statistical significance, in the form of strong log-periodic components. We offer a detailed analysis of what could be the future evolution of the S&P 500 index over the next two years, according to three versions of the theory: we expect an overall continuation of the bearish phase, punctuated by local rallies; we predict an overall increasing market until the end of the year 2002 or at the beginning of 2003 (first quarter); we predict a strong following descent (with maybe one or two severe up and downs in the middle) which stops during the first [six months] of 2004." The second chart is the lead chart presented in their paper, comparing the Japanese Nikkei index from 1985 to 1992 to the S&P 500 from 1996 to August 2002. Their prediction for the future course of the S&P 500 is derived from a curve fitting procedure that is too complex for the purposes of this newsletter. Very long-term subscribers may recall one of our most spectacular forecasts made back in 1980 involved a curve fitting procedure which enabled us to call both the March 27, 1980 and the April 21, 1980 bottoms virtually to the day. The controversial aspect of curve fitting is determining the time period of the data used for the curve fitting procedure. In the current case, the UCLA professors chose bubble time periods and have already enjoyed success in predicting the Japanese Nikkei. The final chart in this section shows an extrapolation out to late 2005 of what they call the combination of the effect of the second order formula with the impact of the second harmonics used in the curve fitting procedure. The corresponding fit is represented by the thin line and compared with the thick line which is the second harmonic effect only. The tick marks used for the years on the x axis of these charts represent the first trading day of that year.

Curve fitting procedures do not attempt to project the market's direction on a day-to-day basis. They do attempt to give a feel for the overall future progress of the Index being analyzed. It should be clear from these data that this particular curve fitting procedure contends that the market's upside potential has either been extinguished or will be extinguished in the first quarter of 2003 at the latest. The bottom of the ensuing decline will not be due until sometime within the first six months of 2004. In other words, the year 2003 is scheduled to be a sharply declining year either from the very beginning or, at the latest, from some time in the first quarter. These three arguments presented above should suffice, at least for the time being, in resenting evidence as to why the year 2003 stands an excellent chance of being a down year and betraying the election cycle theory that the third year of the four year presidential election cycle is always positive. We know from 1930 that if the third year is unsuccessful, it can be unsuccessful in a big way. Who knows? Perhaps professors Sornette and Zhou will make the financial world forget the foolish incantations of Professor Fisher 70 years before them. The year 2003 could go a long way in producing that effect.

Technical Indicators

There are many technical arguments supporting the contention that the October 2002 market low will not end up to be a major bottom. We have presented several of these over the past few months, both here in the newsletter and on our daily telephone updates. The CI/NCI ratio, is one of the strongest arguments against October being an important bottom. There has never been an important market bottom in the history of the data going back to the 1920's with the CI/NCI ratio above 0.980 as it was in October 2002.

Perhaps the most important argument, however, against having seen a market bottom of importance continues to be market sentiment. The oldest surveyor of market sentiment in the stock market is Investor's Intelligence (New Rochelle, New York) headed up by the talented Michael Burke. For almost 40 years, they have been compiling weekly (it was initially bi-weekly) sentiment data from newsletter writers. Typically, at an important market bottom, bears will have outnumbered bulls by a significant margin for a significant period of time. Perhaps a few examples will make the picture clearer. In May 1970, the Dow Jones Industrial Average reached an important low. For 27 of the prior 28 weeks before that bottom was achieved, there were more bears than bulls on the Investor's Intelligence (New Rochelle, New York) survey. In fact, the bearishness continued well beyond the bottom and for almost the next three months after the low, there were more bears than bulls in the advisor survey. The next major bottom occurred in October 1974. Prior to the low achieved in early October that year, there were 27 consecutive weeks with more bears than bulls. During those 27 weeks, the average plurality of bears over bulls was 25 percent. In the important bottom registered in early March 1978, 17 of the 20 previous weeks had registered more bears than bulls. Before the very major low in August 1982, 34 of the 35 previous weeks had registered more bears than bulls with the average plurality of bears over bulls at 18 percent. At the late July 1984 bottom, even after it was obvious that the Dow had finally broken above the 16-year resistance level of 1000, there were 19 consecutive weeks of bearish over bullish advisers. Even after the very major low in October-December 1987, the market continued to climb a wall of worry. From early April 1988 through early February 1989, there were only three weeks in which there were more bulls than bears. In late 1990-early 1991, there were 26 consecutive weeks of more bears than bulls prior to the market's explosion in early 1991. In 1994-1995, the last major bottom prior to the market's excursion into bubble mania, there were 46 consecutive weeks of more bears than bulls. Imagine that! Almost one full year went by with more bears than bulls every single week.

The most amazing part of that time period was that the Dow Jones Industrial Average was higher after that 46 week stretch than it was at the beginning of it. Move forward to 1998. Even during that short lived decline that culminated in early October 1998, there were seven consecutive weeks with more bears than bulls.

Now let's examine the last few years in the light of prior history. The Dow Jones Industrial Average reached its all-time high on January 14th, 2000. Over the next 20 months, while the NASDAQ Composite Index suffered one of the greatest declines of any index in market history, a decline of 67 percent, there was not one single weekly survey showing more bears than bulls. Finally over a year after virtually every market index had reached its all-time high, and perhaps precipitated more by the events of September 11th, 2001 than by the market itself, there were more bears than bulls for the first time in 153 weeks. The plurality of bears over bulls was almost minuscule considering the gravity of the events that had occurred. The greatest plurality over the three consecutive weeks showing more bears than bulls in September 2001 was 8.4 percent. After those three consecutive weeks showing a marginal plurality of bears over bulls, another 41 weeks went by without a bearish plurality. Fast forward to this year. Finally, in July 2002, after almost four years had gone by with only three weekly readings showing a plurality of bears over bulls, it occurred again in mid July. By then, the NASDAQ Composite had declined a stunning 77 percent. Please stop and consider this in the light of the sentiment data we presented to you above. Examine the number of weeks of bearish opinion that have been required in the past to set up a major market bottom. Compare that to what we have seen over the past few years. Even this year, during which all the major indexes have seen major declines, there has not been one stretch of three consecutive weeks with a plurality of bears over bulls. There were two consecutive weeks in July when, by the way, the greatest plurality of bears over bulls was 4.2 percent, and there were two consecutive weeks in October. One of those weeks showed a plurality of just under 15 percent bears over bulls, but it was enough to get the bulls excited on a contrary opinion basis, rejoicing at the smallest bullish sentiment reading since 1994. Amazingly, that lack of bullish sentiment was reversed in one week and by the next week there was a healthy plurality of bulls over bears once again. Those are the facts. How anyone with a sense of market history and the interaction between sentiment readings and important market bottoms can believe that we have seen a major market low should stretch the credulity of believers in history. Sorry, bulls! Unless you have rewritten the books, market history tells us there is no way we have seen an important market bottom. In fact, after the bubble mania that we saw in the late 1990's, one could legitimately argue that the next important bottom will stretch the limits of prior bearish sentiment that generally accompanies market bottoms.

Since the October 1998 market bottom to the present day, there have been only nine weeks with a plurality of bears over bulls. Let's put that in perspective. At the October 1998 bottom, there were 36 weeks over the preceding four years with more bears than bulls. At the December 1994 bottom, there were 58 weeks over the preceding four years with more bears than bulls. At the October 1990 bottom, there were 86 weeks over the preceding four years with more bears than bulls. At the December 1987 bottom, there were 31 weeks. At the August 1982 bottom, there were 132 weeks. At the March 1978 bottom, there were 53 weeks. Finally, at the October 1974 low, there were 53 weeks. Was that an important market bottom we saw in October 2002? Step back dispassionately, look at the statistics, then give us your judgment.

Because of the length of these initial two sections of the newsletter, we will consolidate the following two sections in this final paragraph. A case can be made there are significantly lower projections outstanding as we have discussed in prior newsletters, but it would be unfair to the bullish case if we did not also report that upside projections remain out-standing and will remain until they are either met or invalidated. On the weekly Dow Jones Industrial Average projection chart, there is a nominal 20 week upside projection calling for 9,919.60 +/- 280 points. Mutual-fund switchers-Rydex switchers remain in the Rydex Ursa Fund. Fidelity select switchers sold select American Gold at 10:00 a.m. Eastern time on November 15th at 20.47 for a profit of 6.2 percent on the trade. All mutual-fund switchers should remain in daily contact with the telephone updates for possible changes in instructions. For those of you who do not subscribe to the daily telephone update, the special update is programmed to answer only when special instructions are placed on line or on occasional weekly updates. You remain responsible for two daily phones call to that update. If there is no message, the phone will not pick up. If there is a message, the phone will pick up by the second ring at the latest. We have two different specific model portfolios--one for Fidelity Select switchers and one for the Rydex Group switchers. How you distribute your own portfolio is up to you as an individual.

Minting of gold in the U.S. stopped in 1933, during the Great Depression.