Trader’s Narrative

You wake up, you sleep. The sun rises, it sets. The seasons change. Cycles are part of life.

Since the stock market is just another human activity, it too has patterns and cycles. There are many different ones spanning the short term (daily ebb and flow of intra-day trading) to the very very long term (kondratiev or sometimes: Kondratieff waves). Previously I mentioned the four year cycle and showed a long term graph of its uncanny timing ability.

Since we are starting a new year, I wanted to take a look at the 10 year cycle. The graph below shows the relative performance of the stock market in the different years of the decade.

Years ending with 1 and 2 have the lowest returns; years ending with and 8 or a 9, the highest. I get the feeling we are divining the entrails of the market (with about as much scientific rigor) but from this historical view, 2008 has the wind to its back.

Here’s to another great profitable year!

Is it possible to time the market using a system that is so simple, it only requires you to be able to count up to four? Can we invest for the long term using a system that only requires a few minutes of our attention every four years?

Not only is it possible, such a system has beaten the pants off the pros in the long term. Being so amazingly successful, it has garnered a name: the four year stock market cycle.

Many theories have been put forth to try and explain it. Some say it is due to the presidential cycle, some that it is due to the business cycle, some to astrology or other esoteric phenomena. While the reasons are up for grabs the results are quite clear. And they are the sort that makes EMH proponents pull their hair out in frustration. How can something so simple, so replicable, and so consistent exist decade after decade?

While academics debate it, you can use it to boost your long-term investment account. All you need to do is to watch for a low every four years. The start year is important, so I’ll give it to you: 2006. From that year, you can go back and forward in four year increments. Those years will be (in the future) or were (in the past) great times to invest in the stock market. Or to add to an existing investment portfolio.

Take the previous cycle: 2006. That was the last intermediate low. Before that, in 2002 we had the trough of the multi-year bear that resulted from the popping of the internet mania. The one before that? 1998 which was the trough from the Asian currency contagion that shook financial markets. Keep going and you’ll see that the four year cycle marks great buying opportunities in an uncanny way.

Of course, it doesn’t have a perfect track record. But it is a damn good one. Out of the last 27 four year cycles, only 5 of them have not been great buying opportunities. They were 1946 (flat), 1930 (ouch!), 1910, 1906 and 1902. You can keep going back in time but my chart (below) stops there:

Click to enlarge graph

For extra mojo, we can combine the 4 year cycle with the annual cycle. That is, we can take the best month within the year (historically October) that coincides with the four year cycle. But remember, the four year cycle is only a guide. No individual occurence has to follow the script to the letter. All we are interested in is putting the odds in our favour as we have detected them from historical observation.

The following graph shows the decennial performance of the Dow Jones Industrial Average. Think of it as putting the annual performance of every decade into a blender and mashing them together. We get a graph that shows the average performance of each year within a decade:

As you can see, year 4 has an unusual lift that the other years don’t. If you’re sharp, you’ll notice that years 7 and 8 also have some pretty good kick as well. This data is not showing the same thing as the four year cycle but it does present us with further proof that returns from the stock market are not random. If they were, then each year would show fairly similar performance.

It is notoriously difficult to pinpoint tops because unlike bottoms, they tend to form over a longer period of time. Still, there are several factors which are making me cautious here - just as I was bullish in mid-March.

Pedal to the Metal
Last week marked a historic occasion for the market. Albeit one that went unnoticed: the Dow closed positive in 19 out of 21 trading days. This was only the third time this has happened! The other two times? I’m not sure you want to know…

The first time was in August 1927 when the Dow corrected 10% (only a pause in its rocket ride to the 1929 top). The second was in July 1929 just before the last surge of the great bull market of the 1920’s. I don’t think this means necessarily that we’re going to crash. Just something to tuck into your hat.

Sentiment
The usual sentiment measures aren’t actually showing a lot of froth. Investor’s Intelligence is showing a tad too much bullishness from newsletter writers. But other sentiment measures are lukewarm at best. Put/Call ratios are, as well, in the middle ranges.

Annual Stock Market Cycle
There’s a saying on Wall Street: “Sell in May and go away!” for good reason. We have just entered one of the weakest portions of the 12 month stock market cycle. Many studies have shown a persistent bias towards the later months in the year (Sept - March) for relative outperformance. Obviously this is a pattern that emerges over many, many years and no one specific year has to follow it. Also, there are some rumblings that the pattern may be pushed out to late May or even June. According to Hirsch, from 1985 to 1997 May has been a stronger month than before. But summer doldrums are still summer doldrums.

Technical Signposts
Mark Hulbert mentioned today that Investors Intelligence is raising a red flag citing their “buying climaxes” proprietary measure. A buying climax is defined by II to have taken place when when a stock makes a 52 week high and then closes the week down. This is seen as a sign of distribution and as such, marks tops.

Last week there were 206 buying climaxes. But readings as high as 500 or 600 are not unheard of.

Conclusion
If you’ve been intelligent (aka lucky) enough to participate in this short burst rally, consider paring your longs and taking a defensive posture to allow the market the respite it needs.