U.S. Equities: Room to Run

Summary

  • The bull market since March 2009 is one of the longest on record.
  • But the advance has been refreshed by two cyclical bear markets, the latest in 2015-16.
  • The current rally is less than two years old, suggesting further upside before the next cyclical correction.

“Cycles… Where are they when you need them.” – Richard Russell

Is the stock market running on borrowed time?

That depends on how time is measured. Today’s bull market began in March 2009, making it one of the longest on record. But the advance has been refreshed by two cyclical bear markets, the first in 2011 and the second in 2015-16. The latest cyclical advance is less than two years old. It would be normal, then, for another year of stock market gains ahead of the next cyclical correction.

This claim is based on the four-year cycle, a stock market phenomenon with impressive credentials.

Chart 1. Four-year cycle

What is the four-year cycle? A concise description is given by Walter Deemer in his invaluable text, Deemer on Technical Analysis:

The four-year cycle can be traced back to work done by Harvard’s Joseph Kitchin in 1923. Kitchin analyzed data that predated the establishment of the Federal Reserve in 1913 and also noted the presence of a four-year cycle in the United Kingdom late in the nineteenth centuryand early in the twentieth century, well before the two economies were linked as closely as they are today. The four-year cycle, in other words, was not based on either Federal Reserve actions or presidential elections. It simply states that the stock market makes a major low every four years or so. (Nobody calls this low the “Kitchin Sink,” and I can’t imagine why not.) –Walter Deemer

The four-year cycle is most likely a business-cycle phenomenon, as first postulated by Kitchin. Or perhaps four years is a natural span of human emotion, the time it takes to traverse fair value along the spectrum from fear to greed.

Whatever the case, investors should be aware of this historic stock market rhythm. Chart 1 examines the track record. The post-WW2 period has, in fact, witnessed important bottoms roughly every four years.

There are two notable exceptions in which the scheduled bottom was temporarily absent or, in the words of Deemer, “pushed forward” by a bull-market extension. In both instances, the market eventually returned to a four-year rhythm – much like an electrical wave, temporarily knocked out of phase by an outside force or internal disturbance.But let’s not get carried away. This is market analysis, not science. The best we can achieve is a rough guide. And Chart 1 raises some obvious questions. How do we know, for example, that the minor price corrections of 1986 and 2006 were not cyclical bottoms? And that the minor price corrections of 1994 and 2016

But let’s not get carried away. This is market analysis, not science. The best we can achieve is a rough guide. And Chart 1 raises some obvious questions. How do we know, for example, that the minor price corrections of 1986 and 2006 were not cyclical bottoms? And that the minor price corrections of 1994 and 2016 were in fact cyclical bottoms? In our experience, market internals provide the required evidence. Chart 2 presents the four-year cycle since 1982, along with a measure of breadth momentum: percentage of NYSE stocks above their 200-day average. As you can see, important bottoms have exhibited severe internal weakness.

In our experience, market internals provide the required evidence. Chart 2 presents the four-year cycle since 1982, along with a measure of breadth momentum: percentage of NYSE stocks above their 200-day average. As you can see, important bottoms have exhibited severe internal weakness.

The cyclical bottom of January 2016, for example, was not particularly deep. The S&P 500 and Dow Jones Industrial Average lost only 15%-16% from their prior tops. Beneath the surface, however, many stocks were clobbered. Equal-weighted and small-cap investors suffered a bona fide bear market. Energy investors experienced a horrific rout.

In January 2016, breadth momentum plunged to a panic reading of 9%. (Readings below 20% are severe.) This occurred roughly four years after a comparable reading in August 2011, suggesting that the four-year cycle is back in sync.

Chart 2. Detecting cycle bottoms

Room to run

Labeling important bottoms is all well and good. But of what current value? If January 2016 was a cyclical bottom, and January 2020 is the next scheduled bottom, when can we expect the next cyclical top? The four-year cycle does not directly answer this question, as it is measured from bottom to bottom. A few observations, though, are worth noting:

  1. Today’s cyclical advance is less than two years old;
  2. The four-year cycle is typically “skewed right,” meaning that cyclical tops usually occur late in the cycle;
  3. In our experience, three years up, one year down is the rule of thumb.

Our rule of thumb is not always operative. But a glance at Chart 1 makes the point. Cyclical tops usually occur to the far right of the two-year midpoint. Only one important top – March 2000 – was skewed left. And there are no left-hand translations in the early years of a secular bull market. This observation is not rocket science, but enough to form a working hypothesis. The current advance should run until mid-2018 or longer before achieving a normal duration.

Any other evidence?

Yes. Market breadth has not shown classic divergence with market price. New highs in the NYSE advance/decline continue to corroborate new highs in the S&P 500, suggesting broad participation and ample liquidity. A normal, multi-month divergence ahead of the next important top would absorb additional time, supporting the case for right-hand skew.

Conclusions

Cycle analysis is far from perfect, as observed in our opening quote from the late, great Richard Russell. The four-year cycle is, nonetheless, a venerable market phenomenon. We don’t use cycles in isolation of other factors. But there’s no reason to exclude the dimension of time from market analysis. The four-year cycle provides a working hypothesis, to be supported or refuted by other evidence.

The bull market since March 2009 is long in the tooth. But the advance has been refreshed by two cyclical bear markets, the latest in 2015-16. Today’s cyclical advance is less than two years old. It would be normal, then, for another year of stock market gains ahead of the next cyclical correction.

 

By | 2017-10-18T10:59:40+00:00 October 17th, 2017|Categories: Market Strategy Report|0 Comments

About the Author:

Mark Ungewitter is a Senior Vice President & Investment Officer at Charter Trust Company. He was formerly Director of Portfolio Management at Investors Bank and Trust in Boston, Massachusetts. He holds an M.S. from Bentley University and a B.S. from Massachusetts College of Liberal Arts. He is a member of the American Association of Professional Technical Analysts.

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