CAPITALIDEAS
EXECUTIVE SUMMARY
In this Capital Ideas we are going to address the subject of cycles as they pertain to the economy and financial markets, explain why they persist and offer some examples of longer-term cy-cles. Through this explanation of cycle analysis, we hope to provide some guid-ance on where we might be in the cur-rent cycle and what we can expect in the current market environment. While cycle analysis is not a guarantee of what hap-pens next, it should provide a view into probable outcomes.
WHAT ARE CYCLES?
“History doesn’t repeat itself, but it does rhyme.” ~ Mark Twain
So what is a cycle? According to Merriam-Webster a cycle is defined as
“an interval of time during which a sequence of a recurring succession of events or phenomena is completed.”
In practical terms, cycles are a measure-ment of time in which history repeats, resembles or mirrors itself. When applied to markets, cycles reflect shifts in mass psychology at regular intervals. Cycles are not exact, however, and history nev-er repeats itself in exactly the same way at exactly the same intervals. Cycles show up in our everyday lives in ways that most of us never notice. For example, night turns to day and day turns back into night, seasons slowly roll from one to the next and life itself cycles from beginning to end. Even sound and light move in cyclical waves. While we can never tell very far in advance how hot or cold it will be, how much daylight we will have on a given day or how long each of our lives will last, we can make some judgments based on experience that can serve as references. So if we cannot determine exactly how and when cycles will persist, why should we study them at all? The rea-son for studying cycle analysis is so that we can have a gauge with which to anticipate upcoming events. Study-ing cycle analysis allows us to have reli-able timeframes with which to anticipate shifts in mass psychology. Cycle analysis also helps us determine the effects those shifts have on financial markets.
February 2015
What Can We Learn From The Past?
KEY HIGHLIGHTS
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Cycles can be applied to markets and economies through the study of mass psychology and its repeti-tions.
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Because we don’t place much weight on events that happened prior to our lifetimes, when we make decisions, we are doomed to repeat the mistakes of the past over and over.
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The Decennial and Presi-dential Cycles suggest a favorable environment for stocks, while the Genera-tional Cycle suggests one more major sell-off before 2017 or 2018.
CAPITAL IDEAS REGIONS INVESTMENT MANAGEMENT
HOW DO CYCLES APPLY TO FINANCIAL MARKETS?
“There is nothing new on Wall Street or in stock speculation. What has hap-pened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly built into human nature, that always gets in the way of human intelligence.” ~ Jesse Livermore
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Humans have an understandable bias in placing the most weight on per-sonal experience when making deci-sions. Because of this bias, we tend to make decisions without the wisdom of previous generations to help guide us when making those decisions. This hap-pens on a personal level, but more im-portantly this is true on a generational level. In the book,
The Fourth Turning,
historians William Strauss and Neil Howe went back and studied the his-tory of Anglo-American people all the way back to the late 1400’s. What they found was that history repeated itself ev-ery four generations in the same order – what they called turnings and other cycle analysts have called seasons. They found that these four turnings re-peated every 70-80 years, or about the length of the average human life. This suggests that as generations die off, the following generations forget all of the lessons learned by the previous genera-tions, and therefore make similar deci-sions and experience similar events as the generations that came before them. This decision making causes long 70-80 year lifetime cycles as well as shorter 17-20 year generational cycles. Below is a chart which shows how major events such as wars have unfolded at regular intervals in American History. WarsAmerican Revolution (1773-1794)Civil War (1860-1865)World War II (1941-1946)Future Great War??? (2001-2026)
Source: The Fourth Turning
If we look at the current generations, we can understand how Baby Boomers who have been hit twice in the last 14 years by 50% sell offs in the stock market might be quite uneasy about putting their investment funds into the stock market, especially with retirement so near for most of the age group. Similarly, people from Generation X may be uneasy about diving back into the housing market after being burned so severely in the financial crisis. Many people in these age groups lost their homes or were forced to own a house where the mortgage was greater than the value of the home. Taken a step further, those who experienced the Great Depression are probably more likely to save and take out less debt. By looking at markets through this long lens, you can begin to see how the life experiences of each generation affect decision making when it comes to poli-tics, economics and financial markets. Cycles also exist on shorter timeframes and similarly have underlying causes for the regularly occurring economic events. For instance, there is a distinct presiden-tial cycle which is based on campaign promises, actual political agendas and more campaign promises. Take, for example, a presidential candidate who is running for office. He is going to make grandiose promises about the changes he will make once elected and the positive effects these changes will have on the country. If he is running against an incumbent, the incumbent candidate will try to position the economy and the country in a light that makes people feel good about what has happened in the previous 2-4 years. These promises make people feel good, and this boost in confidence naturally results in an increase in spending and investing. After the election is over, the new president pushes the unpopular items on his agenda that will negatively af-fect the country and the economy in the first 2 years of his term because he knows that he has to have things mov-ing in a positive direction when it is time for the next election. This will cause a negative mood among the people who will be less inclined to spend and invest during these first 2 years of the term. Because of these repeated actions and timeframes we can see definite, repeat-able presidential cycles. These are just two of the vast number of cycles across all timeframes that exist in the markets and economy.
CAPITAL IDEAS REGIONS INVESTMENT MANAGEMENT
EXAMPLES OF CYCLES AS THEY RELATE TO INVESTING
“I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like they performed in the last 17 years.” ~ Warren Buffett
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The longer the cycle, the more bear-ing it seems to have on the markets. As timeframes get shorter, outside influenc-es can override cycles to the point that daily market fluctuations can be seem-ingly chaotic. For this reason, we will focus on the Presidential, Decennial and Generational Cycles in this section. As mentioned above, the Presiden-tial Cycle lasts 4 years and is based on the actions of the President and the public’s response to those actions. We are currently beginning year 3 of the current Presidential Cycle, which is the strongest year in the cycle with a positive return 80.95% of the time and a mean S&P 500 return of 17.27% according to data going back to 1928.
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As shown in the chart below, the strong returns typically begin in November of year 2 and continue into June of year 3. This suggests that we are currently in the middle of the strongest period of the 4 year cycle. Not only are we in the middle of the strongest period in the 4 year Presi-dential Cycle, we are also beginning the strongest year in the 10 year Decennial Cycle. The Decennial Cycle is a 10 year market cycle that uses the average return for each year of the decade. Unlike the Presidential Cycle, which repeats directly because of the actions of Presidents and their tendencies to enact tougher legisla-tion during certain parts of their terms for political reasons, there are no direct causal relationships that can be pointed to for the Decennial Cycle. Although no one has been able to determine the causes of the Decennial Cycle, the pat-tern was first documented in 1932 when Edgar Lawrence Smith wrote about it in his book
Tides and Affairs of Men
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The cycle has continued to hold up over the 80 years since it was first discovered. As shown in figure 2, we are cur-rently in the beginning of decennial year five, which is by far the strongest year in the cycle. Since 1886, the Dow Jones Industrial Average year 5 returns have been positive 91.67% of the time with a median increase of 28.82%. Since 1935, the S&P 500 year 5 returns have been positive 100% of the time with a median increase of 28.56%.
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The stron-gest portion of the cycle tends to last from approximately November of year 4 through early into year 6. Lastly, we turn to the Generational Cycle. This cycle tends to last about 17 to 18 years and has been noticed in
Figure 1: Presidential Cycle Median Returns 1928-2014
Source: BofA Merrill Lynch Global Research, Bloomberg
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