Cycles, Bounces, & The Only Question That Matters

Submitted by Lance Roberts via RealInvestmentAdvice.com,

Market Cycles And Expected Outcomes

The “Visual Capitalist” website had a terrific market diagram explain the “best time to buy stocks.”

“Is it possible to time the market cycle to capture big gains?

 

Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.

 

The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff.

 

The theory is: the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”

understanding-market-structure

So, the question to answer, obviously, is:

“Where are we now?”

I’m glad you asked.

Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see the Wyckoff’s theory in action.

1992-2003

SP500-Wyckoff-Cycle-1992-2003

The accumulation phase, following the 1991 recessionary environment was evident as it preceded the “internet trading boom” and rise of the “dot.com” bubble from 1995-1999.

The distribution phase became evident in early-2000 as stocks began to struggle as Enron and WorldCom because poster children for “greed and excess” of the preceding bull market frenzy. It is worth remembering that during this phase the media and Wall Street were touting the continuation of the bull market indefinitely into the future. (Jim Cramer published his list of 10 Tech Companies for the next decade.)

Then, the decline.

2003-2009

SP500-Wyckoff-Cycle-2003-2009

Following the “dot.com” crash investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns and focusing on capital preservation as the core for long-term investing.

Okay. Not really.

It took about 27 minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.” 

Once again, during the distribution phase of the market, analysts, media, Wall Street and now a rise of bloggers, all touted “this time was different,” “green shoots,” “Goldilocks economy,” and “no recession in sight.” 

They were disastrously wrong.

2009-Present

SP500-Wyckoff-Cycle-2009-Present

More than 7-years into the current economic recovery the headlines ring of “no recession in sight,” “the bull market is still cheap” and “this time is different because of Central Banking.”

Need I say more.

Bounces Do Not Imply Ends

There has been a good bit of discussion as of late about the bounce in manufacturing data over the last couple of months as a sign that the “manufacturing recession was now at an end.”To wit:

“The U.S. manufacturing sector just batted five-for-five in its version of spring training.

 

Since mid-2014, the collapse in oil prices has hit manufacturers tied to the energy industry while the rise of the U.S. dollar was broadly crimping activity. These headwinds are no longer strong enough to dim Goldman Sachs Group Inc.’s “near-term optimism” on U.S. manufacturing.”

This is an extremely short-sighted and ill-thought out view.

First, the manufacturing reports are “seasonally adjusted.” These seasonal adjustments are designed to smooth the data over time to account for DECLINES in manufacturing activity during seasonally cold times of they year when inclement weather normally shutters in manufacturing activity.

However, given that the economy just experienced one of the most unseasonably WARM winters in 122 years, activity ran ahead of normal seasonal tendencies. When combined with the normal seasonal adjustments manufacturing data saw extremely sharp, and abnormal increases.

This is clearly seen in the chart below which is a composite economic output indicator which is comprised of the Fed Regional Manufacturing Surveys, Chicago Fed National Activity Index, Chicago PMI, ISM surveys, NFIB Survey and the Leading Economic Indicators.

EOCI-Index-042116-2

Secondly, these bounces are simply normal restocking cycles as inventories are drawn down during protracted declines in activity. Furthermore, as with all economic data, nothing travels in a straight line either up or down.

However, in particular, the recent bounce in manufacturing data was a clear anomaly caused by the extremely warm winter weather. This could be seen in the recent slate of data points from the Fed Philadelphia Region as shown below:

  • February: -2.8
  • March: 12.4
  • April: -1.6

The weakness in the manufacturing data will likely reassert itself as the seasonal cycle realigns with the seasonal adjustments.

However, if we compare the Economic Output Cycle Index (EOCI) above to both GDP and the Leading Economic Indicator Index, we see a clearer picture of what is currently happening in the economy.

EOCI-Index-042116

Not surprisingly, the EOCI has bottomed coincident with Central Bank interventions which drag forward future consumption. Unfortunately, when you “drag forward” future consumption today, you leave a “void” in the future that must be filled.

That future “void” continues to expand each time activity is dragged forward until, inevitably, it can not be filled. This is currently being witnessed in the overall data trends which are being reflected in the deterioration in corporate earnings and revenues.

While the media continues to “protest too much,” the reality is that earnings and revenue are a  direct reflection of real economic activity.

The only question is whether Central Banks can continue to support asset prices long enough for the economic cycle to catch up.

Historically, such is a feat that has never been accomplished.