Laying Out Major Cycles in 2010

I have touched on some of the major cycles at play in the equity markets before, but I wanted to take a bit of time to make an educated projection on when they may come into play this year.

This chart from Sentiment's Edge Blog show average yearly returns and risk/reward profiles for each year of the decade since 1928. While this is note a big enough sample size to draw much conclusions from, the basic pattern is weakness in the first few years of the decade. The year sending in "0" have a negative average return (and the worst of all ten years) and greater risk than reward on average.

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The chart above shows the S&P 500 as the top graph and a "real" inflation adjusted S&P below to more clearly highlight the dips. The chart shows the 4 year cycle in stocks, also called the Presidential cycle because it is thought to be the result of our political calendar, and there are consistent sub-cycles within each 4 year term. Note that there is a very consistent tendency for major lows to be put in place every 4 years, typically the 2nd year of every term.

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This chart adds to the end of the last chart and shows the 1998, 2002, and 2006 lows. Then the last vertical blue line is shown in the middle of 2010 this year which would be the expected time frame for the next 4 year low.

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This chart shows both an average year in the markets and an average 2nd year of a presidential term. The average year shows that most gains come from November through April and the seasonally weak time is Sept-Oct, with many years showing corrections in the autumn months.

It is not too dis-similar for the 2nd year of the presidential term but the returns are worse, with sharper and larger corrections in the fall that typically take the return negative on the year. That sharp correction in the autumn of the 2nd year of the term would be the typical 4 year cycle low.

So putting these charts together.....the 4 year cycle tells us to expect a sharp correction this year, and the 2nd year annual sub cycle suggests that it would be expected in the autumn or summer.

Now I will also say that there will be differing opinions on when a cycle bottomed, etc. Some argue that the 2006 low was not a 4 year cycle bottom, but rather that the bottom was extended to January 2008. And I have seen some suggest that the March 2009 low was a 4 year cycle bottom.

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The chart above shows several years of data with overlying 40 week cycles. This is also called the 9 month cycle. While the 4 year cycle seems to be clearly non-organic (caused by political events), it is not clear (at least to me) that the 40 week cycle is non-organic. There are different speculations to why this cycle exists, but I couldn't tell you anything definitive.

Regardless, this cycle is not something to look at rigidly, but rather that there is a tendency for significant lows to occur every 40 weeks on average. Small deviations are normal (i.e. 37 weeks or 44 weeks, etc). Also, there does appear to be a half-period harmonic of this cycle in that minor lows tend to occur at roughly 20 week intervals. There are computer programs that can filter through data and tell you whether or not there are "cycles" that occur with regularity compared to random distribution, and the 40 week cycle appears to be one for whatever reason. And beyond that, it has been recognized for some time, and is factored into the collective conscious of the markets. It often pays to stay abreast of those types of things.

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In this chart I have continued the 40 week cycle on from the previous chart. I suppose one could argue about what the dates are, but from the past history and from what I've looked at as resources, I think what I have here is the best way to look at it. This would then suggest that the next 40 week cycle bottom is due this spring, around March/April.

With the market overbought on a weekly time frame from a technical perspective, and sentiment clearly overly bullish, the idea of a turn down into this spring makes sense. Also, the positive seasonality of the Christmas/New Year time begins to wane this week.