Saturday, November 15, 2008

The 40 Year Cycle

The 40 Year Cycle

By The Prudent Trader | 9 November 2008

Cycle theories in stocks and commodities have been around for at least a couple of centuries. While intriguing they are also quite controversial. Cyclists vehemently disagree on what constitutes a cycle and which cycles are most important; but most agree that it's a good idea to use cycles only as rough guidelines (or road maps if you will), and not as a means of day to day trading. Cycle theory should always be combined with other analytical methods such as fundamental, technical, and/or market psychology.

The following 3 paragraphs of interest are from Cliff For a more detailed description and analysis visit his site.

"Another important consideration in the analysis of the long-term economic/equities outlook is the economic super cycle known as the "K-Wave," named after its discoverer, the Soviet economist Nikolai Kondratieff. Kondratieff tracked wholesale commodity prices back hundreds of years to determine regular rhythmic peaks and valleys in long-term price trends. Since wholesale commodity prices include no value added, they represent the most causal approach to identifying the real supply/demand balance in the economy. Here is how one commentator describes the K-Wave:

"The K-Wave is the manifesto of economic determination. It is the ultimate boom/bust condition. The cycle is caused by the beginning acquisition and the ending liquidation of debt. Debt creates a false or created incremental demand in addition to intrinsic, real demand. When debt assumption becomes excessive, the system becomes illiquid. At that time, debt must be reduced to alleviate the pressures of illiquidity. Once debt is liquidated, the system reliquifies, debt is reacquired, and the economic super cycle begins anew."

"The K-Wave must be distinguished from the S-Cycle in that the former is not a true market cycle in the sense of having a definite bottom. Unlike the S-Cycle, the K-Wave's duration is variable and according to Ian Gordon, editor of the Long Wave Analyst , Vancouver, B.C., can be as short as 40 years or as long as 70 years. This is why the K-Wave is termed a "wave" as opposed to a cycle. The K-Wave is unique in that it is the only long-term economic rhythm that can be heavily manipulated at both peaks and valleys by government or central bank intervention. Needless to say, the U.S. government/banking establishment has been extremely active in recent years with their interventionist policy, therefore we can expect a longer-than-normal K-Wave this time around before we see the next bottom. A 55-year duration would see the K-Wave bottoming in 2004/5. A 60-year duration would see a K-Wave bottom around 2010, and a 65-year bottom would witness a 2014 K-Wave bottom. Kress of SineScope favors the latter timeframe as the most likely time for a bottom, as does another cycle expert, P.Q. Wall."

Of all the long term cycles I've played with, perhaps the most prominent is the 40 year cycle. Again according to Cliff Drake at the 40-year cycle bottomed in the following years: 1894, 1934, 1974. Its next bottom is scheduled for 2014. In each of those years when the 40-year cycle bottomed it produced a dramatic decline in the stock market as well as being preceded in each case by a severe economic recession (or outright depression in the case of 1894 and 1934).

The most damaging part of any cycle is the final 10% of the cycle's phase, i.e. the last 4 years. Let's look at what happens when the 40-year cycle enters its final "hard down" phase.

The four years prior to the 1934 expected cycle low was of course 1930 to 1934. The great crash of course, most believe, was in September/October of 1929. Actually the worst part of the decline occurred after a rally into April 1930, the decline occurred from April 1930 through July 1932; a whopping decline of 86.5% from the April 1930 high.

Click Here, or on the image, to see a larger, undistorted image.

Moving on to the 1970's, the 'bottoming process', or the last 10% of the cycle, would be 1970 thru 1974. The beginning of this four year period was marked by a recession in the U.S. economy, yet the Dow Jones advanced after the 1969 dip to about 1,000— up from about 700.

It wasn't until January of 1973 that the market topped out at 1,067. In fact I remember watching Louis Rukeyser's show on PBS (Wall Street Week) on the eve of the New Year, when he always asked his panelists for their high/low predictions for the coming year. In this particular show, one panelist stated that the low was already in. Rukeyser challenged this projection— "You mean we will not go any lower than last close of last year at any time?"— the panelist answered "yes". Being the contrary opinion person I like to consider myself, all I could think of was uh-oh. And that was the beginning of the hard down phase of that 40 year cycle, taking the Dow from 1,067 to 570 in 23 months. A decline of almost 50% in two years.

Click Here, or on the image, to see a larger, undistorted image.

The following chart is courtesy of from 1900 to present. Perhaps the big picture look will make this 40 year cycle more apparent.

Click Here, or on the image, to see a larger, undistorted image.

Now the big "IF" questions; If the 40 year cycle has credence and if we will soon be staring into the last 10% of a 40 year cycle due to bottom in 2014, what shape will it take? 1930's or 1970's? The only answer of course is "no one knows"— although it seems everyone has an opinion. So far at least, the chart does look similar to the 1970's and if that turns out to be the case then we should essentially trade sideways, with perhaps one more hard down move in 2014, as in 1974. [[But watch out for 2010! As you can see from the decade chart below, starting in the last quarter of the '9 year and continuing through the first three quarters of the '0 year, the market takes a noticeable dip.: normxxx]] That of course is not a prediction; it's merely a guess— an observation.

[ Normxxx Here:  The best explanation for the 40-year cycle is as follows: 1. there is a very pronounced 4 year cycle, also known as the Presidential or business cycle. 2. there is also a somewhat less pronounced 10 year cycle. The Least Common Denominator of 4 and 10 is 20; so one would expect a 20-year cycle, and indeed there is such a cycle. But successive 20-year cycles tend to have an alternating positive and negative bias; so the reliable long cycle is 40-years.  ]

The following chart presents the Dow Jones Industrial Average's 4 year presidential cycle from 1897 to the present.

Point of Interest— Notice how the upward trend falters starting in the later part of the post election year. It is argued that any major economic policies that may cause hardship are implemented early in the presidential cycle with hopes that the economy will recover in time for the next election and hence improve the chance of re-election for the party in power.

The following chart presents the Dow Jones Industrial Average's average decade cycle from 1896 to the present.

Point of Interest— One shouldn't put too much emphasis on this popular cycle as there isn't any particular underlying reason why the stock market's performance should be tied to any given year within a decade except, perhaps, as it relates to the 'presidential' cycle.

Large 100+ Year Dow.

Click Here, or on the image, to see a larger, undistorted image.

The following Dow chart compares the Dow (1900 - Present) to an inflation-adjusted Dow (1925 - Present).

Point of Interest— To better demonstrate the true magnitude of the great bull and bear markets of the last century, it is necessary to adjust the Dow Jones Industrial Average for inflation. What the CPI (Consumer Price Index) adjusted Dow chart shows is that the 1966 to 1982 bear market was almost as severe as that of the early 1930s. And since 1982, a true and great bull market has ensued (even when adjusted for inflation).

For some long-term, inflation perspective, this chart also illustrates the Dow adjusted for inflation since 1925.

Click Here, or on the image, to see a larger, undistorted image.

Click Here, or on the image, to see a larger, undistorted image.

There are several points of interest. For one, when adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is now less than double where it was in 1929 and trades a mere 29% above its 1966 peak. Not that spectacular a performance considering the time frames involved. However, the magnitude of the bull market of 1982 to 1999 (even when adjusted for inflation) was truly of historic proportions. It is also interesting to note that the magnitude of the current bear market (when adjusted for inflation) is greater than that which occurred during the dot-com bust of 1999 to 2003. As a result, the Dow currently trades at 12-year lows! Finally, Market Price Volatility first defines a best-fit, +1.64%/yr compounded annually, trend curve for these Real Dow data. The average Real Dow volatility (“+ or – difference of Real Dow from the trend curve”) is equivalent to 20 years of the 1.64%/yr trend growth! A range of Real Dow market price of a factor of 2.0 is equivalent to this average volatility.

[ Normxxx Here:  So, all we needed to match the Dow over approximately the last 100 years was a guaranteed investment return of inflation + 1.64%! Not much. In fact, what this tells you is that stock market 'capital gains' are mostly a myth; the stock market total return is scarcely greater than its (inflation and tax adjusted) dividend return!

In fact, assuming a real Dow of ~9 in 1925 and ~32 at its peak in 1929, the DJIA close of 8497.31 on 11/14/2008, by CPI-U* estimation and interpolation, would correspond to a Real Dow of 57.7,
less than 100% above where it was in 1929!  ]

*Note: Specifically, points are monthly Dow averages starting with January 1924; each 'market datum' = the monthly average of daily closing Dow values, divided by the CPI-U for that month, multiplied by 1.49629 (in order to adjust the all-time high in January 2000 to be equal to 100). These data are designated the “Real Dow”. Note: CPI-U is the broadest, most comprehensive consumer price index published by the U.S. government.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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