Long-term clients and readers know that we pay close attention to the alternating long strong and weak cycles that have characterized the U.S. stock market for more than two centuries. These cycles vary in length, but each phase has averaged just under a decade and a half since the beginning of the nineteenth century. Long weak cycles begin at excessively high equity valuations with investors extremely optimistic about the outlook for stocks. Conversely, long strong cycles begin at extremely low equity valuations with most investors licking their wounds from prior market declines and swearing off stock market participation for the foreseeable future.
The nearly two-decade-long cycle that closed the twentieth century was the strongest ever when combining both return and duration. The current long weak cycle began in 2000 and has encompassed two stunning market collapses and two powerful rallies. Even at the two market troughs of this century’s first decade, however, equity valuations never approached levels that characterized the inception of past long strong cycles. Today’s valuations are more similar to major market tops than to bottoms.
In his May 16 publication, the always-informative John Hussman examined the components of the long weak cycles since the beginning of the twentieth century. With long cycles averaging almost a decade and a half in length, there are inevitably several “cyclical” mini-bull and mini-bear markets within the longer “secular” bull or bear cycle. The following table, which Hussman attributes to Nautilus Capital, delineates all the cyclical bull markets that took place within the four secular bear markets since the early 1900s.
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There were four cyclical bulls in the secular bear that covered most of the twentieth century’s first two decades. Three cyclical bulls unfolded in the troubled 1930s, with four more through the secular bear that extended from the mid-1960s into the early 1980s. So far, only two cyclical bulls have provided the upside strength in the secular bear that began in 2000. While the average long cycle lasts almost a decade and a half, there is reason to expect that this long weak cycle might exceed that average. The excesses of the powerful strong cycle that covered almost all of the 1980s and 1990s and ended with the explosion of the dot.com bubble will eventually demand correction. Never had valuations nor debt loads been greater.
The table’s second and third columns show the duration and return of each cyclical bull. Columns four and five show the decline and duration of the bear market immediately following each cyclical bull. The average cyclical bull has lasted for 26 months and provided an 85% return. It is interesting to note that no cyclical bull had exceeded 33 months prior to the 63-month marathon extending from 2002 to 2007. I suspect that the Fed’s unwillingness to accept a normal corrective recession and the investing public’s confidence in the “Greenspan put” unnaturally prolonged that cyclical bull. In any case, the current cyclical bull that began in March 2009 is now 26 months long, the average length of its 12 predecessors. The 102% gain in this rally is a bit above the 85% norm.
These patterns are certainly not precise, and many factors can override expected outcomes, not least among them current confidence in the “Bernanke put.” At a minimum, however, investors should recognize that few cyclical bulls extend much beyond the 26 months of the current rally.
Should our assumption that the secular bear market remains intact prove true, an average decline would bring stock prices well under 8,000 on the Dow Jones Industrial Average if the May 2 high is not exceeded. In many respects, this is not just a normal cyclical bull market advance. This rally has been supported by the greatest infusion of new money in history. That money production is scheduled to end next month. It’s noteworthy that the Fed’s prior loose money escapade resulted in a housing bubble and a far greater than average 57% collapse, when the market gave up the Fed-sponsored gains.
Perhaps the Fed will get it right this time, although the stock market and commodity prices are so far the major beneficiaries of the Fed’s largesse. As the QE2 program is coming to its scheduled end, economic growth is slowing perceptibly, both here and abroad. Major corporations have improved their balance sheets, but the average household is still hurting. Overwhelming debt burdens have become commonplace around the world. The caution added by a study of cyclical bulls within secular bear markets is just one more yellow flag waving.