Market Cycles: The Correction We're Due For

Includes: AAPL
by: Spencer Knight

Traders often determine when to buy and sell based upon cyclical patterns in the stock market. The ability to spot these cycles enables traders to open positions near the bottom while closing near the top. Just as individual securities, these same cyclical patterns can be seen in the main indices as well. I will pay particularly close attention to the pre-recession movements of the Dow Jones Industrial Average.

The main point to note is that moves with strong momentum are worse for the stock market when compared to a market with continuous momentum checks. Another important note to remember going forward is that the stock market has become very inflated since the economic boom in the 1990s, therefore it is imperative to compare trends using percentage change and differences in rates of change. I will also disregard most outside economic factors as well.

Click to enlarge:

(Dow Jones from January 1997 to January 2000)

First we will need to return to the "dot com" bust and take a look at the chart to form a starting point. I will begin here because this is the perfect market crash after a long economic boom. The decade prior to 2000-2001 saw extreme growth from the American economy. At the time investors thought the stock market was going to grow to the moon. Investors could have made millions by investing half a month's paycheck into many different technology companies a decade earlier. Unfortunately this all came to a debilitating end after a peak was reached in January 2000. What followed was a 36% slide that saw the Dow reach a bottom in September of 2002. The same story applies to the 2008 dip as well, but not so much during the 1991 downward move.

The question is how did the market get to the point where a huge correction is needed and how can we use this to brace for the future?

Before moving forward it is important to look at how the market crawled out of the 1991, 2001, and 2009 recessions. This is important because there is a pretty standard pattern an index follows after sharp falls; most of us know this as the funny phrase "dead-cat bounce." After reaching a bottom in October 1990, the index grew 26% over the next 12 months despite the economy still being in a recession. The following year we saw a characteristic slowdown after a recession as the Dow only grew about 6.4%.

(Dow Jones from October 1990 to September 1992)

Similarly after the 2001 slide the Dow ran 27% from September 2002-2003. This was followed by the same 6.4% growth over the following 12 months. Therefore a full two years after the recession ended the general stock market was very slow just as the previous recession. Not coincidently this same pattern can be seen after the 2008 "crash." From the ultimate bottom in March 2009 the Dow ran an incredible 61% from March 2009-2010. Granted most of this run can be attributed to overselling to the nth degree the prior year. More importantly to us, from March 2010-2011 the market grew a standard 15.6%.

(Dow Jones September 2002 to September 2004)

(Dow Jones from March 2009 to July 2011)

The Dow normally follows a similar pattern of huge runs preceding a corrective slowdown after all three recessionary lows. The key point to note of this is the average difference in first year gains to second year gains of all three periods, after a recessionary low, is right around 75%. What this tells us is after investors leave the stock market, everybody buys back at irresponsible levels. This is then followed by a year of profit taking before any kind of stabilization can occur.

Another cycle the indices follow leading up to a large slide is sporadic growth two years prior to the slide. Please note that prior to the 2000 crash, the market saw much more inflated growth due to a booming economy compared to the 2007 dip. Nevertheless, there was a pattern leading up to these crashes.

Leading up to the dot com bust of 2000, the market had began to move at an exponential rate. For instance, from January 1997-1998 we saw a 15% rise; in 1998-1999 we saw a 17.2% rise; and from 1999-2000 we saw a 28.5% gain in the Dow before the dip began. Similarly leading up to the 2007 crash, the Dow rose 1.6% from October 2004-2005; followed by a 15.8% gain from 2005-2006; and finally a 19.4% gain from October 2006-2007 before the crash.

(Dow Jones from October 2004 to October 2007)

These numbers are important because in an ideal theoretical market that does not crash, the Dow would slowly grow at the same rate every year. Unfortunately this does not happen as analysts hand down unrealistic goals to companies while the market grows exponentially like we saw from 2003-2007. When this process happens, the company is forced to bring in more revenue than is possible. This is a breaking point that will always be reached.

An easy example is if Apple (NASDAQ:AAPL) continually brings in strong revenue every quarter; just as the company actually does. However, if this continues for, say X amount of years, analysts will set unrealistic targets. More specifically, let's say analysts set a yearly target revenue at $200 billion because Apple has been destroying predictions through 2019. At this point Apple will most likely miss the prediction and the stock would fall a pretty large amount. Now, think about if every company faces this same fate? It would cause investors to panic and sell off everything.

It must be noted this example is a bit ridiculous. The point is to show as the market continues to grow, analysts have to make revenue and EPS estimates higher. And eventually a breaking point will be reached. If investors did not panic, large sell-offs would not happen. But since people panic, stock market crashes are inevitable.

The stock market tends to follow general patterns. For this reason investors with more experience are better off because these investors have most likely seen everything that can happen. With that said, it is important to note I am not claiming to have an infinite amount of experience. Therefore I advise speaking with other, more experienced traders about this topic. Nevertheless, one should keep these patterns in mind for when the market begins to get overloaded, investors can close out positions before losing too much money. Also, it is important to note the market will never grow to the moon as many optimists such as myself dream of.

It may go without saying, but we are right on track for another large correction in several years. In fact, the more inflated the stock market gets, the steeper the correction will be. Since less experienced investors and traders will panic, they will cause huge sell-offs that are not necessary. Some say it is just part of the game; but think about this; whether you love or hate Jim Cramer, he is right when he warns investors not to panic because panicking is never good for anybody.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.