Mapping The Markets: The Big Picture

Mr. Market is at it yet again. Last week, he was euphoric, as global stocks were breaking through new record highs. Five days later, he's wringing his hands about the credit crunch as global markets once again have caught the jitters. Yet, it's precisely at times like this that cool heads prevail -- and a longer-term perspective is key. And that's exactly what Deborah Owen -- managing director of Investment Research of Cambridge [IRC] -- provided when she spoke recently at the London Junto.

Founded in 1945, IRC was one of the first companies in the United Kingdom to specialize in technically-based research and it has the ear of some of the most sophisticated global investors in the world. Deborah Owen also is co-author (with Robin Griffiths) of Mapping the Markets, published by the Economist in 2006.

Mapping The Markets: Roots in the Austrian School of Economics

Joseph Schumpeter -- a former finance minister of Austria, and later iconoclastic Harvard professor -- provides the original intellectual inspiration for IRC's approach. The flamboyant Schumpeter once said he had only three goals in life: to become the world's best horseman, lover and economist. In his analysis of markets, Schumpeter knitted together three long waves: the very long Kondratieff cycle (average period of 54 years), the medium-term Juglar wave (10 years) and the short-term Kitchin wave (four years). If all three cycles moved harmonically in the same direction at the same time, they would tend to reinforce each other to produce strong trends in both an upward and a downward direction.

Schumpeter believed that the upward phase of any cycle was caused by clusters of innovation. Think of Florence in the Renaissance, Britain in the Industrial Revolution, or the Silicon Valley since the 1950s. Schumpeter famously described the birth of new industries and the death of old ones as "creative destruction." This is what gave the market economy its dynamism.

IRC itself places little emphasis on the long-term Kondratieff wave -- a cycle that Kondratieff himself admitted could vary between 45 and 60 years. That's just too imprecise for worthwhile market analysis. IRC does focus on readily identifiable long-term secular trends that influence different markets and sectors. The secular trends fall into in three broad categories: Industrialization, Demographics and Innovation. IRC also cites the work of Larry Summers, the ex-president of Harvard, who describes the world's current state as the third big wave in the development of mankind, if you take the Renaissance as the first wave and the Industrial Revolution as the second. Undoubtedly, this third wave will result in some sectors and industries falling by the wayside. But overall, it is an optimistic outlook on the future.

IRC also integrates the United States' four-year election cycle in its analysis. The rise of global markets notwithstanding, the U.S. market is the dog that wags the tail of global stock markets. The year before an election (2007) traditionally is a very good one for the stock market. The market also tends to hold up very well during the following year. In contrast, the first two years after the presidential election often are periods of fiscal restraint and poor stock market performance. Within each year, there also tends to be a seasonal pattern to the markets.

Mapping the Markets: The Current Outlook

The post-2003 bull market had been looking very long in the tooth. Based on what had happened in 1987, at the start of the year, IRC was looking for some pull-back during the summer period. The U.K. market did experience a correction over the summer -- defined as anything up to a 10% fall within a sustained uptrend. Wall Street never quite saw a 10% pull back.

IRC is optimistic that the summer correction does not presage the start of a long-term downtrend. Because the global economy was growing in excess of 5% per year going into this financial crisis, the credit crunch should merely brake economy activity rather than bring it to a grinding halt. After the credit crunch works itself through the system, we should see another upward leg of the bull market. As long as the FTSE -- the U.K. stock index -- does not drop below 6,000 (it stands at 6,500 as I write this) -- IRC expects the market to end the year with a traditional rally.

Now the bad news. According to IRC's cycle analysis, we are due for an economic slowdown in 2009/2010. This won't necessarily mean that the world economy tips into recession. Central banks have become much better at managing regular cyclical downtrends. But a major economic contraction could be triggered by a negative 'external' factor -- say the avian flu or some sort of water crisis. Most likely, the cause would be what Nassim Taleb, a former London Junto presenter, calls a "Black Swan" event -- by definition an event that is unpredictable but extremely important. Not to worry, though. Long-term secular forces already are in place that eventually will power a recovery from this downturn. Right when the pessimism is the deepest, there will be the buying opportunity of not just a generation, but of a century.

Mapping the Markets: Offering Much Needed Perspective

The argument for market cycles is seductive. After all, they provide order and structure to what often seems like a random process. Yet, we need to be careful. As the recent Nobel prize-winning work of economists Daniel Kahneman and Amos Tversky has shown, we humans are vulnerable to "confirmation bias." We love to shoehorn events into pre-existing categories that confirm our own pre-existing opinions. That applies as much to a star analyst at Goldman Sachs as it does to "financial astrologers" or the perennial Cassandra "doom and gloom" crowd. All of these prognosticators have examples to justify their views. Even a broken clock is right twice a day.

But to say that markets are completely random is also unsatisfactory. Like history, market cycles may not repeat themselves exactly -- but they do rhyme. The long-term framework developed by Deborah Owen and IRC allows us to see beyond the market noise and to gain a terrific antidote to the daily mood swings of manic Mr. Market.