Cycles can be used to develop a longer term view of our current markets. At present, there are two competing scenarios. They are:
This is a standard business cycle. In the not-too-distant future the market will recover OR
This is more than just a standard business cycle. Different strategies need to be employed.
The Standard Business Cycle is shown by the above diagram. Typically having an average of 4 years, it is largely a result of the federal reserve varying the money supply and raising and lowering interest rates. The desire for economic growth is balanced against the desire to curb inflation. An acceptable compromise between the two is attempted to be achieved.
If we are in the slow-down phase of a standard business cycle, then investment strategies which have worked well in the past may continue to work well in the future.
Longer-Term
Bear Market Scenario
Currently, there exist a
number of factors which support the possibility of a protracted Bear Market.
Comparison to 1929
The magnitude of the bubble which preceded this decline resembles the 1929 stock market in many ways.
Likewise, the deflation pattern of the bubble has been very similar so far.
During a strong month it's easy to forget the longer-term pattern which has been established.
Impulsive Waves
There is little disagreement among technicians that major market moves follow a predictable pattern. This pattern is elaborated in elliot-wave theory. An important market move will normally have 5 waves as shown at the right. This will be followed by a 3 wave correction.
The wave which ended on April 4, 2001 was probably only a 3rd wave. Although it was a harsh decline, it did not meet many of the cirteria for a final 5th wave. This implies that the correct pattern is as illustrated below.
As of June 10, 2001, the current rally might be considered a Wave 4.
If so, it will likely end sometime between June 30, 2001 and August 15, 2001.
Wave 5 would then project to take the NASDAQ significantly lower, perhaps even under 1000.
Dow-Gold Ratio
Another measure which can be used to gain a historical perspective is the Dow-Gold Ratio.
The Dow-Gold Ratio is the price of the Dow Jones Industrial Index / Price of Gold. It appears that the parabolic advance of this indicator has been halted by its upper trendline. It can be seen that steep rises have always been followed by sharp falls. In order for this indicator to become normalized, the Dow would have to fall significantly and/or the price of gold would have to rise significantly. The price of gold usually rises as a result of a falling dollar, inflation, and/or political or economic uncertainty.
One should keep in mind that this is a very long-term chart and a small blip on it may take years to transpire. Nevertheless, it may be an important indicator that provides a good idea of where we are in relation to where we will be.
Valuations
The chart below compares the current valuation of the S&P 500 to its historical valuation. The valuation is based on the average price-earnings ratio.
If the index went to its normal historical level, the S&P 500 would be around 750. However, often after a period of overvaluation the market will seek a temporary level of undervaluation. This could bring the index all the way down to 500. Although such an event would seem shocking at the time, it would be perfectly normal and precedented within a historical context.
Conclusion
It isn't the purpose or desire of this site to be "Bearish". But as market technicians, it is important that we be "right".
