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2015: What Does Cycle Analysis Suggest?

  • Written by Syndicated Publisher No Comments Comments
    December 27, 2014

    We can’t predict the future – if it were possible fortune tellers would all win the lottery. They don’t, we can’t and we aren’t going to try to. However, we can analyze what has happened in the past, weed through the noise of the present and try to discern the possible outcomes of the future.

    The biggest single problem with Wall Street, both today and in the past, is that they consistently disregard the possibility for unexpected, random events.  In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During that 25 year time frame Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy. Ed Yardeni published the two following charts which show that analysts are always overly optimistic in their estimates.

    Wall-Street-Estimates-1

    Wall-Street-Estimates-2

    This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic.  Furthermore, the reason that earnings only grew at 6% over the last 25 years is because the companies that make up the stock market are a reflection of real economic growth.  Stocks cannot outgrow the economy in the long term…remember that.

    However, as we enter into the 5th year of the decade what do the decennial trends tell us about the probabilities of stock market returns in the coming year.

    In reviewing 2014, we find that the 4th year of the decade has been positively biased over its history turning in an average return of 5.42%. However, the positive return years have outnumbered the negative by 12 to 6.

    Decenniel-Cycle

    As shown, 2015 is extremely “bullishly” biased. The average annual return in the 5th year of the decade is a monstrous 21.47%. The 5th year of the decade has a history of large double-digit returns.

    Avg-Gain-PerDecade-121914

    The win/loss ratio equates to an 83% probability of further gains in the coming year.

    Win-Loss-by-Decade

    While statistics suggests that 2015 leans more heavily towards positive returns, there is sufficient cause for concern. Before you go piling into equities, it should be noted that there are only THREE (3) previous periods where all three prior years were positive return years. One of those three periods returned a -8.5%.

    Furthermore, there is NO precedent for the 5th year of the decade when the previous SIX (6) years were positive.

    In fact, there are only TWO periods going back to 1835 where the markets have had sequentially positive returns for six years or more.  The first was from 1866-1872 which was followed in 1873 with a -12.7% decline. The second was the unprecedented nine (9) year run from 1991-1999 during the “tech boom” which ended dramatically with a three (3) year bear market beginning in 2000.

    While there are many analysts and economists suggesting that we are repeating the 1990’s secular bull market, the 1990’s were not marked by global economic weakness, rising deflationary pressures, and an ongoing scramble by Central Banks globally to support asset prices. With the current bull market already very aged by historical standards, valuations above all but one secular bull market peak and the Federal Reserve tightening monetary policy, there are significant risks that should not be readily dismissed.


    Help From The Oval Office?

    The 5th year of the decade is also the pre-election year of the Presidential election cycle. Like the 5th year of the decade, the pre-election year of the Presidential cycle is the best performing of the four-year span. However, that does not mean that 2015 is a guaranteed “winner” either. With President Obama now a “lame duck President,” the market and economy will begin to deal with higher costs and taxes from the Affordable Care Act, reduced liquidity from the Federal Reserve, ongoing geopolitical risks and a lack of fiscal policy.

    Presidential-Cycle

    The good news is that the second year of the President’s term has a 75.56% win/loss ratio.  Since 1833, the market has been positive 34 out of 45 pre-election years. Furthermore, returns have positively biased as well gaining 10.43% on average.

    As you can see in the accompanying table returns during the third year of the election cycle can have wild swings. However, since 1941 there has not been a single instance of a negative return year to date. Could 2015 break that trend? Absolutely. There are certainly enough risks currently to trigger such an outcome.

    Furthermore, there have only been two periods where the market was positive in all three of the preceding years which occurred exclusively during the “Tech Bubble” in the late 90’s.

    While the odds of a positive year in 2015 are favorable, one should not dismiss the potential for a decline. The real economy is not supportive of asset prices at current levels, and further elevations in prices increase the potential for a future market dislocation. For investors that are close to or in retirement some consideration should be given to capital preservation over chasing potential market returns.

    Third Stage Of The Bull Market

    While there are ebullient hopes that the markets will continue their near unprecedented rise, it should be remembered that all things move in cycles. As I discussed in “Are We Entering The 3rd Stage Of A Bull Market?”

    “In the final phase of the bull market, market participants become ecstatic. This euphoria is driven by continually rising prices and a belief that the markets have become a “no risk opportunity.”  Fundamental arguments are generally dismissed as “this time is different.”  The media chastises anyone who contradicts the bullish view, bad news is ignored, and everything seems easy. The future looks ‘rosy’ and complacency takes over proper due diligence.  During the third phase, there is a near complete rotation out of “safety” and into ‘risk.’  Previously cautious investors dump conservative advice, and holdings, for last year’s hot “hand”  and picks.”

    3-Stages-Bull-Market-121914

    “It is necessary to remember what was being said during the third phase of the previous two bull market cycles.
    • Low inflation supports higher valuations
    • Valuation based on forward estimates shows stocks are cheap.
    • Low interest rates suggests that stocks can go higher.
    • Nothing can stop this market from going higher.
    • There is no risk of a recession on the horizon.
    • Markets always climb a wall of worry.
    • “This time is different than last time.”
    • This market is not anything like (name your previous correction year.)”

    Well, you get the idea.

    There are two things to note in particular about the chart above. The first is the extreme deviation of the market above its long term linear trend. The second is the near parabolic ascent. If you do not understand that the eventual “mean reversion” will be quite destructive, you should not be investing…period.

    A Note On Risk Management

    What the vast majority of investors forget is that greater returns are generated from the management of “risk” rather than an attempt to create returns.

    My philosophy was well defined by an interview I did with Robert Rubin, former Secretary of the Treasury, when he said;

    “As I think back over the years, I have been guided by four principles for decision making.  First, the only certainty is that there is no certainty.  Second, every decision, as a consequence, is a matter of weighing probabilities.  Third, despite uncertainty we must decide, and we must act.  And lastly, we need to judge decisions not only on the results, but on how they were made.

    Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

    It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it.

    Another benefit of acknowledged uncertainty is it keeps you honest. “A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”

    The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

    Will 2015 be the seventh (7th) consecutive year of the current bull market cycle? It is possible. But with 100% of all analysts and economists betting on that outcome, it is quite possible that something else will happen.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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