Garrett Jones' August Market Strategy article relied on his years of technical analysis and cycle development. He put together the following paper “The Sequence of Events in the Cycle," to explain his philosophy on market cycles:
In covering the sequence of events in the Long Wave cycle, we need a starting point. A logical point would be the absolute economic bottom that was the beginning of the cycle we are currently in. That would be 1933. At the bottom of the cycle, we slowly begin to rebuild a devastated economy. After the crash (1929 to 1932), debt is wiped out because most of it results in default. People are hungry and desperate -- so they are willing to work hard. There are no "slackers" because slackers don't get hired. The work that is produced is of the highest quality because there are few jobs available and only the best workers are hired. This philosophy permeates the society. If you want a job, you've got to work hard and produce a top quality product.
The process is slow, but once the economy begins to grow, debt creeps back into the picture. As businesses grow and seek expansion, the most logical and efficient method for acquiring capital is to get a loan. As the cycle progresses, business begins to boom and debt increases at a much faster rate to compensate for the demand (1960s). Demand translates into necessity. The necessity brings on inflation and the inflation begins to rise at an increasing rate (late 1970s). Inflation then peaks due to leverage, reduced returns and increased debt (1980). The peak in inflation is usually followed by a recession lasting a year or two. This is followed by the Plateau Period which is the period following the peak in inflation. I’m sure you have heard the term “necessity is the mother of invention” – the increased demand of the period leading into the peak in inflation brings about a new technology in the Plateau Period. The semi conductor boom of the late 60s led to the computer craze of the 1980s and 1990s – the New Technology.
This ushered in the Information Age at the expense of the Industrial Age. The Plateau Period is characterized by declining rates of inflation; declining interest rates; a psychological return to "normalcy" and a roaring bull market in paper assets. The plateau period is a period of disinflation -- initially, this is inflation where the rate of inflation is declining. This new technology enhances production and, ultimately, leads to overproduction. The high debt and overproduction set the stage for deflation after many years of disinflation during the Plateau Period. The breadth of the stock market peaks (1998) which ultimately predicts a peak in stock prices (2000). This sets up a crash in the stock market (2000 to 2002). At this point in the cycle the stock market is the market of choice and is the vehicle where the vast majority of investment funds reside. Later, this trend changes from disinflation to deflation.
When the stock market peaks and ultimately crashes, it puts extreme pressure on all other investments (2007). At this point, due to the high level of debt and unemployment, people are forced into liquidation -- initially liquidating their investments, but later their homes and other valued possessions. This ultimate liquidation in society brings us to the bottom and completes the cycle. As you can see, each separate phase of the cycle sets up the next. It is perfectly logical -- it should be, Mother Nature doesn't make many mistakes.
Now that we are familiar with the cycle, how do we utilize it? I have said from the very beginning the most important part of the cycle is knowing the sequence of events. The reason you want to know the sequence of events is so you can determine where you are in the cycle. If you know where you are, then you know what economic events should follow. If you know what is coming, you can plan for it and use it to your advantage rather than having it take advantage of you. It's really that simple.
Now that you have a comfortable idea of the cycle from this information, let's see if we can determine where we are in the cycle at this point in time. Once we determine where we are we will then be able to determine what economic events are likely to follow -- in other words, what are the implications of our current position in the overall cycle? Once we know the implications we can act accordingly i.e. we either seek protection or opportunity … or both. Note: For simplicity, the sequence of events in the cycle is listed in bullet points later in this communication.
We have already had the peak in inflation. That was in 1980 when gold hit $877/oz., silver was $50/oz.; Oil was over $40/bbl., CRB futures price index at 337.60, etc. There was a one to two year recession that followed in 1981-82. The stock market took off in 1982 and peaked in 2000. There has been a market crash that was primarily centered in the area of the “new technology”. This was an 83.5% peak-to-valley crash in the NASDAQ 100, the market of choice. That was “the first shoe dropping” i.e. the warning shot for mankind to “pay attention”. There is always a warning. In the prior cycle it was the real estate boom and bust in Florida in 1927. In fact, we have had the same warning this time – once again with Florida real estate.
This was followed by another inflationary run where both the Dow Jones Industrials and the S&P 500 went to an all time high in October 2007, but the institutional index peaked in 2000 and could only generate a 61.8% Fibonacci retracement – thus creating a major divergence with the all time highs of the major indices. Remember, it is the institutions that run the show. This is a very interesting and very major point that was missed by virtually all of Wall Street – but it was blatantly there for all to see.
Wall Street is aware that bear markets correct the bull markets that immediately precede them. The1982-2000 bull market was corrected by the 2000-2002 bear market. In a similar manner, the bull market of 1932-1937 was corrected by the bear market of 1938-1942 … and, the bull market of 1942-1966 was corrected by the bear market of 1966-1982 (with major lows in 1974 and 1982). Unfortunately, most people don’t realize that the larger cycles also have corrections. Markets are constantly in the process of going from one extreme to the other. Larger cycles (Long Wave cycles) comprise three bull markets and roughly cover the time span of an average lifetime. The current Long Wave cycle began with the stock market extreme low in
1932 and corresponds with the extreme economic low in 1933. It completed its ‘orthodox’ high in 2000 with the stock market top and “real value” peak in 1999 (the stock market peak in terms of real value). This was followed by the final thrust higher to the market’s all time peak in October 2007 (a higher market price, but divergence in real value). It is this advance (from the all time stock market low in 1932 to the all time high in 2007) that is now in the process of being corrected. Correcting an advance that spans 75 years is much more significant than merely correcting the advance of the most recent bull market. The chart below will give you an idea of the potential for what can happen when an entire cycle faces a correction. Note that in just the first wave down, the market has corrected almost the equivalent of the entire 2000-2002 bear market.
We live in a world that is defined by cycles. One of the best examples of this is the seasonal growing cycle. We can all readily relate to summer, autumn, winter and spring. Each season comes at the same time every year and has the same characteristics. The seasons can be intense or mild; extended (an Indian summer) or contracted (a short winter); but they happen in order and their characteristics remain the same. The growing season follows the same seasonal pattern and provides an example of why each individual season actually set up the season that follows. For example, in the spring, seeds germinate with the warming temperature and rain to nourish them. In the summer they flourish into mature plants. In the autumn, the plants are harvested. Finally, in the winter, the process rests by going dormant.
This process is classic action in a cycle. Once you have defined the cycle, it becomes quite logical and follows a defined process. As you can see in the seasonal growing cycle, each predecessor phase (season) augments the one that follows. This same process occurs in the economic cycle. By spending some time going over the sequence of events, you will soon see how logical this process is and how well it defines any particular phase of the cycle. It is an incredibly helpful tool in business and investment planning and it brings logic and explanation to difficult economic times that otherwise confuse economists and other economic observers.
THE SEQUENCE OF EVENTS IN THE CYCLE
- The Ultimate Economic Bottom (DEBT DEFAULT; BANKRUPTCIES; BANKS CLOSED; ETC.)
- Slow Rebuilding Process (LITTLE DEBT; QUALITY WORK; DEBT SLOWLY CREEPS BACK)
- Business Expands (LOANS ARE THE MOST EFFICIENT WAY TO FUEL THE GROWTH)
- Business Booms (DEBT EXPANDS AT MUCH GREATER RATE TO MEET DEMAND)
- Increasing Inflation (DEMAND becomes NECESSITY brings on INFLATION)
- Inflation Peak (SHORTAGES; LOWER RETURNS; LEVERAGE; INCREASED DEBT)
- Plateau Period (RECESSION; DECLINING INTEREST RATES; DECLINING RATE OF INFLATION; PSYCHOLOGICAL RETURN TO NORMALCY; ROARING BULL MARKET)
- New Technology (NECESSITY is the MOTHER of INVENTION-COMPUTERS-INFORMATION AGE)
- Overproduction (NEW TECHNOLOGY enhances production and, ultimately, OVERPRODUCTION)
- Stock Market Peak (FOLLOWS PEAK IN BREADTH)
- Stock Market Crash (PARTICULARLY IN THE AREA OF THE NEW TECHNOLOGY) THERE IS AN INITIAL CRASH IN THE FAVORED MARKET SECTOR FOLLOWED BY A RECOVERY IN STOCK PRICES. LATER THE SECOND DECLINE BEGINS WHERE THE REAL SHARE DEVASTATION OCCURS
- Disinflation becomes Deflation (PRICES OF ASSETS FALL)
- Bankruptcies and Liquidation (DUE TO DEFLATION, UNEMPLOYMENT & HIGH DEBT LEVEL)
- Debt Default (INDIVIDUALS AND CORPORATIONS BELLY UP ON DEBT)
- Stock Market Bottom (TOTAL CAPITULATION) AT THIS POINT PEOPLE LITERALLY HATE STOCKS AS THEY HAVE FALLEN TO AN EXTREME LEVEL OF UNDERVALUATION
- Economic Bottom (BANK CLOSINGS; DEBT RESTRUCTURING; REMONETIZATION; NEW CURRENCY)
NOTE: WAR IS A PART OF THIS PROCESS, AS WELL. PEAK WARS OCCUR DURING PERIODS OF STRONG ECONOMIC EXPANSION (VIETNAM); ARE A BURDEN ON THE ECONOMY; AND ARE UNPOPULAR. TROUGH WARS FOLLOW A DEPRESSION; HELP THE ECONOMY DUE TO UNEMPLOYMENT AND UNDERCAPACITY; AND ARE POPULAR (WORLD WAR II). TERRORISM AND OTHER SUCH ‘WILD CARDS’ ENTER THE CYCLE AT VARIOUS STAGES. THIS TIME AROUND IT BEGAN IN 1970 WHEN 3 ARAB TERRORISTS ATTEMPTED TO HIJACK AN EL AL BOEING 707 AT MUNICH AIRPORT IN GERMANY.
The Psychology of the Market:
It is important to tie the cyclical information in with the psychology of the market. The market is driven by two forces, fear and greed. It’s interesting to note that both are negative. It is also interesting to be aware that the stock market is unique when compared to other markets – particularly, on a psychological level. If you want to attract buyers in a retail market, you have a “sale” – the attraction is lower prices. In the stock market, you attract participants by raising prices. Go figure.
Anyway, when you analyze the psychology of the market and how it fits in with the sequence of events in the cycle, it is important to be aware of the nuances. I’ve put together two charts that deal with the phase of the market (and the economy) that are the most important. Interesting things occur throughout the cycle, but the real challenge, as one might expect, occurs at its conclusion. During the body of the cycle, the worst you have to deal with is recessions. Some of them have been quite serious, but they are recessions nonetheless. Further, after these recessions conclude, the market and economy have always moved on to new all time highs. This can lull one into complacency and cause one to assuming that you 1) never get anything worse than a recession, and 2) once the recession is over, the market will always rally to a new high. This is a reasonable assumption throughout the cycle … and a very dangerous assumption as you approach the end of a cycle.
It is psychology and emotion that drive markets – both up and down. The chart that follows shows the most basic of the emotions that have driven the market over the past 15 years. The chart tells a lot. First of all, you have had two bull cycles and two bear cycles. It is obvious that the strongest motivator is fear. Markets can move up quickly, but they fall much faster. For example, have you ever noticed that you can run faster when you are feeling fear than when you are feeling greed? The market reacts the same way.
The following chart shows essentially the same thing as the above chart, but it breaks down the emotions from basics to specifics. The distinctions are very important because the basics don’t do justice to the reality of the situation. The move from 1994 to the market top in 2000 was a mania, driven by technology stocks. It was a “new economy” and the pundits said the extreme valuations were justified because “it’s different this time” -- a comment made at every major market top in US stock market history. After the mania, the market had the initial collapse where the S&P fell by about 50%, but the real story was in the technology stocks where the decline was much larger. The NASDAQ 100 had a peak-to-valley collapse of 83.5%. That was the “first shoe dropping” and a serious warning to “smart money” investors.
In the stock market, “smart money” is not defined as educated people with money. As we have recently seen, these people have gotten hurt just as badly as those with less savvy and far less money. An argument can be made that the CEOs of Lehman, Bear Stearns, Wachovia, Merrill Lynch and others were the dumbest of all – and these are very smart people with an abundance of money. They are not “smart money”. Smart money is that rare investor who inherently has a feel for where we are in the cycle and acts on those feelings. These are people with “anticipatory intelligence”. Everyone else essentially “fights the last war” i.e. they assume what is happening will continue – therefore, any change will be a surprise.
Following the mania and the initial collapse is the denial phase. A snappy rally ensues and everyone is bullish again and expecting the worst is over. These feelings carry into a peak of hope where there is knowledge of serious problems such as debt, deficits, war, derivatives, lack of leadership and a myriad of other such negatives – however, they are digested and, essentially ignored. At the peak of the hope phase, some markets set new all-time highs (such as the Dow Jones Industrials and the S&P 500) and some don’t (such as the NASDAQ and the Institutional Index).
This is followed by the recognition phase – where the market crashes and creates a year like 2008 where you have the worst performing year for the stock market in 77 years (and 2009 beginning with the worst performing January in history). In the recognition phase, everyone realizes there are problems and that the problems are quite serious. There is general recognition that there is no quick fix.
The next phase is the reprieve phase. Here the market rallies because there is a belief that 1) the worst is over and, 2) the government’s actions will help to solve the problem(s). This is a dangerous phase because it gets everyone leaning in the wrong direction. When it becomes clear that the worst is nowhere near being over and the government’s actions have actually exacerbated the problem, it leads into the liquidation phase. This is where people sell their assets because they need the money to survive. This malaise continues and spreads throughout the society – it is accompanied by fear and anger. At the extreme of this phase, you enter the final phase – CAPITULATION. Markets are always in the process of moving from one extreme to the other. At this point, the market is at the opposite extreme of the bull market top – it is at its lowest ebb. It is a time where everyone hates the stock market – including those who are employed by it (in one form or another). People swear they will never buy another stock for the rest of their lives. The capitulation phase, by definition, is the best buying opportunity you will ever have – unfortunately, most will never benefit from it because the market psychology is so overwhelmingly negative that everyone will hate everything about the stock market at that point. In fact, at the point of capitulation people hate all forms of investing because everything they have ever believed in has been devastated.
In many ways, the recognition phase is the most critical phase of the cycle because there is recognition of the problem, but no one has any idea of what to do about it. There is no guarantee how long the reprieve phase will last, but you can count it will last long enough for most investor to believe “the worst is over”. This has been a very large and extended cycle – which means that the downside will almost assuredly be extreme – it already has been and it’s far from over. This is the final chance to prepare for the final two phases (liquidation and capitulation). It will be difficult to do because all the “professionals” who did so poorly in the recognition phase will make a comeback during the reprieve phase. These people who completely missed the top will now chime in and say the worst is over. They don’t understand the cycle; they didn’t see the fall coming; and they don’t understand what caused it, but they will be the biggest cheerleaders that the bear is dead. Ironically, most investors will remain with these people even though they have proven they have little to no ability in markets that go in a direction other than up. Now, at the most critical stage of the cycle, people will continue to trust their funds to people who have just proven their worth in turbulent markets. In addition, these questionable “professionals” have zero knowledge of the long wave cycle. They will parrot what the financial news media says and assure you that the worst is over. Most likely, they will be correct for awhile.
You now have the information in your hands to be your own best advisor, however, the “smart money” player realizes that knowledge is only one part of the equation for success. There are two other mandatory components. The first is discipline. Knowledge without discipline is like having money without a place to intelligently spend it. The third component is experience. You have a roadmap – one that took me decades to perfect. The combination of knowledge, discipline and experience will allow you to navigate the roadmap.
AUTHOR’S COMMENT: If you take the time to learn the sequence of events in the cycle, you will have a very valuable tool that will assist in business and investment planning and providing you with the knowledge and peace of mind in knowing where you are in the cycle. Knowing what is next to come in a cycle removes the element of surprise and replaces it with expectation. Expectation allows one to plan and take advantage of the situation as opposed to having the situation take advantage of you. In closing, the quotations by Marx, Twain, and Livermore on page 2 are interesting, but the focus should be on the content of the article. No one really knows if a quote from someone in the past is valid or not. At this phase in the cycle, it is absolutely imperative to be focused on where we are in the cycle and the extreme implications of being there. If you missed seeing the top in 2000 or the more recent top in October 2007 and were hurt by what followed, you now have no excuse to not be paying attention.
Important: Note that the charts are all updated to October 2009 with the exception of the chart on page 8 which was not updated. The purpose is so you can see what my expectation for the market was on February 24, 2009 when this report was initially written. If you compare the chart on page 8 with the chart below – the expectation became reality. That is the benefit of learning the sequence of events in the cycle. When you consider that bearishness and fear were extreme in February 2009, it was impressive to predict 1) the market going lower, and 2) then having a sharp rally into this time period. It is also important to be aware that my Special Alerts called the July 2007 top and the October 2007 top as indicated with the arrows below. Clearly, expecting that top would have saved one from losing a lot of money. In a similar manner, expecting the March bottom would have saved further loss and presented an opportunity. Without question, the study of the sequence of events in the cycle can be quite helpful to an investor or businessman.
The chart below shows the two “bubble” tops of this decade in the stock market. The 2000 top was the Tech Bubble and it resulted in an 83.5% peak-to-valley loss in the NASDAQ 100 (the leading market index at that time). The 2007 top was the Stocks Bubble and it resulted in the worst loss for the benchmark S&P 500 Index in 77 years – down 57.7%. These losses were absolutely devastating for most investors and money managers. In fact, the recent decade is the worst performing decade in US history.
I was interviewed by Dave Allman of Wall Street Uncut in June 1999 when the stock market and technology stocks in particular were in an explosive move to the upside – an extremely bullish time. I commented that I expected two more rallies and then expected the market to top – so the 2000 top was not a surprise either – it was an expectation. That is the significance of learning the sequence of events in the cycle – it provides a roadmap of sorts and helps to remove the surprises.
As you can see, the Reprieve rally began as expected. Bullish sentiment was 2% (an obvious extreme). The rally got everyone bullish – with bullish sentiment well over 90% at times. The belief is that “the worst if over” and we are in a new bull market. What you must not forget is that this is followed by the Liquidation phase of the cycle and, ultimately, Capitulation. The cycle suggests a depression with the potential to be worse than the Great Depression. This phase of the cycle separates almost everyone from their money – the rich and poor as well as the intelligent and the ignorant. It is an “Equal Opportunity Destroyer”-- it has already devastated a number of rich and intelligent people – yet another hint as to where we are in the cycle … but will anyone listen? Frankly, that is the whole reason for studying the Long Wave Cycle – to give you an advantage in knowing what to expect. The market’s job is to fool most of the people – particularly at critical points – and we are about to enter the most critical phase in the past 80 years.