From the August 01, 2010 issue of Futures Magazine • Subscribe!

Garrett Jones philosophy on market cycles

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.

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