cycles and possible outcomes

CAPITALIDEAS

EXECUTIVE SUMMARY

In this Capital Ideas we are going

to address the subject of cycles as they

pertain to the economy and financial

markets, explain why they persist and

offer some examples of longer-term cy-

cles. Through this explanation of cycle

analysis, we hope to provide some guid-

ance on where we might be in the cur-

rent cycle and what we can expect in the

current market environment. While cycle

analysis is not a guarantee of what hap-

pens next, it should provide a view into

probable outcomes.

WHAT ARE CYCLES?

“History doesn’t repeat itself, but it

does rhyme.” ~ Mark Twain

So what is a cycle? According to

Merriam-Webster a cycle is defined

as “an interval of time during which a

sequence of a recurring succession of

events or phenomena is completed.” In

practical terms, cycles are a measure-

ment of time in which history repeats,

resembles or mirrors itself. When applied

to markets, cycles reflect shifts in mass

psychology at regular intervals. Cycles

are not exact, however, and history nev-

er repeats itself in exactly the same way

at exactly the same intervals.

Cycles show up in our everyday lives

in ways that most of us never notice.

For example, night turns to day and day

turns back into night, seasons slowly roll

from one to the next and life itself cycles

from beginning to end. Even sound and

light move in cyclical waves. While we

can never tell very far in advance how

hot or cold it will be, how much daylight

we will have on a given day or how long

each of our lives will last, we can make

some judgments based on experience

that can serve as references.

So if we cannot determine exactly

how and when cycles will persist, why

should we study them at all? The rea-

son for studying cycle analysis is so

that we can have a gauge with which

to anticipate upcoming events. Study-

ing cycle analysis allows us to have reli-

able timeframes with which to anticipate

shifts in mass psychology. Cycle analysis

also helps us determine the effects those

shifts have on financial markets.

February 2015

What Can We Learn From The Past?

KEY HIGHLIGHTS

▲ Cycles can be applied to

markets and economies

through the study of mass

psychology and its repeti-

tions.

▲ Because we don’t place

much weight on events

that happened prior to our

lifetimes, when we make

decisions, we are doomed

to repeat the mistakes of

the past over and over.

▲ The Decennial and Presi-

dential Cycles suggest a

favorable environment for

stocks, while the Genera-

tional Cycle suggests one

more major sell-off before

2017 or 2018.

CAPITAL IDEAS REGIONS INVESTMENT MANAGEMENT

HOW DO CYCLES APPLY TO FINANCIAL MARKETS?

“There is nothing new on Wall Street

or in stock speculation. What has hap-

pened in the past will happen again,

and again, and again. This is because

human nature does not change, and

it is human emotion, solidly built

into human nature, that always gets

in the way of human intelligence.”

~ Jesse Livermore1

Humans have an understandable

bias in placing the most weight on per-

sonal experience when making deci-

sions. Because of this bias, we tend to

make decisions without the wisdom of

previous generations to help guide us

when making those decisions. This hap-

pens on a personal level, but more im-

portantly this is true on a generational

level.

In the book, The Fourth Turning,

historians William Strauss and Neil

Howe went back and studied the his-

tory of Anglo-American people all the

way back to the late 1400’s. What they

found was that history repeated itself ev-

ery four generations in the same order

– what they called turnings and other

cycle analysts have called seasons.

They found that these four turnings re-

peated every 70-80 years, or about the

length of the average human life. This

suggests that as generations die off, the

following generations forget all of the

lessons learned by the previous genera-

tions, and therefore make similar deci-

sions and experience similar events as

the generations that came before them.

This decision making causes long 70-

80 year lifetime cycles as well as shorter

17-20 year generational cycles. Below is

a chart which shows how major events

such as wars have unfolded at regular

intervals in American History.

Wars

American Revolution (1773-1794)

Civil War (1860-1865)

World War II (1941-1946)

Future Great War??? (2001-2026)

Source: The Fourth Turning

If we look at the current generations,

we can understand how Baby Boomers

who have been hit twice in the last 14

years by 50% sell offs in the stock market

might be quite uneasy about putting their

investment funds into the stock market,

especially with retirement so near for

most of the age group. Similarly, people

from Generation X may be uneasy about

diving back into the housing market after

being burned so severely in the financial

crisis. Many people in these age groups

lost their homes or were forced to own a

house where the mortgage was greater

than the value of the home. Taken a step

further, those who experienced the Great

Depression are probably more likely to

save and take out less debt.

By looking at markets through this

long lens, you can begin to see how the

life experiences of each generation affect

decision making when it comes to poli-

tics, economics and financial markets.

Cycles also exist on shorter timeframes

and similarly have underlying causes for

the regularly occurring economic events.

For instance, there is a distinct presiden-

tial cycle which is based on campaign

promises, actual political agendas and

more campaign promises.

Take, for example, a presidential

candidate who is running for office. He

is going to make grandiose promises

about the changes he will make once

elected and the positive effects these

changes will have on the country. If he

is running against an incumbent, the

incumbent candidate will try to position

the economy and the country in a light

that makes people feel good about what

has happened in the previous 2-4 years.

These promises make people feel good,

and this boost in confidence naturally

results in an increase in spending and

investing.

After the election is over, the new

president pushes the unpopular items

on his agenda that will negatively af-

fect the country and the economy in

the first 2 years of his term because he

knows that he has to have things mov-

ing in a positive direction when it is time

for the next election. This will cause a

negative mood among the people who

will be less inclined to spend and invest

during these first 2 years of the term.

Because of these repeated actions and

timeframes we can see definite, repeat-

able presidential cycles. These are just

two of the vast number of cycles across

all timeframes that exist in the markets

and economy.


EXAMPLES OF CYCLES AS THEY RELATE TO INVESTING

“I think it’s very hard to come up with a

persuasive case that equities will over

the next 17 years perform anything like

they performed in the last 17 years.”

~ Warren Buffett2

The longer the cycle, the more bear-

ing it seems to have on the markets. As

timeframes get shorter, outside influenc-

es can override cycles to the point that

daily market fluctuations can be seem-

ingly chaotic. For this reason, we will

focus on the Presidential, Decennial and

Generational Cycles in this section.

As mentioned above, the Presiden-

tial Cycle lasts 4 years and is based

on the actions of the President and the

public’s response to those actions. We

are currently beginning year 3 of the

current Presidential Cycle, which is the

strongest year in the cycle with a positive

return 80.95% of the time and a mean

S&P 500 return of 17.27% according

to data going back to 1928.3 As shown

in the chart below, the strong returns

typically begin in November of year 2

and continue into June of year 3. This

suggests that we are currently in the

middle of the strongest period of the 4

year cycle.

Not only are we in the middle of

the strongest period in the 4 year Presi-

dential Cycle, we are also beginning the

strongest year in the 10 year Decennial

Cycle. The Decennial Cycle is a 10 year

market cycle that uses the average return

for each year of the decade. Unlike the

Presidential Cycle, which repeats directly

because of the actions of Presidents and

their tendencies to enact tougher legisla-

tion during certain parts of their terms

for political reasons, there are no direct

causal relationships that can be pointed

to for the Decennial Cycle. Although

no one has been able to determine the

causes of the Decennial Cycle, the pat-

tern was first documented in 1932 when

Edgar Lawrence Smith wrote about it in

his book Tides and Affairs of Men.4 The

cycle has continued to hold up over the

80 years since it was first discovered.

As shown in figure 2, we are cur-

rently in the beginning of decennial year

five, which is by far the strongest year in

the cycle. Since 1886, the Dow Jones

Industrial Average year 5 returns have

been positive 91.67% of the time with

a median increase of 28.82%. Since

1935, the S&P 500 year 5 returns have

been positive 100% of the time with a

median increase of 28.56%.5 The stron-

gest portion of the cycle tends to last

from approximately November of year 4

through early into year 6.

Lastly, we turn to the Generational

Cycle. This cycle tends to last about 17

to 18 years and has been noticed in

Figure 1: Presidential Cycle Median Returns 1928-2014

Source: BofA Merrill Lynch Global Research, Bloomberg


stocks as well as real estate. Even War-

ren Buffett referred to subdued stock re-

turns for a 17 year cycle during a speech

published in 1999 by Fortune.6 The pat-

tern tends to oscillate between secular

bull and bear markets. During the sec-

ular bear periods, markets tend to sell

off violently for a year or two and then

spend several years recovering only to

sell off violently again over and over for

a whole generation. During the secular

bull periods, markets tend to continu-

ously rise with short, violent sell-offs af-

ter which the market quickly recovers to

new highs.

Arguably we are nearing the tail end

of a secular bear market which started

in 2000 with the Tech Bubble. Being

that these long-term cycles tend to last

between 17 to 18 years, we will likely

not see the end to this cycle until 2017

or 2018. If this is the case, the door has

been left open for one more violent sell-

off to mark the end of this generational

cycle.

Looking at the chart below, some

people would argue that we have broken

out to new highs and thus have entered

a new secular bull market which should

last for another 10-12 years. This would

be highly unusual since that would

mark the end of the generational cycle in

2009, making it the shortest one since

at least 1900.

An alternative view would be to look

at the returns of the S&P 500 on an in-

flation adjusted basis since these are the

real returns that the stock market pro-

duces after the cost of inflation has been

removed. This view shows that the stock

market has actually produced no returns

to shareholders at all since the peak in

2000. It also shows that the stock mar-

ket is still within the trading range es-

tablished at the beginning of the current

generational bear market. Looking at

Figure 2: S&P 500 Decennial Pattern: 1928-2014


Figure 3: Nominal S&P 500 Historical



prior secular bear markets suggests that

they ended near an inflation adjusted

low after consolidating previous gains

for at least 17 years.

CONCLUSION

While cycle analysis cannot give us

specific dates or exact turning points for

the markets, it can give us some basic

guidelines to look for based on the path

and timeframes that the markets have

exhibited in the past. We have chosen

to focus on three longer-term cycles

because short timeframes have less in-

fluence on the markets. As we can see

from the two shorter cycles (Decennial

and Presidential) we are in the middle of

a bullish period which should provide a

favorable backdrop to stocks through the

end of 2015. The bad news is that the

longer-term, generational cycle suggests

that we should see one more sell-off

before this cycle leaves us. Thankfully,

once we transition to the generational

bull cycle around 2017 or 2018, we

should have an environment where

stocks can provide very nice returns for

nearly two decades.

Figure 4: S&P 500 Inflation Adjusted Historical


ABOUT THE AUTHOR RYAN JONES

Ryan Jones is an Equity Analyst and Assistant Vice President for Regions In-

vestment Management in Birmingham Alabama. Mr. Jones joined the firm in

January 2013 and is currently responsible for

analyzing the Consumer Discretionary sector

for the Equity Team. His industry experience

began in 2010. Prior to joining the team,

Mr. Jones was a corporate finance/pension

analyst for Rock-Tenn Company. Mr. Jones

earned a B.S. in Mechanical Engineering from

Auburn University and an M.B.A. in Finance

from Emory University.


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1: Richard Smitten, “Jesse Livermore World’s Greatest Stock Trader” (New York: John Wiley & Sons, 2001), 3142: Warren Buffett, “Mr. Buffett on the Stock Market The most celebrated of investors says stocks can’t possibly meet the public’s expectations. As for the Internet? He notes how few people got rich from two other transforming industries, auto and aviation.” Fortune November 22, 19993: Stephen Suttmeier, “The strongest part of the Presidential Cycle begins now” Bank of America Merrill lynch Chart Blast September 29, 20144: Martin J. Pring, Technical Analysis Explained Fifth Edition (New York: Mc-Graw-Hill Education, 2014), 5095: Stephen Suttmeier, “Years ending in “5” are the strongest year of the de-cade” Bank of America Merrill Lynch Chart Talk January 13, 20156: Warren Buffett, “Mr. Buffett on the Stock Market The most celebrated of investors says stocks can’t possibly meet the public’s expectations. As for the Internet? He notes how few people got rich from two other transforming industries, auto and aviation.” Fortune November 22, 1999

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