Technically Speaking, August 2008

Editor’s note: This has been adapted from previously published client research. Some figures have numbers embedded in the graphics which do not match the caption number. We apologize for the confusion.

Intermarket cycles can change the way we look at asset cycles. This article, starting from 30 year mirroring of commodity and equity cycles, inflation and deflation cycles, this article also redefines Sam Stovall’s sector rotation structure giving new insights about the world order ahead.

It was not just investment gurus, but philosophers and painters who talked about simplicity being solved complexity and a very powerful investment approach. We also saw a Nobel Prize awarded to a simple thought that there is no economics without psychology. Sentiment comes before rationality and human beings are nice and dumb, not profit maximizing smart souls. Crowds are accordingly involved primarily with instincts, biological drives, compulsive behavior and emotions. Hence market success is less about economics than it is about psychological competence.

Many experiments regarding crowd behavior also prove that an individual transforms into another being when he becomes a part of the crowd, so much so that he completely abandons logical and rational thought. He does not think as much as herds. Solomon Asch, a Harvard professor, conducted the matching lines experiment (Fig 1).

Figure 1

Individuals and groups were asked to match the length of a line with three other lines. Individuals in isolation made a mistake less than 1% of the time. However, when placed in a group that had been instructed beforehand to claim the mismatched lines were actually the same, 75% of participants agreed with the majority. This was true even when the actual difference between the lines was very significant. Participants lacked the nerve to disagree with the majority.

Another interesting experiment demonstrating the lack of rational thought was a group exercise conducted by Stanley Milgram of Yale. Individuals were ordered to inflict pain on an innocent victim (who was acting) in the interests of an important cause. More than 60% of the subjects were prepared to obey instructions and administer the highest and most lethal dose of electricity, even after the victim was, to all intents and purposes comatose.

If pain infliction seems too different from the stock markets, we have numerous mathematicians and scientists proving the same simplicity mathematically. It was George  Kingsley Zipf, an early twentieth century scientist who revolutionized our understanding of power law and revealed their astonishing presence throughout society and nature. Zipf’s law states that the most common word used in language is a constant factor (say two times) more common than the second most common, and the second most common word is twice as common as the third etc.

In 1955 Herbert Simon sought to unify the observations of Zipf and others by formulating a single common explanatory model for many of the systems displaying power-law behavior, including language, population and wealth. Stock markets around the world also work on a power law. In 2003 in a paper submitted to Econophysics, Kaushik Matia and I illustrated that Indian market price fluctuations exhibited an intermediate form between Power Law and Gaussian behavior. This aberration also did not last long when Sitabhra Sinha, re examined the prices in May 2006 finding the price fluctuations exhibiting a power law.

Another interesting aspect was that of Fractal geometry, published in 1977 when Benoit Mandelbrot proved that Fractal Geometry was mathematical. His work extended the area of late nineteenth century mathematicians like Giuseppe Peano, who demonstrated the completed inadequacy of the common idea of dimension. The subject of fractal geometry can not only calculate coastline lengths but is used in seismology and a host of other scientific applications. It is scientifically proven that rugged fractals are more efficient in saving coastlines than concrete walls. The fractal nature of the web is also behind Google’s success.

The worldwide web is in the form of a bow tie with four components: a core, inbound links, outgoing links and the disconnected pages. Any way you slice the web – geographically, topic specific clusters, organizationally or into groups of pages owned by the same person – the bow tie shape emerges again and again. This is the same fractal behavior in nature, societies and price behavior that connects all of us. This is also a reason why Elliott’s wave principle and Dow’s theory have survived more than 125 years. 

Fractal self affinity, as Elliott said, is fundamental to nature and all human activity leads to a socionomic process. It follows a law, repeats in time, has a definite number and pattern (Fig 2) and covers areas as diverse as Gold prices, population movement, prices of seats in stock exchanges, patent applications, commodity prices, epidemics, real estate, politics and the pursuit of pleasure.

Figure 2

All of this fractaled nature of Economics, nature and universe has a fixed periodicity linked with it, i.e. there are cycles running through them. Edward R Dewey started the Foundation of Cycles early 1940’s when he realized the uncanny similarity in  data cycles found by Hyde Clark in business activity, Benner in industrial prices and Seton in animal population cycles. Idealized cycles are shown in Figure 3

Figure 3

The 11 year sunspot cycles is linked with human excitability and stock markets. There is a nine year cycle linked with credit, and interestingly the rise of deposits every nine years is inversely linked to the rise in people going to church. Other research has identifi ed a 25 year volatility cycles (Fig 4), a 17 year international battle cycles, and dividend cyclicality. Interest rate cyclicality is a reality that flies in the face of believed truth that the central banker is in charge.

Figure 4

The current linear research model (Fig 5) fails to assume the cyclicality of the market. The model works on an assumption of an economic growth that leads the positive news which leads to price growth and prosperity. Robert Prechter’s socionomic model was the first to illustrate the social mood cyclicality.

Figure 5

The alternative research cycle (Fig 6) considers the social mood at the start of all human action and activity. A positive mood reflects in productivity and creation which reflects in markets and finally confirms as the economic cycle turns up. The positive economic cycle creates positive news and hence the self feeding feedback loops. On the other hand with a negative social mood, it’s the negative feedback loop which works.

Figure 6

Sam Stovall, chief global strategist, S&P recently spoke to the MTA (Market Technicians Association). He was wondering why he was invited as S&P already had a few CMTs. The reason Sam was invited was because his sector rotation structure (Fig 7) are the first steps of a fundamental thought towards cyclicality, which is a technician’s domain. As we move ahead the thick line between fundamental and technical starts to erode. John Palicka’s fusion analysis is another attempt to bridge the two subjects.

Figure 7

Stovall’s sector rotation identified five economic cycle stages in the market – early expansion, middle expansion, late expansion, early contraction, and late contraction. The market sectors move within these five stages. Technology and transportation perform well in the early expansion; capital goods in the middle expansion stage; basic materials, energy, and consumer staples in the late expansion stage; utilities in the early contraction stage; and financials and consumer cyclicals in the late contraction stage.

The father of intermarket analysis John Murphy, defines four broad asset classed of bonds, currencies, equities, and commodities and their linkages. He details how bonds leads equity markets and how commodity upcylces are the inverse of equity cycles.

Just like all other fractals, a link runs through market cycles which Tony Plummer writes about in his book on forecasting  financial markets. Plummer classifies the broad economic cycles into TRIADS with base, trend and terminal cycles. Cycles are seen from low to low and not from high to high, as bullish market bias extends markets longer pushing the cycle top ahead of the symmetrical high. Bear markets correct faster. This is why the bear cycle tops are translated (biased) towards the left and are likely to occur before the symmetrical cycle tops. Plummer identifies behavioral traits linked with the respective base, trend and terminal cycles. Base cycles are characteristic of indolence, recuperation and rejection. Trend cycles are  characteristic of confidence, change and deception. Fear, resistance and accusation are characteristic of final terminal cycles. All these cycles have a three wave pattern labeled as 1-2-3 up and a-b-c down (Fig 3).

These triads build the economic cycles and exhibit a power laws behavior. Kitchen cycles (Fig 8) last from 3 to 5 years and on average are 3.33 years long. These are known as inventory cycles and are close to the well-known US presidential cycles. These are the only cycles conventional economists believe to work. Next comes the Juglar cycle, which lasts for 7 to 11 years and average around 10 years, known popularly as the decade cycles. Juglar cycles, which follow the capital investment cycles, are three times the length of Kitchen cycles. Then next power law that is three times Juglar cycles take us to Berry cycles also known as the infrastructure cycles. Berry cycles last for 25 to 30 years, averaging around 30 years.

We have seen 25 year cycles in commodities, gold and silver ratio, and volatility. A step ahead on power law takes us to the Strauss and Howe cycles (crisis cycles) of 90 to 99 years. Plummer makes an interesting observation about Kondratieff cycles while classifying the triads from 3.33 years to 90 years. Kondratieff is not an economic cycle as Kondratieff saw prices rising and falling in long waves. Not all Kondratieff lows are major depressions because not all Strauss and Howe lows will coincide with a Kondratieff low.

Figure 8

Strauss and Howe crisis alternate between deflation and accelerating inflation. This is why Plummer believes we have finished the deflation Strauss and Howe metacycle in 1946 and now we are in the inflationary cycles that should push until 2030 marked by a possible world war. With a rough calculation and one can see that India’s first war of independence and US civil war of 1857 had an uncanny similarity. This, we at Orpheus believe, was the second 90 year metacycle, the first starting somewhere near 1720, coinciding with the start of capitalism. Hence we are indeed in the revolution cycle which ends the 270-300 years of economic activity near 2030. We are not sure how inflationary things may get or whether we are indeed heading for hyperinflation and destruction of real money, the indicators more indicate at the latter than the former. The intermediate pause before the last 30 year cycle starts should be around 2012-2014.

This should be marked by economic growth accompanied by continued rise in commodity prices – Gold at $3,000 and Oil potentially much higher. New sectors to watch should be the alternative energy and biotech until 2020 and beyond.

Intermarket cyclicality is a subject coined by us at Orpheus. This subject not only redefines Stovall’s sector rotation, but it also attempts to extend market cyclicality from an intermarket perspective. Since cycles work on Triads, Sam’s sector rotation sectors can be reclassified in three broad sectors – early economic, mid economic and late economic cycle sector. Early economic is led by Financials, Information Technology and Discretionary; mid economic by industrials; and late economic consisting of Energy, Materials, Staples and Utilities. As we head into the terminal Kitchen cycle and Juglar cycle low in 2010-2012 the late economic cycle sectors should outperform the market.

This means energy, utilities, staples and materials sector stocks should have more upside left. According to intermarket cycles, the 30 year Berry cycles is linked to equity cycles. That means equity markets grow and decay in about 25-30 years cycles. This is what the gold-silver ratio (the metals maze) and volatility cycles highlight (25 yr cyclicality). This 30 year equity cycle is inverse of the 30 year commodity cycles. This means when equity rises, commodities fall and vice versa. 1975-80 was a commodity market top and an end of equity bear market in US.

And 2000 was an equity market top in US and a start of a commodity boom. The current commodity boom should end in the 2024-2030 (Strauss and Hauss) metacycle low with potential highs in the 2012-2015 time windows. It is in this time frame equity markets should make the decade low. Intermarket cycles can extend the cycle explanations to regional allocations between Asia and the west, between inflation and deflation and between interest rate and yield cycles.

Sector rotation remains a key intermarket strategy for portfolio allocation but in terms of early economic, mid economic and late economic instead of what is classified by Stovall’s five stage economic cycle approach. Commodity and equity intermarket analysis also suggests that materials, metals, chemicals, staples and pharmaceuticals could be defensive and relative performers. Intermarket cyclicality can also help time moves in and out of large and small cap sector stocks. The subject can also help create low correlation combination portfolios to better balance the overall portfolio return to risk profile.

The current multi decade cycle is inflationary and should see rising interest rates. Many emerging markets are between the late expansion and early contraction stage. This means that the sectors which will outperform are energy, staples, materials and utilities. This should happen for at least a primary (more than 9 months) time frame. The late economic sector cycle is in sync with the ongoing 30 year commodity cycle (Fig 9), which started in 1998-2000 and should top in 2012-2015.

Figure 9

This is another reason why food, material and commodity prices will continue to rise. However, we should not forget that this commodity cycle is a 1-2-3 structure up. And we have had no retracement of primary degree as of the time of this analysis. This is the very reason a sharp retracement is pending before the CRB (Reuters Commodity Index) regroups again and heads higher. The real depression activities are likely to start then. The world in 2012 will be a stranger place with the lower billion people of the world struggling for food and the top billion still getting richer. The hedge funds (the ones that survive) which will create news will likely be the ones doing Long Water – Short Oil strategies. The world beyond 2012 will be ruled by global macro funds; market psychology will gain more prominence; fractal forecasting might be taught at Yale. Cycles will get their place in statistics as the relentless cyclical change pushes ahead. And all this will happen while we wonder about the randomness of the world we live in, unaware of the simple structures that got us so far.