A Well Respected Cycle Theory Cannot Be Ignored And It Is Telling…

A well-accepted theory that visualizes and explains the massive risks in stock markets and world economies today.  If you closely read this newsletter, and then read it again, referring to the charts, you will see how major the risks are today.  This will be a series of newsletters looking at key metrics; historical insights; and other key cycle tools that will address how significant the risks are, yet are being ignored, as they always are when we are at the end of a major cycle.

Humans biggest failure at investing is their minds.  To explain further, people are known as ‘herders’ when it comes to investing. When people feel most comfortable to invest is when sentiment in the economy and with investing is at peak. History shows us that that is when corrections and crashes begin.

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The opposite side of this is that when sentiment is at the lowest levels, no one wants to invest, but hindsight always shows us that these are the period where the best opportunities lie.  As of today, sentiment numbers are near all-time highs. People overall are very confident, and few see the risks and realities as they are.  These are classic periods where a major rollover in stock markets and economies occur.

The problem is that investors have been trained by investment firms and banks to buy all the dips. There is a presumption that stocks always have to go up, and any small correction is nothing but a buying opportunity. What we expect to happen is that there will be a decent correction of 10 to 15% with little selling occurring. Then the markets will see a rally, fooling investors that the market has cleansed itself of its excesses and will once again reach new highs. After a minor rally, then stocks roll over again, with losses going beyond 20%. This would then be classified as an official ‘bear market’ at this level.

Investors once again will think the selling is over and look at these levels as a buying opportunity, driven by investment banks who say values are great.  If the correction turns into a crash, this form for the markets repeats itself, as it corrects, rallies and corrects more.  Generally, people only sell when panic creeps in, and they are down about 35% or more. Risks in the market are significant as you will see in the following charts.

Remember, look at these charts logically and not via emotion driven by media and investment firm/advisor rhetoric.

First, there is a great deal in this chart, but it is a close review of the Elliott Wave Theory as well as a high-level view of secular markets:

Let’s review this chart based on the five highlighted areas (purple circled numbers):

First, it is important to understand what Elliott Wave is. Ralph Nelson Elliott came up with this practical methodology and concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves.  It forecasts market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors.  Basically, it shows that there are many cycles that stocks and most things go through based on sentiment and levels of optimism or pessimism. Ralph Elliott theorized that these waves could be predicted and measured.  These price patterns work in all markets and in multiple timeframes.

The Theory is that prices move in a five wave pattern within the direction of the larger timeframe trend.  Once those five waves have been completed, then prices start a three wave correction in the opposite direction before beginning another five wave pattern.  There are very long term waves (Supercycles) and waves of shorter duration as we will describe.  So let’s go through the chart and the five specified areas:

  1. This shows the different Elliott Wave cycles that we have highlighted in the chart.  There are more EW cycles then this, including micro and minuscule waves that traders use. Our focus is on the longer term waves that tell us where we are at in a cycle and when we can expect it to end.

There are six type waves we have highlighted on the chart. The first is the Supercycle where waves go from (I) to (V). The final wave of this major up cycle finished in 2000.Yes, the market has surpassed the level of 2000 in real terms, but it is well below its level relative to gold as you see in the chart below.

The peak for this ratio was in 2000 which coincides with EW theory.We are getting close to a peak in this cycle, which would also be the end of the Grand Supercycle, leading to significant downside risk in stocks, while at the same time, upside in the price of gold.  The ratio in this chart is simply the Dow Jones Industrial Average level divided by the price of gold. If gold rises, and the DJIA stays the same, the ratio falls and vice versa.  Again, for the ratio to crash as it has at the end of other major cycles, gold would have to run up significantly and/or the DJIA would have to crash. Look for a combination of the two.

The Cyle phase of EW ended in 2000, seeing the fifth wave end.This cycle began in 1932, and as we stated, ended in 2000.

The Primary phase of EW went from 1982 and again ended in 2000, with the final fifth wave ending.This period did present significant risk to a major collapse, and the markets did go down 50% but then rebounded. The reason that we have not entered a longer period of economic contraction/depression, and even a bigger, longer-term stock market collapse is due to Central Bank interventions and increased government debts. The problem is interest rates cannot fall much further. Central Banks can spill print money in the form of Quantitative Easing, but it is now shown less impactful; and governments, especially in the Western World, are outright broke, and many could argue bankrupt, especially if you include their unfunded liabilities (health care and pension obligations).Are they out of ammunition – if not today, they are close, as fiscal insanity cannot continue forever.

The cycles below these levels are the shorter term cycles that make up these larger cycles.Waves move up in 5 waves with the trend and correct against the trend in 3 waves. As you can see in the chart, we did highlight the a-b-c corrective phase from 2000 to 2007.Since 2000, Elliott Wave theory highlights that the last 1 – 5 waves are the last wave up ending wave 5 Primary, and leading to Wave 1 down in the next megacycle.

  1. The second area we have noted on the graph is the crash from 1966 to 1982, which was Cycle Wave 4 down.  This crash was a massive 73%, but still lower than the crash from 1929 to 1932 where Supercycle 4 ended. The crash as you can see on the chart was 85%. That was the beginning of the final Supercycle Wave 5 up.

If this trend continues and the next major down cycle is close to beginning, watch out below. With this cycle being the highest level of Elliott waves ending, will the crashes be higher than the two other crashes we noted?  It is very possible, given the massive excesses in the system today. We will address how the foundation of both the stock market and economies have gotten worse each year in upcoming newsletters.

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  1. This area of the chart highlights the longest term Grand Supercycles. It incorporates three major cycles, 1 and three up and two corrective or down.  The first cycle up went from 1695 to 1720, which used British stock prices.  The 2ndwave down went from 1720 to 1785. This phase ended with the American Revolutionary War.  The major wave three up started in 1785 and ended in 2000.  The longer term cycles have been debated, as the longer, you go, it is much easier to challenge the methodology.  Saying that the time frame of each long term wave is very close in time frame.  The current wave is the longest, which could easily be argued is due to Central Banks and government actions throwing trillions of dollars at the global economy and banking system to hold it up. This is unprecedented in history. Even with all the fiscal support, the recovery since 2009 has been the weakest in history, debt is by far the highest in history, and operating corporate earnings have been weak (earnings have been driven by corporate share buy-backs, not organic growth revenues) – a formula for disaster.

If this is the end of the Grand Supercycle, the path down, once it begins, will be long and painful.  The risk to stock markets is massive. Worse than this, the risk to a very leveraged financial system are real and dangerous. A major reset will be required. This means that economic instability will be at a paramount, with risk of a major depression. Stock markets and bond markets would crash, as well as real estate.  Massive amounts of debt in all areas, government, household, financial firms and corporate will be forced to be written off or restructured. This will lead to massive losses.

It is critical to note that no Cycle theories are written in stone, and timing can always be challenged. We have studied the Elliott Wave theory in detail and find it is excellent to understand waves that economies and stock markets go through. The timing at times has been less than perfect, especially with the long waves.  This simply means that you cannot use methodologies like this on their own. We utilize other well accepted timing mechanisms as to when to get out of stocks and when the massive reset will begin. In the interim, stocks that are very overvalued can become more overvalued. What strategies like this show us is that the foundation of stocks and economies are as weak as they have been in our lifetime.  If you understand how a fractured foundation will at some point break apart, you are ahead of most. You need timing tools as to when to get out, and we give those to our customers.

One other point is that other major Cycle theories back up Elliott Wave. This includes Kondratieff Cycle and Foundations of Cycles, both of which show that we are at the end of a major up cycle. We will review this in future newsletters.

  1. The area noted here is the potential crash that is near.  Remember, no crash or up movement is in a straight line.  What tends to happen during major crashes is that you get the first wave down. It could be 10 to 20% followed by a solid rally, fooling investors into thinking the correction is over. All it does is keep investors in the markets invested and has others buying in, thinking the market is running up again.  Instead, it rolls over after a rebound such as 10%, with the next major down wave occurring.   We will highlight this process in a further newsletter but here is a chart to give you an idea of how markets keep investors invested until the final collapse when all hope is lost:

The clear message here is that markets do not go straight up or straight down.The one thing to note is that during Phase 3, confidence is at a peak and investors are as complacent as ever.During Phase 1, the opposite is the case. Fear is at a peak, and investors are on the sell side, not buy side, causing massive losses and not taking advantage of the most opportune time to invest.

  1. The last section of the first chart to review is this area – Secular cycles.  First, it is imperative that our readers clearly understand what a secular cycle is. These periods are defined as an economy or market trend associated with some characteristic or phenomenon that is not cyclical or seasonal but exists over a relatively long period.  The periods tend to average 15 to 20 years in length. Secular bull cycles result in long periods of very strong stock market returns, with smaller corrections throughout.  Secular bear cycles provide very low or even negative returns throughout the cycle, with huge volatility both up and down. The smaller cycles within, the larger secular cycle are called cyclical cycles. So within secular cycles, you have a number of cyclical cycles, especially in secular bear cycles.  Here is an example:

As you can see, there are numerous cyclical cycles that make up a secular cycle. Secular bear cycles end by seeing the price earning level of stock markets crashing to levels in the 5 to 10 range. Currently, the Shiller Price Earnings 10 year average is just under 30.  It has a long way to go to get down to the low range to end the secular bear market.

We do believe that there is one final push up in this cyclical bull phase which should result in historically high sentiment (confidence) measures and one last all-time high. This would be a perfect time for stocks to start their next major cyclical bear crash.  Timing is never easy, but we are looking to the fall this year as a logical time for this process to unfold.

We will build on the argument of this newsletter by addressing other Cycle theories; price earning valuations; a historical look at secular cycles; debt as a percentage of GDP and their relationship; demographic and unfunded liability risks; margin debt levels; and many others.

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Matt Sammut
Founder & Chief Investment Strategist