Technical analysis continues to fascinate me. In case you don't know, technical analysis is the practice of studying stock price data, generally through historical charts, to make a prediction about the future direction of stock prices. I'm sure the technical "analysts" will say that there's more to it than that, but that's my take.
Most of the respected members of the financial industry reject technical analysis as "reading the tea leaves". In other words, it is a false practice in which success is more a matter of luck than any sort of learned skill. The academic community, in particular, derides technical analysis as more of a pseudoscience than a legitimate discipline.
Nonetheless, I like to hear what the chart readers have to say. Much of technical analysis centers around the idea that markets are highly cyclical, and the charts give you insight as to when we have reached a top or bottom of any cycle. Knowing this, of course, means you simply plow your money in when a bottom has been identified, and the opposite at a top. There are two forms of cycles, the normal 3-5 year business cycle, and another longer cycle, commonly referred to a secular market cycle.
It is this last type of cycle that I want to discuss. I recently found a site that posted two charts that attempted to analyze the secular market cycle, and provide some insight as to where in the cycle we currently are. The charts are below.
Chart 1:
Briefly, here is what the chart says. The prices of the stocks in the S&P 500 are tracked going all the way back to 1871 on an inflation adjusted basis. This chart uses the official inflation numbers produced by the Bureau of Labor Statistics. What you see in this chart is the appearance of long range cycles; a peak and a trough that seems to occur every 9 to 30 years. Of course, timing a 9 to 30 year cycle can be awfully precarious. The chart also draws a regression "trendline" through the middle of the data. Essentially, it is a long range median.
The market timers would argue that you don't have to pick the exact top or bottom of the 9 to 30 year cycle. Everyone pretty much agrees that that would be impossible. The market timers would argue, however, that "secular" bear markets warrant additional caution, and market timing is even more prudent. Supposing we agree with that (which we don't), the bigger problem is determining how to identify when we are in a secular bear, and when it has ended.
According to chart 1, we are still above the long range trendline. This would imply that the secular bear market has not yet run its course. As we can see based on the prior secular bear market troughs, the trendline must not only return to the trendline, but drop below it.
Looking only at this chart, things seems pretty clear. We are in a secular bear market, and will continue to see volatile markets with a downward trend. Eyeballing the chart, I would say that prices need to come down another 20% before we reach a secular bear trough. Either that or move relatively flat for another 8 to 10 years as the trendline surpasses current prices.
Before we just accept this as fact, let's look at a second chart:
Chart 2:
Well, gee. Now we have a whole different story, don't we? So, let's start with what is different about the two charts. The Bureau of Labor Statistics (BLS) is the agency which tracks official inflation rates. They have numbers going back to 1913. In 1982, they made changes to the Consumer Price Index (CPI) calculation, which had a substantial impact on "official" inflation. In fact, it made inflation appear much lower. Is anyone surprised that the way that inflation is calculated changed in 1982, amidst a period of sky high, double digit inflation? Social Security has a cost of living adjustment (COLA) that is indexed to the official CPI stats. In 1980, COLA was 14.3%, 1981 was 11.2% and in 1982 it dropped to 7.4%.
I'm not charging conspiracy, but let's be honest, does the current inflation numbers really represent what most of us have experienced. In this decade, the official inflation numbers have averaged 2.72%. This is historically an extremely low rate of inflation. Does that even seem right?
Now, why are the inflation numbers so important? Well, this entire chart is based on inflation adjusted prices. A small change in the assumed rate of inflation, and the chart looks completely different. All of a sudden, the market is no longer overvalued. All of a sudden, it is BELOW the trendline, and by an amount large enough to call it a Secular bear trough!
My conclusion
It is dubious, at best, to believe that there are grand 9 to 30 year cycles that are interrelated and consistently occurring around a straight line 140 year median trendline. However, given that assumption, how accurate is anyone's ability to predict when the cycle is coming to an end? I believe these two charts have demonstrated for us that given a set of data (in this case, stock prices and inflation rates), it is extremely difficult to determine the future direction of the graph.
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