Why the 40-year cycle is bad news for stocks

Lost among all the bullish predictions for the 2014 market outlook is a salient fact that few Wall Street analysts are aware of.  What they fail to realize is that the powerful 40-year cycle bottoms later this year.

Just how powerful is the 40-year cycle?  Well consider that in the previous 120 years the 40-year cycle bottom has never failed to produce a major market decline.  From the decline in late 1894 to the corrective pullback of 1934 to the devastating decline of 1974, the 40-year cycle has always made its presence felt in the stock market. 

It’s worth examining the 40-year cycle since its influence is already being felt as we enter the first month of the new year.  The Kress 40-year cycle belongs to the category of yearly cycles of the first magnitude and is described by Mr. Kress as the Primary Bias Cycle for equities.  The 40-year cycle is arguably the most powerful of the long-term cycles which composite the Grand Super Cycle of 120 years. 

The 40-year cycle is also harmonic of the 20-year cycle and bottoms along with the 20-year cycle every fourth decade.  The most recent 40-year cycle bottom at the time of this writing was in October 1974 while the most recent peak of the 40-year cycle occurred in October 1994.  The next 40-year cycle bottom is scheduled for late September 2014, which coincides with the final low of the latest Kress 120-year Grand Super Cycle.

The 40-year cycle has special significance in that it can be divided by the Fibonacci number five as well as the Fibonacci number eight.  The 40-year cycle is the product of eight fives (8 x 5 = 40), with five being the number of dominance according to Kress.  Accordingly there are five 8-year cycles within a complete 40-year cycle. 

This brings us to the next aspect of 2014 worth mentioning, namely that the 8-year cycle is scheduled to bottom later this year.  Keep in mind that nearly every previous 8-year cycle bottom year was an extremely rocky one for stocks.  The 8-year cycle bottom years of 1998 and 1990 certainly come to mind.  This is the cycle which is most likely to witness trouble in the financial sector. 

The 8-year cycle that bottomed in October 1998 was a powerful one, and before the cycle put in its final bottom it was quite nearly disastrous to the U.S. and global financial markets.  It was one of the catalysts, or at least had a negative impact, upon the notorious Long Term Capital Management Group (LTCM) meltdown, a Russian hedge fund, which figured prominently in the troubled headlines of the summer and fall of 1998.  Concurrently, a crisis in the Russian ruble along with a currency crises in Argentina and Brazil and a commodity market breakdown made it seem as if the entire world’s financial system was on the brink of collapse.  The following graph shows how sudden and severe was the final bottoming phase of the 8-year cycle that year.

The previous 8-year cycle bottom was in 1990, a year that was bad for stocks and for bank stocks in particular.  The Savings & Loan (S&L) crisis was at its worse at that time and a large number of savings institutions became insolvent that year.  Indisputably, the 8-year cycle bottom made its impact known to investors in 1990. 

Prior to 1990 the 8-year cycle bottomed in 1982, which marked the formal end of a 14-year bear market for stocks.  The great secular bull market of 1982-2000 was heralded by the 8-year cycle bottom of ’82. 

In view of the two important long-term cycles bottoming this year, perhaps it’s no coincidence that we’re witnessing a revival of emerging market troubles.  Argentina is faced with the specter of default while Brazil’s currency is under pressure.  A potential debt crisis brewing in China has the potential to roil global markets on a scale not seen since 2008.  The Emerging Markets ETF (EEM) chart shown below throws into relief the extent to which these countries are being roiled by the final “hard down” phase of the 40-year cycle.

As economists have already discovered, an increase in deflationary pressure is possible further into 2014, which in turn could increase financial market volatility.  Accordingly, investors should be prepared for anything and should remain leery of the unfettered optimism of Wall Street’s legions of ultra-bullish pundits.

Kress Cycle forecast for 2014

At the start of every New Year we always publish a Kress cycle “echo” forecast for the year ahead. For the benefit of those unfamiliar with a Kress Cycle “echoes,” these stock market patterns are based on four key yearly equity market rhythms. These rhythms tend to repeat and have therefore been invaluable in providing a rough guideline or “road map” for what to expect in the coming months.

What exactly are Kress cycle echoes? Quoting at length from chapter 4 of the book on Kress Cycles: “In any given year, one or more of the Kress Cycles is dominant. Market moves are determined by the actions of the cycles, whether the cycles are in the peaking or the bottoming phase and it’s our task to ascertain which of the multiple cycles are most dominant.

“In 2008 it was the simultaneous peak of the 12-year cycle and the bottoming 6-year cycle which exerted a profound influence over the market. In 2009 the most dominant cycle was the 10-year cycle, which peaked in the late September/early October time frame. One of the things I’ve learned from Mr. Kress is that while the peaks and troughs of the various yearly cycles are fixed in time, during any given year one can use certain key cycles as “mirrors” or echoes if you will, of the same cycle in a previous time frame. Those key cycles, according to Mr. Kress, are the 6-year, 10-year, 30-year and 60-year cycles.

 “With these four cycles we can look back at the comparable time frame and make important observations about past market patterns in relation to today’s market action.” [Pg. 83, Kress Cycles]

Let’s start with a review of last year’s echo analysis. The Kress cycle echo for 2013 was based on the years 2006 (6-year rhythm), 2003 (10-year rhythm), 1983 (30-year rhythm) and 1953 (60-year rhythm). Based on an analysis of these four rhythms, here’s what I concluded in the January 2, 2013 report:

“The 6-year rhythm…warns us to be especially wary of increased market volatility in February-March, the August-September period, and October-November. Of immediate interest, the dominant intermediate-term weekly Kress cycle is scheduled to bottom in March 2013, which increases the odds of a February-March correction for stock prices.”

As it turned out, the February 2013 correction was muted by the Fed’s vigorous effort at stimulating demand via its quantitative easing (QE) policy. A minor pullback can be seen in the S&P 500 chart for February 2013 during the period of the interim weekly cycle bottom, but it wasn’t as serious as it would have been under normal circumstances (i.e. without Fed intervention).

The anticipated August-September correction materialized, as you can see in the following chart. This was a product of the Kress cycle pattern echoing from the years 1983, 2003 and 2007.

There was no correction in last year’s October-November period, however, due to the market’s exceptionally strong internal momentum profile heading into the fourth quarter. In retrospect I erred in my expectation of an October-November 2013 pullback: in two of the four historical “echo” periods for last year the market actually made gains in the October-November period. These include the years 1953 (60-year echo) and 2003 (10-year echo). Thus the odds of an October-November 2013 market correction were actually only 50/50.

That was the year that was. Now let’s turn our attention to the year that is, namely 2014. The old saw that “No two markets, like snowflakes, are never exactly alike” should be kept in mind here as a disclaimer, but there is a cyclical basis for a similar pattern occurring this time around. In the past we’ve talked about the Kress cycle echoes which tell us that the stock market performance of any given year tends to loosely resemble the performance of the previous 6, 10, 30 and 60 years previous on an aggregate basis, with a special emphasis on the 60-year-ago period….[deleted in fairness to subscribers]

….What the above chart tells us is that the year 2014 has the potential to be an extremely volatile one – much more so than any of the previous five years since the post-credit crisis recovery….

[To read the entire 2014 forecast issue, subscribe to the Momentum Strategies Report today.]

What could go wrong for stocks -- and right for gold -- in 2014

Are investors too bullish on the stock market’s prospects for 2014 and too bearish for gold’s?  It would certainly seem that way based on the near unanimity of analyst consensus.  Most institutional analysts have published bullish forecasts for equities in 2014 and a bearish, or at least cautionary, outlook for gold.  The favorable forecast for stocks and bearish gold outlook is based on the assumption that deflation remains at bay for the coming year.

But what if analyst expectations are disappointed and deflation rears its ugly head?  That is precisely the scenario we’ll discuss here.  For if deflation returns at some point this year it would easily upset the status quo for both asset categories.  

Not without reason economists have recently turned their attention to the specter of deflation.  Christine Lagarde, managing directly of the International Monetary Fund, last week stated her concern for a possible revival of deflation.  “If inflation is the genie, then deflation is the ogre that must be fought decisively,” she said.  Lagarde’s comment came out of left field considering that most economists have assumed that inflation, not deflation, is the new watchword.  Could it be that Lagarde is more perceptive than most economists?  Does she know something that most of us don’t?

This sudden return of the “d-word” to the limelight is actually quite timely.  In view of the upcoming 60-year Kress cycle bottom in September, the long-term cycle of deflation is currently in its final “hard down” phase.  And while it would be easy to sneer at a miniscule eight months, a lot can go wrong in eight months (as the events of the last few years have shown). 

The Financial Times has astutely observed that “it is hard to remember a period, other than in the months immediately following the financial crash of 2008, when core and headline inflation has been so low in so many different economies.”  This in spite of the record levels of liquidity that central banks have foisted upon financial markets.  The fact that inflation hasn’t become a problem is due solely to the undercurrent of deflation courtesy of the long-term deflationary cycle that is scheduled to bottom late this year.

With a growing number of economists becoming aware of a potential deflationary event in 2014, central banks have been even more vigilant.  The ECB is expected to expand its balance sheet even more this year in response to the decline in the euro zone’s core inflation rate.  Dr. Ed Yardeni highlighted the potential risk of a deflationary revival in a recent blog posting.  He noted that initially deflation might actually be bullish for stocks, even causing a “melt-up” since central bankers would respond to it be injecting more liquidity in the system. 

He added that if deflation prevails, however, a melt-up would most likely be followed by a melt-down, which in turn would worsen the deflation.  “In general,” he wrote, “falling consumer prices would be bad for corporate earnings.”

As for gold, many analysts erroneously assume that gold can only benefit from inflation.  Samuel Kress maintained that gold performs best as a safe haven investment during two phases of the 60-year inflation/deflation cycle: the final "hyper-inflationary" phase of the cycle (e.g. late 1970s) and the final "hyper-deflationary" phase (e.g. the last 10 years or so).  With deflation comes investor uncertainty, which in turn causes them to search for financial safe havens.  Gold and bonds are the two most obvious choices in the minds of most investors in times of uncertainty.  Indeed, as the last 10-15 years have shown that both gold and Treasuries benefit more from deflation than from inflation. 

What could go wrong for equities in 2014?  A revival of deflation could easily emanate from a credit crisis in China.  China’s stock market is reflecting the growing debt problem in China.  Below is a chart showing the Shanghai Composite index.  A debt-laden and slower growing China could have repercussions on the global economy, including the U.S. economic and equity market outlook, for 2014.  Should China’s problems begin to weigh on the U.S. and Europe, a gradual return to the safe havens of gold and Treasuries could emerge later in the year.

Also worth noting is that despite its internal economic problems, China’s gold demand has shown a dramatic increase in the past year.  Even more demand is expected heading into the start of the Chinese lunar New Year on Jan. 31.  Bloomberg reports that contracts traded on the Shanghai Gold Exchange jumped to a one-week high on Monday.  Last year, the Chinese imported an estimated 1,000 tons of gold, which more than offset the decline in gold-backed ETF holdings, according to Sharps Pixley.

If China’s voracious appetite for gold continues in 2014, even in the face of a slowing economy on the home front, it could add even more impetus to a turnaround for the yellow metal later this year.  Moreover, a palpable slowdown in China would eventually be felt in the U.S. and would give investors pause to reconsider gold as an investment safe haven as financial market volatility increases.

It’s worth mentioning that Bank of America Merrill Lynch strategist David Hauner has noted that commodity prices are back to the “ominous” highs of 2008 in South Africa and Turkey.  He believes this divergence “will have a significant impact on growth and inflation in 2014: weak pricing power means that higher commodity prices act as a tax on demand, slowing down growth and thus ultimately reigning in current account deficits and inflation.” 

Incidentally, take a look at the iShares MSCI Turkey ETF (TUR) which reflects the stock market situation in that corner of the globe.  This provides us with a simple overview of the tenuous economic situation in the Middle East region.

South Africa’s stock market isn’t too far behind Turkey’s in terms of global underperformance (below).

In his latest research report, Hauner observed concerning China that the country’s “rebalancing is a closely connected disinflationary factor.”  He added that consumer prices in Europe, the Middle East and Africa “are highly correlated with China’s with a lag of a few months. In fact, the betas to China and to commodities are themselves highly correlated, likely as demand in China is the key factor driving both.” 

He concludes that the sharp drop in China's headline inflation from 3.2% to 2.5% “is likely to have a dampening effect” on consumer prices in Europe, the Middle East and Africa in the coming months. 

In other words, Hauner’s analysis loosely corresponds with mine that a pick-up in deflationary pressure is possible further into 2014, which in turn could increase financial market volatility and possibly lead to gold’s return to favor among investors.

Harry Dent vs. Bud Kress

A reader sends the following email: "Began reading your book, 2014: America's Date with Destiny recently.  I am sure you are familiar with Harry Dent.  He says deflation and crash that is coming will take gold down to 250oz. He says all asset classes will collapse because of deflation.  It seems logical to me.  How can you & Kress be at odds with him?  A little confusing to me.  What about hedge funds?  They as you say are levered to the moon.  If they have to meet margin calls, will they not have to sell everything like they did in 2008 including gold and silver?  I think the easy money has been made in the stock market since March 2009.  However, I am really confused about the metals.  Your response appreciated."

Answer: Kress always maintained (and I agree based) that gold performs best as a safe haven investment during two phases of the 60-year inflation/deflation cycle: the final "hyper-inflationary" phase of the cycle (e.g. late 1970s) and the final "hyper-deflationary" phase (e.g. the last 10 years or so).  With deflation comes investor uncertainty, which in turn causes them to search for financial safe havens.  Gold and bonds are the two most obvious choices in the minds of most investors.  

As far as deflation and equities go, it actually works both ways.  Initially, deflation can cause higher stock prices due to lower input costs for companies that produce things and higher profit margins.  Also, deflation tends to scare central banks into dramatically increasing monetary liquidity, which of course stock investors love.  However, the melt-up in stock prices caused by the initial onset of deflation sows the seeds of its own demise.  Since the run-up is unsustainable in an ongoing deflationary environment, a collapse usually follows.

As for hedge funds, I suspect they've sold out a substantial portion of their long positions in the metals over the last year or so.

A contemporary art bubble?

Along with all-time new highs in the stock market, it’s not unusual to see affluent investors flaunt their newfound wealth by splurging on expensive collectibles.  It comes as no surprise then that 2013 was a blowout year for fine art sales.

To take just one highly quoted example, Francis Bacon's "Three Studies of Lucian Freud" garnered a record $142 million bid at auction.  But 2013 was also a banner year for vintage cars, books, wines and numismatics.

“It’s a pure demonstration of the wealth of the top percentage throughout the world,” asset advisor Michael Moses told Barron’s in reference to the record-setting year for art and collectible sales.  “We’re seeing astronomical figures because of astronomical wealth.”  As the ranks of the world’s billionaires has increased over the last five years – 800 new ones on top of the pre-existing 1,200 – the financial market boom has stimulated the acquisition impulse among this elite group.

                   

Bubbly prices for rare art and collectibles suggests that there is an almost “irrational exuberance” among the jet set.  Since the stock market recovery of the last five years has seen participation highest among the rich, could this not be interpreted as a sign that a correction looms ahead for stocks – and collectibles – at some point in 2014?  I view the near-mania conditions apparent at fine art auctions as a psychological indication that the wealthy are beginning to overreach, which in turn often sets the stage for a reversal of fortunes. 

This by no means is an objective indicator but the situation should at least be considered a yellow flag as we proceed further into the year.

Bitcoin and the magazine cover indicator

It had to happen sooner or later and this week it finally did.  

The Bitcoin phenomenon made the front cover of a major news magazine when Bloomberg Businessweek ran a story on the intricacies of Bitcoin mining.  The impressionist art on the front cover was evocative of the dream of fabulous wealth entertained by many Bitcoin enthusiasts.

The question that naturally comes to mind is whether or not this qualifies as a legitimate "magazine cover indicator" and does it therefore have predictive value?  Historically, whenever an investment craze makes the front cover of a major magazine it reflects the saturation of that investment and implies that the value of said investment has (temporarily at least) overextended.  A "correction" or decline in the investment's value often follows soon thereafter. 

Bitcoin is a bit different than more classical investment crazes, however, and requires an entirely different set of tools to evaluate it.  The appearance of Bitcoin on theBusinessweek cover likely doesn't signal the end of the craze -- especially since the vital ingredients of full-fledged mania status are missing, viz. strong institutional and hedge fund involvement and widespread public participation.  What the cover could signify, however, is the commencement of an extended "internal correction" in Bitcoin's value.  

An internal correction can be defined as a lateral trading range-type market in which consolidation takes place over an undetermined length of time.  This would give Bitcoin a much-needed rest and would also take some of the heat off the market by removing it from the mainstream media spotlight.  This is necessary from the vantage point of the hedge funds who need a dull, uneventful market in order to quietly build a substantial position.  

Don't be surprised, then, if Bitcoin posts an underwhelming performance for a while.

How Washington is ruining the recovery

Columnists and newsletter writers are tripping over themselves to describe what they collectively believe will be a bullish year for stocks and the economy in 2014.  They point to the Fed’s artificially low interest rates and continued commitment toward a lower unemployment rate as key reasons why the party will continue in the coming year.  They also believe that government intervention both at home and abroad will produce a sixth year of recovery.

Even the most famous of bearish economists, Dr. Nouriel Roubini, has joined the bullish bandwagon for 2014.  The infamous “Dr. Doom,” who correctly predicted the 2008 economic collapse, has been incorrectly bearish for much of the past five years.  In his 2014 outlook, published on the Project Syndicate website, he states that the risk of economic shocks is becoming “less salient” due to central bank-led monetary stimulus and government intervention. 

Yet ironically, it is the continued intervention of governments that may well undo the recovery of the last five years.  Each time the economy makes a forward stride and consumers begin to improve their balance sheets, they are penalized by Washington in the form of higher taxes. Obamacare represents one such tax penalty to consumers.  Corporations, meanwhile, are being penalized by the recent minimum wage hike, which will pinch already-tight profit margins.

What we’re faced with entering 2014 is dual policy structure between central bank monetary strategy and government fiscal strategy.  In effect, Washington continues to embrace a backward-looking austerity policy even as the Federal Reserve is desperately trying to increase monetary liquidity.  Neither side is coordinated, which explains the disjointed nature of the economy as well as the mixed results.

The Fed has also made clear its intention of tapering its asset purchases in 2014, going so far as to announce the first stage of paring bond purchases in December 2013.  What the Fed fails to realize, however, is that this effort is premature.  With the 60-year deflationary cycle not due to bottom until September/October of this year, an early diminution of bond purchases could prove to be disastrous – especially if deflationary pressure in Europe and/or economic trouble in China flares up in the coming months. 

Cycles analysts realize that 2014 has the potential to be a turbulent year, certainly much more volatile than previous years.  How 2014 turns out will largely hinge on Washington’s continued poor policy choices.  A stubborn insistence at embracing austerity policies will put a drag on the year ahead and will only add to the deflationary undercurrent courtesy of the long-term Kress cycle.

Now what about the gold outlook for 2014?  Goldman Sachs analyst Jeffrey Currie sounded yet another bearish note for gold on recently.   Goldman’s head of commodities research told CNBC that his end-of-year price target for 2014 is $1,050, which represents a 16 percent decline from current prices.  His forecast is predicated on continued economic recovery in the U.S.

If Currie is wrong and the U.S. economic recovery stumbles in 2014, gold will have a reason to rally as investors turn to the yellow metal as a safe haven from economic uncertainty (as they did in the years leading up to 2011).  

Surprising hedge fund plays of 2014

A number of hedge fund managers have already begun to make waves at the start of the New Year.  In this commentary we’ll look at a couple of areas where hedge funds have taken big stakes and which could have major repercussions in the year ahead.

The first surprising hedge fund play of 2014 has emerged not in an established stock or commodity, but in the emerging digital payment platform known as Bitcoin.  While purists insist it is neither a currency nor a commodity, there’s no denying the growing popularity of Bitcoin.  The digital unit of stored value is attracting more and more interest from a wide array of individuals seeking an alternative to fiat currencies.  Now it seems that even major financial institutions are set to enter the fray.

As with any speculative medium, it was only a matter of time before hedge funds jumped on board the Bitcoin phenomenon.  According to a Bloomberg report, a San Francisco-based hedge fund is looking for a junior Bitcoin trader.  As one reporter put it, “Where big money is, hedge funds go as well.”

The Bitcoin protocol will undoubtedly attract more interest from hedge funds, which in turn will push its value higher.  As an analyst interviewed by Bloomberg pointed out, “Huge price fluctuations is exactly what [hedge funds] are looking for.  [They] love nothing more than mad volatility, and that’s exactly what you’ve seen in Bitcoin.”  And as we’ve seen in all too many cases, when hedge funds commit their capital to anything that’s already in an established uptrend, it can only succeed in generating additional upside momentum. 

Analysts have noted the lack of liquidity in the Bitcoin market and have suggested this as a reason why a bubble may not grow to gargantuan proportions.  Conventional trades in Bitcoin aren’t possible at this time due to the extremely slow transactions times, but that will likely soon change with Wall Street’s increasing presence in the market.  Hedge fund managers are momentum specialists who not only thrive on upward trending markets, but who can collectively create a manifold increase in momentum in the markets they focus on. 

Consider for instance the presence of hedge funds in certain individual China stocks.  You’ll recall the bubble in U.S.-listed China stocks from a few years ago.  While many of these stocks have since deflated, there are still to be found a few conspicuous examples of the active influence of hedge fund managers.  At the time the hedge funds took speculative positions in certain low-priced China shares, these stocks were highly illiquid.  Sometimes two or three days would go by without a single transaction being made in them.  Yet this didn’t deter the “hedgies” from taking a large stake in them. 

Two examples that come to mind are Ping An Insurance Group Co. (PNGAY) and the U.S. listed version of Agricultural Bank of China (ACGBY), both of which are known to be heavily owned by hedge funds.  To this day, despite China stocks being in a bear market, PNGAY has not only seen increased liquidity due to hedge fund presence, but the stock recently experienced a run-up that can only be attributed to hedge fund-created momentum.  Note the follow chart which shows PNGAY’s price trend in relation to the sagging Shanghai Composite Index, the main benchmark for Chinese stocks.  After experiencing a “blow off” top in November-December, PNGAY has since sagged.  Yet the heavy trading volume and upside momentum of recent months is testament to the power of hedge fund speculative activity in a historically illiquid market.

From the above example we can learn an unmistakable lesson, namely that hedge fund presence in Bitcoin is a double-edge sword.  While it will only serve to attract more attention toward the emerging virtual currency and eventually increase its liquidity, it will also create ever-increasing price gyrations.  This will defeat the goal of Bitcoin’s stability vis-à-vis the dollar that many of its exponents had hoped for.  In short, the early appearance of hedge funds in the Bitcoin market virtually assures the expansion of a massive bubble – and its eventual implosion. 

In the gold market many hedge funds have raised their bullish bets on gold to a six-week high.  The net-long position in gold jumped 19 percent to 34,104 futures and options in the week ended Dec. 31, U.S. Commodity Futures Trading Commission data show.  Short holdings slid 4.6 percent to 72,571, the lowest since Nov. 19. 

Billionaire hedge fund manager John Paulson, however, is the largest holder in the SPDR Gold Trust (the biggest ETF).  He told clients recently that he personally wouldn’t invest more money into his gold fund because it’s not clear when inflation will increase.

While not specifically a hedge fund, the gold outlook of investment bank Goldman Sachs is also worth noting.  The group foresees a decline of at least 15% for the yellow metal this year.

“We expect gold to continue to fall as better data from the U.S. continues to see interest rates rise, causing reduced demand for non-yielding gold,” wrote Goldman Sachs’ Eugene King in December.  “We expect outflows from ETFs to continue and a reduced rate of central bank buying.  Better jewelry demand on a lower price and physical buying of bar and coin in India and China, in our view, will be insufficient to support the price.  We forecast gold at US$1,144/oz in 2014.”

Goldman’s Jeffrey Currie, head of commodities research, believes that prices are “likely to grind lower” through 2014.  Further, he believes the metal will reach $1,050 by the end of 2014, according to a Nov. 20 report.

You can mostly discount what the bankers are saying, but Goldman seems to be an exception since its prediction tend to be reasonably accurate.  I suspect this has more to do with Goldman’s ability to set an agenda that Wall Street follows (i.e. self-fulfilling prophecy) than with any prognosticative ability on their part.  At any rate, it normally pays to find out what the boys at Goldman are saying.

Stock market outlook for 2014

Stocks sagged on Monday as the annual “Santa Claus rally” season came to an end last week.  As Stock Trader’s Almanac points out, “Santa Claus tends to come to Wall Street nearly every year, bringing a short, sweet respectable rally within the last five days of the year and the first two in January.”  Santa Claus did indeed appear on Wall Street this time around but was a bit stingy compared to the previous five years. 

This year’s Santa Claus rally began with the S&P 500 Index (SPX) at 1,828 and ended with the index at 1,831 for a miniscule 3 point gain.  While each year’s Santa Claus rally season since December 2008 has witnessed a net gain, this one was by far the smallest.  (The last seasonal loss occurred during the Santa Claus season of late 2007/early 2008, which of course heralded the credit crisis).

“Santa’s failure to show tends to precede bear markets,” writes STA, “or times stocks could be purchased later in the year at much lower prices.”  STA discovered this phenomenon in 1972. 

It’s probably worth mentioning that the last time a similar Santa Claus rally failed to result in a significant gain for the SPX was in the December 2006/January 2007 period.  At that time the Santa Claus rally delivered a net zero gain – the SPX opened the 7-day season at 1,418 and closed it at 1,418.  If there was any predictive value in this it was that 2007 would go on to be a turbulent year leading into the infamous credit crash of 2008.  It’s also worth noting that while the S&P did deliver a net gain for the year 2007, the gain was very small and the year itself could almost be classified as a net neutral, range-bound year for stocks as defined by the S&P 500 (the NASDAQ 100 and Dow 30 indices did much better than the SPX in 2007).

One must be careful of being overly dogmatic in assigning too much weight to the Santa Claus rally phenomenon, for as with every stock market seasonal tendency it can sometimes be misleading.  If there is any inference to be drawn from this year’s Santa Claus rally result, however, it’s that we should be prepared for the possibility that 2014 will be a much bumpier year for stocks with more downside potential during cyclical weak spots, as per our discussion in the 2014 Kress cycle forecast issue of the newsletter.

One reason for greater caution when trading equities in 2014 is provided by the economists at Kiplinger’s.  In the latest issue of The Kiplinger Letter they write: “Look for public corporations to pour less into share buybacks this year.  Though a disappointment to stockholders who reap the benefits of fewer shares…That’s good news for economic growth.”  The economists believe that Corporate America will begin spending more of its record piles of cash in expansion and hiring.  Kiplinger points out that “buybacks end up acting as a brake on growth rather than helping to fuel it.”  By the same token, a reduction of share buybacks will likely take momentum away from the equities bull market. 

Speaking of buybacks, Dr. Ed Yardeni featured an important chart in his latest commentary (http://blog.yardeni.com).  “Since the start of the bull market during Q1-2009 through Q3-2013,” he writes, “share buybacks totaled $1.6 trillion and dividends totaled $1.2 trillion, summing to a whopping $2.8 trillion!  Corporate cash flow rose to a new record high of $2.3 trillion (saar) during Q3.  Yet nonfinancial corporate net bond issuance totaled a record $665 billion over the past four quarters through Q3, with issuers using some of the proceeds to buy back their shares.”

According to Barron’s, the ratio of insider transactions has reached a high level of selling as you can see in the following graph.  Corporate insiders are apparently expecting a bumpy ride in the not-too-distant future as they have increased sales of shares. 

 We haven’t yet reached a turning point in the market, however, as most major indices are still above their 15-day moving averages.  The NYSE short-term directional indicator, moreover, is still rising as of Jan. 6.  The market appears to be somewhat unsettled, however.  While the Dow and SPX remain above their 15-day MAs, the NASDAQ 100 Index (NDX) closed below its 15-day trend line recently, as did the Market Vectors Semiconductor ETF (SMH).  Thus we have a classic “split tape” in the making.  Caution is in order for now.

Bitcoin’s prospects for 2014

Is it a bubble or mania destined for collapse?  Or can it beat the odds and become a viable alternative to the dollar?

That’s what many are wondering about Bitcoin, the electronic currency which has captured the Internet world’s imagination.  Many observers have dismissed the e-currency as a passing fad – a flash in the pan destined to suffer the same fate as break dancing and Beanie Babies.  This conclusion is far too simplistic, however.  Due to the complexities of the new currency the Bitcoin issue demands a deeper analysis. 

Looking beyond the rhetoric yields a complex series of possibilities for Bitcoin’s future.  Let’s start with the most glaring observation, namely the e-currency’s lofty valuation.  At its current level, Bitcoin is unquestionably too pricey to be considered as a legitimate alternative to the dollar.  The average American quite simply can’t afford to own Bitcoins, and few are technologically savvy enough to “mine” them.  This is one major obstacle standing in the way of Bitcoin’s widespread acceptance.

Bitcoin’s ride to stratospheric levels over the past year is reminiscent of the speculative bubble in the gold market – a bubble which eventually imploded and scared away multitudes of investors.  Runaway speculation caused its price to soar from $140 to $266 in only four days in April 2013, only to erase most of those gains a few days later.  In October and November Bitcoin’s value went parabolic, far exceeding the April run-up.  This in turn was followed by a sharp decline in December, followed by another recovery rally (see chart below).  Most recently one Bitcoin was quoted as being worth $842. 

It stands to reason that any commodity (or potential currency) which is subject to excessive speculation and wild volatility will never succeed in supplanting the dollar as a primary medium of exchange.  There must be relative stability before buyers and sellers will consider using Bitcoin as an everyday method of payment.   To that end a collapse in Bitcoin’s value would go a long way in paving the way toward this end.  But a deflation in Bitcoin’s value alone won’t secure its future as a viable currency.  Once Bitcoin has returned to a reasonable level the speculative element must be largely – if not entirely – eliminated to ensure that it doesn’t suffer a similar fate in the future. 

“For all its weird politics and bad press,” writes David Wolman in the November issue of Wired, “Bitcoin may just be the most ingenious system ever created for settling online transactions.  Done right, it could put small ecommerce sites on a level playing field with the likes of Amazon and Apple.”  He urges us to “commandeer it from the radicals and make it work for the rest of us.” 

To circumvent the volatility factor, Wolman proposes that individuals make it a habit to not hold Bitcoins very long and to convert them only when making an online transaction.  To this end, a San Francisco-based startup called Coinbase is offering merchants free conversion from Bitcoin into other currencies.  This allows vendors to accept Bitcoins as payment without having to maintain a cash register full of them.

Admittedly any proposal based on self-restraint is likely to fall far short of taming Bitcoin’s extreme volatility.  To that end, more extreme measures have been proposed to decrease volatility and thereby make the e-currency more attractive as a mainstream medium of exchange.  A group called the Digital Asset Transfer Authority is trying to establish guidelines for digital currencies such as Bitcoin.  E-currency advocates have even suggested the creation of a central authority to intervene when price fluctuations become too extreme.  Much of Bitcoin’s wild volatility is undoubtedly due to the fact that it hasn’t yet achieved the critical mass of widespread acceptance.  Venture capitalist Chris Dixon believes that everyday mainstream use of Bitcoin would help diminish the price oscillations. 

“This currency, like all currencies,” concludes Wolman, “needs to inspire trust to succeed.”  He suggests that centralization is required to tamp down on Bitcoin’s volatility problem, a suggestion that will no doubt rankle the die-hard members of the e-currency community. 

For owners of Bitcoin concerned with a possible loss of value, a more practical safeguard is in order.  Consider using a basic “stop loss” exit system based on a retro-fitted moving average.  An example would be the simple 60-day moving average, which has captured most of Bitcoin’s intermediate-term turning points over the years of its existence.  A 2-day close below the 60-day MA is a good rule of thumb for exiting Bitcoin in anticipation of additional volatility.  As long as Bitcoin stays above the rising 60-day MA, however, its dominant interim trend should be considered up.

As I concluded in my Dec. 18 commentary on Bitcoin, chart pattern analysis suggests there is more upside in the coin’s future before the bull market in its value comes to an end.  The breakout to new highs in Bitcoin’s price which occurred in November was preceded by six months of base-building.  In classical chart analysis this is normally a good indication of additional upside ahead. 

Beyond the near-term outlook is anyone’s guess.  Bitcoin will likely suffer the same fate as every speculative craze, namely eventual price deflation culminating in a crash in value.  The suspicion is that this will occur sometime before the end of 2014 while the long-term Kress cycles are bottoming.  The true test to the new coin’s value will in fact occur after a cataclysmic setback, for that will determine whether the public is willing to embrace a currency subject to extreme fluctuations.  It will also determine if the public is willing to risk capital in what may or may not be a safe store of value relative to the dollar.

Will the bears prevail in 2014?

So far the Santa Claus rally has lived up to expectations, delivering a 2% gain so far in the brief window that encompasses the historical season.  Keep in mind that the Santa Claus rally season began on Dec. 26 and ends on Jan. 3. 

As I pointed out in the previous report, the Santa Claus rally phenomenon has resulted in a net market gain 75% of the time for an average gain of 1.5% since 1950.  Whenever the market has failed to rally during this seasonal period it has tended to produce bear markets at some point in the subsequent year.  This has led to the famous saying, “If Santa Claus should fail to call, bears will come to Broad and Wall.”

Although I see no reason to doubt that the Santa Claus rally will once again deliver a net gain for stocks, there is already a reason for concern as we head into 2014.  The yield on the benchmark 10-year Treasury exceeded the psychological 3% level on Friday.  Once Wall Street traders return to work after the holidays we could witness a reaction to this developing since stocks generally don’t like rising rates (i.e. falling bond prices)….

Once the initial upside impetus from the interim cycle dissipates in a few days the market will be potentially vulnerable to selling pressure.  The bears have been waiting restlessly for their chance to pounce after being routed for the last 10 weeks.  There are preliminary warning signs [deleted in fairness to subscribers]…. 

The 10-year Treasury Yield Index (TNX) has reached its highest level since July 2011.  Sustained rallies in TNX normally end with equities coming under pressure sooner or later….[Excerpted from the Dec. 27, 2013 issue of Momentum Strategies Report]