Another look at the Year Five Phenomenon

Most investors are familiar with the Year Five Phenomenon, which assumes buoyant stock prices in the fifth year of the decade.  Yet few realize that there are also corollaries to this phenomenon, viz. a sluggish economy and negative investor sentiment.  All three aspects of the Year Five Phenomenon are a direct consequence of the 10-year cycle, which we’ll discuss in this issue of the report.

The 10-year cycle is the dominant directional cycle for equity prices.  Its influence can be seen clearly in most decades.  In the first half of the decade the cycle tends to create unusually volatile and choppy market conditions.  The second half of the decade, by contrast, is usually marked by steadily rising stock prices and often witnesses a runaway stock market.  Indeed, most stock market manias occur in the second half of the decade.  The reason for this is because the 10-year cycle bottoms at the end of the fourth year of the decade; the subsequent lifting of cyclical downside pressure in years five through nine accounts for the relentless bullish tendency of stock prices in most decades. 

It can easily be seen then why stocks tend to rise in year five of the decade.  It’s also easy to see why investor sentiment tends to be bearish during the fifth year despite rising stock prices.  Negative psychology is a consequence of the volatility and slowing monetary velocity during the previous year in which the 10-year cycle bottoms.  It takes about 1-2 years for the typical investor to recognize a shift in the market tide.  Therefore the lack of juncture recognition on the part of most investors is apparent in the fifth year of the decade. 

The fact that the 10-year cycle was down last year explains why the economy is sending mixed signals in 2015.  Consumer spending has noticeably slowed this year, as the latest retail sales figures have shown.  Another sign that willingness to spend right now is at a low ebb can be seen in the recent appeal for donations in the wake the major earthquake in Nepal.  According to reports, donors in the U.S. and other Western countries have been slow to respond to a United Nations appeal for $415 million.  Two weeks after the earthquake only 2 percent of that sum had been pledged.  By contrast, in other major disasters such as the 2010 earthquake and the 2013 Philippines typhoon, at least 60 percent of the goal was raised in the first two weeks after the event despite the fact that in both cases the requested sums were much larger.

A similar occurrence took place following the previous 10-year cycle bottom of 2004.  In 2005 the stock market spent several months of that year in a trading range before finally closing the year with a gain.  Moreover, the U.S. economy was slow that year while consumer sentiment was tepid and retail spending was sluggish.  The following year 2006 witnessed the proverbial coming out party for the consumer spending and stock market gains.  I expect the economy will show a similar pattern in the coming year with retail spending slowly picking up traction and showing improvement by the fourth quarter.  Next year should be the “coming out” year for the consumer and retail investor alike. 

Consumers have been adding to their savings stash this year, as previously mentioned.  Economists assumed at the start of 2015 that plunging oil and gasoline prices from late 2014/early 2015 would stimulate a consumer buying binge due to the savings in energy costs.  But instead of spending the fuel cost savings, consumers funneled that extra money into their piggy banks.  This creates a rather substantial reservoir of fuel for a future spending binge. 

Consumers tend to oscillate wildly between overspending and over-saving.  When they go too far to one extreme, the pendulum goes in the opposite direction.  When consumers are convinced that fears of a global economic slowdown are overblown, they’ll eventually emerge from their shells and start spending and investing again.

I note with interest that the New Economy Index (NEI) is still on a positive trajectory as of mid-May despite a slowdown in the more mainstream retail economic indicators.  NEI broke out of a multi-month sideways trend a few weeks ago and is near an all-time high as of this writing.  Although the indicator has been a bit sluggish since the breakout to new highs a few weeks ago, the chart still points to a positive intermediate-term retail spending outlook for U.S. consumers in the aggregate. 

Clearly, investor sentiment among investors is considerably less bullish than it was in the previous two years.  Aside from the residual effect of the 10-year cycle bottom, central bank monetary policy can also be blamed for this.  So far, 2015 has been marked by extreme apprehension on the part of traders and investors as the U.S. Federal Reserve’s monetary policy is uncertain.  While central bankers in Europe and China are embracing a dovish stance, the Fed seems uncertain as to which policy to pursue in light of conflicting reports on the state of the U.S. economy.  This uncertainty on the part of the Fed is holding the market hostage and is generating unnecessary anxiety among market participants. 

The solution to this problem is simple, but the Fed’s current leadership appears clueless to what is required.  A straight-forward statement by the Fed as to whether the central bank will raise interest rates this year or keep them unchanged – yea or nay – is all that’s needed to lift the veil of uncertainty.  I’m convinced that if the Fed made an unequivocal public statement on interest rates for the balance of 2015, it would push a lot of sidelined money back into the market.  For now, though, the market remains hostage to the Fed’s equivocation and lack of decisiveness. 

The confused interest rate outlook on the Fed’s part is nothing new, though.  The same thing was witnessed in the previous Year Five of the decade in 2005.  The Federal Reserve under Chairman Greenspan’s leadership had embarked on a campaign of rising interest rates starting in 2004, and by 2005 the rising rates were generating uncertainty on the part of investors.  Yet the effect or rising rates – and the initial uncertainty it generated – gave way to a desire to purchase equities as a hedge against a perceived inflationary trend. 

Rising interest rates always create apprehension at first, but this uncertainty gives way to the widespread belief among investors that the economy is on the mend since interest rates are trending higher. For this reason it will be important to monitor the progression of the 10-Year Treasury Yield Index (TNX) in the coming months. 

If market interest rates have indeed bottomed (as the long-term inflation/deflation cycle suggests) then we should eventually see higher bond yields in the coming year.  This in turn would send the message that the economy is definitely improving and would also remove all reason for equivocation on the part of the Fed.  

Sell in May and go away?

The theme of “bad news is good news” continues as several economic reports weighed on investor sentiment.  Recent reports have been disappointing, but this has also served to bolster investors’ belief that the Fed will respond to the weak data by passing on an interest rate increase. 

A Wall Street bromide tells investors to “sell in May and go away.”  The rationale behind this adage is that the stock market historically posts its best performance between the months of October and April.  According to Stock Trader’s Almanac, “A $10,000 investment compounded to $578,413 for November-April in 57 years compared to a $341 gain for May-October.”  While May-October period is statistically less impressive in terms of overall percentage gains in most years, this isn’t always the case.  It should also be noted that the “sell in May” aphorism is deceptive; indeed, some of the most impressive market rallies of the last 20 years have occurred in the summer months. 

According to our friends at Stock Trader’s Almanac, the period between May and June was a “disaster area” between 1965 and 1984 with the SPX down 15 out of 20 Mays.  However, between 1985 and 1997 May was the best month with 13 consecutive gains, gaining 3.3% per year on average.  Since then the record has been volatile with a mixture of up and down Mays.

The reason why the May-September period tends to be weak compared to the October-April period is that interspersed between the impressive summer rallies are periods of sometimes wild volatility.  The classic case in point is 1998, which witnessed a meteoric rally in June-July before a nasty spill in August-September.  A more recent example would be the June 2007 rally to new highs in the SPX which was followed by a harrowing sell-off in July-August. 

With that said, are there reasons for believing that this year’s May-October period will break the mold of underwhelming stock market returns?  Yes there are, and the biggest reason is that this is the phenomenal “Year Five” of the decade.  The fifth year of the decade has historically always been a winner for stocks and the reason is simple: the 10-year cycle always bottoms late in the fourth year.  The subsequent lifting pressure in the following year virtually guarantees a buoyant stock market, which accounts for the winning tendency of the fifth year. 

This time around there is the added benefit of several longer-term yearly cycles also having bottomed late last year, which means those cycles are now in the up phase in 2015.  This is one reason why stocks have stubbornly refused to decline in a meaningful fashion so far this year.  There’s simply too much of a cyclical upside bias, which in turn has counteracted the negative U.S. and global economic developments this year. 

There are also other reasons for believing that we could witness a surprising rally at some point in the coming months.  Consumers have been adding to their savings stash this year.  Economists assumed at the start of 2015 that plunging oil and gasoline prices from late 2014/early 2015 would stimulate a consumer buying binge due to the savings in energy costs.  But instead of spending the fuel cost savings, consumers funneled that extra money into their piggy banks.  This creates a rather substantial reservoir of fuel for a future spending binge.  Consumers tend to oscillate wildly between overspending and over-saving.  When they go too far to one extreme, the pendulum goes in the opposite direction.  When consumers are convinced that the fears of a global economic slowdown are overblown, they’ll eventually emerge from their shells and start spending and investing again.

The fifth year of the decade tends to follow the same basic script each time, and this year (to date) has been no exception.  While the stock market tends to outperform in the fifth year, consumer spending tends to be subdued and the economy sometimes even skirts recession (without actually entering it).  That script is being played out again in 2015, but as with previous fifth years the cautious attitude of consumers and investors turns to optimism when they realize their fears are without merit.  The stock market is telling us that despite the economic potholes here and there, the 6-year recovery trend remains very much intact.

Is the death of the U.S. bull market imminent?

A common refrain from commentators over the last year or so is that the bull market in U.S. equities is “long in the tooth.”  The very use of this phrase implies a market which has reached a stage of decrepitude from which only bad things can result.  “Long in the tooth,” in other words, implies the imminent demise of the bull and the birth of a new bear market.

But does an old bull market necessarily give rise to a bear market by virtue of its age?  Does old age in fact kill bulls?  A careful study of market history provides a negative answer to this question.  Old age doesn’t kill bull markets; in fact, it’s not uncommon for equity bull markets to last 8-9 years before they terminate.  For perspective, the present bull market has only just entered its sixth year.

If anything, age “mellows” a bull market in much the same way that it mellows wine.  The early phases of a new bull market are often characterized by wild volatility and uncertainty.  As market sage Richard Russell once observed, “The early stage of a bull market…always tests the nerves of the participants.  The bull will try to advance while attracting the fewest possible numbers of ‘riders.’”  That’s exactly what the U.S. equity bull market did in its infant stages between 2009 and 2011 (remember the infamous “Flash Crash”?)  Indeed, there weren’t many analysts who were willing to go on record in those years to proclaim that a new secular bull market was underway; most cautiously referred to it as a either a “cyclical” bull or an extended bear market rally.

The second half of a bull market (prior to the final “distribution phase”) is typically characterized by declining volatility and by a decisive upward bias that is all but impossible to ignore.  This what can be termed the “momentum phase” of a bull market.  It’s during this phase that retail investors come to accept the reality of the secular bull market and begin participating without the trepidation that characterized the bull’s early years.  Low volatility is absolutely necessary, from the standpoint of the insiders, to establishing the bull’s claim and luring the public into the market.  Without widespread public participation there can be no culmination of the bull market since the “smart money” has to have someone to sell to.

The proof that a secular (long-term) bull market had been birthed in 2009 wasn’t evident to the majority of investors until 2013.  It was during this year that the Dow and S&P 500 finally overcame their previous highs made in 2007.  Viewed another way, it was only two short years ago that the U.S. equity market reached the “break even” point from 2007.  The gains that have been made since then can be viewed as the “real” start of the momentum phase of the bull market.  At only two years of age, the momentum phase of the bull market has a ways to go before it gives way to the final stage of a secular bull market, namely the “distribution phase.”

No bull market can end until the distribution phase commences.  As the name implies, distribution involves the selling of equities by “smart money” participants who wish to finally cash out of what has been (for them) a long and profitable bull run.  Since they can’t sell to themselves, they must bring the public into the market in order to unload their holdings onto the unsuspecting small investor.  Distribution phases are always marked by glaring advertisements for stock ownership in the form of news articles in the popular press, TV shows, Internet advertising, etc.  The previous two bull markets which ended in the late 1990s and the mid-to-late 2000s, respectively, were characterized by this widespread advertising and public participation. 

Currently, nothing even remotely similar to those two periods can be seen.  Today the average small investor is nowhere to be found.  Still feeling the psychological effects of the late credit crisis, he is in no hurry to leap back into an equity market which he believes to be “overvalued” and “long in the tooth.”  But before this bull expires you can rest assured Mr. and Mrs. Small Investor will once again rejoin the fray, just as they did before the culmination of all previous bull markets.  Before the public enters as active participants, the secular bull market will remain very much alive.

Returning to our original proposition, if old age doesn’t kill bull markets then what does?  If you listen to the opinions of most economists your answer would be that economic recessions kill bull markets.  That belief is of equally dubious merit, however.  There have been more than a few instances in history of recessions running concurrently with equity bull markets.  In fact, the recent experience in Japan late last year is a case in point.  Even though Japan experienced two consecutive quarters of economic contraction and officially entered a recession, the Nikkei stock market index remained very much in bull market territory (see chart below).  Conversely, there have been many cases in which an equity bear market precedes an economic recession, often by a lead time of several months or even up to a year. 

In the final analysis, virtually every bull market in U.S. history met its demise due to a common factor: the Federal Reserve.  Fed policy is what kills bull markets in almost every instance.  The progressive increase in Fed interest rates and subsequent tightening of credit is what eventually chokes off demand for equities, thus culminating the bull’s run.  There’s even a Wall Street aphorism which attests to this: “Bull markets don’t end until the Fed removes the punch bowl.”  As long as Fed policy remains accommodative, the secular bull market will live on. 

The last few months have been a time of consolidation for the stock market.  As measured by the NYSE Composite Index (NYA) the market has gone essentially nowhere for the 10 months.  To many investors this lack of forward progress may feel like a bear market, but it’s actually laying the foundation for the next phase of the bull market.  Think of the sideways range as a launching pad for the market’s next advancing phase, which in turn is necessary before the final distribution/ending phase can begin. 

MSR annual performance review

I make it a point to record the performance of the Momentum Strategies Report on a weekly basis.  I believe this is important for providing subscribers (and potential subscribers) with an accurate representation of how my recommendations have performed in the recent past.  Instead of posting the performance in the form of percentage gains/losses (as most newsletter do), the cumulative results are presented in the form of a simple line graph.  The old saying “charts don’t lie” applies in this case.

Below is the performance graph of the last 12 months.  It shows the cumulative performance of the stock and ETF recommendations made in the “Trading Positions” section of the Momentum Strategies Report.

The above graph is an unvarnished reflection of how the recommendations made in MSR have performed since April 2014.  This performance was achieved, throughout most of the last year, by holding only a single stock or ETF position in the model portfolio.  While I’m not averse to recommending multiple trading positions, I felt that the market environment of the past year didn’t warrant the undue risk of holding several stocks or ETFs simultaneously due to the volatility risk inherent within a trading range market.

The upside to using a technical trading discipline is that your drawdown and relative volatility will be much lower than that of the broad market.  Moreover, in bear markets a technical trading system such as this one will invariably outperform the broad market, even without resorting to short sales.

In summary, the trading system employed in the MSR newsletter is one of the most conservative, yet consistently reliable systems you will find in any stock market newsletter when it comes to delivering long-term gains without exposure to extreme volatility.  It’s based on the principle of making market commitments only when the odds are decisively in your favor.  Otherwise, a cash position is warranted in the name of capital preservation – the first commandment of the financial markets.  

For subscription info, click here:  http://www.clifdroke.com/subscribe_msr.mgi

Lowered expectations for earnings season

The latest earnings season begins this week as investors switch their focus from big-picture economic concerns to company-specific earnings reports.  The energy sector will receive most of Wall Street’s attention with analysts expecting oil/gas company revenues to drop by 64% on a year-over-year basis. 

Earnings expectations for most sectors have been falling sharply in the last few weeks with the most recent estimate showing a 2.8 percent decline in earnings growth, mainly due to diminished expectations for the energy sector. 

More than 80% of Q1 earnings pre-announcements for all sectors were negative, according to Thomson Reuters data.  As one writer pointed out, this sets the bar lower than is usually the case toward the start of earnings season. 

Typically, about 63% of companies beat estimates while just 20% miss.  As one analyst observed, the negativity has set the bar so low for Q1, it may have set the stage for some positive earnings surprises.  With as much short interest that has built up in certain sectors in recent weeks, a series of positive earnings surprises could easily catalyze a short-covering rally and put the bears on the defensive.  

The tyranny of trading ranges

Sideways trading range markets have their own unique characteristics – both technically and psychologically.  More than any other emotion trading ranges tend to elicit frustration from investors.  Nothing, after all, is more irritating to an investor than having to sit through long periods where stocks are making little or no progress.  The longer the trading range persists, the more frustrated and impatient investors tend to become. 

If the trading range is established in the midst of a longer-term uptrend it’s not uncommon for investor sentiment to remain stubbornly bullish for an extended period.  Investors have become so conditioned to rising stock prices that it often takes several months of a grinding lateral trend before they finally lose their enthusiasm.  It’s when investors finally become more pessimistic on equities that the market commonly breaks out from the trading range.  In other words, investors normally have to be “head faked” before the market can proceed to a higher level.

That pattern appears to be playing out in the U.S. broad market.  After spending the better part of the last six months in a sideways trend, the NYSE Composite Index (NYA) appears to finally be on the brink of a breakout to a new high this spring.  What makes this even more intriguing is the current backdrop of investor sentiment….

Market psychology isn’t as important as the market’s internal momentum and overall technical backdrop, yet it can still yield clues as the market’s next directional move.  And the current readings of both the “smart money” and “dumb money” sentiment indicators reflect an improving psychological backdrop.  Once the short-term internal momentum indicators improve this should prove quite handy in providing the market with enough fuel for an extended rally later this spring.  [Excerpted from the Mar. 23 Momentum Strategies Report]

Are biotechs in a bubble?

Q: Do you think biotechs are in bubble? 

A: Biotechs may be undergoing a "melt-up" but I don't think they're in a bubble yet.  We'll know they're in a bubble when everyone -- including friends, relatives and neighbors -- is talking about them and buying them with reckless abandon.  I definitely don't get that vibe right now.  A lot of the biotech ownership is among professional investors, not small retail traders.