Pain First, Gains Ahead

Barron’s

Decennial cycles suggest a sharp stock decline in early 2012 setting up for a big buying opportunity.

A big drop, then a big pop. That prediction stood out in the latest technical analysis piece from the folks at Bank of America Merrill Lynch Global Research. Their analysis of the well known « decennial cycle » suggests that after a serious decline in the early part of the year, a significant buying opportunity will develop.

Chart 1

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Source: CMF Advisors

That means, according to this cycle, 2012 could present investors a great buying opportunity in a few months at much more attractive prices than are available now. Of course, to take advantage of those future opportunities means preserving capital now in order to have the cash to buy when stocks go on sale.

The decennial cycle breaks the performance of the stock market down by each year of the decade. Over time, some years, such as the ninth year, have a history of strength. Indeed, 2009 and 1999 before it were hot years for investors. Others, such as the third year, tend to struggle.

Year two is usually unremarkable based on annual returns. But BofA Merrill’s Stephen Suttmeier, a technical research analyst with the group, confirmed that after a meaningful early correction, year two also tends to offer meaningful, midyear bottoms.

Cycle analysis seems arcane to many investors. But it is just a way to follow the tendencies prices have to rise and fall in a periodic manner, despite what is happening in the news or elsewhere outside the market. And they really are more common than one might think.

The famous « sell in May and go away » mantra is an easy way to remember that there is an annual or seasonal cycle at work. Indeed, the phrase « cyclical stocks » can find its origin in the natural ebb and flow of the economy, although cycles more often are driven by government policies.

For a more advanced treatment of cycles, Richard Mogey, principal at CMF Advisors and former executive director of the Foundation for the Study of Cycles, combines many cycles into one unified analysis. He uses many different cycles, including some with which investors may be familiar such as the 40-month Kitchin business cycle and the four-year Presidential cycle. Other inputs include observation of the behavior of markets when interest rates reach multidecade lows.

« The bottom line is that we think that the stock market is in a secular and cyclic bear market, » he writes in his latest publication. « And by the second quarter of 2012 we expect serious damage done to the major indices. »

But again, the good news is that later in this year his cycles charts turn higher (see Chart 1).

Cycles form a framework on which we can hang other analyses. As can be seen in the chart, cycle projections are not always right as other forces can overwhelm them in the short term. That is why it is important to find confirming evidence in other types of technical analysis.

Aside from trendlines and chart patterns, technical analysts try to dig deeper into investor psychology. To do that, analysis firm Lowry Research studies what it calls « buying pressure » and « selling pressure. » It measures the forces of supply and demand based on daily volume and price movement. Simply stated, a healthy market has greater buying pressure than selling pressure.

Richard Dickson, senior market analyst at Lowry’s, said that with a brief exception last October, buying pressure has been falling and selling pressure has been rising for the better part of a year. « We think we’re in a bear market right now, » he added tersely.

Cycle analysis, confirmed with supply-and-demand analysis, suggests that the early part of the year will not be kind to investors. But the good news is that sometime this year, likely before the election, investors could have the opportunity to back up the truck to buy for the next bull market—provided they have preserved their capital through the decline.

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