Hello again, Sleuths,

In my prior two columns this month, I’ve made the argument that 2006 will be a tough year for equities. One of my reasons for having a bearish outlook was because of where we are in the four-year, or presidential, cycle. In my most recent column, I explained what the four-year cycle was and why I believe there is merit in its recurring patterns.

Last time, I laid out the theory behind the four-year cycle. In this column, I’ll give you some numbers to demonstrate those recurring patterns and what the cycle suggests is in store for us in 2006. Then you can reach your own conclusions and formulate your game plan for the year accordingly.

Before I throw some numbers at you, I know what you may be thinking. You’ve been reading the paper or going online and wondering, “What is this guy Bail talking about? How could he be such a bear when the market is ripping?”

The Four-Year Cycle: 2006 Is the Year of Bearishness in the Cycle

As I watched the market close out last week so strongly, I asked myself those very questions — except I didn’t refer to myself as “Bail.” But then I reminded myself that this forecast encompasses an entire year. And despite the market’s positive start to 2006, we’re just putting the finishing touches on the first month. So we’ll see what the remaining 11 months have in store for us.

I have one other thought to share with you. Two days after I penned my last Sleuth issue, I was watching CNBC. Right in the middle of that morning’s festivities, a money manager appeared on the tube and declared that 2006 was going to be a tough year for stocks. What was his reason for being so bearish? He said the four-year cycle pointed to 2006 being a bummer for most stock investors.

Now, I don’t remember who that guy was. But he went on to state in no uncertain terms that the four-year cycle led him to conclude that we should be in for a rough time this year. Well, that certainly caught my ear. I even wondered if he was a Sleuther.

No matter. He was articulating a lot of the same points I’ve been making. I generally don’t like to have a parade of financial folks appear on CNBC espousing the same views as my own. Quite frankly, I take comfort in being different from the crowd. And it’s not because I’m a loner or a contrarian. It’s just that I’ve noticed that consensus opinion is usually wrong.

But then I took comfort in the thought that most people probably didn’t agree with that money manager. I figured — with the market off to such a nice start this year — most folks probably let the man’s words drift in one ear and out the other. Besides, most people probably hadn’t heard of the guy. I know I hadn’t. So I just sat back and chuckled.

Now, let’s take a look at those numbers and you will see for yourself the power of this pattern. In my Jan. 17 Technical Tuesday column, I compared the first two years of a four-year, or presidential, cycle with the second two years. I wrote that the third and fourth years of the cycle have typically outdistanced years one and two, and why that happened. And since we’re smack in the middle of years one and two, let’s check the numbers and see what history tells us about what we might expect at this point in the four-year cycle.

The numbers I’ll share with you are from the S&P 500 and quite interesting. However, I also looked at the annual historical returns of the Dow Jones Industrial Average and the Nasdaq. The implications from the historical results of all three indexes with respect to the study of cycles are similar.

OK, so what can the S&P 500’s history tell us? First, I looked at the previous 11 presidential terms — going back to 1961. In other words, I analyzed every presidential cycle beginning with the start of the Kennedy administration. I then combined each term into two two-year periods in order to evaluate the combined total return for the S&P 500 during the first and the second years of every four-year period against the results achieved in the third and fourth years of the cycle. 

The Four-Year Cycle: The Second Two Years of a Term Explain It All

Here’s what I found. In nine out of the 11 presidential terms from 1961-2004, the combined total return for the second two years exceeded the return for the first two years. The only exceptions were in 1985-86 and 1997-98.

Now I know that (like the current situation) — those two exceptions occurred in the second terms of presidents -– Ronald Reagan and Bill Clinton, respectively. However, three points need to be made that I think differentiate those times from this one.

First, in both of those prior instances, the economy was booming. That’s certainly not the case now. And both the 1985-86 and 1997-98 periods were supported by an accommodative Federal Reserve. Given the Federal Reserve’s string of 13 consecutive increases in the federal funds rate — with possibly one more scheduled today — that certainly hasn’t been the case this time.

Here’s one more difference — and it’s a big one. In both of those two-year periods, the first year returned outsized gains. In 1985, the S&P 500 went up 26.3%, and in 1997, it jumped 31%.

Contrast that with the year just completed. Unlike those eye-popping gains of 1985 and 1997, in 2005, the S&P 500 was able to inch ahead a rather modest 3%.

What about the other nine presidential terms? I’m glad you asked. In every single one of those nine four-year cycles, at least one of those first two years — either year one or year two — finished with a negative return. Now, 2005 was a positive year, albeit modestly. Therefore, if this pattern continues to hold, odds point to the S&P 500 finishing 2006 in the red.

You want more? To really put this historical pattern to the test, I went back further — all the way back to 1929, the beginning of the Hoover administration. And I looked at the eight four-year cycles covering the period from 1929-1960.

Now, prior to the 1960s, the S&P 500 sometimes scored greater gains in the first two years of a presidential cycle. For example, the index posted higher returns in the first two years of the four-year cycles of the immediate postwar period — the second Truman term (1949-1953) and both Eisenhower terms (1953-1957 and 1957-1961).

But as with the results from 1961-2004, I was interested to learn exactly how many times the S&P 500 suffered through at least one down year in the first two years of the four-year cycle. Well, guess what I found? Seven of the eight four-year cycles encompassing the presidential terms of Hoover through Eisenhower contained at least one down year in either year one or two. Only in Truman’s second term did the S&P 500 finish with positive returns in each of the first two years, 1949 and 1950.

Now think about what I’ve just said. In the last 19 presidential cycles — a period stretching from 1929-2004 — the S&P 500 ended at least one of the first two years of the four-year cycle with a loss on 16 occasions. That’s a rate of 84%. Those are pretty good odds. So with the S&P 500 having ended 2005 in the black, odds greatly favor 2006 being a negative year.

The famous Spanish philosopher George Santayana said, “Those who cannot learn from the past are doomed to repeat it.” I hope that this look into the last three-quarters of a century of market history gives you a longer-term context from which to view current equity trading patterns. As always, it’s smart to watch current stock trends and react accordingly — rather than try to force your will upon the market. Still, it’s always good to know from whence we came — and thus, where we may be headed.

Trade well,

Mark Bail
January 31, 2006

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The Four-Year Cycle: The Four-Year Cycle — Let’s Check the Numbers was originally featured in the Penny Sleuth.

Hello again, Sleuths,

We kicked off our first Technical Tuesday column of 2006 with a forecast for the new year. The burning question I batted around two weeks ago was how equities would fare over the next 12 months.

My answer to that question was decidedly negative. I said that 2006 would be a rough year for stocks and that timing would be an important factor in your ability to make money investing in equities this year.

Well, the market took my 2006 outlook and shoved it right down my throat. In just the first nine trading days of the new year, the Dow Jones Industrials, S&P 500, Nasdaq Composite and Russell 2000 indexes have all scored more gains than they did in all of 2005. How’s that for throwing mud all over a brand-new prediction?

The Four-Year Cycle: Short-term Vs. Long-term Trading

Actually, it’s not that bad. First, let me remind those Sleuthers who are not MST subscribers that I’m a short-term trader. I made some 2006 predictions for those of you who are Agora Financial Reserve Members (although I’ve been told by the folks in Baltimore that the Webcast containing forecasts from 11 editors and publishers is available for purchase for a small fee). Anyway, I thought it would be fun to share my 2006 market predictions with you while touching upon some elements of technical analysis in the process.

Now, since I am a short-term trader, my bearish outlook for 2006 has no influence whatsoever on what we try to do in MST Trader. In other words, I’m not writing about any put plays right now. That’s because we look to exploit short-term trends. And — as you are undoubtedly are aware — the short-term trend is up.

That brings me to my second point. A year is a long time. And this year has just begun. In no way have the first two weeks caused me to alter my outlook for 2006. I’m not saying that if the market continues to act as strongly as it began this year that I won’t alter my forecast. I’m not inflexible. But we need more evidence to convince me that 2006 will be a year of plenty in the stock market.

In the meantime — I’ll stick by what I wrote on Jan. 3. If you need a refresher on my earlier comments — as a lot has transpired since I penned those words of wisdom — feel free to take another look. But please don’t throw any mud, OK?

In that Jan. 3 Penny Sleuth issue, I declared that 2006 would be a difficult year for equities. In reaching this bearish conclusion, I used the three technical indicators I employ in MST Trader to observe that all of the indexes I mentioned above were experiencing a noticeable slowing of long-term
momentum. Coupling that red flag with the fact that the Dow Industrials, S&P 500, and Nasdaq Composite were all trading at the upper reaches of multiyear trading ranges caused me to conclude that the market’s downside risk over the next 12 months clearly surpassed its upside potential.

Finally, I took note of a few other factors that are bound to take a bite out of market returns — namely rising oil prices and higher interest rates — and I arrived at my conclusion that 2006 was going to be a year of tough uphill sledding. But as I mentioned two weeks ago — I had one more reason for forming a dour 2006 outlook for stocks — the four-year cycle.

For the rest of this issue, I will discuss the importance of cycles in technical analysis and why market technicians use them. I will also make the case for following this particular cycle — and why its patterns are likely to recur. Then in the next Technical Tuesday column, two weeks hence, I will throw some numbers at you from the four-year cycle that support my
bearish outlook for 2006.

First, we need to ask why should we even bother to look at market cycles when assessing likely future market action? I believe the answer to that question is that — at least to some degree — the past does help predict the future.

The Four-Year Cycle: It All Runs in Cycles 

I believe that things tend to go in cycles — especially in the markets. I’m not saying that things repeat themselves exactly. I don’t believe they do. But I do believe that many different patterns have a way of recurring over time. Therefore, I believe it’s wise to be aware of what has
previously transpired in the markets, because we’re likely to see these things again — albeit with a twist.

I believe that’s true because when we’re analyzing the markets, we’re really analyzing human behavior. Humans don’t really change a whole lot. Oh, people can change. But the change is gradual. And when confronted with a set of market conditions, people tend to respond in similar ways –
especially in groups. So if you are cognizant of historical market patterns, you have a greater chance of anticipating how people — and, thus, the market indexes — are likely to respond.

It’s this understanding of typical human reactions that underlies the entire study of technical analysis. You see, technical analysis involves studying human behavior — as depicted primarily through chart patterns, volume totals and the movements and configurations of various indicators. All of these methods of tracking human responses are used to assist us as we assess the likelihood of future stock and index changes based upon past occurrences.

The study of cycles falls into this category as well. Market technicians theorize that not only are recurring patterns discernable on charts, but events also tend to repeat themselves in similar ways in similar time periods. We often hear about seasonal influences that repeat themselves in
the market. For example, it’s a well-known axiom that stock market returns between November and April typically dwarf those earned in the other six months of the year.

Studying cyclical patterns that are examined over the course of a multiyear time frame is another means by which market technicians use repeating human behavior patterns from the past to try to understand the present — and anticipate what’s likely to transpire in the future. The four-year cycle is one such pattern.

Now, why not another multiyear time frame? In fact, many technicians track other multiyear time frames — such as three, five, and 10-year periods — to divine recurring market trends. These and other, more esoteric long-term time periods are often cited as containing within their pasts predictive
clues about the market’s immediate future. And they may.

The Four-Year Cycle: Why I Use a Four-Year Cycle

Nevertheless, I have primarily limited my long-term cyclical time frame to a four-year period. Why? The reason is that I think it’s important that any pattern you study should have some logical reason for working. For me, the four-year cycle fits the bill. Unlike some of the other cyclical studies I’ve read about, the four-year cycle has a very straightforward reason why it can have influences on the stock market. You see, the four-year cycle almost exactly matches the terms of U.S. presidents.

With presidential elections in the United States occurring every four years, the incumbent party — be it Republican or Democrat — has an incentive to have its party hold onto the executive branch’s levers of power. And with the American government growing ever larger, the federal government exerts an increasing influence over the economy. It is that influence that enables an incumbent president — at least partly — to serve his own electoral interests or those of his presumptive successor.

Now, let’s consider the market in terms of a four-year presidential term. The first two years of the four-year cycle typically result in lower returns than the second two years. Plenty of articles have been written about this pattern. These articles have usually been written in the context of the
second two years — as generally befits a financial media with a pronounced bullish bias.

Now, you most often see these articles the third year of the cycle. In the most recently completed four-year cycle, that was 2003. And it’s usually pointed out that the third year of the presidential cycle is historically the year that provides stock investors with the best returns. And that’s true.

It makes sense when you think about it. In the first two years, a president has just gotten elected or re-elected. His political capital is higher — after all, he’s just won. And his initiatives are beginning to go through the congressional legislative process — what the 19th-century German Chancellor Otto von Bismarck called “making sausages.”

In the first two years of a president’s term, typically not much has gotten accomplished. That’s one reason why the party that occupies the White House more often than not suffers a midterm election reversal halfway through the presidential term.

In the latter two years of a president’s term, the incumbent is either gearing up for re-election or attempting to ensure the electoral success of his successor, as a means of cementing his historical legacy. Thus, there is a push to achieve results. There is also an incentive to use the fiscal
stimuli at the president’s disposal to make sure that the economy is humming when Election Day arrives. Then, voters — especially those in the middle of the ideological spectrum, who typically decide American presidential elections — will be kindly disposed toward the incumbent party.

That’s the theory behind the four-year, or presidential, cycle. It doesn’t always work as the party in power intends. And it hasn’t prevented incumbents in both parties from being sent packing after one term in office. But more often than not, both economic numbers and stock market returns tend to be higher in the latter two years of a presidential term. And since I do not believe this is mere coincidence, I find merit in tracking — and even attempting to make forecasts using — the four-year cycle.

In my next Technical Tuesday column, I’ll share with you some numbers I came up with in my research of the four-year cycle. I think you’ll find them interesting. It might even turn you into a bear.

Trade well,

Mark Bail
January 17, 2006

The Four-Year Cycle: Technical Tuesdays With Mark Bail was originally featured in the Penny Sleuth.