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.