Street Smart: A look at market cycles

by Sy Harding, editor The Street Smart Report

We have been saying for a couple of years now that the economic recovery will have to begin in the housing industry. That‟s not theory, but history.

Since the early 1900‟s the main driving forces of the economy have been the housing and auto industries. A significant slowdown in one or both usually foreshadowed recessions, while recoveries in one or both provided the fuel for the economy to recover.

It makes sense. Consumer spending accounts for 70% of GDP, and homes and autos are the largest purchases that consumers make.

Further, since they typically pay only 5% to 20% of the purchase price in cash and borrow the rest, their purchases of homes and autos are highly leveraged. So those purchases have a much larger impact on the economy than spending the same amount on apparel, electronic games, or vacations.

We’re not talking ancient history here. The recent recession began with the collapse in the housing industry, followed shortly thereafter by serious troubles in the auto industry.

The economic recovery began last year when government programs jump-started the housing industry with $8,000 rebates to first-time home-buyers, and the auto industry with the "cash for clunkers‟ program.

The stock market began an oversold rally last March, which morphed into a new bull market when housing and auto sales did begin to recover, and the long recession ended in the 3rd quarter. The economy continued to recover in the 4th quarter, accompanied by the good news of still improving home sales and home prices, and rising auto sales.  

However, we became concerned about the economy in the new year when the good news from the housing sector reversed to decidedly bad news.

New home sales plunged 11% in January; existing home sales fell 7.2%, and pending home sales declined 7.6%. Meanwhile, the Consumer Confidence Index plunged sharply in February, indicating spending on big-ticket items is probably still in trouble.

Yet, after only a three-week pullback of 8% on those worries, the stock market began to recover again, even as additional negative economic reports crowded in, and even as in the background came negative surprises from Europe.

GDP growth in the 16 Euro-zone nations slipped to just 0.1% in the 4th quarter, raising concerns that Europe is sliding back into recession. Those concerns were not helped by subsequent reports of serious debt problems in Greece, Spain, Italy, Portugal, and Ireland.

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So what does the market see that keeps it positive in the face of increasing signs of the U.S. and global economies slowing again? It may see that the U.S. and global governments cannot follow through on announcements to let some of their stimulus programs expire.

For instance, in the important housing sector, the program of rebates to home-buyers is due to expire at the end of April. And the Fed has announced it will end its $1.2 trillion program of purchasing mortgage-backed securities this month, a program that has been working to hold mortgage rates down.

The stock market may well be anticipating that with the recent bad news on home sales, and plunge in consumer confidence, the government will not dare let those stimulus programs expire, and may even have to expand them.

The market doesn‟t need to care about what that might do to the budget deficit, or the problems it may cause three or four years down the road. All it cares about now is whether the economic recovery will still be underway in the second half of the year. Time enough to worry about longer term problems later.

Supporting the thought of a continuing bull market for some time yet, is that the market‟s seasonal pattern, of making gains in the winter and spring months, seems to be working. Investor sentiment has also declined to well below the extreme of bullishness usually seen at tops. The latest AAII poll showed only 35.9% bullish, 26.2% bearish.

That feeds into the large amount of sideline money that has not come in, but always does before bull markets end, fueling the final leg. The low trading volume indicates investors are still standing aside, leaving the stock market to professional traders and institutions. If the market rises further that will change.

As for the long term, there is little doubt that we are in a secular bear market that began ten years ago in March, 2000. We didn‟t hear much about it during the optimism during  the 2003-2007 bull market, or since the current bull market began a year ago.

But it is pretty much agreed that when the market topped out in March 2000 it was the end of the long 1982-2000 secular bull market, and beginning of a 2000 to who knows when secular bear market.

As Warren Buffett said, and others predicted at the time, “The next 17 years will be quite different from the last 17 years.”

So far the subsequent ten years have certainly been different, with two cyclical bull markets and two cyclical bear markets, which have the S&P 500 still needing to gain 36% just to get back to its level of 10 years ago. The Nasdaq is in need of a 119% gain to get back to its level of 10 years ago.

So what do we know about secular bear markets? They take place when economic problems are of long-term duration, seem incurable, and recoveries are only temporary, with problems recurring.

The last 110 years were clearly divided into three secular bull markets, and three secular bear markets. In secular bull markets the periodic cyclical bear markets can be devastating, like the 1987 crash, but are only temporary and the bull market resumes to ever higher highs.

In secular bear markets the periodic cyclical bull markets can be exciting and profitable, like the 2003-2007 bull market, and the current one, but are only temporary. The secular bear takes over again every few years, in the form of another cyclical bear market that prevents a long-term uptrend from developing.

The three secular bear markets of the last 110 years lasted for 16 years, 20 years, and 16 years respectively, which is no doubt where Warren Buffett came up with his “next 17 years” prediction in 2000. If this secular bear is to last 17 years it has another 7 years to go. That seems reasonable, given the current  long-term problems of record budget deficits and other problems that will take years to resolve.

On the short-term charts it looks like the Nasdaq and Russell 2000, which have led the rally with their impressive strength, have become short-term overbought above their 21-day moving averages to a degree most likely to bring a pullback, possibly enough pullback to again retest the support at the moving average.

If the market does pull back it would only be a potential problem if the major indexes should break below their intermediate-term 20-week moving averages again. That is possible, but unlikely.

The Dow would have to decline below support at its 20 -week m.a., which is at 10,310. The S&P 500 would have to close below 1,100. As we said, possible but not likely.

Meanwhile, we have been long term bullish on gold for several reasons, including the potential for rising inflation being created by the easy money policies of global central banks, if the central banks are tardy in reversing those policies, or are forced by the economy to leave them in place, and inflation gets out of hand. Rising inflation would normally be a big positive for gold, the traditional hedge against inflation.  

We remain on the buy signal of December 13 for the dollar. Intermediate-term technical indicators triggered their first buy signal on the dollar since the 2008 low, and from their very oversold zones.

Except for a bear market rally in 2005, and another one in 2008, the dollar has been in a severe bear market since 2001. Throughout its 10-year collapse the U.S. claimed it supports a strong dollar, but did nothing about its slide. A weak dollar helps the U.S. economy by making U.S. exports less expensive in foreign countries, and imports coming into the U.S. more expensive.

With the economy recovering, that need for a weak dollar is diminishing. Meanwhile, because of its declining value, global pressure has been growing for several years to have the dollar replaced as the world‟s primary currency.

There have also been hints that foreign central banks might move some of their huge reserves out of dollar-denominated assets if the dollar losses continue. So the U.S. may be willing now to actually support a stronger dollar.

With the sell signal on the market on February 4, the non-seasonal Market-Timing Strategy portfolio sold two positions to move to 40% cash. Although our indicators subsequently improved to neutral we have remained 60% invested and 40% in cash.

We continue to hold a 20% position in the PowerShares DB US Dollar Bullish ETF (NYSE: UUP) and a 20% position in the SPDR Gold Trust (NYSE: GLD).

Learn more about this financial newsletter at Sy Harding's Street Smart Report.