The Coming Market Meltup and 2016 Recession

Wed, Jan 15, 2014 - 9:18am

It has been a bit of a bumpy ride for stocks as we kick off the New Year, however, it hasn't been a real disaster either. Of course, you wouldn't know that by the hand wringing and whining going on with mainstream analysts and portfolio managers. As of this writing the S&P 500 has plummeted a whopping 0.66% to start the year. It is simply amazing that with that kind of disaster occurring after a 30% rise in 2013 that the White House hasn't suggested a bailout for Wall Street. (Okay, while that was a little "over the top" you get the idea.)

Currently, the market remains in a very bullish uptrend and there is scant evidence, at the moment, that the current run is starting to end. As I discussed previously in "Bernanke/Yellen to Drive Stocks 30% Higher:"

"That's right, despite all of the recent "bubble talk," it is entirely possible that stocks could rise 30% higher from here. However, it is not because valuations are cheap because as I discussed in my recent analysis of Q3 earnings stocks are trading near 19x trailing earnings.

The primary reason that stocks are likely to climb 30% higher from current levels, over the next 24-months, is because that is what happens during the 'mania' phase of a bull market cycle. This is something that Richard Russell recently defined as:

'The third or speculative phase of a bull market is characterized by a wild and wooly and ever-increasing entrance by the retail public. This phase is characterized by hot tips, hype and pure greed.'"

Of course, behind the speculative push higher in stocks resides the ongoing efforts of the Federal Reserve and the impact of the ongoing monetary liquidity push. The chart below shows the Federal Reserve's balance sheet as compared to the S&P 500 with both being projected through the end of 2016. The dashed lines denote the projected expansion of the balance sheet, and the correlated rise in asset prices, both before and after the Federal Reserve's most recent "taper."

[Must Read: Richard Duncan: Fed Targeting 20,000 on the Dow]

A Correction First to Launch the Melt-Up

The current year is Presidential mid-term election year which has historically had implications for the stock market in the short term. According to Jeffrey Hirsch of Stock Trader's Almanac:

“Midterm election years are historically prone to bottoms, especially in October and 2014 is also a ‘fourth’ year, which has the fourth best record in the decennial cycle for 132 years. Of the last four midterm election years since the start of the Great Depression (1934, 1954, 1974, 1994) that were also fourth years, only 1954 was impressive.”

With the powerful rally in 2013, which had no real pause, it makes 2014 more vulnerable to a more significant correction. Since 1833, the average peak-to-trough fall in US stocks during a midterm year was -12.76%. The minimum decline of 0.6% occurred in 1894 while the maximum pullback was -33.8% in 1930. However, the good news is that these corrections tend to occur in the 2nd and 3rd quarters of the year with an advance heading into year end. The win ratio for all mid-term election years has been 60% with an average overall return of 4.16%. The complete table of Presidential Cycle Returns is shown below.

Midterm election years are also notoriously weaker when Democrats are in control, but in the last 13 quadrennial cycles since 1961, 9 of the 16 bear markets bottomed in the midterm year.

As stated, on average all midterm years have returned 4.16%. However, when the midterm year followed a strongly positive post-election year, as in 2013, that return fell to just 2.4% on average. The chart below, from Stock Trader's Almanac, shows the mid-year correction that generally accompanies a mid-term election year.

This correction will likely provide the necessary respite to set up the last leg of this cyclical bull market to the "mania" peak.

The Decennial Cycle

There is another piece of historical statistical data that supports the idea of a market "melt up" before the next big correction in 2016 which is the decennial cycle.

The decennial cycle, or decennial pattern as it is sometimes referred to, is an important one. It takes into account the stock market performance in years ending in 1,2,3 etc. In other words, since we just finished up 2013 that was the third year of this decade. This is shown in the table below.

This year, 2014, represents the fourth year of the current decade and has a decent track record. The markets have been positive 12 out of 18 times in the 4th year of the decade with an average return for the Dow Jones Industrial Average since 1835 of 5.08%. Therefore, there is a 66% probability that the end will end positively; however, that does not exclude the possibility of a sharp dip somewhere along the way.

2015 - The Mania Year

However, looking ahead to 2015 is where things get interesting. The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015. As shown in the chart above, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%.

The return of the positive years is also quite amazing with 10 out of the 15 positive 5th years (66%) rising 20% or more. However, 2015 will also likely mark the peak of the cyclical bull market as economic tailwinds fade and the reality of an excessively stretched valuation and price metrics become a major issue.

As you will notice, returns in the 6th and 7th years (2016-17) become substantially worse with a potential of negative return years rising. The chart below shows the win/loss ratio of each year of the decennial cycle.

Bull Mania & the Next Recession

It was in 1996 that Alan Greenspan first uttered the words "irrational exuberance" but it was four more years before the "bull mania" was completed. The "mania" of crowds can last far longer than logic would dictate and especially when that mania is supported by artificial supports.

The statistical data suggests that the next economic recession will likely begin in 2016 with the negative market shock occurring late that year, or in 2017. This would also correspond with the historical precedent of when recessions tend to begin during the decennial cycle. As shown in the chart below the 3rd, 7th and 10th years of the cycle have the highest occurrence of recession starts.

With the Fed's artificial interventions suppressing interest rates and inflation it is likely that the bullish mania will continue into 2015 as the "herd mentality" is sucked into the bullish vortex. This is already underway as shown recently in "Charts All Market Bulls Should Consider" which showed individuals are once again piling into stocks and depleting cash reserves in the hopes of "getting rich quick."

While the historical evidence suggests that 2014 will see a buying opportunity going into 2015, it is important to remember one simple phrase that is too often forgotten by the "bullish crowd:"

"Past Performance Is No Guarantee Of Future Results."

There are plenty of reasons that that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest. Such an event would not be the first time that an "anomaly" in the data has occurred.

The inherent problem with the analysis contained within this missive is that it assumes everything remains status quo. The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become more extreme. This was best summed up by Jeremy Grantham who recently noted:

"My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience. And we the people, of course, will get what we deserve. We acclaimed the original perpetrator of this ill-fated plan — Greenspan — to be the great Maestro, in a general orgy of boot licking. His faithful acolyte, Bernanke, was reappointed by a democratic president and generally lauded for doing (I admit) a perfectly serviceable job of rallying the troops in a crash that absolutely would not have occurred without the dangerous experiments in deregulation and no regulation (of the subprime instruments, for example) of his and his predecessor’s policy. At this rate, one day we will praise Yellen (or a similar successor) for helping out adequately in the wreckage of the next utterly unnecessary financial and asset class failure. Deregulation was eventually a disappointment even to Greenspan, shocked at the bad behavior of financial leaders who, incomprehensibly to him, were not even attempting to maximize long-term risk-adjusted profits. Indeed, instead of the 'price discovery' so central to modern economic theory we had 'greed discovery.

What can go wrong for the market? There is a slow and for me rather sinister slowing down of economic growth, most obviously in Europe but also globally, that could at worst overwhelm even the Fed. The general lack of fiscal stimulus globally and the almost precipitous decline in the U.S. Federal deficit in particular do not help."

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