The Little Book of Stock Market Cycles

1. Market cycles are driven by war, peace, and inflation

War and peace and inflation have an indelible impact on the stock market. They are the foundation of the cycle of boom and bust and of secular bull and bear markets.

War stalls markets. During wartime, stock markets tend to be range-bound and unable to sustain new highs. This is due to muted investor enthusiasm and negative events related to the conflict. The government's focus on war-related issues rather than domestic concerns and the economy also contributes to market stagnation.

Peace and inflation fuel booms. Once peace is restored, the economy typically experiences a period of inflation as war spending catches up. This inflation, combined with renewed focus on domestic issues and economic growth, sets the stage for the next bull market. Historical examples include:

• Post-World War I boom (1920s): 504% rise in the Dow Jones Industrial Average
• Post-World War II boom (1950s-1960s): 523% rise in the Dow
• Post-Vietnam War boom (1980s-1990s): Over 1,000% rise in the Dow

Technological innovation amplifies growth. Each of these boom periods was also characterized by significant technological advancements that transformed society and drove economic expansion:

• 1920s: Mass production of automobiles, radio, and aviation
• 1950s-1960s: Television, space exploration, and industrial technology
• 1980s-1990s: Personal computers, telecommunications, and the Internet

2. The four-year presidential election cycle significantly impacts stock performance

Politics being what it is, incumbent administrations during election years try to make the economy look good to impress the electorate and tend to put off unpopular decisions until the votes are counted.

Election cycle patterns. The stock market tends to follow a predictable four-year pattern aligned with the U.S. presidential election cycle:

1. Post-election year (Year 1): Often the weakest, as new administrations implement potentially unpopular policies
2. Midterm year (Year 2): Typically experiences a significant bottom, often in Q4
3. Pre-election year (Year 3): Strongest year, as administrations focus on boosting the economy
4. Election year (Year 4): Generally positive, but can be volatile depending on electoral outcomes

Performance statistics:

• Since 1950, the Dow Jones Industrial Average has gained an average of 10.0% under Democratic presidents vs. 6.8% under Republicans
• The best scenario for investors has been a Democrat in the White House with Republican control of Congress, averaging 19.5% gains
• From the midterm year low to the pre-election year high, the Dow has gained nearly 50% on average since 1914

Trading strategy. Investors can potentially capitalize on this cycle by:

• Being cautious in post-election years
• Looking for buying opportunities during midterm year bottoms
• Maintaining long positions through pre-election years
• Adjusting positions based on electoral outcomes and market conditions in election years

3. November through April are historically the best months for stocks

Be long November to January, historically the best consecutive three-month span to own stocks.

The "Best Six Months" strategy. This approach, developed by Yale Hirsch in 1986, involves investing in the Dow Jones Industrial Average between November 1st and April 30th each year, then switching to fixed income for the other six months. Key points:

• Performance: Since 1950, this strategy has produced reliable returns with reduced risk
• Statistics: These six months have gained 14,654.27 Dow points (up 37 times, down 25) vs. a loss of 1,654.97 points in the other six months (up 48, down 14)
• Compounding: A $10,000 investment following this strategy would have grown to $674,073, compared to a $1,024 loss for May through October

Monthly breakdown:

1. November: Strong start to the "Best Six Months"
2. December: Typically positive, fueled by holiday spirit and year-end buying
3. January: Often sets the tone for the year (see "January Barometer")
4. February: Usually consolidates gains, but still positive
5. March: Can be volatile, but generally positive
6. April: Historically the best-performing month

Potential explanations:

• Increased cash inflows from bonuses and tax refunds
• Positive investor psychology during holiday seasons
• Corporate earnings announcements in January and April
• Reduced trading volume in summer months

4. Seasonal patterns in the stock market are influenced by human behavior

Human nature synchronizes market seasonality with Mother Nature to a degree. But market gains are predominantly sown in the late summer and early fall and reaped in winter and spring.

Cultural and behavioral factors. Many seasonal market patterns can be traced back to human behavior and cultural norms:

• Summer vacations: Reduced trading volume in August as traders and investors take time off
• Back-to-school mentality: Increased focus and activity in September
• Holiday shopping: Positive sentiment and increased consumer spending in November/December
• New Year optimism: Fresh outlook and investment in January

Shifting patterns. While seasonal trends persist, they can evolve over time:

• August: Once the best month (1900-1951) due to harvesting money flows, now one of the worst
• "Sell in May" effect: Recently, selling in April has been more effective

Key seasonal opportunities:

1. Late summer/early fall (August-October): Often the best time to establish new long positions
2. November-January: Historically the strongest three consecutive months
3. April: Typically marks the end of the "Best Six Months" and a time to consider reducing equity exposure

Trading strategy. Use knowledge of seasonal patterns to:

• Time entries and exits for long-term positions
• Adjust risk tolerance and position sizing throughout the year
• Identify potential market turning points

5. Options expiration dates create predictable market volatility

Just as the moon affects the tide the expiration of options and futures contracts pulls the stock market into a cycle of volatility that flows cash into and out of the market, which drives the direction of stock prices.

Triple Witching. This phenomenon occurs when stock options, index options, and index futures all expire on the same day (third Friday of March, June, September, and December). Key observations:

• Increased volatility: Trading volume and price swings often increase around these dates
• Quarterly patterns:
  • Q1 and Q4: Generally bullish
  • Q2 and Q3: Often bearish, especially the week after expiration

Monthly options expiration. While less impactful than Triple Witching, regular monthly options expiration (third Friday of every month) can still influence market behavior:

• Pre-expiration strength: Markets often rally in the days leading up to expiration
• Post-expiration weakness: Frequently observed in the week following expiration

Trading strategies:

1. Be cautious of increased volatility during expiration weeks
2. Consider taking profits before expiration if sitting on gains
3. Look for potential buying opportunities in the week after expiration, especially in Q2 and Q3
4. Be aware that these patterns can shift over time as market participants adapt

6. Holiday trading patterns offer unique investment opportunities

Thanks to the Santa Claus Rally, the days before and after Christmas and New Year's Day are best.

Santa Claus Rally. This phenomenon refers to the stock market's tendency to rise in the last five trading days of December and the first two of January. Key points:

• Average gain: 1.5% for the S&P 500 since 1953
• Significance: When this rally fails to materialize, it often signals potential market trouble ahead

Other notable holiday patterns:

1. Christmas: Consistently positive trading days before and after
2. Martin Luther King Jr. Day: Often marks the beginning of January weakness
3. Presidents' Day: Typically bearish before and after
4. Good Friday: Strong market before, weakness after
5. Memorial Day: Weak before, strength after
6. Independence Day: Often lackluster trading around the holiday
7. Labor Day: Positive bias, especially for small-cap stocks

Jewish holidays impact:

• "Sell Rosh Hashanah, Buy Yom Kippur, Sell Passover" strategy has been effective
• Basis: Lower trading volume during these periods creates potential buying opportunities

Trading strategies:

1. Consider holding positions through the Santa Claus Rally period
2. Be cautious of potential weakness following MLK Day and Presidents' Day
3. Look for buying opportunities around Yom Kippur
4. Be aware of potential volatility around Thanksgiving, as recent years have shown mixed results

7. Midweek trading days tend to outperform Mondays and Fridays

Since 1990, Monday and Tuesday have been the most consistently bullish days of the week for the Dow and Thursday and Friday the most bearish, as traders have become reluctant to stay long going into the weekend.

Day-of-week performance. Analysis of stock market performance by day of the week reveals interesting patterns:

• Best days: Monday and Tuesday (combined gain of 11,992.54 Dow points since 1990)
• Worst days: Thursday and Friday (combined loss of 2,677.45 Dow points since 1990)

Potential explanations:

1. Weekend effect: Traders may be reluctant to hold positions over weekends due to event risk
2. Information flow: Corporate news and economic data releases often occur early in the week
3. Human psychology: Fresh optimism at the start of the week vs. caution approaching the weekend

Market conditions impact:

• Bull markets: Monday tends to be the best day, Friday second best
• Bear markets: Friday is often the worst day, Monday second worst

Trading strategies:

1. Consider establishing new long positions early in the week
2. Be cautious of holding long positions into the end of the week, especially in uncertain markets
3. Look for potential short-term trading opportunities around these day-of-week patterns
4. Remember that these are general trends and can be overridden by significant news or events

8. Major market bottoms often occur in August, September, or October

Eleven of the last 19 bear market bottoms (in the modern era since 1950) have fallen in August, September, or October.

Autumn bottoms. The tendency for significant market lows to form in late summer and early fall is a well-established pattern. Key points:

• Frequency: 11 out of 19 bear market bottoms since 1950
• Recent trend: 6 out of the last 8 bottoms since 1982 have occurred in these months

Potential reasons:

1. Reduced trading volume in August due to vacations
2. September portfolio rebalancing and window dressing by fund managers
3. October's reputation for crashes can create a self-fulfilling prophecy of selling pressure

Monthly breakdown:

• August: Historically weakest month, often sets the stage for bottoms
• September: Dubious honor of being the worst-performing month on average
• October: Known as a "bear killer" month, often marking the end of downtrends

Trading opportunities:

1. Look for potential long-term buying opportunities during market weakness in these months
2. Be prepared for increased volatility, especially in September and October
3. Consider averaging into positions over time rather than trying to precisely time the bottom
4. Use technical and fundamental analysis to confirm potential bottoming patterns

9. The "January Barometer" has been a reliable predictor of yearly market performance

Devised by Yale Hirsch in 1972, the January Barometer has registered only seven major errors since 1950 for an 88.7 percent accuracy rate.

January Barometer concept. This indicator suggests that the stock market's performance in January often sets the tone for the entire year. Key statistics:

• Accuracy: 88.7% since 1950 (only 7 major errors)
• Including flat years: 75.8% accuracy rate

Supporting indicators:

1. Santa Claus Rally (last 5 trading days of December + first 2 of January)
2. First Five Days of January
3. Full month of January

Predictive power:

• Positive Januarys: Often indicate a strong year ahead
• Negative Januarys: Have preceded every bear market, 10% correction, or flat year since 1950

Potential explanations:

1. New money flows into the market (bonuses, tax-related investments)
2. Renewed investor optimism at the start of the year
3. Important events often occur in January (new Congress, State of the Union address)

Trading implications:

1. Use the January Barometer as part of a broader market analysis strategy
2. Be cautious if January posts a loss, as it may signal trouble ahead
3. Consider increasing equity exposure if January is positive, especially if confirmed by other indicators
4. Remember that no indicator is perfect, and exogenous events can always impact market performance

10. A new secular bull market and economic boom are likely to emerge by 2025

Based on the war, peace, and inflation market cycle related earlier, my analysis projects that the Dow will stay trapped in the current range visible in Figure 2.1 until 2017 or 2018. By that time major U.S. combat operations should be wrapped up and a period of relative world peace will be emerging.

Forecast rationale. This long-term market projection is based on historical patterns of war, peace, inflation, and technological innovation. Key elements:

1. End of major military conflicts: Reduction in U.S. overseas military involvement
2. Inflation cycle: Rising inflation from government spending and monetary policy to level off
3. Technological breakthrough: Expectation of a new, transformative innovation (e.g., clean energy, biotechnology)

Projected timeline:

• 2017-2018: End of current trading range (roughly 7,000 to 14,000 on the Dow)
• 2018-2025: Beginning of new secular bull market
• 2025: Dow Jones Industrial Average reaches 38,820 (500% rise from 2009 low)

Supporting factors:

• Historical precedent: Similar 500%+ moves followed major wars and inflationary periods
• Pent-up demand: Years of economic stagnation create potential for explosive growth
• Demographic shifts: Aging population driving innovation in healthcare and biotechnology

Potential risks:

1. Geopolitical instability
2. Failure of anticipated technological breakthroughs
3. Unexpected economic crises

Investment implications:

1. Maintain a long-term perspective despite current market challenges
2. Consider increasing equity exposure as signs of the new bull market emerge
3. Look for opportunities in sectors poised to benefit from technological innovation
4. Remember that market timing is difficult, and a diversified approach is still prudent

Last updated: November 19, 2024