2007 A Year of Corrections?  

Guest Commentary by Joerg Schroeder

of Plymouth Capital Management

December 2006  

When applying our long term technical analytical models, we come to the conclusion that there is a high probability that we might encounter significant equity market corrections and increased volatility during the course of the upcoming year in the U.S.  

While our technical models do not deal in an economic vacuum, they typically do provide early warning signals at a time when the general consensus still is filled with optimism/pessimism as the case may be.

The intent of this commentary then is not to advance absolute claims but rather to serve as a signal of caution in what is generally viewed as another Goldie Locks environment by the majority of observers. It is our pleasure then to share our findings/outlook for the year ahead based on the following foundations:  

The “4 Year cycle”

It seems to be accepted wisdom that the “four year cycle”, which is typically comprised of either a) a one directional move; b) a one way move, followed by a correction; and c) a double top or double bottom – which occurred in l/t corrections such as the 70’s and 1938/42 as well as 1998/02 -, found its termination with the summer correction of 2006.  

While a calendar 4YC would make for a duration of 48 month or 1461 days, it is our finding, that since 1932 there was not a single “four year cycle” that aborted prematurely by 3 month or even less as would be the case for the 10/02 to 6/06 period. Moreover, the 4YCs on record over the past 70 years (present one excluded) typically extended over a duration (including correction) of 51 months, which would make the 02/06 4YC unique with a chance of about 6 % of being a correct call. Additionally, the smallest 4YC correction pre 06 amounted to 10%, which would make this 4YC not only the shortest every but also one with the smallest correction at 8%, while the majority of the 4YC corrected typically in the 20% range with the outer bounds for corrections amounting to a full 100% relative to the starting point.  

The 8.6 year Correction Cycle

During the past 110 years we can observe 4 major bull markets: 1896-1905; 1914-1929

1942-66 and 1982-2000. When each of the preceding bull markets ended (prior to the one ending in 2000) they were followed by a minimum duration correction of 8.6 years in nominal price with new bull legs not starting prior to the P/E being eroded to a less than an 8x multiple. While the number of occurrences might not be statistically significant over such a short time span, we can observe a 100% match on the existing corrections, which would lend foundation to the probability that the corrective cycle that started in 2000 has neither met its objective in low “startup” P/E multiples, leading to an at least decade long advance, nor would the empirical data of correction time have been met at this point. Moreover, in all of the aforementioned incidences the bear experienced a secondary bounce before the markets finally took off; leading us to conclude that the secondary bounce of the bottom (DJIA 7,200 or lower) is within a high probability prior to the ‘08 election that coincides with termination of 8.6 year cycle  

Long Term Trend Channel  

The current DJIA price levels hover significantly outside to top of a long term trend channel as defined by the tops and bottoms of 1937 and 42 respectively and confirmed by the top to bottom of 1966/74 nominal correction of 47%.  

In this context it may be significant that Alan Greenspan coined his “Irrational Exuberance” after we had broken out of and bounced off the trend-channel in the fall of 1996. Indeed, the 2000/02 correction bounced off the l.t. trend channel resistance line one more time. The value of the support trend-line in the fall of 2008 dollars amounts to 3,700 DJIA.  While such a move would seem inconceivable under current fundamental scenarios, it is a fact that the last two major corrections, 37/42 and 66/74 defined the boundaries of a 58 year trend channel. More realistically, it appears to us, that the old lows of 2002 have a probability of being touched or even taken out over the next two years with a high probability.  

Deflationary vs. Inflationary Price Corrections  

While in the 30’s we experienced rapid deflationary price adjustments, when the DJIA fell by nearly 90% in a matter of less than 3 years, the adjustments in real terms in the 70’s took 16 years from the DJIA top of 1000 to a nominal price of 777 in 1982, equal to a price correction of 74% (http://woodrow.mpls.frb.fed.us/Research/data/us/calc/).  

Since the technological advances, as well as the abundance of cheap labor from Eastern Europe , China and India are favorable for a low inflationary environment, it is unlikely in our opinion, that we will experience duration of price adjustment in real term DJIA prices that are similar to the high inflation environments of the 70’s. Thus, if history is any guidance, we should expect a rather rapid (deflationary) correction in the near future.

Does History Repeat Itself?

While we don’t favor overlay type of scenarios for projections, we nevertheless like to point out the significant congruence, so far, of price/time corrections in the ‘66/’73 period with the 2000/06 period.

Firstly, during both initial correction periods the DJIA lost 38.5% in nominal price during the initial correction after a 26 year bull market. Moreover, the duration of the roundtrip (66/73 and 00/06) in each case is about 2,500 days (ref. date Nov. 20, 2006 ). Whereas in the first case the correction lasted 1500 days, and the ensuing new higher high (’73) by 6.1% was achieved within 1000 days), the corrective phase in the latter case, from Jan 14, 2000 (DJIA) lasted 1000 days followed by a new high by about 6.1% within 1,500 days (The 4YC?). 

Quantitative Model Price Projections  

Our proprietary long term quantitative algorithm, which was developed through more than a decade of research has been helpful in verifying major price turns tracing back to 1929 with 98% accuracy, currently points towards a major top in the DJIA 12,500 area. The model is comprised of relative as well as fixed quantitative components that are used in conjunction and which work equally accurate in projecting overhead as well as correction targets (using inverse logic). It was extremely helpful in determining not only the correction of 2000 (DJIA 7,200 on the record) but also a high probability of the DJIA advancing to the 12300/500 area subsequently. While the model does not project any downside target at this point, other observations suggest that the DJIA should correct by a minimum of 21% from hereon with a most likely correction target in the mid 40s% at this time. The model will permit us to refine projections during the correction process.

Fundamental Observations  

1. We are currently experiencing a very high quota of analysts straight lining their 2007 projections.
2. The Treasury yield curve has been inverted for quite some time, which historically has been correct in suggesting recession. Unless the substantial purchases of Treasuries by foreign entities created the inversion of the yield curve, it can be expected that the inversion serves as a guidance tool suggesting a recession.
3. While a number of economists anticipate a “soft landing” there is no precedence in the past 70 years for a recession ever being soft on the equity markets.
4. During 2005 the private and public sector combined borrowed $ 2.80 resulting in only $ 1 of GDP growth, implying a deflationary velocity factor in spite of substantial debt creation.
5. The continued war financing will cause dislocation from more productive resources.
6. The price consolidation of the private real estate sector will reduce the probability to extract value via second mortgages to supplement consumption.
7. The negative household savings rate will subject households to increased vulnerability in case of asset price corrections in the equity markets.   

Summation

Both 4 year and 8.6 year historic cycles not completed, hence high likelihood of further time correction.  DJIA prices still far above trend-channel suggesting regression to the mean at minimum. Economic environment suggest adjustment by deflation rather than inflation, i.e. much less time in real terms than the 16 years from 1966 to 1982. Historic congruence could serve as additional guidance. Quantitative model reached multi year price objective at DJ 12,500. Selective major economic data suggests increased vulnerability. While correction magnitude by model not visible yet, regression analysis suggest corrections of min. 21% and most likely 45%. Strategy exit 12,700.

  About Joerg Schroeder:

The author has gained his experience in financial markets in a career spanning over 30 years in 4 countries and two continents holding positions as trader, product specialist, treasurer at money center banks, risk manager at hedge funds and entrepreneur in the investment business. For any detailed questions you may e-mail the author direct at jsstfmdct@aim.com. This article is being published with the expressive permission of the author who retains the sole copyright to this paper.

Copyright 2006 PLYMOUTH CAPITAL MGMT, LLC
STAMFORD, CT 06902-1011
phone (203) 324-1682

Watch Joerg Schroeder Present to the Reno 

Market Technician's Association in New York in Sept. 2006