Profiting from Markets by Understanding How Cycles Determine Trends

``I know you won’t believe me, but the highest form of Human Excellence is to question oneself and others.” Socrates

ON the average, investors think the markets are a function of random events, hence gets easily swayed by ticker based actions. It is such reason why the common man’s interpretation of the financial markets are as gambling havens, simply because they mostly assimilate a gambler’s fallacy mindset or ``the tendency to assume that individual random events are influenced by previous random events”-wikipedia.org.

For instance after a series of coin tosses, where 5 heads appear in a row, what do you think would be the next outcome?

Trend followers would bet that the next throw would still result to a head (due to its streak), while contrarians would bet on a tail (premised on the “running out of luck” or “law of averages”).

But the fact is since the coin tosses are a 50/50 odds proposition, the next outcome is independent of the results of the previous throws. Therefore, both bets were based on flawed grounds.

However, unlike a coin toss financial markets do not basically operate on random. Instead they operate on cycles. As Warren Buffett’s mentor Ben Graham once said, ``In the market is a voting machine but in the long run it is a weighing machine.” Yes, there may be instances where short-term randomness will dictate on markets, but as a weighing machine the likelihood is it follows a general secular trend.

Figure 3: Chartrus.com: Japan’s Nikkei 225 suggests of an incipient bull market

We love to look at the long term macro perspective and for bull markets cycles, long term returns are usually awesome, for instance in Japan the 20-year bullmarket lifted the Nikkei 225 from about the 2,000 level in 1970 until 40,000 or a return of 20 times!

Yet following the Nikkei Bubble bust, the next 14 years saw the Japanese benchmark on a general downtrend until 2003 or a loss of 80% from its peak. Today the Nikkei has broken out of its long term declining trend, has shown signs of convalescence and is apparently on an upward dynamic.

So the secular trend for the Nikkei 225 could most likely be on an advancing phase and such is why we have been bullish on Japanese Equities since 2003 despite its recent underperformance.

We believe that the market clearing phase has sloughed off enough malinvestments to merit renewed revaluations of the Japan’s asset markets.

Further, we also believe that the Japanese are likely to adopt to the globalization dynamics with necessary reforms, such as further liberalization of its markets and unwinding of its opaque web of keiretsu crossholdings, plus a shift to shareholder responsiveness while increasing economic ties with its neighbors are additional boosters.

In addition, we also think that Japan’s demographic challenges will allow its government to adopt policies which will increase migration flows and outsourcing trends. Lastly, we think that increasing rates for the world’s largest creditor nation will help repatriate resident funds invested overseas and bolster Japan’s financial asset markets as well as for the region.

This is in sharp contrast to the long term trends that one can see in the US interest rates markets, where the US 10 year rates appear to be forming a bottom and could possibly segueing into higher rates as shown in figure 4.

Figure 4: Economagic: 10-year Treasury Constant Maturity: shows of advancing rates

As I have shown this in the past, the US interest rates have depicted some 20-year cyclical patterns. US 10 year coupon rates advanced from 1953-1981 (28 years) and fell from 1981-2003 (22 years). The chart shows that if the cyclicality holds then future rates are likely to move higher than lower.

What could be the potential instigators?

Asia’s or Oil Exporting countries’ “reserve currency decoupling” of their “surpluses” from recycling into the US dollar/or US dollar assets, as evidenced by the recent moves by Kuwait to unpeg its currency from the US dollar.

Another is China’s fiery baptism into the emerging realm of Sovereign Wealth Funds by acquiring 9.9% or $3 billion stake of US private equity firm, Black Stone Group or possibly recent surges in the prices of food prices or agricultural products as a result of a global boom and aggravated by market distortions imposed by government policies promoting agricultural feedstock to produce biofuel.

Even Japan’s potential repatriation of resident investments overseas could likewise serve as a trigger.

The other major factor, the underfunded state welfare programs confronted by the present demographic trends could further raise inflationary pressures which eventually translate to higher interest rates.

Of course, one may argue that fears of deflationary bust from an overleveraged US financial economy would prompt the FED to drastically cut rates, but that would essentially be like throwing gasoline into the fire.

Or that a global deflationary depression could lead US treasuries (lower rates) into a new bull market as some analyst suggests. While we see such as a probable risk factor one cannot discount, I think that an implosion of the overleveraged US credit system in today highly “globalized” world has a potential to cause some serious delinkages or financial decoupling from US assets.

As I see it, the world is getting to be increasingly less and less US-centric as enumerated in my “History is not a closed book” series. Today we are seeing intensifying signs of US dollar “currency reserve decoupling”. In the future, the likelihood is that the “economic decoupling” thesis could gain more traction.

Further signs; Asia has fielded more candidates for the CFA or financial analysts exams than that from the US or UK or Canada as reported by the Financial Times. More writings on the wall?

Overall, prudent investors are concerned with long term trends while looking at potential risks that could upend such trends.

And while trends could be influence by some short-term randomness or gyrations they are likely to be dictated by cycles over the long term. And by cycles we can incorporate the business and economic cycles, by considering the Juglar cycle (7-11 years), Kitchin cycles (40 months or 3-4 years), the Kondratieff long wave cycle (50-60 years), and simply the financial markets cycle.