Archive for May, 2008

Intermarket world in 2012

Intermarket cycles can change the way we look at asset cycles. Starting from 30 year mirroring commodity and equity cycles, inflation and deflation cycles, the subject also redefines Sam Stovall’s sector rotation structure giving new insights about the world order ahead.

It was not just investment gurus, but philosophers and painters who talked about simplicity being solved complexity and a very powerful investment approach. We also had a Nobel Prize awarded to a simple thought that there is no economics without psychology. Sentiment comes before rationality and human beings are nice and dumb and not profit maximizing smart souls. Crowds are accordingly involved primary with instincts, biological drives, compulsive behavior and emotions. Hence market success is less about economic but more about psychological competence.

Many experiments regarding crowd behavior also prove that an individual transforms into another being when he becomes a part of the crowd, so much so that he completely abandons the logical and rational thought. He does not think but herds. Solomon Asch, Harvard conducted the matching lines experiment (Fig 1.). Individuals and groups were asked to match the length of a line with three other lines. Individuals in isolation made a mistake less than 1 per cent. However, when placed in a group that had been instructed beforehand to claim the mismatched lines were actually the same, 75% of participants agreed with the majority. This was true even when the actual difference between the lines was very significant. Participants lacked the nerve to disagree with the majority. Another interesting experiment demonstrating the lack of rational thought was when a group exercise was conducted by Stanley Milgram of Yale. Individuals were ordered to inflict pain on an innocent victim (who was acting) in the interests of an important cause. More than 60% of the subjects were prepared to obey instructions and administer the highest and most lethal dose of electricity, even after the victim was, to all intents and purposes comatose.

And if all this infliction and pain seem closed door experiments different from the stock markets, we have numerous mathematicians and scientists proving the same simplicity mathematically. It was George Kingsley Zipf, an early twentieth century scientist who revolutionized our understanding of power law and revealed their astonishing presence throughout society and nature. Zipf’s law (Fig 2.) states that the most common word used in language is a constant factor (say two times) more common than the second most common, and the second most common word is twice as common as the third etc.

In 1955 Herbert Simon sought to unify the observations of Zipf and others by formulating a single common explanatory model for many of the systems displaying power-law behavior, including language, population and wealth. Stock markets around the world also work on a power law. In 2003 in a paper submitted to Econophysics, Kaushik Matia and I illustrated the Indian price fluctuations exhibiting an intermediate form between Power Law and Gaussian behavior. This aberration also did not last long when Sitabhra Sinha, re examined the prices in May 2006 finding the price fluctuations exhibiting a power law.

Another interesting aspect was that of Fractal geometry, published in 1977 when Benoit Mandelbrot (M SET fame Fig 3.), Mathematician, Yale proved that Fractal Geometry was mathematical. His work extended the area of late nineteenth century mathematicians like Giuseppe Peano who demonstrated the completed inadequacy of the common idea of dimension.

The subject of fractal geometry can not only calculate coastline lengths but is used in Seismology and Helioseismology and in a host of other scientific applications today. The marine drive, Mumbai, coast line carries fractal drums to safeguard the coast. It is scientifically proven that rugged fractals are more efficient in saving coastlines than concrete walls. The fractal nature of the web is also behind Google’s success.

The worldwide web is in the form of a bow tie (Fig.4) with four components, a core, inbound links, outgoing links and the disconnected pages. Any way you slice the web, geographically, topic specific clusters, organizationally or into groups of pages owned by the same person, the bow tie shape emerges again and again. This is the same fractal behavior in nature, societies and price behavior that connects all of us. This is also a reason why Elliott’s wave principle and Dow’s theory has survived more than 125 years.

Fractal self affinity as Elliott said, is fundamental to nature and all human activity leads to a socionomic process. It follows a law, repeats in time, has a definite number and pattern (Fig 6) and covers areas as diverse as Gold prices, population movement, price of seats in stock exchanges, patent applications, commodity prices, epidemics real estate business, politics and the pursuit of pleasure. We have also talked about Malthus population curves redefined by Verhulst as S curves (Fig 5), another form of fractals.

All this fractaled nature of Economics, nature and universe has a fixed periodicity linked with it i.e. there are cycles running through them. Edward R Dewey started the Foundation of Cycles early 1940’s when he realized the uncanny similarity in data cycles found by Hyde Clark in business activity (Fig 7.), Benner in industrial prices and Seton in animal population cycles.

The 11 year sunspot cycles linked with human excitability and stock markets. The nine year cycles linked with religion and credit (Fig 7.), where rise of deposits every nine years is inversely linked to the rise in people going to church, 25 year volatility cycles (Fig 12), 17 year international battle cycles, dividend cyclicality etc. Interest rate cyclicality is a reality that flies in the face of believed truth that the central banker is in charge.

The current linear research model (Fig  8 ) fails to assume the cyclicality of the market. The model works on an assumption of an economic growth that leads the positive news which leads to price growth and prosperity. Robert Prechter’s socionomic model was the first to illustrate the social mood cyclicality.

The Alternative research cycle (Fig 10) considers the social mood at the start of all human action and activity. A positive mood reflects in productivity and creation which reflects in markets and finally confirms as the economic cycle turns up. The positive economic cycle creates positive news and hence the self feeding feedback loops. On the other hand owing to social negative mood, it’s the negative feedback loop which works.

Fundamental meets Technical. Sam Stovall, chief global strategist, S&P was recently invited to the MTA (Market Technicians association). He was wondering why he was invited as S&P already had a few CMT’s. The reason Sam was invited was because his sector rotation structure (Fig 11) are the first steps of a fundamental thought towards cyclicality, which is a technician’s domain. As we move ahead the thick line between fundamental and technical starts to erode. John Palicka’s Fusion analysis is another attempt to bridge the two subjects.

Stovall’s sector rotation identified five economic cycle stages in the market viz. early expansion, middle expansion, late expansion, early contraction and late contraction. The market sectors move within these five stages. Technology and Transportation perform in the early expansion, capital goods in the middle expansion stage, basic materials, energy, and consumer staples in the late expansion stage, utilities in the early contraction stage. And financials and consumer cyclicals in the late contraction stage.

Father of Intermarket analysis John Murphy, connects defines the four broad asset classed viz. bonds, currencies, equities, and commodities and there linkages. How bonds leads equity markets and how commodity upcylces are inverse of equity cycles.

Just like all other fractals, a link runs through market cycles which Tony Plummer defines in his book on Forecasting Financial markets. Plummer classifies the broad economic cycles into TRIADS with Base, trend and terminal cycles. Cycles are seen from low to low and not from high to high, as bullish market bias extends markets longer pushing the cycle top ahead of the symmetrical high. Bear markets correct faster. This is why the bear cycle tops are translated (biased) towards the left and lie before the symmetrical cycle tops. Plummer identifies behavioral traits linked with the respective base, trend and terminal cycles. Base cycles are characteristic of Indolence, recuperation and rejection. And trend cycles are characteristic of confidence, change and deception. Fear, resistance and accusation are characteristic of final terminal cycles. All these cycles have a three wave pattern labeled as 1-2-3 up and a-b-c down (Fig 7).

These triads build the economic cycles and exhibit a power laws behavior. Kitchen cycles last from 3 to 5 years and on average are 3.33 years long. These are knows as inventory cycles are closer to the popularly know US presidential cycles. The only cycles conventional economists believe to work. Next comes the Juglar cycle, which last for 7 to 11 years and average around 10 years. These are also knows popularly as the decade cycles. Juglar cycles, which are also known as the capital investment cycles, are three times Kitchen cycles. Then next power law that is three times Juglar cycles take us to Berry cycles also known as the infrastructure cycles. Berry cycles last for 25 to 30 years averaging around 30 years. We have seen 25 year cycles in commodities, gold and silver ratio, volatility etc. A step ahead on power law takes us to the Strauss and Howe cycles (crisis cycles) of 90 to 99 years. Plummer makes an interesting observation about Kondratyev cycles while classifying the triads from 3.33 years to 90 years. Kondratyev is not an economic cycle as Kondratyev saw prices rising and falling in long waves. Not all Kondratyev lows are major depressions because not all Strauss and Howe lows will coincide with a Kondratyev low.

Strauss and Howe crisis alternate between deflation and accelerating inflation. This is why Plummer believes we have finished the deflation Strauss and Howe metacycle in 1946 and now we are in the inflationary cycles that should push till 2030 marked by the world war III. A rough calculation and one can see that India’s first war of independence and US civil war of 1857 had an uncanny similarity. This we at Orpheus believe was the second 90 year metacycle. The first starting somewhere in 1720, the start of capitalism. Hence we are indeed in the revolution cycle which ends the 270-300 years of economic activity near 2030. We are not sure how inflationary things may get or whether we are indeed heading for hyperinflation and destruction of real money, the pointers more indicate at the latter than the former. The intermediate pause before the last 30 year cycle starts should be around 2012-2014. This should be marked by economic growth accompanied by continued rise in commodity prices, Gold at 3000 dollars and Oil potentially much higher. New sectors to watch should be the alternative energy and biotech till 2020 and beyond.

Intermarket cyclicality is a subject coined by us at Orpheus. This subject not only redefines SAM Stovall’s sector rotation. But it also attempts to extend market cyclicality from an intermarket perspective. Since cycles work on Triads, Sam’s sector rotation sectors can be reclassified in three broad sectors viz. early economic, mid economic and late economic cycle sector (Fig 11). Early Economic i.e. Financials, Information Technology and Discretionary. Mid economic i.e. industrials and Late economic consisting of Energy, Materials, Staples and Utilities. As we head into the terminal kitchen cycle and Juglar cycle low in 2010-2012 the late economic cycle should outperform the market.

This means Energy, utilities, staples and materials sector stocks has more upside left. According to intermarket cycles, the 30 year Berry cycles is linked to equity cycles. That means equity markets grow and decay in about 25-30 years cycles. This is what the gold-silver ratio (the metals maze) and volatility cycles highlight (25 yr cyclicality). This 30 year equity cycle is inverse of the 30 year commodity cycles (Fig 14.). This means when equity rises, commodities fall and vice versa. 1975-80 was a commodity market top and an end of equity bear market in US.

And 2000 was an equity market top in US and a start of a commodity boom. The current commodity boom should end in the 2024-2030 (Strauss and Hauss) metacycle low with potential highs in the 2012-2015 time windows. It is in this time frame equity markets should make the decade low. Intermarket cycles can extend the cycle explanations to regional allocations between Asia and the west, between inflation and deflation and between interest rate and yield cycles.

Sector rotation remains a key intermarket strategy for portfolio allocation but in terms of early economic, mid economic and late economic than what is classified by Sam Stovall’s five stage economic cycle approach. Commodity and equity intermarket also suggests that materials, metals, chemicals, staples and Pharma could be defensive and relative performers. Our XTR products cover global sector rotation and intermarket cycles for emerging markets including India and Romania and for global sector indices. Intermarket cyclicality can also help move in and out of large and small cap sector stocks. The subject can also help create low correlation combination portfolios to better overall portfolio return to risk profile.

The current multi decade cycle is inflationary and of rising interest rates. Many emerging markets are between the late expansion and early contraction stage. This means that the sectors which will outperform are the Energy, Staples, materials and utilities. This should happen for atleast a primary (more than 9 months) time frame. The late economic sector cycle is in sync with the ongoing 30 year commodity cycle, which started in 1998-2000 and should top in 2012-2015.

This is another reason why food, material and commodity prices will continue to rise. However, we should not forget that this commodity cycle is a 1-2-3 structure up. And we have had no retracement of primary degree till now. The very reason a sharp retracement is pending before the CRB (Reuters Commodity Index) regroups again and heads higher. The real depression activities will start then.

The world in 2012 will be a stranger place with the lower billion of the world struggling for food and the top billion still getting richer. The hedge funds (the one’s that survive) which will create news then will be the ones doing Long Water – Short Oil strategies. The world beyond 2012 will be ruled by global macro funds, market psychology will gain more prominence, fractal forecasting might be taught at YALE, Cycles will get their place in statistics as the relentless cyclical change pushes ahead. And all this while we will wonder about the randomness of the world we live in, unaware of the simple structures that got us so far.

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The OIL rocket

Nothing can rise exponentially, even if it’s OIL. The asset’s exponential rise is more an indication of an ending trend and not vice versa.

We don’t have any chilly warning about OIL heading to dollar 200, like many in OPEC believe. Does OPEC really know? The axiom linked with 40 dollar plus OIL, as harbinger of recession has been long trashed and now not only we are waiting for recession but also for dollar 200 OIL. It all seems a bit strange to us.

OIL moved up 3 times from the 40 dollar mark and DOW is still at 13,000, just 7% lower than historical top. So either the other best indicator for recession that is S&P500 and DOW Jones have stopped working or econostats have blinded us.

For a start we have some common sense rules, which say rockets come down to earth and satellites remain in the sky. The way OIL is behaving makes it either a rocket potentially getting ready to become a satellite or this all is an illusion. OIL can never become a satellite, no asset can. And the almost ninety degree inclination to new highs is destined to collapse. And what will collapse along with this is the dream of OIL riches.

It’s how you look at it. Bloomberg Markets looked at it as the END of OIL era and a few Wall Street brokers looked at is a great time to solicit mass mailing lists for OIL CALL options. Well we don’t subscribe to the OIL end era yet, but if the best broker suggests buying CALLS with such confidence, we definitely don’t know something he knows or something everybody knows. But that’s good, if we don’t know, what everybody knows. Because if everybody knows something it’s already discounted and the truth is already out there that OIL is TOPPING.

Of course the reason of the fall, when it happens will be like this…”Winters were cold so OIL rose and summers are hotter so OIL is falling”. When OIL falls in winters, which it did from 2000 to 2002 and later in 2006 to 2007, the winters were warm. For us OIL is more than a climate barometer. It’s like all other assets, which are connected with 0.5, 4, 11, 30, and 90 year cycles. And all these time cycles can explain cycles of inflation, deflation, disinflation, food, gold, equity, recurring geopolitical crisis, interest rates and also how we should handle a portfolio within the year. It also tells us about what is going to happen to OIL in 2012. We will be discussing this next time when we talk about asset cycles in 2012.

At this stage what we can see is a sentiment euphoria which is hard to sustain. The five legged fractal structure both starting 1999 till 2008 and the smaller five legged sub structure starting in 2007 seems complete. And holding one’s impulses to ride on this rocket seems reasonable to us. FIB and CHANNEL targets lie at current levels. We don’t see OIL above $ 125 at this stage and our research IMPULSE (we are humans too) shows more of a PUT than a CALL.

What will happen can also be explained with another magical previous 4 rule. Price impulse moves in a five wave structure. And you can label them like a school exercise of counting 1 up, 2 down, 3 up, 4 down and 5 up. Now this exercise can be done on a large (multi year) time frame and a multi day time frame. This is what we keep mentioning as mass psychology fractals impulsing again and again at all degrees. It’s the magic human nature plays with precision.

After every impulse the markets take a pause and fall in three wave structure (a down – b up – c down) and then the impulse starts again in an unending process. That is why we say that world may never come to end, it’s just that some time the volatility of relentless market action becomes too much for a society looking one way. This always happens, like the subprime mess and the credit crisis. We all look up to OIL now and not NAT GAS, which is the next multi year outperformer. We love to see rockets and ride them, other things don’t excite us.

So whenever an impulse (five legs) takes a pause, they fall to the previous 4 wave. This is a much witnessed event in fractals. Previous 4 wave supports are also mentioned as the last supports standing. Prices should not fall below the previous 4 wave or rise above the previous 4, if the trend has to continue. Of course this is a guideline, but this appears more time than coincidence.

You can see this everywhere, BSE OIL, BSECG, BSE BANK, BSEAUTO, SENSEX, NIFTY and CNXIT (Indian Sector Indices). They are all full of previous 4 wave retests. OIL when it turns down could fall to first a previous 4 wave support at dollar 90. And if it indeed breaks that, we can be in for sub dollar 70 levels. And this we are talking about the next few months. We can be wrong. But not like the poor chicken, an anecdote quoted by the late A J Frost, Market Guru.

The chicken used to run at the presence of the man, but man’s appearance on the scene was linked with corn. This happened 999 times, till the Chicken went to thank the man and had his neck sliced. Though anatomy proves that we are more like sheep and herd, we indeed might be chickens when it comes to cause and event linkage. We are miserable here and believe summers and winters drive the Oil rocket. Indeed a poetic tragedy.



WAVES.OIL is a perspective product published once a week. The report covers BRENT, WTM, XLE (Energy SPDR), top energy stocks, Natural Gas and related FUTURES. The product highlights Primary (Multi Month) and Intermediate (Multi Week) price trends. The report illustrates key price levels, price targets, price projections and time turn windows. The product uses Elliott waves, traditional technical analysis tools and sentiment indicators.