Long Cycles - Part I
I have written often before about long cycles in stock prices. The chart below gives a clear picture of those cycles since the beginning of the 
twentieth century. These cycles are not caused by celestial phenomenon, Kondratieff Waves, or other mysteries,but are the result of cumulative impact of emotion on investor behavior, the decay of investor memory, and the magical power of mass hysteria.
The dark color represent secular (long term) Bear Markets, the light color show secular bull markets. This chart of the Dow Jones average shows that for 56 of the last 110 years the market as a whole has shown little or no long term gain.
As a general rule each of these secular bear markets contained several short term (cyclical) bear and bull markets with at least one correction of 50%. Although the bear markets appear fairly benign on this chart, they are anything but. As anyone knows who has had skin in the game for the last eleven years, the market has been a roller coaster that has provided the average investor with many great opportunities for wealth destruction.
In the early part of the economic cycle central banks are expanding credit and printing money. This transmits to the market place a message that the demand for products is increasing. This sets in place the expansionary business cycle. In the Nineteenth Century economic cycles where a good deal shorter, than the cycles experienced in the Twentieth Century with panics appearing every ten to twenty years instead of the thirty to forty years of most the last century. The fact that central banks have become more ubiquitous and powerful, and that money is no longer backed by any hard asset may go a long way to explaining this lengthening of the business cycle.
While the rise of the central banks has not been able to eliminate the economic contractions, the power of these central banks to print money does allow them to prolong the expansionary cycles which while this is politically popular is dangerous for investors because it allows little bubbles to become big bubbles
Corporate Profits
The table below lists corporate profits at the beginning and the end of the market cycles identified in the chart above. The table begins with 1929 because that is the first year for which the Bureau of Economic Analysis gives us data on corporate profits.
Obviously, the most interesting thing about the table is the fact that there is no obvious relationship between the market cycles identified above and corporate profits. In all but one case (1966-1982), corporate profits where better during the bear markets that they were during the bull markets. Since Investors expect stock prices to follow the path of the per share earnings of the underlying stock, how do we explain these long periods where Mr. Market ignores positive earnings?
The 1970’s Economist Hyman Minsky said that Capitalism is inherently unstable, by which he meant that during periods of prosperity, when banks and other financial institutions are earning money and their earnings are increasing steadily year after year, competitive pressures from the market place will tend to push these institutions into investments with higher and higher risk. Investors start the bull cycle with a very low tolerance for risk, having just survived 15 to 17 year bear market, but by the end of the cycle a couple of decades later, after years of steadily risings prices and low levels of loan defaults, investors have lost their memory of, and the ability to understand, risk. Time numbs the pain of the past as the investor discovers that the guy across the street is making more money than he is, so his risk tolerance expands.
The irrationality generated by our recent cycle created two great bubbles, the internet bubble and the housing bubble. These bubbles have generated a level of collective insanity unmatched by anything we have experienced in the past, and were not in any sense limited to the United States, but spread like a virus throughout the developed and the developing world. Nor was the insanity limited to financial institutions, but spread across the populace of most of the countries involved, as citizens of all stripes sought instant gratification bought with someone else’s money. Michael Lewis’ excellent new book “Boomerang” details fascinating tales of this financial mania as it traveled from an exploitative Wall Street to naïve and unsophisticated Banks in Ireland, Iceland, and Germany. He details how the financially corrupt were aided and abetted by morally bankrupt political systems in places like Greece and U.S.
(best example: California).
So we have a long bull cycle where PE ratios expand till they are a bubble, and a long bear cycle where PEs shrink down to single digits. It is apparent that markets are not ruled by corporate earnings so much as they are measuring the investors’ current psychosis.
Implications
What does this mean for investors? It important is know what cycle you are in, and what part of that cycle. While the cycles have little day to day impact on stock prices it is important to understand that interpretation of PE ratios will be continuously changing and that, in a long term trend, PE ratios will either be contracting or expanding irrespective of the trend in corporate earnings. It also obvious from the chart above that the best time to buy stock is toward end bear market cycle. This may have some interesting implications for investments made in the next two or three years, and we will return to the subject in the future.
Even for those of us who accept that these cycles are real we have to wonder how long they will continue. For the answer to this question we clearly do not need to consult with stock market analysts, but need to study the nature of human behavior and mass psychology. Probably we can expect these cycles to disappear about time the there is a genetic mutation that eliminates greed and ambition from the human gene pool.