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It’s the Cycle, Stupid - Following Market Patterns

Markets follow predictable patterns, not policy. Investors should prepare for a long bear cycle in stocks and bonds, according to Charles Nenner of the Charles Nenner Research Center.

The recent turbulence in financial markets has sent institutional investors frantically searching for direction. Is the economy entering a “double dip”? Will the Fed embark on a new round of quantitative easing? Will the euro survive?

These are not the right questions to ask. You don’t have to wait until events unfold to make financial decisions if you have a way to tap into patterns that clearly exist in the markets.

My work is based on two foundations: Markets do not move at random, and there is no way of influencing their behavior. Markets are part of creation and follow natural laws. Cycles run the markets and are more “fundamental” than so-called fundamentals.

The idea that cycles, not human actions, guide the markets is difficult to accept emotionally. It means there is no free choice. Whatever President Obama or Congress or the Federal Reserve does makes no difference. However, once you understand the power of cycles, the correlations to market moves are uncanny. Patterns of past market actions and reactions repeat and are therefore predictable. Timing works.

A study of the Australian dollar clearly shows the existence of a regular cycle — as I define it, a combination of many equidistant price tops and bottoms — no matter what happens in the “real” world. The chart below shows three lines: The blue squiggly line at the top shows the Aussie dollar price, the blue sine curve shows the combined weekly cycles, and the red trend line represents part of a much longer weekly cycle. The chart indicates that since the mid-1990s the currency has moved in a regular cycle despite interest rate fluctuations, recessions or booms in commodity prices.

Looking at the broader markets, what do we see now amid all the “crises” that abound? How does an investor position for the long view while protecting against short-term swings?

I have been predicting for almost a year that there will be a major decline in equity indexes over the next few years — one that will take the Dow Jones Industrial Average down to about 5,000 — starting in 2012 and continuing into 2013, following the long-term cycles. Equities will stay down, with some tradable swings, for almost a decade, as in Japan.

Most government and corporate pension funds, which are heavily long-only, are stuck because they have rules on how much money must be invested in equities. Even if they sense that the market is coming down, most will take the hit and ride out the storm. I obviously don’t agree. I advise taking advantage of several projected shorter-term up moves — including a year-end rally in the Dow — while also positioning for the big bear market.

The bigger issue is what to do about bonds. The perception that bonds are the safe place to be long term, as they have been for the past 30 years, is also something that our models predict will prove to be incorrect. We were almost begging our clients to go long bonds when ten-year U.S. Treasury yields topped about 4 percent in April 2010.

Rates are now at a major inflection point: They are about to rebound in the start of a 30-year increase. I have followed a 60-year cycle in rates, topping around 1860, 1920 and 1980 and bottoming around 1890, 1950 and 2010. This means that markets are due for a sustained rise in rates over the next 30 years, with counterdirectional moves along the way. Investors should play intermediate-term swings within that longer-term horizon, going long bonds in November, for example.

I believe that the economy is ultimately the problem. It too follows cycles, regardless of what the politicians do. The cycles in industrial production, gross domestic product, employment, leading economic indicators, producer prices and consumer prices all turned down around April, which I had predicted six months earlier. These indicators all predict weakness for most of this decade. • •

Charles Nenner is founder and president of the Charles Nenner Research Center, an Amsterdam-based investor advisory service.

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