This week, let's update a couple of cyclical factors that have influenced the market and/or may influence the stock market in the near future. 

LET'S GET BIG AGAIN

In an article dated 12/06/06, entitled "Let's Get Small," I highlighted the fact that smaller-cap stocks tend to outperform larger-cap stocks between the middle of December and the end of February. As I write this there are still a few days left in February, so the jury is still out. Still, as this is written the small-cap Russell 2000 Index has indeed outperformed the large-cap Russell 1000 Index +3.9% to +2.1%. As you can see in Chart 1, the large-cap index actually outperformed the smaller cap index until early February, when the small fry flexed their muscles just a bit and led the market higher during the rally in February.

Chart 1 – Percentage gain registered by Russell 2000 Small-Cap Index (purple line) versus Russell 1000 Large-Cap Index (blue line) since 12/15/07

Chart 2 displays the December 15-February 28 comparative results since 1989.

Chart 2 – $1,000 invested in Russell 2000 Small-Cap Index (purple line) versus Russell 1000 Large-Cap Index (blue line) each year between 12/15 and 2/28 since 12/15/1989

After the end of February, the benefit of the doubt shifts back to large-cap stocks. Chart 3 displays the cumulative performance for large-cap stocks during the end of February through December 15^th time frame, versus that of small-cap stocks since 1989.

Chart 3 – $1,000 invested in Russell 2000 Small-Cap Index (purple line) versus Russell 1000 Large-Cap Index (blue line) between 2/28 and 12/15 each year since 12/15/1989

40-WEEK CYCLE

In a number of articles including "What a Difference 140 Days Make," dated 6/21/05, I have detailed the fact that the market seems to have been working within a 40-week cycle for a very long time (I know that sounds a little crazy, but please bear with me a little here). The first 20 weeks of the cycle is the "bullish" phase and is typically accompanied by a rise in the stock market (in this case, "typically" is defined as 76.4% of the time since 1967). The 2^nd 20-weeks is referred to as the "bearish" phase. In actuality, it might more accurately be labeled the "maybe yes, maybe no" phase. The point here is that the bullish phase has been much more consistently bullish than the bearish phase has been consistently bearish.

Chart 4 displays the growth of $1,000 invested in the Dow only during the bullish 20-week phase of each 40-week cycle, starting on April 21,1967.

Chart 4 – Growth of $1,000 invested in the Dow only during the first 20-weeks of each 40-week cycle (since April 1967)

Chart 5 displays the growth of $1,000 invested in the Dow only during the bearish 20-week phase of each 40-week cycle, starting on April 21,1967.

Chart 5 – Growth of $1,000 invested in the Dow only during the second 20-weeks of each 40-week cycle (since April 1967)



The contrasting results that appear in Charts 4 and 5 are compelling. The long-term trend during the bullish phase has typically been uniformly bullish. On the other hand, the bearish phase has been uniformly – well, whatever. Sometimes bullish, sometimes bearish, but in the end net bearish ($1,000 invested only during the "bearish" phase since 1967, would be worth about $740 as of 2/23/07).

For the record, since 1967 there have been 51 completed "bullish" phases. Please note the following:

• 39 times the market advanced, 12 times the market declined, a 76.4% winning percentage
• The average gain during the 39 advances was +9.7%
• The average loss during the 12 declines –4.1%

Most importantly, please note that the next "bullish" phase is due to start at the close of trading on 3/2/07.

212-WEEK CYCLE

Another interesting cycle I follow is known as the 212-week cycle. I first heard of this one back in the 1980s from a gentleman named Peter Eliades, then and still the editor of Stock Market Cycles. This cycle begins anew each 1484 calendar days (212 weeks times 7 days a week and voila!). The next "cycle bottom" is scheduled for June 11, 2007. "Why would I care?" you might ask.  Well, here's what I have discovered from examining this particular phenomenon over the years:

• The 212-week cycle start date has been known to produce a low-risk buying opportunity, and the six-month period immediately following the start of each new cycle has shown a strong tendency to witness some extremely bullish stock market activity.

Let's take a closer look.

IMPORTANT DISCLAIMER: For the record, when I started out in this business I never intended to "waste my time" doing silly things like "analyze cycles." I started out trying to do more "useful" things like forecasting earnings and sales growth for every company in the U.S. Unfortunately – and as I mentioned last week – my crystal ball broke very early on and even more unfortunately, it took me a long time to figure out that it wasn't working. As a result I kept trying to forecast how the economy would perform over the next 6-12 months. Then I'd try to predict which companies would have the best earnings and sales growth and were thus most likely to perform the best. Turns out this is not easy to do with a broken crystal ball (or under any other circumstances as far as I can tell). Ultimately, I enrolled in a "self-study" course at "The School of Whatever Works." With no pre-conceived notions about what "should" or "should not" work, I ultimately found a lot of things that have worked. Certain cycles seem to be among them. (Who'd a thunk it?)

This phenomenon can be traced back to the first 212-week cycle bottom that occurred on May 16, 1938. If we go forward from that date in increments of 1484 calendar days, we get the dates shown in Table 2. Note the action of the stock market in the first six months of each new cycle as also displayed in Table 1.

Table 1 – Bullish portion of the 212-Week Cycle

A few things to note from Table 2:

• The Dow has been up during the first 6 months of each cycle 15 out of 17 times
• The OTC Composite (which came into being in 1971) has been up 8 out of 8 times
• The average 6-month gain for the Dow during this favorable 6-month period has been +14.9% (that is an annualized rate-of-return of +32.0%)
• The average 6-month gain for the OTC Composite during this favorable 6-month period has been +21.4% (that is an annualized rate-of-return of +47.4%)
• In 14 out of 17 occurrences, the Dow did not decline more than 3% from its price level at the start of the new cycle
• In 7 out of 8 occurrences, the OTC Composite did not decline more than 3.1% from its price level at the start of the new cycle

Like anything else, nothing is ever perfect. In 1946, the Dow suffered a loss of –14.2 during this supposedly bullish period, including a maximum decline along the way of –21.0%. So no one should make the mistake of thinking that the stock market is guaranteed to rally between 6/11/07 and 12/11/07. 

Chart 6 displays the growth of $1,000 invested in the Dow only during the first 6 months of each 212-week cycle since May 16, 1938.

Chart 6 – Growth of $1,000 invested in Dow only during six months after each 212-Week Cycle start date (since 1938)

Chart 7 displays the growth of $1,000 invested in the OTC Composite and the Dow only during the first 6-months of each 212-week cycle since December 9, 1974.

Chart 7 – Growth of $1,000 invested in OTC Composite (purple line) and the Dow only during six months after each 212-Week Cycle start date (since 1974). Bullish periods started in 1974, 1979, 1983, 1987, 1991, 1995, 1999 and 2003

The future never fits the past perfectly. Still, the results displayed in Table 1 and in Charts 6 and 7 are fairly compelling and suggest that we might do well to give the bullish case the benefit of the doubt in the second half of 2007.

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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site