One way to look at the markets is to view them as a combination of cycles. Most people would accept that there is seasonality as regards the calendar year, but there are many other cycles too. It is, of course, easier to accept this as a phenomenon than it is to know where we currently stand among all the important cycles for the markets. That being said there are some cycles that are so dominant and historically well defined that we really should take them in to account in our investment calculations.
It also helps when we can understand the motivations that drive a cycle. What Mayer Amschel Rothschild understood over 200 years ago is as true today as it was then. What matters as much as anything else is what is in the best interest of the people who control our money. Once we understand this we can use it to our great advantage.
The markets and the election cycle
Fortunately, one of the most reliable and easily understood cycles is the 4 year election cycle. This is well documented going back several decades and it is dominated by the need to produce a strong economy a few months prior to the Presidential election. What this means is that starting 2 years prior to an election, policy needs to turn highly expansionary as there is about a one year lag before this policy feeds through to the economy. In other words 2007 needs to be a year of significant stimulus to ensure the economy feels good in 2008 well ahead of the election at the end of that year.
It also means that any restraint on the economy needs to take place in the first 2 years of the cycle with the second year, 2006 in our case, being the year in which the economy becomes sufficiently weak to justify a subsequent easing of policy going into the third year, 2007.
So interest rates are usually rising in the first two years, as they have been, and falling in the latter two years. As interest rates tend to lead equity markets, which lead the economy, equity indices tend to have a patchy first two years followed by strong performance in the third year and follow through upside in election year. For example, this would typically mean a weak or erratic equity market in 2005 and the first 9 months of 2006, with a major rally starting possibly in the fourth quarter of 2006.
The influence of this on the equity markets is not precise but the two charts below show clearly that the second year of the cycle has experienced somewhat patchy performance, but the third year has typically been very good and has not had a negative year in recent history.
What to do now
According to our election timetable we have just entered the worst 9 month period for equities. Historically it has paid to wait at this juncture before getting too committed to a large equity exposure. Alternatively, it may be advisable to keep investing in equities, but calibrate your overall exposure with offsetting 'short' positions, perhaps with put options, which are still cheap.
At some point this year, most likely in Q4, it will be time to become much more aggressive on the long side. But for now it would be highly unusual, even unprecedented, for 2006 to pass without a few significant downside moves in the indices. Indeed, unless the equity markets have at least some kind of medium term correction, how can the policy makers be sure that there is sufficient economic weakness to embark on a durably accommodative policy stance?
For now it is still not unequivocally clear that the economy is sufficiently weak and so short term interest rates may still have to rise in the near term to ensure the election cycle is on track. Only when it is clear that interest rates have peaked will equities be able to begin a major pre-election rally. So the key to timing and indeed the trade before equities begin their election rally, is when the two year note finally begins a sustained rally, so this is where our main focus should be right now, whether you are an equity or bond market investor.
The 2 year note trade
The timing on the 2 year note trade will depend on the data and other market based indicators. Forget economic forecasts. According to a 2002 IMF study, out of 74 identified episodes of recession in different countries, only four had been correctly predicted by economic forecasts published just three months prior to the recession year. In two-thirds of cases, consensus economists failed to "forecast" the recession even four months after it had started. So much for forecasts.
Are we on track? Most likely we are but, as usual there are a few caveats. An economic slowdown is clearly signalled by both the recent doubling of energy prices and the flattening/inversion of the yield curve. Historically these market based indicators have both reliably signalled a recession. Furthermore there is strong evidence that the housing market has now peaked, as we have discussed before, and we are very likely to see a weaker Q4 2005 growth rate, possibly below 3%. So the stage is set.
However, there are some unusual factors at play that are complicating the cycle. Deficit financing and global money supply growth have become huge factors.
Although the Fed has been tightening rates for about 18 months now, the world remains awash in liquidity. Total global foreign exchange reserves continue their rapid rise and despite the Fed's tightening stance the total supply of US dollars is 8.4% higher than a year ago. While it would hardly be a surprise for the Fed to give us the impression that it is fighting inflation, while it is simultaneously fuelling inflation, this does not seem to be the case in this instance. The monetary aggregates over which the Fed exerts most control are barely higher than a year ago. The main culprit is explosive Federal Government borrowing/spending which has increased by $557bn over the past year. Incidentally this represents a much more realistic level for the true annual budget deficit than the fantasy numbers used by politicians.
The point is that we are currently experiencing substantial policy activism through government spending/borrowing, money supply growth, and global liquidity on a scale we have not experienced before. This is a new part of the equation and is unlikely to moderate with Bernanke in the Fed chair.
More than likely the election cycle trades are on track and this will provide the key to trading a probably erratic 2006. The second year of the election cycle is a major turning point in this cycle both for interest rates and for equities, and the remarkable reliability of this cycle should provide a guide as we go through the year.
While this may be enough, we should also be on guard about what is happening to money supply, the real budget deficit, and global liquidity as measured by total global foreign exchange reserves. These factors will influence the intensity of the cycle, timing and the asset choices we need to make.
The Fed recently announced that it will no longer publish M3 money supply statistics, and this astonishing development will make it much harder to track the money supply. Unfortunately we live in a world in which the state collects more and more information about its citizens, while providing less and less information about its own conduct.