Time to Read: 8 Minutes
During our recent webinar, we discussed the Ned Davis Research (NDR) S&P 500 Cycle Composite—a unique chart that raised a lot of questions from our clients. Shown below for 2021, the cycle composite creates a roadmap for a given year in the stock market by placing equal weights on the following:
- One-year seasonal cycle
- Four-year presidential cycle
- Ten-year decennial cycle
At BWM Financial, we believe this chart illustrates a potential pattern the US stock market could follow. As most of our readers know, we never try to predict market behavior, but instead listen to the weight of the evidence to make tactical decisions. The cycle composite can give us a “heads up” for what might be ahead, as markets may not repeat but they do often rhyme.
One reason this chart has received so much attention from our clients is the close correlation between the cycle composite prediction (blue line) and actual S&P 500 performance (orange line). The other reason is the chart’s warning of an imminent decline in the weeks ahead!
Let’s take a closer look at each component of the cycle composite and the reasons behind the projected retracement this fall.
One-year seasonal cycle
Looking at the Dow Jones Industrial Average going back to 1900, the US stock market has exhibited strong seasonal tendencies. The year usually begins with a rally, followed by a spring pullback, a summer rally, an autumn decline, and a year-end rally that carries into the following year, as depicted below. The popular Wall Street cliché “sell in May and go away” speaks to the seasonally weak periods.
Multiple opinions and data points can explain the seasonal patterns, including:
- Heavy investment inflows at the beginning of the year before the April 15th tax deadline
- Above-average stock repurchase plans in the second quarter of each year
- Above-average IPO issuance in September (historically the worst performing month of the year) resulting in increased supply
- Summer holidays and lower volume
While the market does not always follow this pattern, 2021 has lined up very well in terms of the seasonal tendencies and potential IPO issuance in the fall.
Four-year presidential cycle
The presidential cycle can be felt not only in the economy, but also in the markets. As shown below, data going back to 1900 point to the potential for a fall pullback. We also see that the second year of a presidential cycle is the worst out of the four, historically.
The chart below reveals one macroeconomic reason behind the four-year cycle. The bottom section shows the four-year cycle of the NDR Real Monetary and Fiscal Policy Index, which measures what the Federal Reserve and federal government are doing to stimulate the economy. The policy index peaks early in the post-election year, falls until shortly before mid-terms, and reaccelerates through the election.
This also seems to mirror actual events so far in 2021. The US entered the year with a massive amount of stimulus from the federal government and the Federal Reserve. Stimulus levels are still high but the year-over-year change is waning, and we believe the Federal Reserve will announce some degree of tapering of asset purchases in the coming months, potentially following the direction illustrated in the chart’s bottom portion. Note that passage of the infrastructure bill could offset some of this decline.
Ten-year decennial cycle
As shown below, the period from April of year one to June of year two is the weakest in the decennial pattern, on average.
The decennial portion of the cycle composite receives the most scrutiny, perhaps because the rationale is less obvious. One explanation is that economic growth has been below average in years ending in one. Since 1930 and 1950, the median GDP growth rate in years ending in one has ranked ninth. Since 1930, S&P 500 returns have also ranked ninth; since 1950, they have ranked sixth.
Three recessions have started in year ones: 1981, 1991, and 2001. That is tied with years ending in zero for the most.
While GDP growth likely peaked in Q2 or Q3 of 2021, recession risks appear low. For all of 2021, GDP growth should be the highest in decades. According to NDR, the 10-year cycle appears to be the least applicable to 2021, a sentiment with which BWM agrees.
Current portfolio positioning
As stated above, we don’t try to predict market behavior but instead make portfolio changes based on the weight of the evidence. The 2021 cycle composite provides some insight into what might happen over the next few months. At BWM, we are still overweight equities over bonds and cash until our indicators tell us differently. We’ll be quick to cut our overweight positioning if a pullback turns out to look more ominous rather than presenting another good buying opportunity.