Sunday, January 25, 2009

Searching for the Comfort of Cycles

Our earliest experience has to do with being fed on a regular basis. After the very first drink, we learn there is a second which is followed by a third and so on. Thus we learn rhythms, albeit two separate notes between being fed and sleeping. A little later we start to identify the time pattern between feeding and sleeping, and the third state of waiting for either to happen. From this three stage development we learn about cycles, and to keep us in good humor, the predictability of these cycles. Now that we are larger, in many ways no less baby-like, we search for the comfort of the predictability of cycles. After all, we know about the cycle of day and night. In order to schedule joint activity with others, we introduced the primitive concepts of a clock which divided time into segments of hours. To effectively regularize our lives we introduced an abstraction of assigning 24 hours to a day. Using this abstraction one could be certain as to the future. There WILL be a six o’clock tomorrow morning, and for most of us that is comforting because it means that we will consume our first meal of the day.

The problem in applying this abstraction is that we don’t know whether the sun will be up over our horizon on any particular morning. We are unsure for two reasons. First, the “rising” of the sun, in reality is the rotation of the earth, a predictable cycle which is not based on our clock system. The second reason is that we may not have great light at dawn (or any other part of the day), as there may be clouds overhead, sometimes dark clouds. These primitive experiences help us appreciate the frustration of today’s investors attempting to predict market movements.

We would all like to have the predictability of being fed on time, in a pre-ordained way like the sun rising. We want to be able to believe that next Tuesday most stocks, or more importantly my stocks, will begin a ten year rise of historic proportions. The problem is that there are serious economic, financial, political, social and scientific black clouds overhead. We are not only losing money, but we are also frustrated about our inability to predict the future. While I can not predict the future, I can examine the nature of selected past cycles with you.

As usual, we can learn from the ancients who had to supply stories to worried people without the aid of Bloomberg and Blackberry devices. While the ancient Greeks looked at the stars and saw various perceived actions, in effect what they were doing was dealing with the mysteries of human behavior. But due to the unfathomed rotation of the earth, they “saw” movements with enough regularity as to make their stories predictable. Similarly, we seek predictability even though we don’t understand the reality of the mechanism that creates the predictability. We really don’t care why the market, and particularly our stocks, are going up as long as they do. (A lesson Bernie Madoff learned early and well.)

Agriculture, with its dependence on weather, has always been a cyclical activity. Farmers and herdsmen want to supply their markets with substantial volume at high market prices. Their desire is to develop a bumper crop, when many others don’t for whatever reason. If successful, these farmers would be living in what is today called Fat City. I will let the various religious and scientific authorities determine whether the seven fat years followed by the seven lean years is mathematically accurate or just a very useful allegory. From a humble analyst’s point of view, the Biblical story deals with a beautiful description of both secular cycles and a tendency to reverse directions when a trend becomes historically excessive. Let me point out that small market caps seem to move in periods similar to the seven good years followed by seven bad years. Again the explanation for this cycle is a lot like the ancients looking at the nighttime sky for human answers; we could be looking at the wrong place.

I believe the small cap cycle is really a function of recognizing that prices are full for large, seemingly mature capitalization stocks, while searching for alternatives before the economic cycle turns down. My evidence is that operating earnings, if any, of small caps do not lead small cap stock prices. The best coincident indicator for small cap stock prices is the frequency and intensity of Initial Public Offerings (IPO), excluding the IPOs of closed end funds. Thus, when we examine the records of venture capital funds we see certain vintage years standing out as big winners.

The different types of cycles, and the various abstractions used to explain the cycles, in truth do not yield a useful understanding of what really drives the cycles. All we want is predictability! In particular we are searching for a predictable turnaround for a depressed and depressing market.

Allow me to look at the nighttime sky and suggest that the conditions are favorable for a turnaround. Since 1920 there have been 17 designated recessions in the U.S, including the present one. Only four of the sixteen recessions have lasted more than the current duration of 13 months. Narrowing the focus to exclude the recessions that began in 1920 and 1929, there were only two modern day recessions which lasted more than the 13 months, and they were both finished in 16 months.

There are lots of things wrong with these predictions, including:

  1. Stock prices and the movement of the economy are tightly correlated. Our bullish friends point out that stock prices have a discounting of the future function, and often the market anticipates the economy by three months or more.

  2. The current global economic malaise seems to be more like the destabilization period which began in 1873, when financial and political power was shifting from agriculture to the industrial sector. (Perhaps the real meaning of the US Civil War).

  3. The absence of an identified cause for the reemergence of consumer faith, that is faith in a better future.

Even though I do not have appropriate answers to my own questions, I want to believe in a turnaround as well as the availability of my next meal. The danger in searching for simple declarative, forceful answers is that we become vulnerable to the new Great Policy, Man or Party. (Now more than ever we need the minority to protect the majority.)

As they said on “Star Wars,” which really dates me, “Let the force be with you.” I say, “Let the cycles be with you.”

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