Equities: Reading the cycle warnings
The spectrum of indicator evidence points to a rally through the first quarter of 2014. But the outlook could worsen if valuations start to look stretched as the year’s second quarter approaches.
The vast majority of MSCI All Country World Index component markets have already been rising for much longer than normal without 20% corrections. And the ACWI’s one-year cycle and four-year cycle warn that equities will encounter headwinds by the second quarter.
To determine the one-year cycle, we average each year’s ACWI activity since 1987. The four-year cycle averages the performance over successive four-year time frames, with 2014 the second year of that four-year cycle. Using the one-year cycle’s roadmap for 2014, we use data for every year, whereas the four-year cycle’s projection for 2014 uses only every fourth year – 2010, 2006, 2002 and so on.
In conducting this analysis for all of the ACWI’s component markets, we found that the cyclical tendencies are global in scope. In addition to each country’s one-year cycle and four-year cycle, we identified the maximum drawdown dates for each market – that is, the starting and ending dates of the biggest corrections that the cycles project for next year. For most markets, the one-year cycle’s worst correction starts by early May, while the four-year cycle’s worst correction starts by mid-April. Both cycles show the correction ending in October for most markets.
Asian markets dominate the group of markets that would be first to encounter one-year cycle headwinds, followed by European markets. The four-year cycle implications are similar, although Latin American markets can also be found among the markets that tend to peak first. After the corrections, year-end rallies would bring about half of the markets to new highs for the year, according to the one-year cycle. But the four-year cycles show only a handful of markets returning to new highs by the year-end.
Given the ominous cyclical forecast for the second and third quarters, we wouldn’t hesitate to cut back on equity exposure if the rally were to lose momentum.
Tim Hayes is chief investment strategist at Ned Davis Research.