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What Do The Cycles Say Comes Next? image

The markets turned ugly on Wednesday as traders ushered in the new quarter with a steady stream of selling. The S&P 500 fell -1.32 percent while the embattled Russell 200 once again led the way lower by dropping -1.42 percent. It is also worth noting that the smallcap index closed at a new low for calendar year 2014 and is now down -6.72 percent for the year.

There were lots of excuses for the selling, but once again, taken alone, none of the issues cited were really worthy of the type of damage seen on the major indices yesterday. Here's a brief rundown of most talked about problems facing the market on Wednesday:

  • The continued rise in the dollar (affecting dollar-carry trades)
  • German Manufacturing PMI slipped into contraction mode
  • Eurozone PMI continued to slide
  • China PMI was below expectations
  • Construction data disappointed
  • The first case of Ebola virus in the U.S.
  • More trouble in Hedgie-land
  • The stand-off in Hong Kong
  • More election driven selling in Brazil
  • Argentina's Central Bank Governor resigned
  • The usual chatter about the end of QE

To get a clear picture of what is happening in the market, we can turn to the charts. First up is a weekly chart of the Russell 2000.

Russell 2000 Smallcap Index - Weekly

While the week is not yet over, the weekly chart of the smallcap index appears to be breaking down. In short, this is not a positive development. Up until this point, one could argue that the Russell was merely in consolidation phase. But this week's breakdown suggests that there could be more downside ahead.

A similar situation can be seen on the daily chart of the S&P 500...

S&P 500 - Daily

While there were no vital support zones broken during Wednesday's rout, it should be noted that the uptrend line that had been intact since February was broken. And if the bears have their way, a test of the 1910 area could be in the cards. This area represents both a 5 percent pullback from the recent highs and the lows seen in August. Therefore a meaningful break below 1910 could be a problem.

But Wait, There Is Some Good News!

Although the mood of the market is fairly dour at the present time, there is some good news to discuss. You see, our cycle composite work suggests that (a) we've likely seen the worst of the selling and (b) it will be mostly uphill from here until New Year's eve.

What Is a Cycle Composite?

For anyone new to our cycle work, the cycle composite is a combination of the one-year seasonal, the four-year Presidential, and the 10-year decennial cycles - all going back to 1928.

By combining these three cycles, a cycle composite is produced. And while expecting the market to follow the cycles exactly is just plain silly, it is surprising how often the market tends to follow the general direction of the composite - especially when viewed from a longer-term perspective.

To review, we don't make predictions about the stock market. However, the cycle composite can be a valuable guide regarding what may come next in the market. Remember, history never repeats exactly, but it does often rhyme.

Below is a picture of the cycle composite (the blue line) and the S&P 500 (the red dashed line) for 2014.

Projected Cycle Composite

Inside the red oval, we've added a black vertical line intended to show where we are at on cycle composite. And as one can see, from this point forward, the general direction of the cycle projection is pretty clear!

It is also interesting to note that yesterday was the low point for the year on the cycle projection.

The Takeaway

Should you expect this projection to play out exactly as shown? Of course not. In fact, the current level of the S&P is about as far away from the projected level as it gets. So, it is safe to say that the cycle composite and the actual market aren't exactly in sync.

Should you base your investment decisions solely on this type of analysis? Uh, no. The bottom line is that the review of cycles should NOT be used in a vacuum or as a stand-alone indicator. Using only the cycle composite projection, or any other indicator for that matter, to guide your investing decisions is a fool's game.

However, experienced investors know that we are coming into the best seasonal period of the year. Assuming the market can get through October without a "crash," history suggests that it is getting to be the time of year when it has paid to hop on board the bull train.

So, if the stock market turns on a dime and starts movin' on up again, you'll at least know that history had a hand in the move.

Turning To This Morning

The fear of an Ebola outbreak is being overshadowed today by the outcome of the ECB meeting as well as word that the standoff in Hong Kong is coming to a head. On the ECB front, so far we know that the bank has left rates unchanged. However, there will be more to come from across the pond as the morning progresses. In Asian trading, Japan's Nikkei tanked in response to a sharply stronger yen while both Hong Kong and Shanghai markets remain closed for holidays. Here at home, traders continue to watch the outflows at PIMCO, the news relating to Ebola, the incoming data, as well as the price action on the charts. On the economic front, Challenger reported that planned layoffs hit a 14-year low in September. In addition, we'll also get reports on Initial Jobless and Factory Orders. In the early going, U.S. futures are pointing to a modest rebound at the corner of Broad and Wall when the opening bell rings.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: -2.61%
    Hong Kong: closed
    Shanghai: closed
    London: -0.07%
    Germany: +0.16%
    France: -0.04%
    Italy: -0.62%
    Spain: -0.33%

Crude Oil Futures: -$1.63 to $89.10

Gold: -$1.80 at $1213.90

Dollar: higher against the yen and pound, lower vs. euro.

10-Year Bond Yield: Currently trading at 2.409%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +4.19
    Dow Jones Industrial Average: +31
    NASDAQ Composite: +10.86

Thought For The Day:

Be a good listener. Your ears will never get you in trouble. -Frank Tyger

Important Reminder: In order to keep pace with our growth, better serve our advisors and clients, and to provide scale for future growth, Heritage is teaming up with CONCERT Global - an SEC Registered Investment Advisor with more than $2 Billion in assets under management. CONCERT will provide more robust back-office, compliance, technology, and trading infrastructure. Client packets to make the transition will be arriving in the coming weeks.

Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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