Stock Market Follows Multiyear Cycles

I (RAH) use the chart of the S&P 500 inflation-adjusted (real) prices as my to guide to predict the future direction of stock prices. The chart below shows three major cycles constrained by the lower boundary and upper boundary of a 100-plus year secular upside price channel. The two long parallel green trendlines define the price channel.

The upside green line midway between the upper and lower boundaries is the long-term trendline that was fitted using a simple linear regression model.

The three major cycles within the price channel are quite complex, making the overall pattern of prices quite volatile over long periods. Each cycle is defined by a multi-year upside (green trendlines) and a multi-year downside (red trendlines). There are mini cycles within each of the three major cycles.

Currently, stocks are on the downside of the cycle (labeled 3 on the chart) that peaked in 2000 after an 18-year upside. Consumer deleveraging, reduction of debt, could take many years, putting a damper on consumer spending, overall economic activity and ultimately corporate earnings, which would translate into lower and volatile stock prices for many years to come.

Be careful in this market.

The chart is updated the last trading day of each month.

Click chart to enlarge it.

Deviations from the Long-term Trendline

The next chart shows the deviation of each price from the long-term trendline. When the actual price is above the trendline, the deviation is positive and shown in green. When the actual price is below the trendline, it is negative and shown in red.

The general pattern of deviations shows multiyear green areas of positive deviations as stock prices rise to a peak and then start to decline. As prices continue to decline, they lie below the trendline to form multiyear red areas.

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The chart of the deviations clearly shows the red areas of negative deviations after stocks peaked in the early 1900's, 1929 and the 1960's. But where is the red area after the 2000 and 2007 peaks? The answer is that not enough years have elapsed for a multiyear area of red to form.

But if history repeats, investors can expect a multiyear period of downside prices to occur in the coming years. As the financial bubbles associated with years of misallocation of capital, labor and materials continue to unwind, stock prices will erode and the dreaded red area will form.

More Information

For additional updated charts of the S&P 500 Follow the S&P 500 - PDI Analysis of the S&P 500 from Its Peak to Now, Stock Market Returns Are Cyclical and When Will the S&P 500 Reach 1,500?

Updated February 1, 2010.