Are we there yet: Has our share market bottomed out?

We have all been on a car trip when inevitably someone says “Are we there yet?” While the share market is not a car, it has been on a long downward journey followed by a protracted sideways move over the past few years. The sideways move seems like an eternity of going nowhere. Emotions are running hot as people wonder if the market has bottomed out, or if good times will return.

When taking a trip in a car we have a map, road signs, and predictable situations where someone needs to go to the toilet or gets carsick and so too, the share market gives us a map, road signs and predictable events. These become evident in the study of market cycles – and they can tell us if we are actually there or whether we have further to go. Let me explain.

Cycles, whether economic, business or share market, are caused by predictable human reactions to various circumstances. When something happens, like a traffic light turning from green to red, we react by applying the brake and stopping our car. Human behaviour is sometimes programmed into us – like stopping at red traffic lights – while other times it is hardwired into our DNA, such as how we react when subjected to fear or greed. What is clear is that human behaviour is predictable as we are all creatures of habit.

For example, I am sure that if I followed you for two weeks, noting what you do and where you go, I could predict what you were going to do and where you were going to be in the future with high accuracy. The share market is no different, as en-masse investors, whether professional or personal, generally act as they always have.

Market cycles are a highly technical area for skilled and experienced traders. Given this, I will keep my explanation simple. Like economic/business cycles, share market cycles can run for centuries down to minutes within a day. The chart below shows the Australian share market from 1875 through to October 2011. On this chart I have placed the major cycles experienced during that time, and these cycles are about 40 years in length.

The first cycle starts after a five-year bear market from 1888 to 1893 and runs for 37 years through to the great crash of 1929 with the eventual low in 1931. The second cycle unfolded over 43 years from the low in 1931 to 1974. The last cycle, and more importantly the one we are attempting to determine if it has completed, has run for 35 years from the low in 1974 until our current lowest point in March 2009. In essence, given the severity of the fall into 2009 it is reasonable to assume the low has arrived. However, we cannot just measure time to formulate our conclusion.

To determine how a cycle is unfolding, and more importantly, if a cycle has finished, we must use all the information we have including price, pattern and time. The best traders in the world are experts in all three.        

Chart 1

Studies by Russian economist Nikolai Kondratiev (or Kondratieff) in his book The Major Economic Cycles (1925) show the existence of economic cycles. If you look into this by visiting Wikipedia you will read: “Averaging 50 and ranging from approximately 40 to 60 years in length, the cycles consist of alternating periods between high sectoral growth and periods of relatively slow growth.”

The unfolding of economic cycles affects the movement of all markets, and looking at the chart above you can easily see the approximate 40-year cycles – or Kondratiev waves – in our market. Cycles, like driving to work, can come in early or late depending on the current economic climate and dare I say, factoring in when governments try to stimulate or slow economies.

So has the Australian share market bottomed? The simple answer is that we cannot say with 100% accuracy that 2009 was the long-term low. What we can do is assume that there is a reasonable probability that it may be, however we will not really know until a new all-time high has occurred.

Given this, when investing in the share market investors should do so with the knowledge that there is the possibility of a double-dip, and if this occurs investors will need to act quickly.