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HISTORY AND THE 6-MONTH CYCLE... . Stocks are currently in the bullish part of the six month cycle and about to enter the bullish portion of the presidential cycle. First, let’s look at the six month cycle. History shows a clear bullish bias from November to April and a neutral bias from May to October. Because the stock market has a long-term upward bias, we can break these down into periods of outperformance (bullish bias) and underperformance (bearish bias). According to the Stock Trader’s Almanac, the Dow averaged a .10% gain from May 1st to October 31st from 1950 to 2008. If we add data for 2009 and the first part of 2010, this average creeps up to .38%, which is still miniscule.

Stock market performance from November 1st until April 30th is much different. From 1950 to 2008, the Dow gained an average of 7.26% during this period. Adding data from 2009 increases this average to 7.35%. Over the last 61.5 years, the bullish bias is clearly stronger from November 1st until April 30th. This is where the term “sell in May and go away” comes from. If you think these results are good, the Stock Trader’s Almanac also shows how to improve these returns by using MACD for timing. It’s a great book to have throughout the year and it is available in our bookstore . The table below shows the six month cycle results for the last 10 1/2 years.

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6-MONTH CYCLE STAYS BULLISH UNTIL APRIL... Chart 2 shows the six month cycle with the S& 500. The green arrows mark the beginning of November, which signal the start of the bullish cycle. The red arrows mark the beginning of May, which signal the start of the bear cycle. This cycle has its share of hits and misses, but the hits seem to outweigh the misses. The Detrended Price Oscillator (DPO) is shown in the indicator window. DPO is designed specifically for cycle identification. It takes some practice to use though. In a nutshell, DPO shows the difference between price and a displaced moving average. This is why DPO does not extend to the end of the chart. Typically, the parameters for the Detrended Price Oscillator are one half the cycle length. A six month cycle on a weekly chart is 26 weeks. Therefore, the DPO would be set at 13. Chartists can look for cycles by identifying peaks and troughs in the DPO.


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PRESIDENTIAL CYCLE TURNS BULLISH IN 2011... The presidential cycle covers the four year presidential term. There is a bearish bias the first two years and a bullish bias the second two years. This one is pretty easy to fathom. In general, presidents prescribe the tougher medicine in the first two years. As mid-term passes and the presidential election comes into focus, presidential policy turns toward legislation designed to stimulate the economy. Hmm....this looks awfully familiar right now. Congress just passed a big stimulus package that will increase spending and cut taxes. We can also throw in the historical tendency for looser monetary policy in the second half of a presidential term. After all, the president appoints the Fed chairman. Current fiscal and monetary stimuli reinforce a bullish bias for the next two years. The Stock Trader’s Almanac shows a table detailing this presidential cycle all the way back to 1833. Historical evidence shows stocks performing much better in the second half of the presidential term. Chart 3 shows the S& 500 with the presidential cycle lines. The green lines mark the midterm for each president and the beginning of a bullish cycle. A green line is due in 2011 as President Obama begins the second half of his term. It is important to remember that cycles does not always work, even when they cluster (overlap). Even though the historical evidence is bullish, this evidence is based on an average over a long period of time.

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JANUARY EFFECT FAVORS SMALL-CAPS ... Not only do we have a bullish six month cycle and a bullish presidential cycle, but the January effect is taking shape. This is not a cycle, but rather a phenomenon that sees small-caps outperform large-caps in January. While this is still called the January effect, it seems to get earlier and earlier every year. Small-caps have been leading the market since late August and this outperformance accelerated in the second half of November. The Russell 2000 is the perhaps the most popular small-cap index. This index represents the 2000 smallest companies in the Russell 3000 ($RUA). The other 1000 stocks form the Russell 1000, which represents the 1000 largest stocks in the Russell 3000 universe.

Chart 4 shows the Russell 2000 in a strong uptrend that began at the end of August. There was a flat consolidation in October and then a pullback in November. Since the mid November breakout, the index has moved sharply higher with 10+ percent move the last five weeks. The indicator window shows the Russell 2000 relative to the Russell 1000 ($RUTRUI ratio). This ratio bottomed in mid November and moved sharply higher as the Russell 2000 outperformed the Russell 1000. Looks like the January effect is well underway. Charts 5 shows the Russell 1000 and chart 6 shows the Russell 3000 for reference.

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MICRO-CAP PERFORMANCE SUGGESTS AN EARLIER EFFECT... Micro-caps are fairing even better than normal small-caps. The Russell 2000 can be broken down even further with the Russell Microcap Index ($IJE). This index consists of the 1000 smallest stocks in the Russell 2000. It is the bottom half of the small-cap index. According to the Russell website (Russell.com), the 1000 stocks in the Russell Microcap Index make up less than 3% of the US equity market. How’s that for a small footprint. Chart 7 shows the Russell Microcap Index surging around 35% since late August. The indicator window shows the $IJERUT ratio, which measures the performance of micro-caps relative to small-caps. Here is where the story comes out. Micro-caps outperformed as the ratio rose from mid September until mid October. The ratio turned flat until early December and then surged over the last 12 days. Judging from this performance, it seems that the January effect began in early December. The related ETF is the iShares Russell Microcap Fund (IWC).

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