A Short Word on Cycles: Sunday 11 July 2021
In January of 1923, economist Joseph Kitchin’s Cycles and Trends in Economic Factors was published in The Review of Economics and Statistics (you can find a copy of the paper here https://www.jstor.org/stable/1927031?seq=1#metadata_info_tab_contents). In the paper, Kitchin used different economic data from roughly three decades around the turn of the century to identify a ~40-month cycle which would go on to be called The Kitchin Cycle (or Kitchin Inventory Cycle).
· In his own words:
“The movements of economic factors, whether made up of price or volume, are, it is suggested, mainly composed of:
- Minor cycles averaging 3 1/3 years (40 months) in length;
- Major cycles, or so-called trade cycles, which are merely aggregates usually of two, and less seldom of three, minor cycles; and
- Fundamental ‘movements or trends, which are largely straight-line movements.”
Interestingly, a spectral analysis of the entire price history of the S&P 500 reveals a maximal peak at 41 months (shown in Chart 1). This suggests that the Kitchin Cycle is a fundamental economic or “permanent” cycle.
· In fact, it is believed to be accounted for by time lags in information movements affecting the decision-making of commercial firms. Firms react to an improvement of the economic situation through an increase in output and full employment of the extant fixed capital assets. Consequently, within a certain period of time (ranging from a few months to two years) the market gets ‘saturated’ with commodities whose supply gradually becomes excessive. The relative demand declines, prices drop, the produced commodities get accumulated in inventories, which then informs entrepreneurs of the necessity to contract output. However, it takes some time for the information that supply significantly exceeds demand to get back to entrepreneurs. These are the time lags that generate the Kitchin cycles. Another relevant time lag is the lag between the decision (causing the capital assets to work well below the level of their full employment) and the decrease in the excessive amounts of commodities accumulated in inventories. Yet, after this decrease takes place one can observe the conditions for a new phase of growth of demand, prices, output, etc.
For example, the volume of oil production on tight oil formations in the US depends significantly on the dynamics of the WTI oil price. About six months after the price change, drilling activity changes, and with it the volume of production. These changes and their expectations are so significant that they themselves affect the price of oil and hence the volume of production in the future.
· A search for dominant cycles, i.e. recently active cycles, shows the same Kitchin Cycle as the most dominant. This is shown in Chart 3 using two representations:
- A saw-tooth overlay on the SPX chart
- A projection line with 6 harmonic overtones in the panel below
· Notice that the chart of the SPX does not include price after June of 2019. In other words, I have used the beginning of summer 2019 as the learning border as I want to see if this dominant cycle, as determined using data until June 2019, has been ‘adhered to’ in the last two years.
Before we do so, let us focus on its history. Notice how the second half of the Kitchin Cycle (i.e. after excess inventory has built up) is when the stock market tends to peak and run into trouble. In fact, almost all the major market corrections and economic crises have occurred with a regularity defining/consistent with the Kitchin Cycle.
Therefore it is intriguing that the current cycle shows a “danger zone” between now and mid-2022. In fact, judging from the chart below, two down-beats are called for by the cycle. The first is in mid-September 2021 and the second in June 2022.
· Also shown in Chart 6 is the Relative Price Oscillator of the SPX in purple and the testing period of the last two years shows that the cycle beats (market troughs) are, so far, consistent with the Kitchin Cycle.
· All this suggests that should the Kitchin Cycle remain dominant, a period of market weakness in Q3 2021 could give way to another squeeze higher into year-end before an end-of-cycle bear market ensues.
· The billion-dollar question is whether or not the end-of-cycle slump would be a large dip within a secular bull market or a crash.