This week’s article focuses on data inputs to complete the 2012 scenario analysis I began last week. A brief description of the method is provided, followed by relevant tables and charts with subsequent scenario updates. The primary goal is to quickly quantify some of the factors that may exert some influence on the market in 2012. It is not intended to provide a guestimate of the year-end Dow, but rather to keep traders and investors grounded in the “typical” in a time when media coverage may broadcast the extremes.

Scenario Analysis Method

The scenario analysis begins with typical (i.e. expected or average) characteristics of a secular bear. From that point other relevant cycles, wave counts and conditions that may impact 2012 returns are considered. The goal is to arrive at a forecast that uses historic returns for perspective on what’s typical. It is my belief that this can keep investors in particular grounded as market swings occur throughout the year.

Secular trends are long, multi-year trends with specific characteristics. My preferred author on the topic is Ed Easterling who has written two books: “Unexpected Returns: Understanding Secular Stock Market Cycles”, and a more recent update, “Probably Outcomes: Secular Stock Market Insights”. Mr. Easterling provides nice information on the economic backdrop and other characteristics of secular bulls versus bears. I continue to believe we remain in a secular bear market so I continue to lean towards data from bearish years.

Table 1 Easterling’s Secular Bear Stats (1901–1999)¹

Scenario Analysis

I generally begin the analysis by assigning probabilities for Positive and Negative Returns based on secular conditions. For instance, in secular bears the there were 42% positive years and 58% negative years from 1901-1999. Te next step was a qualitative adjustment which addresses current conditions in this secular bear. Assuming it will be similar to those experienced in the last century, it currently:

• Has a higher than average number of years with positive returns and
• A three year absence of negative returns

These two factors prompted an upward adjustment for the probability that 2012 will be negative as reflected in Table 2

Table 2 Scenario Using Current Secular Bear versus Previous Secular Bears

Other Factors Impacting 2012

For the information that follows, data for the Dow Jones Industrial Average^SM [DJ-30] is from Worden Brothers Inc.’s Telechart^® service and charts are from Hubb Organisation Ltd’s ProfitSource [PS].

Years Ending in 2 (Decennial Cycle)

Two cycles which may come into play this year include the decennial cycle and the Presidential cycle. The selection of these is partially based upon the more clear-cut nature of each in terms of identification. Table 3 provides return data for years ending in 2 since 1915.

Table 3 displays annual returns for years ending in 2 from 1922 through 2002.

To get a better sense of typical movement during the year for years ending in 2, Figures 1a & b provide the price path for DJ-30 when average daily returns and median daily returns from previous years are applied to an index that starts the year at 1,000. I first saw a similar approach when reviewing analyses from Martin Pring.

Figure 1a Daily Mean Returns for DJ-30 Years Ending in 2

Figure 1b Daily Median Returns for DJ-30 Years Ending in 2

Election Year (Presidential Cycle)

A more relevant cycle is the Presidential Cycle with Table 4 providing return details for other Year 4 periods since 1915. In addition to providing this data for all years, statistics are broken out by Secular Bull or Secular Bear years as identified by Mr. Easterling.

Table 4 Dow Jones Performance in Election Years (1915-2010)

Using data from Tables 3 & 4, the Scenario Analysis is updated in Table 5:

Table 5 2012 Scenario Analysis Updated with Two Cycles

Elliott Wave

PS provides automated Elliott Wave (EW) counts which have remained in place since the March 2009 low from a price standpoint, but continues to be pushed out in time. Figure 2 provides the DJ-30 weekly chart with a Long Range EW count. It is expected that even if the price aspect of the wave structure is realized (5,310.73), the time horizon will be pushed back once again. It remains possible for a bulk of the move to occur during 2012 so this scenario has been incorporated into the analysis.

For those less familiar with PS’s EW tool, there are statistical versus Fibonacci levels that may come into consideration. Keeping a more correct start to the wave structure places the Wave 2 retracement at the 2008 peak (DJ-30 @ 13,058.20) rather than where it currently appears. In the event DJ-30 surpasses this level, it is my view that the PS wave structure will be invalidated and this bearish price projection would no longer apply.

Figure 2 Weekly DJ-30 Line Chart with EW Counts from PS

Linear Regression Channel

A linear regression channel is the second technical tool used for price projection purposes as part of a second potential bearish move for the scenario. Two channels have been constructed and refined on the weekly charts since 2007. One is bullish and the other bearish, both of which have done a nice job of providing insight on how prices move extend or reach areas of support or resistance. Figure 3 provides a weekly bar chart of DJ-30 with both linear regression channels.

Figure 3 Weekly DJ-30 Bar Chart with Linear Regression Channels

The price projection uses the regression line value for the week ending Dec 31, 2012 (6,230).

Table 6 provides another update to the scenario which incorporates bearish moves based on EW and the bearish regression channel. The reason such an analysis is not added to the bullish case is due to the bearish bias 2012 brings to the current secular environment.

Table 6 2012 Scenario Analysis Updated with EW & Regression Channels

Scenario Analysis 2012: Final Update

The last update to the analysis addresses both bullish and bearish cases and uses best bullish year returns and worst bearish year returns for secular bears identified in Table 1.

Table 7 2012 Scenario Analysis Final

Next week a look at outliers for the data inputs will be reviewed.

¹ Easterling, E. (2005). Unexpected Returns: Understanding Secular Stock Market Cycles. Fort Bragg, CA: Cypress House (p 97)

² Ibid.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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