I was interviewed by Corporate Interviews this morning

Interest rates, oil prices, trade balance, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, fiscal policy, etc. — NONE have a reliable effect on the stock market.

This is the last part of the series “Robert Prechter Dispels 10 Popular Investment Myths,” where EWI president explains why traditional financial models failed in 2007-2009 — and why they are doomed to fail again (and again).

The Socionomic Theory of Finance
The Conventional Error of Exogenous Cause and Rational Reaction

Reasoning in Reverse: from Market Actions to Prior Causes

We have investigated [see Parts I-XI — Ed.] whether one can find any consistent cause of financial market price changes by looking at dramatic events and trying to tie them to market movements. What if one reverses the investigation to look for dramatic price changes first and then try to fit them to causal events?

In their 1989 paper, Cutler, Poterba and Summers investigated just such situations. Starting with days during which stock prices moved dramatically, they scoured the news to find exogenous causes. Their conclusion is stunning: “…many of the largest market movements in recent years have occurred on days when there were no major news events.”

In other words, whenever the stock market was leaping or plummeting on any particular day, there was often no news sufficiently striking to explain it. And it happened regardless of the fact that there is lots of news all the time, providing substantial opportunity for data fitting, which is what financial reporters do at the end of every trading day and what many economists do in their monthly reports. The evidence from this study of news events and market action contradicts the exogenous cause paradigm.

Perhaps you are thinking that important background conditions are trumping daily events. Surely the two most dramatic price changes of the past century have clear causes. Or do they?

Economists of all stripes have tried to come up with an explanation for the 1987 crash. Yet in a 1991 paper, four years after the fact, William Brock studied economists’ commentaries and concluded, “In my opinion, no satisfactory explanation has been found [for] the most recent crash…Black Monday, October 19, 1987.”

What about the most devastating event of the 20th century, the Great Depression and the collapse in stock prices that led to it? The Winter 1999 issue of the Federal Reserve Bank of Minneapolis’ Quarterly Review observed, “Economists and policymakers are still studying and debating what caused this catastrophic economic event.” Dissatisfied with this fact, the Minneapolis Fed “decided to find out what caused this event.” So, in October 2000, it held a conference titled “Great Depressions of the Twentieth Century.” It invited 56 noted economists, including a Nobel laureate, the current chairman of the Federal Reserve, economists from various Federal Reserve banks, and professors from the University of Chicago, U.C. Berkeley, Carnegie Mellon, Brown, Penn, Stanford and other top schools. …

Two months later, the Minneapolis Fed’s quarterly Review filed its report on these presentations. Pertinent excerpts are as follows:

A guiding premise of the conference was to apply neoclassical growth theory…to events that occurred over 60 years ago, in the hopes of shedding light on one of the most vexing questions in economics. …As one economist said in the middle of his presentation: “And then, in 1933, something unanticipated happened.” The task of those gathered in Minneapolis was to explain how those unanticipated events caused these economic depressions.

Although many causes have been suggested for the Great Depression, economists have yet to agree on a uniform explanation. The standard approach of the profession since the 1940s has been to try to determine the causes of the depression by searching for relationships or correlations in the data. But since the Great Depression was so unique, there is no basis for comparison and, therefore, empirical analyses always come up short.

In the end, if the Great Depression is, indeed, a story, it has all the trappings of a mystery that is loaded with suspects and difficult to solve, even when we know the ending; the kind we read again and again, and each time come up with another explanation.

In a line loaded with irony, the article notes, “It may strike some as odd to describe economists as storytellers, but it’s a term they use when discussing themes and ideas.”

These commentaries are dated December 2000, 78 years after the bottom of the Great Depression. Economists have had eight decades to extract something of value out of their exogenous-cause model, only to find that it offers no useful answers and no explanation upon which its proponents can agree. Remember, we are not even asking economists of the time to have predicted the event. As history reveals, the opposite occurred; the most famous economists assured the public that nothing of the kind was on the horizon, that the economy had reached “a permanent plateau.” Considering that we seek only a retrospective explanation from this report, a more damning indictment of the exogenous-cause paradigm could hardly be imagined.
When you are brilliant, your mind is rational, your logic is sound, and yet your conclusions are continually wrong or inadequate, there is only one explanation: Your premise is false.

We have shown that the phrases “interest-rate shock,” “oil-price shock,” “trade-balance shock,” “earnings shock,” “GDP shock,” “war shock,” “peace shock,” “terrorism shock,” “inflation shock” (and therefore “deflation shock”), “monetary shock” and “fiscal shock” have no value (and in my view not even any meaning) when it comes to analyzing the behavior of financial markets. There must be something wrong with the premise behind these terms.

To summarize our findings up to this point:

1) No type of exogenous event leads to a consistent result in financial market movement.
2) The biggest stock market movements have no clear exogenous causes even in retrospect.
3) There are no consistent correlations or relationships between supposed exogenous causes and market results.

Why the Failure of Exogenous Causality Is Not Often Apparent to Most Observers

Most of the time, the stock market rises and the economy expands. During such times, economists confidently cite half a hundred various exogenous causes to explain the growth that is occurring. Even though the explanations are either tautological (“the increase in jobs has fueled a pickup in GDP”) or bogus (and refutable in every case by showing a single historical graph), no discernible cognitive dissonance occurs among economic theoreticians or practicing economists and their clients. All these people feel comfortable, so they accept the adequacy of the explanations and demand no evidence.

But when people are uncomfortable, they begin to seek valid explanations, which do require some evidence. People are uncomfortable during bear markets and economic contractions, so this is when they actually bother to investigate economists’ theories, methods and explanations.

At such times, the theories, methods and explanations are always found wanting. They are just as wanting when times are good, but during such times no one bothers to check.

Michael Campbell: I’m glad you’re with us and what better way to start off the New Year than to welcome back to the show Don Vialoux. We love Don, he’s been 38 years in the investment industry and he’s probably Canada’s best known technical analyst when it comes to looking at the seasonality of the markets. 

Don, I’d like to reintroduce people to exactly what you do and I know they’ll find it absolutely fascinating. Talk a little bit about the kind of analysis you do, especially as it pertains to seasonality.

Don Vialoux: Every market, every stock or security has a period of seasonal strength and a period of seasonal weakness. By concentrating on stocks which have seasonal strength and checking out their technicals and fundamentals, we put all three of them together and we make investment decisions. The great thing about the process is that there’s a starting point, and probably most important, there’s an ending point for all these trades. Normally a trade in a seasonal move could be as short as two to three months, and could be as long as six to seven months. The key is you have a buy point and a sell point over a period of time.

Michael: Let’s start as an example the broad markets.  Give us an example an illustration of seasonality such as  “Sell in May and Go Away”.

Don: That’s actually an interesting expression because it’s very false. Sell in May actually doesn’t work. It turns out on average during the summer time, from May to September, markets tend to be random. Some years higher, some years lower. The reason is there are no annual returning events that have an impact on markets during that time.

There are times in the market, like normally from the end of October till the end of April, when there are a series of events which have a positive impact on markets. So rather than saying sell in May and go away, the real expression is: Buy when it Snows, Sell when it Goes. In other words buy in October and sell in April.

Michael: What kind of probability do you assign to general trends like that?

Don: Generally a seasonal trade is possible if you have success 70% of the time or more. Frequently you can get as high as 90% in some of these seasonal trades, but 70% is probably the minimum you want to see over a period of time. The key is not only the frequency of success but also the returns relative to the market. You not only want to have something that works quite frequently but you also want to have an investment that outperforms the market.

I’ll give you an example of something which is current,  platinum.  Its period of seasonal strength is from the beginning of January right through untill the end of May. This trade has worked 20 of the last 24 periods, and the average return on investments has been 9.2%.  That’s seasonality.

The next thing to look at is the reasons why the seasonality occurs.  A lot has to do with the demand for platinum as we begin the car season in spring time. New cars are manufactured, they use platinum for catalytic converters and the more cars manufactured the greater the demand for platinum which moves it higher. That’s the annual recurring event that causes the seasonality.

The next thing is to look at the fundamental reason why it should work this year, and it turns out it’s fascinating this year. There is a reason why it’s starting to work very very  nicely. Its not to do with demand, it has more to do with the supply. 77% of platinum is produced in South Africa and in order to produce platinum you have to have power. Right now the power source in South Africa is basically at full capacity. If there’s any kind of disruption in their power production that will quickly shut down the platinum mines. During the past few weeks they’ve had some rain storms in South Africa that have closed down some of the coal mines that provide the coal for the power plants. So we’ve got  an interesting situation that if there is any kind of disruption in power production in the next little while, it will have a significant impact on platinum coming into the spring time.

That’s the fundamentals now we’ll look at the technicals.  The technicals to watch are the short-term momentum indicators to give you an indication of when to enter this particular trade. In this particular case the buying point didn’t happen on January 1st, it actually happened in the second week of December of this year,  a little bit earlier than usual. So we’re currently in that mode when you want to be in this particular trade thatany kind of weakness on platinum during the next little while is just an opportunity to buy.

Michael: An Absolutely Fascinating Approach to Markets Don.  Are there any other items that affect seasonality in this next month or two?

Don: No, but for a strange reason. First of all for background,  I am very bullish on equity markets for the current fiscal year. I think this is the pre-election year in the US, amd the presidential cycle says that in a pre-election year it’s the strongest year of the four year cycle. Normally the presidential cycle is strongest from just before the mid-term election right through until about a year later,  and on average the S&P 500 has gone up 24% during that period of time. Now, we’ve already gone up 10%, so that implies that we have upside potential between now and this October of another 15%. That also implies upside technical targets for the S&P 500 of 1450, and for the TSE composite 15500. So we’ve got another 15% to go.

That’s the good news but let’s take a closer look. The next two months could be difficult because the markets are very over-bought and we’re starting to get some technical indications that the market short term has started to roll over. It started appearing in just certain sectors during the last week or so, most notably in the materials sector. We’ve also seen what’s happened with the gold stocks, consumer staples, and consumer discretionary stocks. Negative rotation will likely continue for another four to eight weeks, but the important thing to remember is that this weakness is a buying opportunity to fully take advantage of the four-year presidential cycle. I’m calling for a 5-8% correction in this market from the recent peak which will provide the buying opportunity. In short, be very careful short term, but we’re going to have some fun before the spring is out.

Michael: Can you give us some seasonality numbers on gold?  Where we are  right now?

Don: We’ve probably seen most of the correction in gold during the last ten days or so. Gold actually broke support at the $1,360 level on Friday. The next important support level is the $1,330 level and we’re not that far off.  The technicals are oversold, very short term so we don’t have much farther to go on the downside.

On the seasonal basis gold usually has a bit of weakness in early January then moves very strongly right through till the third week in February. So look for that as a possibility once again. If you’re currently long in the sector you want to stick with it for now. If you are looking for an exit opportunity look to do so around the third week in February. 

Michael: What is your take on silver?

Don: The case of silver is very similar to gold in that Silver’s had some technical weakness during the last little while. Its technical pattern is very similar to gold, though because it is an industrial component and is in greater demand for consumer electronic goods,  Silver has significantly outperformed gold and that likely will continue. Regardless just like gold it’s under pressure right now, looking a short-term low, probably around the middle of this month to be followed by a nice move coming into the end of February.  At that point in time that will be the end of the seasonal trade for silver.  The key is you’re now getting closer to the end of the period of seasonal strength for silver and the next bounce you get into February is an opportunity to take some really good profits.

That’s also applies to the silver stocks, congratulations if you’ve been in some of these silver stocks, you’ve done very well despite the correction that we’ve seen during the last little while.

Michael: We’re excited about the World Outlook Conference that’s coming February 11th & 12th. A great roster of speakers: David Bensimon, Jack Crooks, Peter Schiff broadcasting to us from New York, Dennis Gartman broadcasting to us from Virginia, Joseph Schachter. Ryan Irving, Ozzie Jurock, Dunnery Best, Tyler Bullhorn, Mark Leibovit, and of course Don Vialoux are going to be there.

Don, let’s talk about oil and the Canadian Dollar.

Don: Great question, particularly on the oil. First of all I wanted to thank you for asking me to the conference last year, it was really a great conference. I particularly remember the presentation by Joseph Schachter.  Joseph said at the conference that  now was the time to start looking at energy stocks, right around the second week in February last year when your Conference was on. Lo and behold anybody who was at the conference did very, very well for the next three months as that’s when crude oil took off very strongly. Energy stocks did very well.

So what about crude oil? On a seasonal basis, I’m looking on my free website, www.equityclock.com,  at a chart showing what crude oil futures do over a long period of time.  Historically they’ve weakened right through until the third week in January. That tends to be a bottom for crude oil prices,  then they tend to move significantly higher right through until August of each year. That trend is expected to continue this year. Technically, crude oil rolled over last week, giving a series of momentum sell signals, implying that we’re currently into a very shallow but important period of weakness. We’re looking for an opportunity to accumulate crude oil and energy stocks as we get into February. Historically, the bottom of the energy stocks themselves has been around the second or third week in February,  look for that to happen again. We’ve got this on our radar screen and we’re looking very closely at when we want to enter this particular trade.

Michael: Is there a seasonality with the currencies?

Don: Very important; this is the time of year when the Canadian Dollar tends to go flat. But of more importance is the US Dollar has a period of seasonal strength,  from the beginning of January right through till the end of February, that has a direct impact on commodity prices. That US Dollar strength has a tendency to dampen commodity prices during that period of time. It’s happening again this year as we’ve seen the US Dollar being very, very strong particularly last week. Look for it to continue to strengthen as we get into early February.  That will probably be peak for the US Dollar for a while and set the stage for commodity prices, particularly crude oil, to go up significantly higher.

Michael: Don there’s always so much to talk about with you. People can go to Don’s Analysis at  www.timingthemarket.ca,  as well as www.equityclock.com for Seasonal Analysis.

I’ve often come out with bold forecasts and have been told I’m nuts. I’ve been scoffed at by most other analysts and certainly those from Wall Street or those with any other traditional financial background.

Like when I predicted, way back at the end of 1999, that gold would soar from the $260 level to well over $1,000 an ounce in the years ahead.

Or when, in the year 2000, I forecast that the U.S. dollar was entering more than a decade of a deep bear market that would eventually see the currency lose its world reserve status.

Or when, in August 2004, I warned about the world’s brewing shortages in water, or “blue gold.” Or in January 2005, when I first foretold of skyrocketing food prices. Or when I forecast in 2006 that oil would hit $150 a barrel within a couple of years.

Then there were my repeated forecasts throughout the middle years of this past decade that China’s economy would roar like no other in the history of the world, and that Asian emerging markets would not be far behind it.

Joe Keohane