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Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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Effects of 10-year Cycle Already Being Felt

As mentioned in a previous commentary, this will likely be the year the financial regulators give the financial markets a much-needed "adjustment" by letting interest rates and the U.S. dollar rally a bit, while at the same time taking some of the excesses out of the stock and commodity markets. We've already witnessed a beginning of this process as the interest rate on the 10-year Treasury yield has really taken off these past few days. And as of this writing (Tuesday, April 13) the dollar index has broken out above its 30-week moving average, thus confirming a short-term low and the start of a bear market correction for the dollar.

This rally in the dollar will take some of the excesses out of the commodities markets, which is needed to keep the inflation rate from getting out of hand.

In a previous commentary I referred to the "necessity" of the 10-year, or decennial cycle. Why is this important long-term cycle necessary? If you look back at a history of the markets you will notice this tendency to have general weakness every tenth year during the "four" year of the decade. This is essential for wringing out the excesses that have built up in the markets and the economy in the previous years along the inflation curve. While no one particularly enjoys seeing financial asset prices slide during the fourth year of the decade, it keeps the system in check for the all-important fifth year of the decade (the "05" year). Did you know, for instance, that in 140 years there has never been a "five year" where the stock market was down? This is a testimony to the bottoming of the 10-year cycle late in the previous "four year." Implication? The year 2005 will likely witness another strong rally in stock and commodity prices, notwithstanding the periodic setbacks that will be suffered along the way in 2004.

In my February 5 commentary titled "Will real estate return to earth in 2004?" I made the following statement concerning the Morgan Stanley REIT index (RMS), which is a leading indicator for the real estate sector:

"I believe we will witness at least one steep correction, perhaps rivaling a "mini-crash," in 2004, probably at some point this summer. This could easily take on the appearance of a 1987-style, straight-down correction that quickly finds support and eventually retraces its losses heading into year-end (more on that in a future article). In other words, I don't expect we'll see the end of the bull market in real estate this year, although I do believe we'll see the first major correction in real estate since 9/11."

Well that prediction has already come true to some extent as of this week as the RMS plunged below its 30-week moving average for a total loss of 100 points from its year-to-date top. The steep correction took place sooner than I expected in terms of time, but the principle is the same: a rampaging bull market always suffers at least two or sometimes three crashes (or mini-crashes) along the uptrend before it finally tops. This is really only the second mini-crash in the RMS index in the past five years so I believe we'll see at least one final upward thrust in real estate prices before the real estate "bubble" finally pops. This could be a humdinger of a rally, though (once the current correction has ended), so be prepared for the most extreme upside move you can imagine.

Why did RMS plunge so steeply? And for that matter, why has silver plunged so steeply in such a short amount of time? Because both the real estate equities and the silver market had pulled way too far out of alignment with their respective 30-week moving averages, the sub-dominant interim trend indicator for these markets. As discussed in my first book on moving averages, whenever price pulls too far above the underlying moving average(s) a steep pullback is guaranteed. For example, when live cattle futures prices on the CME pulled too far away from its 30-week MA it experienced a mini-crash of its own in December 2003.

Undoubtedly there will be some real estate bears growling right about now that the "real estate bull market is dead!" I don't think we can make this diagnosis yet, especially given the position of two very important long-term trend indicators for the RMS index (the leading indicator for real estate). Note the rising trend of the 20-month and 30-month moving averages in the long-term monthly chart of RMS below. We really can't make any definitive long-term judgment on the real estate index until the 30-month MA is tested. The 30-month MA (long-term trend indicator) was tested in the Dow Jones Industrial index back in 1998 during the mini-crash that year, which in many respects is similar to the mini-crash now underway in real estate equities. At that time, the test of the 30-month MA proved successful and the Dow had at least one more year of rally left before it topped in early 2000.

Another reason the RMS index plunged this week was in response to the recent spike in interest rates. As mentioned in one of my previous commentaries, 2004 will witness a controlled rise in interest rates, but only a temporary one. Interest rates have been artificially held down for so long that a rally in rates are necessary to prevent the consumer borrowing bubble from getting out of hand and popping prematurely. Again, this is a function of the 10-year cycle.

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