Why the Goldman Sachs Case Could Trigger a Nine-Month Market Slide

Not even the savviest soothsayer can predict the long-term market fallout of the SEC's legal action against Goldman Sachs (GS). But from the point of view of cycles of history, the Goldman Sachs case could be the straw that breaks the back of a top-heavy stock market which has rallied for 13 months on the promise of a V-shaped global recovery.

Despite doubts about the European Union's response to the debt crisis in Greece, and despite fears that China's extraordinary real estate bubble is doomed to burst, world stock markets have gamely continued their ascents based on the evidence of global recovery.

Was the shiver that convulsed the markets after the SEC's filing against Goldman Sachs merely a sneeze, or was it the harbinger of a steep, nine-month long decline to come?

One review of historical patterns offers a tantalizing, if sobering, suggestion that the stock market has typically topped in March or April of the second year of a presidential cycle -- that is, right now: 2009 was the first year of the Obama administration, and 2010 is the second year of this presidential cycle.

This chart displays the market action in the second year of presidential cycles within what the investment community refers to as "secular bear markets." These are long-term bear markets which may witness explosive rallies even as the overall trend remains flat to down.

The last secular bear market in the U.S. ran from 1966 through 1981. The Great Depression years are also considered a secular bear market which lasted from late 1929 through 1946. Some observers believe the current secular bear market began in 2000 or 2002, while others date the start from the October 2007 market top.

Also displayed in this chart is whether the secular bear was deflationary or inflationary in nature. That is, did asset values and prices generally decline or remain flat, or did they rise? The Great Depression bear was deflationary, as prices and tangible assets valuations both fell. The secular bear of the late 1960s and 1970s was inflationary, as both tangible asset prices (for real estate, gold, etc.) and consumer prices rose considerably.

Remarkably, the market has declined in both inflationary and deflationary environments in the second year of the presidential cycle within secular bear markets.

The chart was generated from data drawn from a historical-data spreadsheet on the website of Robert Shiller, co-founder of the Case-Shiller Home Price Index. Shiller's data is the average of the daily closing prices for a given month; as a result, there will be a statistical variance between Shiller's data and the closing prices recorded on the last day of each month. The data displayed is "price only" and does not include any dividends paid.

Take Finance Industry Profits Out of the Picture, and the Picture Gets Bleak

So what does the SEC/Goldman Sachs case have to do with the second year of the presidential cycle? The answer is nothing; historical cycles do not offer specific reasons for decline, they merely suggest that markets are ripe for a fall or poised for a run up at certain times in a cycle. History is not predictive, of course; but as Mark Twain is reported to have remarked, history doesn't repeat, but it does rhyme.

Nonetheless, we should be aware that two sectors, financial and energy, are expected to account for 53.9% of all incremental S&P 500 earnings between 2009 and 2011 even though they account for just 25% of the total market capitalization of the S&P 500.

By comparison, the consumer discretionary and retail sectors are expected to contribute just 5.5% of incremental earnings from 2009 to 2011.

Therefore, given the importance of the financial industry's profits to the S&P 500's growth, anything which would significantly degrade those earnings -- such as years of litigation and settlements, and/or strict government regulations on the free-wheeling derivatives business -- could plausibly trigger a major decline in overall corporate profits and thus darken the stock market's rosy outlook.