Kondratieff for Investors

I believe you have to build mental models to help you understand the investment environment and one of the mental models I rely upon are business cycles. 

“Austrian School” economist, Joseph Schumpeter, classified the following business cycles and their duration:

Kitchin – 3 years

Juglar – 9-10 years

Kuznets  – 15-20 years

Kondratieff – 48-60 years

Currently, I believe the “Long Wave” or Kondratieff cycle is having the largest impact on financial markets. 

In studying economic or technical indicators, I find it helpful to go back to the original source of the information to get a first hand understanding of the material.  Several internet sites are peddling the idea that we are in a Kondtratiev “Winter” which will be marked by the coming financial Apocalypse.   While this interpretation probably sells newsletters, I believe it presents a distorted picture of the Long Wave and what it means for the financial markets. 

Download The Long Wave.pdf (784.7K)

First, Kondratieff never mentioned seasons in his 1926 work “The Long Waves In Economic Life”.  The ideas of a Kondratieff Spring, Summer, Fall and Winter, while clever, are not really representative of Kondratieff’s theory. 

Second, Kondratieff’s observations of “long-term” economic waves started with his empiric observations of economic and price data.  He then postulated his theory based on the observed data.  It seems to me that many economists today are starting with the theory (48 to 60 year long term economic cycles) and are trying to fit the data to the theory. 

Finally, Kondratieff never mentioned stock prices or overall levels of economic debt in his theory.  He based his observations on economic data, commodity prices and interest rates.  Therefore, I’m uncertain as to whether you can draw direct conclusions on the direction of stock prices based on the Kondratieff wave.  In addition, several economists argue that the world cannot be in the beginning stages of an upswing because the total levels of debt were never “cleansed” out of the economy.   While an interesting argument, Kondratieff did not mention debt levels and therefore, I believe this has little bearing on where the economy stands in the long wave. 

Kondratieff_waves_2

Kondratieff made five empiric observations about the Long Wave in economic cycles.  I have taken the following quotes from a translated copy of the 1926 article “The Long Waves in Economic Life” by Nikolai Kondratieff.   

1)  “Our investigation demonstrates that during the rise of the long waves, years of prosperity are more numerous, whereas years of depression predominate during the downswing.”

If you look at US economic growth since the 1970s you might believe that this observation is incorrect since the US has suffered relatively few severe recessions.  However, as Marc Faber wrote in “Tomorrow’s Gold,” after the 1973/74 recession in the United States, the world has experienced more severe recessions and relatively weak recoveries.  “We had, after 1981, a depression in Latin America that lasted until the late 1980s (a depression combined with high inflation), a relatively severe global recession in 1982, the Japanese economic downturn after 1990, the post-communist economic collapse in Easter Europe and Russia, anemic growth in Europe following the 1991 recession and, more recently, first the extremely intense economic downturn in Asia, and in 2001, the slowest growth rate for the global economy in 30 years”.

As an aside, I think the fact that the US has avoided a major depression during the past 20 years speaks volumes about the success of Lazier Faire economics with some moderate government intervention.  Only in the 1970s, when President Nixon instituted price controls on energy and took the US off the gold standard, did the economy truly enter into a severe recession.

2) “During the recession of the long waves, agriculture, as a rule, suffers an especially pronounced and long depression.” 

Marc Faber makes a convincing argument that energy has taken the place of agriculture as the driver of the economy and therefore should be relied upon as the market for the beginning and end of the Long Wave.  Again, from Tomorrow’s Gold.  “Whereas wheat, corn and cotton were the most important commodities in the 19th Century, crude oil is now by far the most important industrial commodity in value terms and as a cost factor in industrial societies.” 

Therefore, if we replace agricultural prices with oil prices, we can see that energy commodities have truly been in a price “depression” during the downswing, just as Kondratieff described.  Aside from the spike in 1990 because of the Iraq war, oil has been in a basing pattern for the greater part of the 1980s and 1990s.  If we assume that the Kondratieff wave bottomed in 1998 – 2003, the current steady rise of oil prices makes sense, as does most analysts skepticism toward the sustainability of rising prices.  During the down wave, oil prices always made new lows after a run up.  However, at the beginning of this new up wave, oil prices will unlikely see the $20s again. 

Oil_1983_2005 

3) “During the recession of the long waves, an especially large number of important discoveries and inventions in the technique of production and communication are made, which, however, are usually applied on a large scale only at the beginning of the next long upswing”

Of all of Kondratieff’s pronouncements, I believe this is the most enlightened.  If 1974 to 1998 represented the downwave of the long wave, the development of the personal computer and subsequently, the Internet falls right into Kondratieff’s pronouncement.  One can take issue with the statement “applied on a large scale” arguing that the US has already applied this technology on a large scale.  However, if you take a world-wide view, the adoption of the PC and internet have only truly begun. 

4) "At the beginning of a long upswing, gold production increases as a rule, and the world market for goods is generally enlarged by the assimilation of new and especially of colonial countries"

Both these observations, gold production increasing and the world market enlarging, are currently being fulfilled.  I believe they are clear signs that the Long Wave has bottomed and is currently in a new upswing. 

Gold_1990_2005

The assimilation of China and Eastern Europe into the world economy will be a constant theme throughout the next decade as well.  This phenomenon is already well covered and understood. 

5) "It is during the period of the rise of the long wave, i.e. during the period of high tension in expansion of economic forces, that, as a rule, the most disastrous and extensive wars and revolutions occur. "   

I’ll quote Marc Faber one more time since he so succinctly states his case:  “It is interesting to note that the French Revolution, the Napoleonic Wars, the European revolutions of 1848, the Crimean War, the American Civil War, the Franco-Prussian War, the Russo-Japanese War of 1904, the First World War and the February Revolution in Russia all took place during the rising wave of the long cycle.  An exception was the Second World Ware, which took place right at the end of the downward wave of the third cycle or the very beginning of the fourth cycle….However, since the downward wave began in 1980, we have had only contained confrontations that did not have  worldwide economic impact.”

Several current or potential wars have the potential or already have a  “worldwide economic impact”:

1)    George Bush’s drive to rebuild the Middle East into a capitalistic and democratic society

2)    China’s assimilation of Taiwan

3)    North vs South Korea

4)    President Putin’s desire to re- nationalize Russia’s economy could turn into a coup or revolution

I believe one or all of these conflicts could evolve into World War.  Already numerous governments stand on one side or the other of these conflicts and as these relatively minor infractions escalate, the world could face “disastrous” wars as Kondratieff suggests.

I have quoted Marc Faber extensively because I believe he has done an excellent job in bringing the existence of economic long waves back to the forefront.  However, I think he errs in one key judgment – in “Tomorrow’s Gold” he states that the Kondratieff wave is still in the downswing.  But given the strong rise in gold and oil prices, the assimilation of China and Russia into the world economy, the increase in serious conflicts around the world and the increase in inflation – I believe investors can only draw one conclusion – the long wave has bottomed and is currently in the beginning of an upswing which will top out in 2020 at the earliest. 

I’ll ellaborate on what the upturn in the Long Wave means for investors in follow up posts. 

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