Studies addressing the occurrence and causes of cycles in the financial markets in recent years have tended to place a strong emphasis on the supposed causative effect of mass psychology. Several noted cycle theorists have made aggregate human psychology the cornerstone of their cycle work. But all available evidence points to a basis for the trade cycle that is beyond the influence of humans, indeed, is a variable that has an impact on every living creature: the weather.
Nearly all study on the various cycles that impact the prices for stocks, bonds, currencies and commodities have tended to ignore this crucial variable. Most regard its influence as ephemeral in nature and of little consequence to long-term trends in the financial markets. But we would argue that weather is the determinative factor in the analysis of any cycle, irrespective of its size or time element.
As a starting point, we looked at the famous Kondratieff Wave Theory, formulated by the noted Russian economist and cycle theorist Nikolai Kondratieff in 1926. The "K Wave," as it is called, is basically a 60-year long-wave cycle which coincides (and causes) the rise and fall of all kinds of prices: land values, farm commodities, gold and silver, stocks and bonds, etc. The last time the K Wave bottomed was during, or shortly after, the Great Depression of the 1930s. Adherents of the K Wave expect the next K Wave crash sometime early in the new millennium.
A corollary of K Wave Theory is that cycles in the financial markets alternate between the two basic sectors of equities and commodities. For instance, when stocks are in a secular bull market late in the K Wave (as they are now), commodities tend to be in the midst of a raging bear market, or at least forming a bear market base prior to a new bull market. The basic idea is that stock and commodities alternate between bull market and bear market-—when one sector is rising the other sector is almost certain to be falling. The reasons for this are varied, but the essence for this phenomenon is that since commodities are highly sensitive to inflation and can rally for sustained periods only when inflation is at its peak, equities tend to perform well in periods of low inflation, since inflation kills stock values. Thus, our current period of "low inflation" (typically a precursor for runaway deflation in the late stage of the K Wave) has been very beneficial for stocks.
In reality, however, in a market where government controls the production of paper money (via the Federal Reserve) there will always be inflation in some sector of our economy. This is because of the inveterate tendency of bureaucrats to print their way to a country's prosperity. The only exception to this rule is when a gigantic build-up of debt (which inflation always leads to) eventually collapses of its own weight and leads to widespread deflation, i.e., the money disappears into a veritable black hole. Until the citizens of the country can accumulate enough capital to begin investing and speculating again the country remains mired in recession or depression.
Capital has a relentless tendency to seek ways of multiplying itself in a free market (or semi-free market, as in the U.S.). Unless the aforesaid conditions of recession are underway, capital can always be expected to funnel into the financial sector that promises the greatest returns in the least amount of time. At the present moment, that sector is the stock market, which promises to reward investors and speculators with windfall profits in exchange for shouldering the risk. Since the stock market is up, this creates a suction which funnels all available capital into its coffers. Since commodities are in the dump, hard assets offer little or no competition to paper assets at the moment, thus guaranteeing that all available capital will be channeled directly into the equities market.
When commodities do lift their head and begin rising, capital immediately takes an interest and begins to follow the trail blazed by the suddenly hot financial sector. This draws money out of stocks and into commodities, thus reversing the fortunes of the two great financial sectors. This phenomenon can only occur, however, with a rise in inflation. Since we have already established that inflation is always present at any given time (the exception being a deflationary recession or depression), the question becomes one of "what causes inflation (i.e., liquidity) to seek commodities?" The answer to that is the weather.
Kondratief used as his starting point in his research of the K Wave the long-term trend in grains prices. This was an excellent choice of research data since grains form the basis for the entire commodities sector as well as the economy as a whole. After all, human civilization would soon collapse were it not for grains such as wheat and rice, and humans can survive (if forced) without such things as stocks, bonds, currencies, and even gold and silver. But they cannot live without the basic element of food. Thus, grains are the foundation for the entire economy, foreign and domestic. Furthermore, any rise in inflation in the hard asset sector will first make its appearance in the grain complex.
Now we come to the crux of our thesis: grains (and for that matter any asset in a capitalist economy) can rise in value only when the balance of the supply/demand equation is tilted in favor of demand due to a diminished supply. And this falling supply is caused both directly and indirectly by trends in the weather. For when the weather trends, as measured by temperature and precipitation, are not conducive to growing conditions, it decreases the supply of grain stocks and eventually leads to higher prices. The trend since the 1980s in U.S. grains production has been toward over-supply and over-production since weather has seen a change from freezing winters and shorter growing seasons to longer growing seasons and milder winters. Average annual rates of rainfall and temperature have also been increasing for the better part of the last 20 years. This has made conditions more conducive for an over-supply in grains, and has served to remove the pressure and competition from the equities market. So it is not surprising that stocks have been the beneficiary of all available inflation for the past 20 years while commodities have been in a bear market. Also, Congressional policy has served to exacerbate this trend since it encourages over-production in farming as well as over-speculation in stocks (courtesy of the U.S. taxpayer, of course).
If this trend continues over several growing seasons and the price of grains keeps rising, the inflation that funnels into the grains sector will eventually spill over into other hard assets as well since higher prices for food mean higher prices for other physical assets and consumer items. Gold enters the picture since it is the ultimate barometer of inflation and rises in price the more inflation makes its appearance in the commodities market. So even gold benefits from a long-term change in the weather.
"Long-term" is the operative word since a short-lived weather trend exerts little lasting influence on commodities. So if we are to see a change in the current supply/demand balance in equities versus commodities we must look first for a change in the weather cycle. This is where our theory becomes quite interesting. Looking at both long-term and short-term charts of weather patterns, such as charts showing average daily and yearly temperatures and precipitation levels, particularly in the U.S., we were easily able to isolate definitely recurring cycles in almost all of the charts concerned. In fact, even on a very short-term basis, we found an almost perfect two-week cycle in the chart showing daily high temperatures in the Mid Atlantic region whereby temperatures fluctuated in cyclical fashion between a low temperature of 40 degrees F and a high of 70 degrees F, alternating between either extreme over a period of two weeks (give or take a couple of days), for a three month period before a change in seasons forced a change in the parameters of the cycle.
A glance at the longer-term chart showing U.S. weather cycles shows that the average temperature for the last 130 years has been in a rising trend for the better part of the past 120-125 years. Only in the past few years has the uptrend been challenged (to use a term of technical analysis) as both the angle of ascent and the momentum of the temperature increase has slowed dramatically and is more or less moving in a sideways pattern. In other words, the trend may well be in transition from a rise in temperature to a decline. This would naturally entail a shift from paper assets to hard assets if the falling trend gets underway for any length of time.
We are not the first to draw a correlation between rising temperatures and rising equity (and hence, falling commodity) markets. A couple of years ago, Bob Prechter of Elliott Wave International did a study which showed that nearly every mania in paper assets over the past 200 years has coincided with periods of rising temperatures. In fact, the greatest speculative manias in recorded history, such as the Mississippi Bubble and Tulip Mania, occurred when rates of yearly temperature increases were at their highest.
In the twentieth century, the Great Depression of the 1930s in the U.S. coincided with the "Dust Bowl" of the Mid West which destroyed much of the wheat and corn crop across the principle growing regions of the country. This led to the financial conditions which eventually caused a boom in commodities (since it greatly decreased the supply of grains). In fact, an argument could be made that the Great Crash of 1929 was, in part, in anticipation of the Dust Bowl of the 1930s.
In more recent years, the severe drought which wreaked havoc on large portions of the growing regions of the Mid South and Mid West in 1988 caused a magnificent spike in commodities prices, and was perhaps forecast by the stock market mini-crash of October 1987.
Many noted climatologists are forecasting a fundamental shift in global weather patterns over the next several years which, if realized, would definitely alter the supply/demand equation between equities and commodities. Eva Browning, a noted climatologist and the editor of the widely-read The Browning Letter, a newsletter for investors which specializes in analyzing global weather trends and their potential impacts on major investment sectors, has also predicted that weather trends in the first decade of the new millennium will be extremely erratic and "extremely extreme." This forecast dovetails nicely with the expected bottom in the K Wave in the next couple of years.
In conclusion, we assert our proposition that the K Wave is nothing more than a long-wave cycle reflecting the basic trends in weather. It is, in reality, a weather cycle, and cycle theorists must begin to recognize this fundamental truism and the profound influence weather cycles exert on financial markets. When they do it will add greatly to our understanding of the trade cycle and will provide considerable enlightenment into the ways we can protect ourselves from the exogenous events that impact our everyday lives.
Clif Droke is editor of the weekly Leading Indicators newsletter, covering the U.S. equities market outlook from a technical perspective as well as the general economic outlook. He is the author of the recently published book, Technical Analysis Simplified. For a free sample issue of Leading Indicators, send name and mailing address to email@example.com or mail to: Leading Indicators, 816 Easely St., #411, Silver Spring, MD 20910.
Also by Clif Droke
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