Kondratieff Student Sees Stock Market Plunge and $2,000 Gold

July 19, 1999

Ian Gordon is a broker with a major Canadian brokerage firm. Admittedly, he is not a household name - at least not yet. That might change if he is reading the current stock market cycle properly. Ian is a student of the Kondratieff Cycle. To many of you, Kondratieff may be about as unknown as Ian Gordon. After all, the establishment has chosen to ignore this great Russian's work, even though a very accomplished Harvard economist, Joseph Shumpeter, said that "The Kondratieff Wave is the single most important tool in economic forecasting."

As a student of the Kondratieff cycle Ian is absolutely convinced that we have already reached the peak of the greatest bull market in stocks the world has ever seen. He is equally confident that now is not the time to allocate most of one's portfolio into stocks and bonds. Ian has graciously agreed to be interviewed by your editor so that you can benefit intellectually and hopefully financially from his wisdom. It was on Friday, June 4th that the following conversation took place with Ian from his Vancouver office.

Q - Ian, you named your newsletter the Long Wave Analyst. Why did you select that name?

A - The long wave is a synonym for the Kondratieff cycle, which is a long economic cycle of approximately 60 years discovered by Nikolai Kondratieff in the 1920's.

Q. - Can you give our readers a little background on Kondratieff?

A. Kondratieff was a Soviet economist who was asked by Stalin to determine how long it would take for Capitalism to fail. Unfortunately, after he studied historical commodity prices, trade and industrial production in the capitalist countries, he discovered a long business cycle that would ebb and flow, but couldn't break. Since this was not what Stalin wanted to hear, Kondratieff was thrown into a gulag where he perished.

Q. So I guess that Kondratieff's fate was the result of his honesty and truthfulness, since it didn't suit the Russian establishment's views and justification for its existence. Of course here in America, where we long for truth, we can count on leaders like Bill Clinton to act more honorably. In any event, could you provide our readers with an overview of the Kondratieff cycle?

Since the Kondratieff cycle is a long cycle of approximately 60 years, it is often difficult to pinpoint our exact position on the cycle. However by using PK Walls' analogy by splitting the cycle into 4 season of the year, we can view our position at any point in the cycle more clearly. Kondratieff himself defined two complete cycles and a half of the next cycle. The first cycle was from 1789 to 1849. The second was from 1849 to 1896. The third cycle, which Kondratieff partly identified (before Stalin put him away) ran from 1896-1949. We are now well into our fourth cycle, which I expect, will end in approximately 2009.

Q. So you figure we are only about 10 years away from the end of the current 60-year cycle?

A. Taylor, I have to hand it to you. You have an amazing aptitude for math. Kondratief split each cycle into a rising economy and a declining economy.

Q. You said it is helpful to understand where we are in the cycle by dividing it into the four seasons of the year. Can you explain?

A. That is right. Let me quickly describe the characteristics of the four seasons so that it becomes easier to recognize where we might be in the current cycle.

Q. Lay it on us!

A The cycle begins in the spring season which starts the rebirth of the economy starting from a very low level of consumer confidence. Spring in the current cycle began in 1949.

Q. Has consumer confidence been shattered by the end of the previous cycle?

A. Exactly right. Consumers have had the snot scared out of them by the depression that ended the prior cycle. As the spring season progresses, consumer confidence begins to rise, though not nearly as high as it will get during the summer and autumn seasons.

Summer, which in the present cycle, started in 1966, is the burgeoning economy characterized by rapidly increasing consumer confidence and increasing inflation. Summer ends with an inflationary blow off. 1980 was the end of our summer in this cycle and 1920 was the inflationary blow off at the end of summer in the previous cycle.

Autumn is always characterized by growing speculation in stocks, bonds and real estate, which really grows to excessive proportions. Traditionally autumn has always ended in a stock market crash so for instance the two autumns ago we had an autumn stock market crash ending 1874. We had the 1929 crash ending our last autumn. And, we have had the Japanese stock market crash when their autumn ended in 1990 and then we have really had the Asian stock market crashes during the past two years, which ended their autumn period.

Then, winter is the season of deflation and depression. Its purpose really is to ring excessive debt out of the economy and to right the banking system because the banking system has gotten into really rather difficult problems with excessive credit, which has been made available by benevolent central banks.

Q. During what season does this excessive credit really start to take place? Is that in the spring or the summer or when?

A. It starts in the summer with the rise of inflation because everyone is just trying to keep up with the rise of inflation. So that banks start to lend dramatically, but the real excess grows in the autumn period when the Federal Reserve, frightened by very high interest rates at the peak of summer, drops the rate of interest quite dramatically. They are worried about the recession that usually follows the end of summer and they start to put a lot of money into the banking system. Money in the summer period goes back into a capital goods expansion. But in the autumn period, those factories have already been built so it is consumers rather than companies who begin to borrow aggressively from the banks. And consumers eventually begin to use that money to speculate in stocks bonds and real estate.

Q. Can we say that the autumn season then is a period when supplies of all sorts of items in the economy begin to become excessive?

A. Yes.

Q. So you have declining prices and consumers have a field day?

A. Right. And that's a characteristic of autumn. It's a disinflationary period in the cycle. The summer period of the cycle is the inflationary period and the spring is the very benign period of inflation. Winter is characterized by DEFLATION or rapidly falling prices.

Q. If we are within 10 years from the end of the current Kondratieff cycle, what season are we in right now?

A. Well, I think based on those seasonal characteristics that I just related to you, there can be no doubt that we are fast approaching the end of our autumn season. In fact I think there is technical evidence that the U.S. stock market has already made a top.

Q. Could you tell our readers what some of that evidence is?

A. Well I'm talking purely from a technician's standpoint now. I believe that the orthodox top, if we use Elliott Wave analysis, was made in July 1998. Just as the orthodox top of the previous summer peak was made in 1928, not 1929. And the correction in October was the "A Wave" correction. The high which I believe was made in late May this year was the "B Wave high. I believe that was a high because at that point in time we have a key point reversal on both the Dow and S&P.

Q. O.K., for our non-technician readers, can you tell us what you mean by a "key point reversal"?

A. It is simply when a weekly bar makes a new high but closes below the close of the previous bar of the previous week. That is a very, very strong indication that the trend has been reversed.

Q. So your feeling is that this great bull market is over?

A. I feel that we have already come to the end of autumn and autumn is nearly always signaled by a stock market crash.

Q. So a stock market crash is what we have to look forward to here? Thanks a lot Ian!

A. Well, if we use the previous autumn - 1929 - even if we are to look at values say 1929 stock values vs. 1999, using things so simple as PE ratios, book values and so on, we see that we are excessively overvalued in 1999 compared to 1929. But using 1929 is a good example because it was the end of the previous autumn period. The Dow topped on September 3rd., about out six weeks before the crash started. By the middle of November 1929, stocks had fallen by 50%.

Q. Amazing! Stocks fell by 50% in just a few months. But didn't the Dow actually fall by something closer to 90% until this stock market debacle was all over?

A. Yes! The ultimate result by June-July 1932 was a decline of 90% from its September 1929 high.

Q. Amazing! But you hear most analysts talk today about corrections. They believe bear markets have been eliminated forever. We are only going to have corrections - you know - on the order of 10%, 15%, 20% and then we will inevitably move toward new highs. Investors these days cannot fathom even a 50% decline, never mind a 90% fall in prices. And you know if you go back over the century, the only time we have had a decline anything like a 90% fall was during the 1929-1932 down period. How does the magnitude of the 1929 decline compare to these crashes that took place during the winter of the previous Kondratieff cycles?

A. The 1874 autumn decline was about a 40%. During the autumn season ending in 1819 stocks plunged 80%. So the autumn is really characterized by a significant loss in stocks values. But the one that is, in my mind, the most relevant to the current period is 1929.

Q. Why so?

A Because in 1874, the U.S. economy was built around the railroads. It was not yet an industrial economy. By 1929 we had a full-fledged stock market that was driven by an industrial economy. Another example I think is important to look at too is the Japanese autumn because the Japanese economy is also fully industrialized. The Japanese market peak was on December 28, 1989, but in its initial decline, it lost 50% of its value.

Q. Right. What did it ultimately lose?

A. Well, it hasn't finished losing but since its December 28, 1989 peak it declined from 39,000 to 12,000 so that's nearly a 70% decline. But in my view the Nikkei has still not yet bottomed.

Q. You must be kidding! All the media discussion I have seen and heard is certain the Nikkei can't go lower and that in fact, with its most recent advance is on the mend.

A. I think that when the U.S. stock market declines the Nikkei will suffer further decimation. I think you can use the Nikkei as a close approximation for the New York market in 1929 because the Nikkei topped at just under 39000. NY topped at just under 390 in 1929. NY dropped to 41. So if we are going to see a similar decline, we can see the Nikkei at about 4100.

Q. Sounds like a thrill! Of the three Kondratieff cycles, 1929 was the worst wasn't it?

A. Right.

Q. Well, this is kind of scary stuff for a lot of people. Readers of this letter are perhaps not so shocked because this newsletter serves to provide hedging advice for the small investor. They are comfortable and prepared to face the day when stocks suffer a devastating decline. But most of the world of course looks at these predictions as "off the wall" just as they did in 1929. But if the masses refuse to learn from history, I suppose there isn't much we can do. What are the implications for gold then? If stocks are destined to suffer through a devastating decline, what do you see for gold?

A. Well, the winter period of the long wave season is the deflationary depression segment of the cycle. The whole purpose of that period is to clean up the debt. And so during that period, the value of commodities themselves, drops dramatically as demand drops. But I think that gold on the other hand comes into the fore, fulfilling its traditional role as money. This is because during the winter period, enormous pressure is placed on the world banking system. A good example of this is Japan, which is now well advanced into its winter season. When you get this intense pressure in the banking system, there is a huge flight out of paper money.

Q. Right - So are the Japanese buying lots of gold now?

A. Well, they are beginning to, but don't forget, they are still sending a lot of capital into the U.S. market. And it is only when the U.S. market declines that those capital flows reverse back to Japan. Once the U.S. stock market drops it will lead to a drop in the U.S. Dollar and there will be no safe haven currency. The Japanese Yen is still a leading currency, but the Japanese have tremendous problems. The Japanese are going to issue 90% of the world's debt this year, so the yen is going to remain suspect. The Euro certainly has displayed its problems, and I believe its promise will never even come to fruition by 2002 as it is scheduled to do.

Q. Can you run that by me again? You said the Japanese will issue 90% of all debt in 1999. Why are they doing this? To monetize their debt? To try to print their way out of trouble? Is that it?

A. When the U.S. stock market gives up, the U.S. dollar will become suspect, especially since the U.S. is now the world's largest debtor nation - unlike the last cycle when the U.S. was the largest creditor nation.

Q. So what's going to happen then? Will there be a flight to gold because investors will have lost confidence in paper money?

A. Well, that's what happened during the 1930's. While the Dow was losing 90% of its value during the 1929 to 1932 time frame, Homestake Mining for example rose in value by 300% without any corresponding rise in the price of gold, which was fixed at $20.67/oz.

Q. Right you are Ian! Our readers know all about that. As you know, I actually received daily stock price data from Homestake dating all the way back to 1888. From that I provided the results of a statistical study I carried out in which I allocated 15% of an hypothetical portfolio to Homestake Mining shares and 85% to the Dow Jones Industrial Average. I assumed that at the end of each year, investors would begin the year with 15% allocated to Homestake and 85% to the DJIA. What we found was that this gold exposure not only virtually eliminated the huge 90% decline suffered in the DJIA, but that the portfolio containing Homestake performed significantly better than the straight DJIAportfolio. In fact, as late as December 1998, the portfolio containing Homestake was still worth 25% more than the one without Homestake despite the fact that gold has been in a 19-year bear market. So you are definitely preaching to the choir on this issue. Actually, Roosevelt revalued gold from $20.67/oz. to $35 oz. Do you remember when that took place? Not that you were around at that time, but…

A. Very funny! The year was 1933. I was born about 9 years later. Investors knew they could take their paper dollars to a bank and receive an ounce of gold in exchange. Therefore, the dollar was as good as gold. A vast majority of Americans chose to take gold rather than paper because so many U.S. banks were closing their doors. So Roosevelt confiscated the private ownership of gold and at the same time he revalued gold to $35 per ounce which is where it stood until 1971 when Nixon defaulted on this obligation.

Today, with the dollar having no backing by gold, the demand could be enormous. In fact when you look at the public purchases for gold now, it is already up 1,400 times since 1996.

Q. So that's the off-take of gold coins in North America, right?

A. Right. And in the first quarter of l999, North American demand for gold coins rose 141% to 32 tons! So Americans, and to a lesser extent Canadians, are already starting to accumulate gold.

Q. And that coincides with the autumn or winter seasons?

A. Yes, with the onset of the winter cycle and that is why I believe the world's central banks are doing anything and everything they can to keep down the price of gold. They want people to believe that fiat paper is more valuable than gold itself.

Q. I think you might be right about that. While you are talking about this enormous demand in gold, the media and government are acting as though no one except a few radicals want or should want to invest in gold. What we do hear is that "gold has lost its luster" or that it no longer serves as an effective insurance policy against all kinds of political and economic chaos. We hear all kinds of stories about governments and central bank gold sales, most of which are spoken of but never take place. So your belief is that this is an orchestrated effort to keep people believing and hence remaining in paper money rather than gold?

A. Right. And I mean so it was - it has always been that way. Whenever governments have introduced a fiat system, governments have always tried to convince people that paper is more valuable than gold.

Q. And of course, all those paper systems have ultimately failed throughout history. Right?

A. Yes, they have.

Q. Well, there has been an enormous amount of money and credit created during the summer and fall seasons in the current 60-year cycle. So that leads me to ask you what price gold might ultimately rise to, if and when governments are no longer able to fool the populace into thinking paper money is better than gold? Or does that question make any sense?

A. - It's very difficult to come up with a price. However, James Dale Davidson and Lord William Rees-Moog in their book, "The Great Reckoning," wrote that the price of gold in the deflation period - and they traced this back through five periods in history - rose an average of 8% in real terms over the inflationary peak in the gold price. If that's to happen this time - I mean - we are taking the average - but if that is to happen, then we are looking at something over $2,000 per ounce.

If you look at a chart that first brought me to your attention. This was the chart that you showed in your newsletter displaying the price of gold divided by the Dow Jones Industrial Average. That chart now shows the disparity between the price of gold and the DJIA.

Q. That's right. When gold reached $850/oz. in January 1980, and the Dow was under 1,000, we had essentially a 1:1. Now the relationship is around 40:1! So the very high price of gold in 1980 co-incided with the end of the summer season in the current cycle, is that correct?

A. Yes because gold is a commodity as well as money and in 1980, when the summer season ended, we had an inflationary blow off. During such a time, people look to secure their wealth by purchasing tangible items because they realize fiat currency is not all it is advertised by politicians and bankers to be. Following the 1929 crash, the gold/DJIA was a 2:1 relationship. But only because the price of gold was fixed. We know that demand for gold was enormous, but if it were floating as it is now, I'm convinced we would have seen at least a 1:1 relationship. So based on this historical activity, we have to try to envision where the Dow will be and where gold will be if we get back to a 1:1

Q. Well Ian you know that I am of a like mind and agree with most if not all of what you say. I have, since the 1970's always believed that gold provides a portfolio insurance policy. Accordingly, I believe prudent investing requires you to allocate a portion of your portfolio to gold. I'm telling my subscribes to have at least 10% of their portfolios allocated to gold shares and 2% in gold and silver bullion. What is your advice now with respect to allocations of stocks, bonds and gold?

A. Because I believe we are on the cusp of winter in North America, I do not think that stock investments make sense at this very critical juncture of the long wave cycle. Long bonds may act as a temporary haven in any severe stock market decline, but I stress that would only be temporary. During the onset of winter in the long wave, gold and cash have performed very well. Cash because the value of everything falls precipitously and gold because winter creates severe problems within the banking system and the world financial system as well.

When the winter season gets under way, capital will dry up dramatically. In the current Japanese winter, that country will repatriate their long-term holdings, and probably are already doing so and the Chinese will do the same. What you will see is U.S. interest rates rising as foreigners take some or most of their $1 trillion of U.S. debt home. The U.S. dependence on foreign nations should not be forgotten. Without foreigners supplying $1 trillion of the $5.6 trillion U.S. debt, interest rtes would be much higher than they are now. When our winter arrives, we will see much higher interest rates.

Q. So you are suggesting that we could have plunging commodity prices and rising interest rates at the same time?

A. Well, we had that in the 1930's. It's interesting. The U.S. was not a debtor nation, so there were no long government bonds then, but AAA corporate debt rates rose in 1933 to a level where they were higher than at the inflation peak of 1920, even though the U.S. was in the Great Depression!

Q. Wow! People were just scared they were not going to get their money back, even from Dow Jones blue chip companies right? So the default risk was perceived to be very high. Investors had the spit scared out of them, right?

A. Right. Bear in mind that the U.S. will have only two options open to it when the winter season begins. It can either raise rates to attract money or start the printing presses rolling to accommodate credit needs.

Q. But of course if rates rise to any substantial level it will further devastate economic activity.

A. Right. So they will almost certainly monetize the debt by printing money, just as Japan is now doing. That will spell disaster for the dollar and it will also provide an extremely bullish picture for gold.

Q. Yes, and the thing that concerns me however, is the possibility that when we have that kind of economic chaos, what the government may do is choose to make ownership of gold illegal as it has done in the past under Roosevelt. Uncle Sam may in fact make house to house searches for gold.

A. I think they may very well do that again. But that in part is why owing gold shares makes a lot of sense. For instance, if you own gold shares you own gold in the ground owned by the company. So a lot of people buy gold shares in lieu of gold.

A Well, if everyone buys gold shares, who is going to buy the gold? I guess internationally there will be demand for gold no doubt and there will be people who buy gold underground. Some will keep the yellow metal off shore aware from the tyranny of Uncle Sam or hide it in their vaults, right?

A. Yes, and what I also believe you will see is a shift in national ownership of gold so that the Chinese for example who currently hold $145 billion in foreign currency reserves but only 3% of that is in gold will be buyers. On two occasions that I am aware of, Chinese officials have come out publicly in favor of increasing their gold ownership to approximately the same levels as Germany and France. That would mean something like 35% to 40% or $40 or $50 billion worth of gold transfers to the central bank of China. And don't forget, the Japanese, who do not hold much in the way of gold as a reserve currency. So I think what you are going to see is the economic power shift from North America to Asia at the start of the next Kondratieff cycle, just as we saw the power shift from England to the U.S. at the start of the current cycle that began in 1949. There has already been some evidence of that. In 1989, the Japanese stock market was bigger than New York's and 10 of the largest banks in the world were all Japanese. And that was the same kind of evidence of the U.S. overtaking Britain as the number one economic power at the start of the current cycle.

Q. Of course, you realize that most people believe your views (and mine) are a little off the wall. What do you have to say to such critics?

A. All I am trying to do is to take a look at an economic cycle and provide an investment framework within that cycle. Bear in mind that the Kondratief cycle holds considerable credibility for people who care to look seriously at it. No less an economic genius than Joseph Shumpeter, the famed Harvard professor, has identified the Kondratieff Wave as… "the single most important tool in economic forecasting." Shumpeter has done the definitive studies of long term economic cycles and the interrelationship of long and short cycles. Yet few people seem to care now.

Q. Why do you think it is so difficult for people to recognize these cycles? You lay it out so clearly in your newsletter and of course other people like Shumpater have spoken about it. Why is the long cycle disregarded by so many people, when it appears to be so clearly intact today?

A. I think that most people are caught up in the moment. In other words, they are caught up in the frenzy of the stock market. And there is always a feeling when this sort of thing is going on, that is when a bull market is well advanced, that this is a perpetual event - that we are experiencing a new paradigm as people like Larry Kudlow are fond of saying. But as Allan Greenspan has said, he has lived through many times when new eras were supposed to take place only to recognize at quite a great cost that the laws of nature had not changed. Consider Japan for example. I have been to Japan and I have spoken to the Japanese about their experience. They remember the Nikkei at 39,000 and the value of real estate in Japan when it was rising to astronomical levels. They remember that the value of the Emperor's palace in Tokyo was worth more than the whole state of California. At that time, the Japanese had a feeling that nothing could ever bring them down. But you go there now and you can see the effects of the winter in Japan. Real estate values are probably 1/10 the value they were in 1989. The bankruptcies associated with real estate speculation are enormous and their banking system is now in incredible trouble.

Q. Well, this certainly was a sobering experience for the Japanese as it was for the U.S. in our last winter season - the 1930's. I guess your recommendation is to buy a lot of gold and stay liquid, right?

A. Well, the two things in the winter period of the cycle that seems to make a lot of sense as they did in the last cycle are cash and gold. And each period of the cycle has a different investment cycle. It just so happens that at this time of the cycle, gold and cash are the best investments. Gold isn't a good investment in the spring and as we have seen, it is a horrible investment in the autumn whereas stocks and bonds are a fantastic investment during autumn.

Q. So what we have to look forward to now is buying gold in order to preserve our capital so that we can live to see the next spring, or the beginning of the next 60 year cycle. I'm 52 years old and I know you have made at least a couple more trips around the sun than I have. So I presume neither you nor I will be around to witness the end of the next cycle, right?

A. Jay, we don't know that. Science is so good these days that perhaps they may be able to keep us going for a long time.

Q. O.K., maybe we will live forever. Perhaps there will be a new paradigm with respect to life and death, even if there is not a new paradigm in the economy. But, seriously, if we can preserve our wealth by moving into cash and gold, we will be in a very strong position to buy stocks when no one else wants them, at the springtime birth of the next cycle, when fear of the stock market runs supreme. Of course, this philosophy is very much in keeping with the philosophy of people like Bernard Baruch, who suggested that he wanted to buy stocks when no one else wanted them and to sell them when the shoeshine boy and elevator operators were doing nothing but talking about them. Let me tell you Ian, I don't have a shoeshine boy. I shine my own shoes. And we don't have elevator boys any longer in New York because elevators run by themselves now. But I can tell you that my next door neighbor, Ralph the electrician, .stops by my office two or three times a day to check his high tech stock portfolio. All he can talk about is the stock market. He is even considering giving up his day job to become a day trader. Never before - not even in 1929 have so many Americans watched the stock market as closely as they do now. I take this as another sign that the autumn season is well advanced. Do you agree?

A. I absolutely do.

Q. Again Ian, I want to thank you for your insights and your willingness to share them with our subscribers. Also, thanks for helping me figure out what to do with my money - the little that I have - and also for helping me shape my thinking in portfolio advice I am passing on to my subscribers. Do you sell your newsletter? You do share these views with your clients I presume, do you not?

A. I'm not selling my newsletter. I do share it with my clients. But I welcome a challenge from anyone who seriously thinks they can refute my views. I'd love to be wrong because we are quickly approaching a very unhappy time in the cycle.

Q. Ok. So in my newsletter, I will put the challenge out to those who would suggest the old laws of nature no longer apply to market patterns, to contact you. Would that be OK?

A. That's fine. I look forward to it.

Gold is still being mined and refined at the rate of almost 2,600 tonnes per year.