Kondratieff Wave Cycles

I have long been a cycles fan. My background is in Economics so my introduction to cycles came through studying economic cycles. There is a branch of technical analysis that also studies cycles. It is a fascinating area that sometimes can generate considerable debate and even disagreement between cycle analysts and between economists and technical analysts. Some cycle analysts that I have learned from and continue to follow are Michael Jenkins (Stock Cycles Forecast), Bob Prechter (The Elliott Wave Theorist), P.Q. Wall (PQ Wall Forecast) and Ray Merriman (The Merriman Market Analyst). You might consider them the technical analyst's analysts. There are of course many others.

In a short article such as this it is impossible to go into all the different cycle theories. But there is one popularized one that does bear some explaining (but not detail) in order to give some understanding of where we are today.

Kondratieff long wave cycle (K-wave) was originally used to explain long wave economic cycles. Its originator Nickolai Kondratieff was a Russian economist (1892-1938) in Stalin's Agricultural Academy and Business Research Institute ("Long Waves in Economic Life" - originally published in German in 1926). Kondratieff's major premise was that capitalist economies displayed long wave cycles of boom and bust ranging between 50-60 years in duration. Kondratieff's study covered the period 1789 to 1926 and was centered on prices and interest rates. Stalin, I guess wasn't impressed. Nickolai was sent to the Gulag where he purportedly died.

Still Kondratieff may have been on to something. The 50-60 year cycle of catastrophe and renewal had been observed and recorded by the ancient Mayans of Central America and by the ancient Israelites. Further studies have discovered similar long economic waves from the period of the ancient Greeks and Romans.

Kondratieff identified four distinct phases the economy goes through. They are a period of inflationary growth, followed by stagflation, then deflationary growth and finally depression. Some characteristics are as follows:

Inflationary Growth (expansion): - stable to slow rising prices, low commodity prices, low and stable interest rates, rising stock prices. The period might also be characterized by strong and growing corporate profits and technological innovations.

Stagflation (recession): - rising prices, rising commodity prices, rising interest rates, stagnant to falling stock prices. Stagnant profits, rising debt. This period usually sees a major war that contributes to the commodity and price inflation, and to the rising debt and misdirects business resources.

Deflationary Growth (plateau): - stable to falling prices, falling commodity prices, falling interest rates, sharply rising stock prices, profit growth but probably not as good as in the inflationary growth phase. Sharply rising debt. Possible period of considerable technological innovation. Excess debt contributes to speculative bubbles.

Depression (depression): - falling prices, rising commodity prices (particularly gold), stable interest rates, falling stock prices, falling profits, debt collapse. As the stock market collapses numerous scandals will emerge. A major war occurs that helps contribute to end of the depression phase and the start of the new expansion period.

With four distinct phases in the K-wave a number of analysts have compared them to the seasons. Spring (inflationary growth, expansion), summer (stagflation, recession), autumn (deflationary growth, plateau) and winter (depression).

Our chart below summarizes the generally accepted phases since 1784 in the United States. We have noted the significant wars that accompanied the recession (price peak) and depression (trough) phase. We have also noted the tag name for the Autumn periods that were characterized by massive debt growth and speculative bubbles.

Many have argued as to whether the Kondratieff wave is valid for the post WW2 economy given the fiscal and monetary tools of a modern economy. Others have argued that trough of the K-wave has already passed. Their count is from the stock market trough of the Great Depression in 1932. Add the average 54-year K-wave period and we are in the spring expansion of the new K-wave.

But what the Kondratieff wave is about is a study of long cycles of debt buildup and repudiation. It is not exclusively about price inflation and deflation periods. Deflation is caused in part by the debt collapse. It is also a generational thing as the next cycle of debt buildup and collapse is renewed every 2-3 generations as the previous generation that went through comparable periods dies off. The old adage that "this time it is different" means the circumstances are different, yes, but they fail to recognize that the previous period was the same in terms of excesses and therefore the end result is the same.

Most analysts take the last K-wave to have made its final trough in 1949 when interest rates and prices bottomed. The effects of the Great Depression were softened by WW2 and it was in the 1950's that the world firmly started to shake off the long two decades of depression and war. The K-wave has followed quite true to form with the solid growth and low inflation of the 1950's and 1960's followed by the commodity/price inflation and recession driven 1970's. Commodity prices peaked in 1980.

Following the steep secondary recession of the early 1980's the markets embarked into the Autumn K-wave plateau. We had stock market and real estate bubbles, a collapse in commodity prices, a collapse in interest rates and low inflation. But we also had a huge build up in debt that allowed us to buy our way out of the recessions of the early 1980's and early 1990's. Each succeeding recession required higher levels of debt to purchase an additional dollar of GDP.

Now the debt has become unsustainable and the ability to buy our way out of further problems is severely compromised. One only needs to look at the decade long nightmare of Japan to see that zero interest rates and all the stimulation in the world has failed to bring it out of its slump. We are witnessing merely the beginning of the debt implosion that inevitably follows the excesses.

The collapse of the tech market and NASDAQ, Enron, Aldelphia, K-Mart, Global Crossing, WorldCom, Arthur Anderson and numerous others are the corporate face of the scandals and the debt collapse. On the country side we have the implosion of Argentina and possibly Brazil, which would imperil all of Latin America. African countries never seem to be out of bankruptcy. As the job losses mount the consumer driven economy will fall into a deep funk and the consumer will go through their own debt implosion.

As occurred at the end of previous Autumn plateau K-wave's (1920-1929) the winter that followed revealed numerous financial scandals. This one has been no different. Enron and WorldCom are big and visible but are they merely the tip of the iceberg? The Autumn plateau K-wave brings on excesses in both the stock market and the boardroom. Even the early part of the Autumn plateau K-wave had its share of scandals and debt implosions with the insider trading scandals of the 1980's followed by the debt implosion and scandals of the Savings & Loans. If the 1990's were a decade of loss of faith in government for its excesses of debt buildup then the first decade of the millennium will see the same occur with capitalism and the corporation.

One of the more intriguing characteristics of a K-wave winter is the buildup of sinister forces that are religious in nature. The 1930's saw the rise of Nazism that led to WW2. But in an earlier generation K-wave winter in the latter quarter of the 19th century we saw the rise of the Klu Klux Klan as a backlash to the South losing the Civil War.

Today it is the so-called war on terrorism led allegedly by Muslim fundamentalist fanatics. There is a titanic religious war being played out. The Arab/Palestinian/Israeli conflict has the attention and imagination of conservative evangelistical religions in the United States. It is their belief that the current conflict was ordained in the Bible and will ultimately lead to the apocalypse. The President of the United States George W. Bush owes his election to these same conservative religious groups (as was Ronald Reagan before him). Many of his key aides are cut from the same cloth. Thus the many references to God and evil empires that dot Dubya's speeches.

The religious right firmly backs only Israel in the conflict. They view Israel as integral to their fermentations of the coming apocalypse (Time Magazine - The Bible and the Apocalypse, July 1, 2002 Vol. 160). On the other side conservative fundamental groups, some of whom see glory in suicide bombings, are swaying the Muslim world.

We have entered the downside of the current K-wave. This wave could last anywhere from nine to twenty years as we saw in earlier winter K-waves. The K-wave is the rise and fall of a generation and covers both the social and economic life of the period. The ancient Mayans knew of the inevitability of the cycle and took steps to mitigate its effects (although ironically in the end it did not save them). Our challenge will be to see that we come through so that once again we can rebuild.

The current winter K-wave is still young. We have noted in the past that following a speculative bubble things have a tendency to return to where they started or stated another way the gains of the previous period are wiped out. Already some stocks such as Nortel Networks have fallen 98%. Other big names are just disappearing period. We highly suspect that the NASDAQ will ultimately lose at least 90% of its value from the top. That means a fall to at least 500 over the next decade. We have already fallen about 75%.

For the Dow Jones Industrials, in theory at least that could translate into a fall back to 1000. While that may be only for some super bears vivid imagination we believe that at a minimum the Dow Jones Industrials will ultimately fall at least 50%-60% or down to around 5000. The highs of January 2000 are but a dream for years to come.

The current 4-year stock cycle is coming to an end. Some thought it ended last September 21, 2001. It may still be in play and could bottom in early July 2002 although we suspect it will, following a summer rally, bottom later in the fall of 2002. That should set up a decent run in 2003, which should allow for graceful exits for those still caught in the malaise of the first big drop. That would set the next cycle bottom for around 2005/2006, which could be the ultimate low for the markets. Time of course will tell.

The Winter of the K-wave is a dangerous period. But it will be eased for those holding gold or gold stocks. That new bull market is still in its infancy and may yet face a significant shakeout to make its final bottom. But we would all be wise to hold at least a little gold. The winter of the K-wave is upon us.

June 29, 2002

Charts and technical commentary by David Chapman of Union Securities Ltd. 69 Yonge Street, Suite 600, Toronto, Ontario, M5E 1K3 (416) 604-0533, (416) 604-0557 (fax) 1-888-298-7405 (toll free) email [email protected]

The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. Neither David Chapman nor Union Securities Ltd. take responsibility for errors or omissions which may be contained therein, nor accept responsibility for losses arising from any use or reliance on this report or its contents. Neither the information nor any opinion expressed constitutes a solicitation for the sale or purchase of securities. Union Securities Ltd. may act as a financial advisor and/or underwriter for certain of the corporations mentioned and may receive remuneration from them. David Chapman and Union Securities Ltd. and its respective officers or directors may acquire from time to time the securities mentioned herein as principal or agent. Union Securities Ltd. is an independent investment dealer and is a member of the Toronto Stock Exchange, the Canadian Venture Exchange, the Investment Dealers Association and the Canadian Investor Protection Fund.