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The Kondratiev Cycle: Where Are We Now?

Economics / Economic Theory May 31, 2010 - 10:35 AM GMT

By: Jim_Richter

Economics

Best Financial Markets Analysis ArticleIn one of the early issues of my newsletter, I wrote an article about the Kondratiev Cycle, an economic cycle which was first identified by Nikolai D. Kondratiev (1892-1938) an eminent Russian economist. The famous economist, Joseph Schumpeter, once said that the Kondratiev Wave is “...the single most important tool in economic forecasting.” 


What is the Kondratiev Wave or Cycle? Why is it important for all of us to know about it? Nikolai D. Kondratiev was one of the architects of the first Five Year Plan, an economic program put into place in the Soviet Union after the Russian Revolution. During the 1920s, Kondratiev studied the history of the capitalist system. In 1926, he published his conclusions in “Long Waves in Economic Life.” He found that the capitalist system has cycles which are very similar to the seasons of the year.

Kondratiev’s research showed that capitalism is actually a SELF-RENEWING system.  Implicit in Kondratiev's work was the inescapable conclusion that, while capitalism is cyclical, and while it has significant “ups and downs,” it always renews itself and, as such, it offers mankind the best hope for economic betterment. When he began his work, Kondratiev was in favor with Lenin and Stalin. However, after he published, for obvious reasons, he fell out of favor. Kondratiev lost his position as the director of an economic institute, and he was later sentenced to the Soviet Gulag. He died in the Gulag.

The Kondratiev Cycle or "Long Wave" is an economic cycle which generally lasts between 50 to 60 years. It is marked by four clearly distinct periods during which different asset classes perform better than others. To simplify things, the Kondratiev Cycle has been broken down into four "seasons." They are as follows:

1) Spring: A time marked by economic expansion. Savings are at fairly high levels, and interest rates are low. Stocks and real estate are the most successful investments.

Most recent Spring: 1949-1966. Prior Kondratiev Springs: 1794-1800, 1844-1858, 1896-1907.

2) Summer:  A time marked by high inflation, high interest rates and by volatility. Commodities, gold, and real estate do well during the summer.

Most recent Summer: 1966-1982. Prior Kondratiev Summers: 1800-1816, 1858-1864, 1907-1920.

3) Autumn:  The happiest phase of the K-Cycle. Paper financial investments like stocks and bonds always do best. Autumn is characterized by speculative bubbles or manias in stocks, bonds, real estate, and collectibles. On the other hand, gold, silver, and commodities collapse.  Autumn is also marked by a serious decrease in savings, and a dangerous and reckless increase in debt. The imbalances build up to the point where they cannot continue.

Most recent Autumn: 1982-2000. Prior Kondratiev Autumns: 1816-1835, 1864-1874, 1920-1929.

4) Winter:  The insane excesses of the Autumn are purged or cleansed. The ultimate result is a deflationary recession or depression. Debt is repudiated. There is usually a banking crisis. Bankruptcies and foreclosures increase, as does social discontent. During the Kondratiev Winter, GOLD and CASH are the best investments. Owning shares in mining companies that produce gold is wise during a K-Winter.

Most recent Winter: 2000-? Prior Kondratiev Winters: 1835-1844, 1875-1896, 1929-1949.

More than two years ago, I wrote the following words: "I believe that the actions of the FED, especially under Greenspan, caused a delay and distortion in the Kondratiev Cycle, but did not eliminate it. The Winter began in 2000. However, when the stock markets collapsed in 2000, the FED lowered interest rates and triggered a real estate bubble which has now finally collapsed. All of this was built on reckless debt creation. Now, we are seeing the results as big banks such Merrill, Citi, Bear Stearns, and numerous others are having to write off staggeringly huge losses. The FED has no alternative but to try to inflate us out of this mess by creating unlimited amounts of money through the creation of new debt. The problem is that during a Kondratiev Winter, banks become afraid to lend, and borrowers become afraid to borrow!" [Does any of that sound like what happened during the past two years?]

David Knox Barker is considered to be one of the top experts on the Kondratiev Cycle or "Long Wave," as some call it. In a recent interview, he commented that he believes that the K-Winter began in 2000. He also said that he had originally thought that we would reach the bottom of the K-Winter in 2009. However,  he believes that the massive interventions into the financial markets by governments and central banks have had the effect of prolonging and distorting the current K-Winter. He now believes that we will not see the bottom until 2012, and that we will have to have a significant debt crisis (to wash away the excesses of the K-Autumn) before we do reach the bottom. I agree with all of this.

No economic model is of any use unless one understands it, believes in it, and unless one is prepared to act based upon it. Beyond that, the Kondratiev Cycle is not something which can be used to make short-term investment decisions. It is a very valuable tool for understanding the "big picture." Those who wish to trade in and out of the markets will not find it to be of much help. 

A look at the three most recent Kondratiev Winters tells us that they have averaged over 16 years in duration. Therefore, it is possible that we could have about 6 years to go until we see the end of the current cycle. On the other hand, we could see the end much sooner than that. The K-Winter which started in 1835 lasted for about 11 years.  There is simply no way to make an exact prediction.

We do know some things with certainty.  A Kondratiev Winter culminates in a deflationary recession or depression. The excess debts of the preceeding K-Autumn are repudiated and "washed away."  Although we have seen powerful deflationary forces during the past few years, we have also seen massive inflationary counter-measures implemented by governments and central banks.  In addition, instead of allowing the "too-big-to-fail" debtors to go bankrupt, governments and central banks have propped them up and not permitted the bad debts to be purged. In view of this, it is reasonable to say that we will not see the end of the current K-Winter until we have seen deflation gain the upper hand, and until the bad debts are finally extinguished from the economy. It is my current opinion that a logical scenario could be the following: increased inflation, hyperinflation, followed by the deflationary bust. 

Readers of this newsletter have noticed that I normally post the current Dow/Gold ratio with the other statistics at the beginning of each month's newsletter. The Dow/Gold ratio is derived by dividing the Dow Jones Industrial Average by the price of one ounce of gold (priced in dollars). The ratio is a means by which one can determine when stocks (i.e., paper investments) are overvalued compared to gold, and vice versa. 

In 1929, 1966, and 1999, the Dow/Gold ratio reached high points. Each of these years marked the high mark of a bull market in stocks. Not long after reaching high points, in 1929, 1966, and 1999, the stock markets crashed and entered secular (long-term) bear markets. The Dow/Gold ratio gradually declined. During the 1930s, the ratio went to about 2:1. In 1980, it briefly reached 1:1. Over the course of the past decade, the ratio has dropped from about 43:1 to 9:1. What was the significance of the high Dow/Gold ratios seen in 1929, 1966, and 1999? The high ratios were a "sell signal" for stocks and a "buy signal" for gold and mining shares.

What is the significance of a low Dow/Gold ratio? Just the opposite of a high ratio. A low ratio tells us that gold is relatively highly valued compared to stocks and similar paper investments. In the context of a Kondratiev Winter, when the Dow/Gold ratio approaches 1:1, it is a signal to us that gold may have become relatively overvalued compared to stocks, and stocks may be undervalued. In the context of a Kondratiev Winter, a Dow/Gold ratio of close to 1:1 is our "sell signal" for gold and our "buy signal" for stocks and for real estate.

When the current K-Winter ends, investors will face significant psychological challenges. Just as in 1949 and 1982, many people will have been so badly burned by the stock markets that they will shudder at the thought of ever owning stocks again. Given what has happened to real estate investors during the past decade, I suspect that the same will be true in that sector as well. On the other hand, as the K-Winter approaches its crescendo in approximately 2012, more and more people will be buying gold, silver, and mining stocks at the very time that they are about to reach their peaks.

Whether or not we like to admit it, all of us are influenced by the opinions, actions, and by the responses of others. At the time the current K-Winter is about to end, the general societal mood about stocks and real estate will most likely be very negative. On the other hand, if I am correct in predicting that ordinary investors will rush to buy gold and silver when the K-Winter approaches the bottom, then there will be intense external pressure on us to BUY, and not to SELL, gold at that time. Our challenge will be to take a hard, cold look at the Dow/Gold ratio and the other objective facts. Our challenge will be to re-deploy our money into "the next big thing." It is going to be very difficult to do.

I do not advocate ever selling all of one's gold or silver. In fact, I happen to believe that all investors should have a permanent percentage of their net assets in gold and silver. A 10% to 25% allocation is the MINIMUM under current conditions. However, if we are interested in using the K-Cycle as a means by which to profit, then we must always be ready to sell at least some of our assets so that we can re-invest in whatever asset class or classes will form the new primary trend during the next "season" of the Long Wave. When Autumn is ending, that means selling stocks and buying gold, silver, and mining shares. When Winter is ending, that means selling at least some of one's metals and mining shares and buying stocks and real estate.

No one asset class remains the primary trend forever. Those who held onto their stocks in 1929 had to wait until about 1954 to get back to even. Those who held onto gold and silver in 1980 had to endure a 20 year bear market in precious metals (a Kondratiev Autumn) before they again saw the value of their metals increase. Those who sold precious metals in 1980 (when it was psychologically hardest to do so) and bought equities enjoyed one of the greatest stock bull markets in history. Those who had the courage to sell their stocks in 1999-2000 (when dotcom stocks were "the new paradigm") and bought gold have enjoyed an average annualized gain of about 17% over the course of the past decade. They had the "wind at their backs."  They didn't have to do anything at all. No day trading. No agonizing over the day-to-day fluctuations.

At some point during the next few years, at a time when things will seem to be bleakest, the next Kondratiev Spring will begin.  Stocks and real estate will be the best asset classes to own. Until that time, gold, silver, and mining shares are what investors need to own. 

(This article contains a small  portion of a recent issue of The Richter Report. There's a lot more for paid subscribers. Please feel free to visit the website and look around!)

By Jim Richter

http://richterreport.com

© 2010 Copyright Jim Richter - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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