Kondratieff used wholesale prices as a central part of his theory, but since movements in commodity prices and interest rates are usually so closely interwoven, they could just as easily have been used.
Using U.S. economic data between the 1780s and the 1920s, Kondratieff observed that the economy had traversed through three very long-term structural cycles, each lasting approximately 50 to 54 years in length. It consists of three parts: an up wave, which is inflationary; a down wave, which is deflationary; and a transitional period that separates the two. The up and down waves vary in time, but typically take between 15 and 25 years to play out. The transition, or plateau period, exists for around 7 to 10 years.
Figure 23.1 uses the trend of wholesale (commodity) prices to reflect the cycle. The up wave is associated with rising interest rates and commodity prices. The transition, or plateau period, is accompanied by stable rates and prices, and the down wave with declining rates and prices.
FIGURE 23.1 The Kondratieff Wave 1789–2000
The cycle begins with the start of the up wave, which gets underway when the structural overbuilding of the previous cycle has been substantially worked off. The overbuilding phase involves an excessive accumulation of debt, so cleaner balance sheets are another sign that a new cycle is underway. Kondratieff also noticed that each of the major turning points were associated with a war. Those that developed around the end of the down wave he termed trough wars. They acted as a catalyst to use capacity and get the inflationary process underway again. At some time during the early phase of the up wave, new technology is adopted, and that grows from seeds that were planted in the previous cycle. As the wave progresses, recessions become fewer and less severe and entrepreneurs become more emboldened. Growing confidence results in a progressively higher number of careless decisions being made. Throughout this period, price inflation is building in intensity, culminating in a peak war that sucks up excess capacity with a consequential explosion in commodity prices.
The up wave then culminates in a sharp recession as the price structure reverts toward equilibrium and the careless, overextended nature of many business decisions results in a substantial number of bankruptcies as the economy contracts sharply.
Thus begins the transitional phase, called the plateau period because commodity prices experience a flat or ranging action not much below the up-wave peak. Equity investors love the predictability of this stable phase. Consequently, the plateau period is associated with very strong equity bull markets, such as the roaring 1920s. During the plateau period, the excesses of the previous boom are never unwound and typically new ones develop. It’s really the eye of the Kondratieff storm. As an example of plateau-oriented excesses, 1929 saw the U.S. auto industry with the capacity to produce 6.4 million cars, yet the best previous sales year had been 4.5 million.
The next phase is the down wave in which deflationary forces take over and the system painfully corrects its excesses. Once this cathartic process has run its course, it’s possible for a new cycle to get underway.
There is no question that the very long-term structural and psychological trends observed by Kondratieff continue to operate today. However, as a rigid forecasting tool, it leaves a lot to be desired. For example the idealized cycle shown in Figure 23.1 called for a trough low around the year 2000, yet we know with the benefit of hindsight that this turned out to be a secular peak as far as stock prices were concerned. Bond yields, instead of bottoming, continued lower for the next 12 years. Commodity prices, true to form, did trough around the turn of the century. The idea of peak-and-trough wars suddenly emerging at the two key turning points at first glance appears to be irrational, in that they are a predetermined part of the wave. However, when it is considered that these wars develop at times when the cycle is at its most structurally unbalanced stages, it is not hard to see how domestic economic unrest can transform into a military conflict.
What is not disputable is the fact that commodity prices, real stock prices, and bonds continue to experience secular or very long-term trends of their own and that secular trends between inflationary and deflationary forces do exist. It is these trends on which we will focus since they set the scene for very long-term investment themes and dominate the characteristics of primary or business cycle–associated trends.
Major Technical Principle The best approach to analyzing secular trend movements is to assume that they form over a long but indeterminate period, as opposed to a predetermined period, and are subject to the same trend-determining techniques used in identifying reversals in any other trend.
Secular Trends in the Equity Market
In earlier chapters, we discussed the concept of the secular trend, an extended price movement that embraces many different business cycles and averages between 15 and 20 years. In this chapter, the very long-term or secular trend will be examined in greater detail because it dominates everything, whatever the asset class—bonds, stocks, or commodities. The calendar year goes through four seasons—spring, summer, winter, and fall—and various phenomena are associated with each season, such as winter being the coldest. However, the seasons are not the same in all parts of the world. That’s because the weather is ultimately dominated by the climate. In the Dakotas, winter is extremely cold and long and summers are short, but in Florida, winter is hardly felt and summers are hot and extended. Both areas of the country receive the same seasons, but their climates dictate the nature of those seasons. The same is true for the business cycle, since each one undergoes the same chronological sequence of events, whatever the direction of the secular trend. However, the characteristics of each individual cycle differ, depending on the direction and maturity of the secular trend. Figure 23.2 overlays the secular trend on the cyclical.
FIGURE 23.2 Secular versus Primary Trends
Chart 23.1 shows that since 1900 the U.S. equity market has alternated between bullish and bearish secular trends, which have averaged 14 and 18.5 years, respectively.
CHART 23.1 U.S. Stock Prices, 1900–2012 Showing Secular Trends
We will be concentrating on the secular equity bears here because of their challenging nature, secular bulls being a largely buy-and-hold environment. You may be saying to yourself that the 1900–1920 and 1966–1982 periods were really trading ranges and, therefore, not bear markets. However, we are only looking at part of the picture. For example, it’s possible to buy a stock at $10 and sell it for $20. That would imply a doubling of the original investment, but the real question should be what the purchasing power of the proceeds is when the stock is sold compared to when it was purchased. If the cost of living had doubled, there would be no gain. Chart 23.2 puts this in perspective because it shows the S&P deflated by the Consumer Price Index (CPI). Now the trading ranges reflect their true bear market status. Two questions that might come to mind at this point are: What are the root causes of these secular bear trends? and How can the birth of a new secular bull market be identified?
CHART 23.2 Inflation-Adjusted Equities and the Shiller P/E 1899–2012
Causes of Secular Equity Bear Markets
There are three primary reasons why secular bear markets take place, and they have their roots in psychology, structural economic problems, and unusual volatility of commodity prices. The third factor is, to some extent, an offshoot of the second. Let’s consider them in turn.
Psychological Causes If you refer to Chart 23.2 again, you will see the Shiller Price Earnings Ratio in the bottom panel. This series uses a 10-year average of earnings adjusted for inflation in order to iron out cyclical fluctuations. You may be wondering why we are featuring what is essentially a fundamental indicator in a technical book. The answer is that the price/earnings (P/E) ratio is treated here as a measure of sentiment. For example, why were investors prepared to pay a very high P/E for stocks in 1929? The answer was that they were projecting previous years of upward multiple revisions. Such a level of overvaluation clearly indicated that investors were unusually optimistic. The P/E decline
d during successive secular bear markets to a low reading in the 7 to 8 area. Why? Because investors had watched inflation-adjusted stocks decline for a couple of decades, expected more of the same, and wanted be paid handsomely for the excessive risk that was generally perceived. In effect, sentiment typically reverses from exceptional optimism reflected by a high P/E to panic and despair at the secular low. The chart shows that the psychological pendulum is continually swinging from one extreme to the other. It also demonstrates that a prerequisite for a sustainable new secular bull is a once-in-a-generation mood of despondency and despair. Please note that although the actual low developed in 1932, it was not until 1949 that the P/E ratio was able to rally away from its oversold zone on a sustainable basis. That is a principal reason why that particular secular bear is dated in such a way. These psychological swings associated with giant earnings contraction and expansion cycles are not just limited to P/E ratios. They also extend to other methods of valuation, such as swings in the dividend yield on the S&P Composite, from 2 to 3 percent at peaks, to an average of 6 to 7 percent at secular lows. Replacement value for the whole stock market, as measured by the Tobin Q Ratio, moves from $1.00 to $1.15 at peaks to average a discounted 30 cents on the dollar at secular lows. The same principles hold true. High valuations, whichever method is used, reflect optimism and careless decisions, and low ones reflect fear and extreme pessimism, where investors demand to be paid handsomely for what the crowd thinks is a very risky environment.
Ironically, the actual level of inflation-adjusted earnings, when calculated as a 10-year moving average, actually rose during each of the twentieth-century secular bear markets. Consequently, the more important influence on equity prices over long periods of time is investors’ attitude to those earnings rather than the earnings themselves.
Major Technical Principle It’s the attitude of investors to earnings that is more influential on equity prices than the earnings themselves.
To understand the nature of secular price movements in equities, we need to take into consideration the fact that the longer a specific trend or condition exists, the more mentally ingrained it becomes. Investors are cautious at the start of a secular bull market because they are mindful of the previous bear market. Eventually, they gain confidence, as each successive primary-trend bull market rewards them. This process extends as investors gradually lower their guard, sooner or later falling victim to careless decisions as they are sucked in by their own success and egged on by an ever more optimistic crowd around them. In addition, due to the passage of time, new, younger market participants arrive on the scene, investors who had no experience of the previous secular bear and, therefore, no fear of another one. A common mantra—“this time, it’s different”—typically comes to the fore.
Structural Causes The second cause of secular bear markets is structural in nature. The secular peak is preceded by a decade or so in which a specific industry or economic sector gains in popularity. This results in a misallocation of capital as everyone wants a piece of the action and overbuilding results in substantial excess capacity. In the early part of the nineteenth century, the culprit was canals; in the 1870s, it was railroads. Recently, we saw the dot-com and later the housing bubbles. Such excesses usually take at least a couple of business cycles to unwind, but the pain that that involves gets the attention of governments whose solutions compound the problem and drag out the secular bear. For example, the natural response to the 1930 downturn was to slap on tariffs to protect an overbuilt U.S. manufacturing industry. Other governments around the world followed suit in retaliation. It was worse than a zero-sum game because international trade spiraled on the downside, so everyone lost. In the twenty-first century, the problems are compounded by demographic trends as fewer workers have the burden of supporting greater numbers of older nonworkers. Government response to this reality has been to run huge, mathematically unsustainable deficits, which, not understandably, will become a burden on future growth.
If evidence of structural deficiencies during secular downtrends is required, look no further than Table 23.1, which sets out their characteristics. The third column catalogues the number of recessions experienced in previous secular bears. They number between four and six, which compares to two in the 1949–1966 secular bull and one in the 1982–2000 period. An economy that is continually experiencing periods of negative growth is clearly one cursed with structural challenges. Also, the repeated experience of recessionary behavior adds to the mood of psychological despair at the secular bear market low.
TABLE 23.1 Comparing Secular Bear Characteristics It may take two or more business cycles for valuations to reach historic secular lows.
Unstable Commodity Trends It could be argued that unstable commodity prices are a symptom of structural problems rather than a root cause of secular equity bears. However, there can be no doubt that these secular environments are characterized by unstable commodity prices on the upside as well as occasional pockets of sharp, but mercifully brief, waterfall declines. The drop between 1929 and 1932 was a prime example, though the briefer 1920–1921, 1974–1975, 1980, and 2008 declines remind us that equities do not like unstable commodity prices whichever direction they develop.
Chart 23.3 compares the Inflation Adjusted S&P Composite (spliced to the Cowles Commission Index prior to 1926) to the CRB Spot Raw Industrials (spliced to U.S. wholesale prices prior to 1948). The chart flags secular bear markets with the dashed arrows. It is fairly evident that all of them, with the exception of the pockets of deflation outlined earlier, have been associated with a background of rising commodity prices. The relationship is not an exact tick-by-tick correlation, but the chart clearly demonstrates that a sustained trend of rising commodity prices sooner or later results in the demise of equities.
CHART 23.3 Inflation-Adjusted Equities and Commodity Prices, 1850–2012
The thick solid arrows show that a sustained trend of falling or stable commodity prices is positive for equities as all secular bulls developed under such an environment. This point is also underscored by the opening decade of the last century. It is labeled a secular bear, but real equity prices were initially quite stable, as they were able to shrug off the gentle rise in commodities. Only when commodity prices accelerated to the upside a few years later did inflation-adjusted stock prices sell off sharply.
A useful approach for identifying a secular peak in commodity prices, and usually a secular low in equities, is to calculate a price oscillator or trend-deviation measure. In this case, the parameters used in Chart 23.4 are a 60-month (5-year) simple moving average divided by a 360-month (30-year) average.
CHART 23.4 Inflation-Adjusted Equities versus Long-Term Commodity Momentum, 1829–2012
The downward-pointing arrows indicating reversals from an overextended position have offered four reliable buy signals for equities in the last 150 years or so. If nothing else, the chart demonstrates that dissipating long-term inflationary pressures are very positive for equities.
Secular Trends of Commodity Prices
In the previous section we established the fact that secular trends develop in commodity prices and that their direction greatly influences long-term trends in equities. It’s difficult to pinpoint a specific cause of secular commodity bull markets, as they appear to emanate from a combination of structural imbalances, wars, and liquidity provided by central banks to offset these problems. Long-term uptrends in commodity prices also embolden producers to expand capacity, leading to overbuilding at or just after secular peaks. Secular bear markets, then, evolve as this oversupply situation is gradually worked off. Psychology also plays a part in that monetary velocity greatly affects the inflationary ability of any given dollar of liquidity in the system. Suffice it to say that these factors integrate in such a way that it is possible to observe clear-cut secular trends in commodity prices. Chart 23.5 shows a historical perspective back to the early nineteenth century. You can see that, excluding the rising trend that began in 2001, the avera
ge secular bull market lasted 19 years and the average bear 21 years, for an overall average of 20 years. Some of these “bear” markets were really trading ranges, as the 1950s and 1960s and the 1980–2001 periods testify.
CHART 23.5 U.S. Commodity Prices, 1840–2012 Highlighting Secular Trends
Secular Trends in Bond Yields and Prices
Chart 23.6 shows the long-term history for bond yields. It is fairly evident that their trends are much better behaved than their volatile commodity counterparts, which makes secular reversals relatively easier to identify. The arrows show the five secular trends since 1870. The two completed bear markets for bond prices (bull markets in yields) averaged 30 years, and the bull markets for bond prices (bear markets in yields) averaged 25 years, for an average of 27.5 years. U.S. bond yields had been in a secular downtrend (bull market for bond prices) since 1981, or for about 31 years at the end of 2012. This favorable bond trend is long in the tooth in terms of time served, which makes it likely that it will not extend that much into the second decade of the current century.
CHART 23.6 U.S. Government Bond Yields, 1865–2012 Highlighting Secular Trends
Arguably the biggest driver of secular trends in bond yields is inflation in the form of industrial commodity prices. In this respect, Chart 23.7 compares bond yields to commodity prices.
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