Looking Down the Road
Looking down the road is always a good idea if you want to know where you are going and avoid any problems. And you can look in a rear view mirror to see where you have come from and, more importantly, what dangers may lurk behind you. Trying to look down the road for direction in markets is of course different then driving a car. But many analysts try, including me, because being able to anticipate or analyse dangers that may lie ahead is important for everyone's financial health.
That some of us analyze it from a bull viewpoint and others from a bear viewpoint makes for the differences. And everyone has an opinion about which direction to take to get to their goal, which is coming out ahead and beating the market (or, in a bear market, losing less than others).
So, what analysts and other market pundits try to provide is a road map of where we are going and what to hold to get there. You would of course not go on a trip without a road map; nor do you want to be investing without a map. There are fundamental analysts who examine the innards of companies (micro), and the economic outlook (macro) as provided by economists, and derive their conclusions as to whether the company has the value to justify share ownership, and where we are in the economic cycle so we know whether to continue to hold the stock or sell. Many fundamental analysts hold their positions through all sorts of cycles, both up and down, in the belief that in the long run the stock market only goes up.
Then there are technical analysts who look at historical price action on charts and use it to determine future price trends. Technical analysis has three basic premises: the market action discounts everything; prices move in trends; and history repeats itself (John Murphy - Technical Analysis of Futures Markets). Within the field of technical analysis there are numerous branches, from people who use simple support/resistance, trend lines and breakouts to the esoterics of quantitative analysis, astrology and neural systems. While the fundamental analyst studies the cause of market movement, the technical analyst studies the effect.
Of course there are many who use both fundamental and technical analysis. We use both macro economic analysis and technical analysis. We are also fans of cycle analysis, which is a study of time cycles. Time cycles ask the question when? while regular technical analysis asks which way? and how far? So, by looking down the road and using cycle analysis, we are asking all three questions.
Our favourite cycle analysts are Michael Jenkins of Stocks Cycles Forecast, Ray Merriman of the Merriman Market Analyst and P Q Wall of P Q Wall Forecast. There are many others; too many to mention. Some of the core for many cycle analysts is the works of R N Elliott (Elliott Wave Theory) and W D Gann (Gann Theory). But there are others who may not be as well known such as Edward R Dewey (author of The Mysterious Forces that Trigger Events) who studied thousands of seemingly unrelated cycles spanning hundreds and even thousands of years. One of his findings was that there were many cycles of seemingly unrelated phenomena that had similar cycles. It reminds us that our life is a cycle, our days are made up of cycles, and that there are the cycles of the months, the moon, the sun, the planets, and of course the seasons. These are all cycles based on natural and astronomical events and are quite predictable.
The topic of cycles comes up regularly, even among fundamental analysts. Fundamentalists may talk about economic cycles while the technical analyst focuses on seasonality, particularly as related to commodities. But even the stock market has cycles during a year, such as when we talk about weakness in the fall, particularly September/October. "Santa Claus rallies" that start in November and go through until Christmas or New Years, the "buy when it snows and sell when it goes" or "sell in May and go away" rhymes, the summer rally - all are merely expressions of the seasonality of cycles.
One of our favourite longer term cycles is of decades (something we learned from all three of our cycle analysts to different extents). Price patterns tend to repeat themselves (not the actual price levels) and being able to identify the patterns of a year in a previous decade, or through the decade itself, may help you determine the where and the when of the current market. Also having knowledge of long-term cycles shows you where you are in the very big picture, even as within that very long term cycles there are many ups and downs in the markets.
On the subject of long-term cycle studies, there are two we would like to mention that we believe investors should be aware of. Think of them as really big road maps. One of them has been popularized - the Kondratieff Wave Cycle, a cycle that covers anywhere from 50-60 years but may now be stretching out even as long as 70 years. A Kondratieff cycle might be approximated to a life cycle of a man. The other one is derived from historian Oswald Spengler, whose best known book The Decline of the West put forth a cyclical theory of the rise and fall of civilizations.
Nickolai Kondratieff was a Russian economist in the Soviet Union who studied long-term capitalist economies (US, British and French wholesale prices and interest rates) and concluded that there were peaks and troughs in economic activity that lasted roughly 50-60 years. Other economists also did similar work that traced similar cycles back to the Romans and the Mayans and supported Kondratieff's work. Kondratieff was rewarded for his work by being sent to Siberia by Stalin, who didn't like Kondratieff's news that capitalist economies always rose again from their depressions. He died in a labour camp.
Kondratieff concluded that there were four distinct phases of his long term cycle - spring (inflationary growth phase); summer (stagflation, recession); autumn (deflationary growth); and winter (depression).
The spring of the current Kondratieff cycle fits the periods of the 1950s and into the 1960s very well, as the economy experienced growth with low inflation, low interest rates and rising stock prices as we came out of the long winter of the previous Kondratieff cycle that took us through the Great Depression and WW2. The period of the late 1960s and the 1970s that culminated in two steep recessions (in 1973-75 and 1980-82) fits the description of the Kondratieff summer with its themes of stagflation, rising interest rates, a booming commodities market and a struggling falling stock market.
The next period of the 1980s and 1990s was a classic Kondratieff autumn as commodity prices collapsed, inflation fell and economic growth was steady, although not as powerful as in the 1950s. And of course the stock markets not only boomed, but in the late phases went into a bubble (as they had done in the previous cycle that culminated in the stock market top of 1929 and subsequent collapse and depression). It was as it has in the past also a period of rising debt levels, innovation and new technologies, and greed. The current market topped in 2000 and the collapse seen from 2000-02 ranks amongst the great crashes, especially the one in the technology sector. But commodities turned slowly up during this period - and in the early stages of a Kondratieff winter, commodities do turn up.
That the current cycle has been supported by massive injections of liquidity from the US Federal Reserve and the Bank of Japan is merely a sign of how seriously the monetary authorities took the potential of a deflationary collapse. Alan Greenspan, who was perfectly well aware of both the Kondratieff cycle and Elliott wave analysis, always said that he wanted to be Fed Chairman at the time of a Kondratieff winter. His proposed solution was to inject huge amounts of liquidity that would stave off a collapse. The liquidity was also helped by the Japanese where almost zero percent interest rates set up the conditions for the carry trades where money was borrowed cheaply in Japan and reinvested in higher yield markets including emerging markets.
Many believe that the problems ended in 2002 with the bottom of the market, and that since that time we are merely resuming the long-term bull market in stocks. But we were fed by those liquidity excesses from Japan and the US, and it resulted in bubbles in the housing market and some emerging markets. The housing bubble has yet to fully implode but it remains a real risk. But now we are reaching the event that has hit other Kondratieff winters, and that is rising inflation (even if the real enemy is deflation).
Global rising interest rates and contracting liquidity played a role in the recent global market meltdown. The risk is now that the monetary authorities will tighten too much, triggering a bigger meltdown, especially if it is accompanied by a major geopolitical event. How they react after that is anyone's guess, but the suspicion is that they would once again flood the system with liquidity to try to prevent a meltdown. It is then that we could have our deflationary collapse where even commodities fall. Except one, we believe, and that will be gold (and possibly the gold stocks that performed well during both the deflationary meltdown of the 1930s and the inflationary boom of the 1970s).
We are reprinting our chart of June 28, 2002 that shows the generally accepted Kondratieff phases for the United States. Note how there is a peak war (summer) and a trough war (winter). The autumn plateau is characterized by low interest rates, falling inflation and falling commodity prices, and they all end with speculative bubbles that burst.
(War of 1812)
("Era of Good Feelings")
(Mexican American War)
(Indian Wars, Spanish American War)
("The New Economy")
(War on Terror. Or?)
The theories of Oswald Spengler are much more difficult to get a grasp on because of the sheer length of the cycles. While it provides a fascinating look at history, many will wonder what the relevance is. From our perspective it is relevant of course to know where one might be in a very large cycle because it gives us a lot perspective, even if the interpretation may vary from analyst to analyst. When Spengler wrote his treatise in 1918-23 (The Decline of the West, Volumes 1 and 2) he thought the war of 1914-18 was the beginning of the end of European culture and civilization. Of course it wasn't, any more than probably the current war or events of today are. We are not sure if anyone could ever pinpoint when the decline of a civilization sets in. That can only be determined retrospectively. But that being said we can recognize signs of a decaying society even if it plays out over a few centuries.
Spengler's work has been examined by and has influenced hosts of others, including Samuel Huntington in his Clash of Civilizations. We also note an interesting theory of application using Elliott waves in a gold-eagle article (www.gold-eagle.com) entitled The Rise and Fall of Civilizations (Parts I, II and III - Joseph Miller, Daan Joubert and Marion Butler, 2001). PQ Wall refers to Spenglerian cycles in his writings.
Spengler's main propositions are as follows.
History can not be viewed as "linear", it is cyclical. Therefore he rejects the notion that history, especially Western history, flows in an evolution upward in a progressive manner from the Greek, Roman, Medieval, Renaissance or Ancient, Medieval and Modern.
History is cyclical and not one just of nations, races or events, but of "high cultures". He identified eight such high cultures: Indian, Babylonian, Egyptian, Chinese, Mexican (Mayan, Aztec), Arabian, Classical (Greece and Rome) and European-Western.
Each "high culture" passes through stages of birth (Spring), development (Summer), fulfillment (Autumn) and decay/death (Winter). The high water mark is the period of fulfillment - the height of the culture. The beginning of the end comes when the culture begins to die out amongst social upheavals, mass movements of people, continual wars and constant crisis. In the dying stages rule is determined not by democracy and a free press but by the rule of money and Caesars in a dictatorship. It is an imperialistic age.
This is just the barest of outlines. In their treatise, Miller, Joubert and Butler noted some interesting characteristics in the period of decline, including pollution, degradation of the soil, disease, famine, loss of freedom, security problems and class strife. We summarize and add to some of their observations below from their essays as they are worth repeating.
Degradation of the soil: Today we are faced with global warming or climate change, whatever one wants to call it. But it is real and it is causing the melting of glaciers, the melting of the ice caps, threatening the rise of seas and an impact on the weather and even Gulf Streams. The rate of global desertification is growing from both over-use and global warming. Water tables are falling in many parts of the world. This may be one of the single greatest challenges going forward, and wars are inevitable for both food and water. We are also over dependent on non-renewable resources such as oil and gas and many commodities. Much of the current strife and wars can be traced to a global race for control of these dwindling resources.
Disease: There is a huge threat of natural disasters due to epidemics and biological warfare. In the past thirty years we have already had to deal with AIDS and threats from SARS and avian flu. Many predict worse to come.
Famine: The risk of global famine has never been higher. Since 1950, global population has increased from 2.5 billion to 6.5 billion. Over two billion today do not have adequate water or food. This is a cause behind mass migrations to Western nations, as people flee their poverty stricken lives dominated by pollution, inadequate food and water, wars and disease. By 2050 over half of the world's population will lack adequate food and water. Something has to give. Global famine is also pushed by climate change with increased earthquakes, hurricanes, fires and floods which also played important roles in previous declines.
Pollution: Air pollution kills three million annually around the world. Many in Chinese cities and elsewhere in Asia in particular could not survive without wearing masks every day. Poor sanitation is endemic and kills 12 million annually. The ozone layer is under duress.
Loss of Freedoms: Our freedoms are under attack, driven by the fear of terrorism and politicians who play the hate and terrorism cards to gain power. Fiat credit money has meant a degradation of money and created credit bubbles which, when they burst, plunge many into bankruptcy. Individuals, governments and even corporations are overextended, and all of this plays on lessening our freedoms. We continue to cite gold as the only true monetary means and store of wealth. Gold has been money through the millennia.
Security problems: Security is no longer what it was. We are threatened - or at least we are told we are threatened - from without by unstable nations possessing nuclear weapons. Of course, whether they will use them is not relevant here, but that they might. That they themselves might be obliterated immediately by superior military power does not seem to enter into the equation. We are threatened by terrorism but it is also used by our powers to control and slash freedoms. We move inexorably towards more 1984-style security and fascism. The corporate world profits immensely from the growing need for security.
Class Strife: As an elite few become wealthier, class strife grows. In the US today, walled towns patrolled by private guards to house the very wealthy are not uncommon. The walled towns are meant to keep out the lower classes. The middle class is being squeezed in much of Western society. Wages for the average man have barely budged in the past decade, even as the rich become richer. Class strife is not just in individual nations but between nations as well. In the US one percent of the population controls over 50 percent of the wealth; on a global basis, 20 percent of the world's population is responsible for over 80 percent of private consumption.
Two thousand years ago, Rome stood astride the world and Roman culture dominated the ancient world. But it also marked its zenith as the culture decayed into the age of the Caesars and constant imperial warfare. Today the United States sits astride the world militarily and American culture and corporations also dominates the world. But threats are growing on a number of scales, as we note above. This century promises to bring many of these issues others outlined above to a head.
They say history repeats itself. But they also say that those who do not study history are doomed to repeat it. Cycles are a part of nature and they are a part of history. The evidence of the Kondratieff cycle has been proven over and over again and we appear to be once again on the downside of the cycle. But could we also be entering the winter of the Spengler cycle? We have no argument that technology and innovation may yet help us weather many of the challenges that we will face in the next century. And they most certainly will but it may not prove enough.
Of course we don't know for sure. We can only project what we know and where it might take us. Many of the signs are there that caused decay and decline in the past. But having an understanding of cycles and what they mean may help some of us avoid the pitfalls that will befall many and help us survive the coming turmoil. Think of it as looking down the road and seeing what might be coming and preparing for its eventuality. Sounds like that old Boy Scout motto: Be Prepared.