Every New Year I like to sit and have a conversation with my old imaginary friends from childhood. As a kid I had 2 imaginary friends, “Good Boy” and “Bad Boy”. Over the years these have become two very valuable friends as they have assisted me in listing the pros and cons of many ideas and at times run a little interference for the not so good ideas. For example when my mom would ask “Colby did you spill in the living room”, I would kindly respond, “No, wasn’t me, must have been ‘bad boy’”. While this never avoided the impending reprimand it did make life a little more entertaining.
This past holiday my friends and I spent some time listing the good and bad of the economy and more importantly the opportunities the good and bad create for investing. As we did this it became apparent that we needed a refresher course in economic cycles to enhance the opportunities we were contemplating. As we did our homework we came across some information we felt you could benefit from and have decided to share it with you.
Within the study of economic cycles there are four main cycles that are typically discussed. Some relatively short, such as the four year inventory cycle, or the standard 10-year technology cycle. Some longer, such as the 18-year real estate cycle (We are presently in the downward part of this cycle, which should last until 2009 -2010). And the longer cycles created by both economics, sociology and psychology called long waves, such as the 54- to 60-year long Kondratieff cycle which covers debt and price inflation-then disinflation-followed by debt and price deflation. Because the current economic environment is the result of debt deflation of heavily levered banks and price deflation in housing which can take multiple years to correct my friends and I decided to focus on the longer term Kondratieff cycle or “K Wave” as a tool in creating our market forecast for 09.
Similar to the seasons, the K Wave Economic Cycle goes through four distinct phases.
– Beneficial Inflation (Spring)
– Stagflation (Summer)
– Beneficial Deflation (Autumn)
– Deflation (Winter)
We experienced “Beneficial Inflation” after the last deflationary cycle of the Great Depression. From 1949 to 1966 as WWII ended we moved into a time of government stimulus and infrastructure building throughout the world. During this time unemployment fell, wages and productivity rose and prices remained relatively stable. The mood during this growth phase is one of accumulation and the desire for new product manufacture. During this time we witnessed a secular Bull Market in stocks from 1950 to about 1968.
Eventually the continuation of growth reaches its limits and we enter a period of time termed “Stagflation”. Excess capital produces a shortage of key resources and the economy enters a period where growth creates a shortage of resources. An economy will only support expansion to the limits of its resources, both human and material. The mood of affluence also brings a change in attitude towards work. As an economy gets closer to its limits inefficiencies build up, a dramatic drop in output, rapid rise in unemployment and unusually severe recession followed by inflation characterize this period. We experienced this from 1966 to 1982 a time stock markets were stuck in a secular Bear Market. The change in price structure, along with the mood of a population causes the economy to enter a period of relatively flat growth and mild prosperity. Due to structural changes and the limits of the existing paradigm the economy becomes consumption oriented.
Excesses, along with fiscal liberalism cause popular reaction toward stability or normalcy and leads to “Beneficial Deflation” or the third phase of the Kondratieff Cycle. This is a period of time characterized by selective industry growth (growth of the service sector), development of new ideas (both technological and social) and a strong feeling of affluence, terminating in a feeling of euphoria. The inflated price structure, along with the desire for consumption, produces a rapid increase in debt. Eventually, wealth consumption expands beyond all practical limits. This is a time where consumption fuels affluence as we witnessed from 1982 to 2000. A time of another secular Bull Market in stocks.
Excesses of this period create a collapse of the price structure leading us to the “Deflation” phase which is the fourth and final phase which we are currently experiencing. This exhaustion of accumulated wealth forces the economy into a period of sharp retrenchment. Generally, a three year collapse followed by a 15 year deflationary work out period. The deflation can best be seen in interest rates and wages.
This is typically a cleansing period that allows the economy to readjust from the previous excesses and begin a base for future growth. This is a period of incremental innovation where technologies of the past period of growth are refined, made cheaper and more widely distributed. Incremental innovation consolidates industries paving the way to increased profits.
During this time we typically see a mass sell-off in all assets followed by recovery then one final period of recession before transitioning to a new period of growth. The final recession is mild with very low inflation and appears far more severe than it will be remembered later in the next Growth Cycle. Bailouts and government stimulus provide cushions to this process as the government’s ultimate goal is to limit the pain while allowing time to create remedies. Our job as investors, as I explained to my imaginary friends, is to understand where we may be in this process and how to position our savings.
The significance of the deflation can’t be overstated as investors biggest assets – real estate and stocks – decline in value. Add to that the significant decreases in energy with oil at $40 a barrel, down from $147 coupled with declining food prices and multiply the billions of dollars in government stimulus and the efforts of the Fed (see our last market update)and we have the makings of a very interesting year that will either be filled with opportunity or broken hearts.
First, it is important to understand why all these prices are declining. Prices are declining because perception tells us there is less demand for these assets, with less demand prices dome down. Just as there are limits on the upside there are limits to the downside as we still need a place to live, food to eat and fuel in our cars. Demand will return and with it increases in prices. However, because it takes time for perceptions to turn course we will most likely see all asset prices begin a tug of war as economic numbers are reviewed and digested and perceptions are reformed.
Currently the consensus of most Wall Street gurus is that we will see recovery in the economy towards the second half of the year. If this is the case then we will most likely see a bid in prices and increases in markets in the 1st quarter which seems to be happening with the recent trading we have seen in the market. In order for the markets to continue to build on this foundation we would need to see a plateau or reversal in the leading economic indicators, as well as a decline in the rate of unemployment.
The latter is the more difficult as employment tends to lag the economy. As a result of not having all the fundamentals in line we will typically see a bifurcated market as money flows from one sector to another due to shorter term business cycles. In order for the market to have a broad sustained rally there needs to be new money added to the market, not just money moving from one sector to another. New money will be added when investors confidence begins to build and confidence is created after stability is seen. Because the longer term cycle is so dramatic and historical in nature as well as the fact that we are still attempting to create stability it is less likely we will see a new bull market develop in stocks during 09 as opposed to a strong first quarter and a range bound market for the remainder of the year.
In response to this investors should do a combination of the following:
Remain conservative and begin to buy on dips as long as the bigger picture appears to be improving. There is no need to rush in this environment, cash is still king especially if deflation continues.
Remain or become nimble. One of our on-going strategies will be buying the dips and selling the rallies through the use of index exchange traded funds or Rydex and Profunds.
Understand that buy and hold can be detrimental if the markets deteriorate. There is still plenty of evidence that the economy could get worse and if so we could see another leg down in the markets in 09 (the broken dreams part). The effects of the longer term KWave Cycle were very extreme the last time we experienced it (1929 – 1949) and investors with a defined stop loss will protect themselves.
Watch the credit markets. If money moves from treasuries to corporate bonds in an orderly fashion then there will be opportunities in owning corporate bonds (it appears this process may have begun in the past few weeks) and could be a precursor to seeing new money flow into equities.
Lastly, buy the dividends. There are plenty of good quality companies with above average dividends due to the market sell-off. Remember, to have a stop loss in the event our hope for an improved economy doesn’t happen.
On behalf of the staff at Quiver Asset Management and my two imaginary friends we wish you a Happy New Year and will continue to keep you informed.
The opinions expressed are those of Colby McFadden as of 1/3/09 and are subject to change due to market and other conditions.