Paying attention to wave cycles

Last month, I talked about the secular bear markets of the 20th century and how they, by necessity, impact the approach people should take with their equity investments.

But there’s another layer of longitudinal analysis of market performance that’s crucial for anyone trying to properly position their portfolio.

While each of the 20th century secular bear markets is distinct, there’s a school of thought that believes they all fit into a much longer, and somewhat predictably recurring super-cycle of growth, plateau and decline over a period of decades.

Long-wave investing is normally associated with a Russian economist of the 1920s named Nikolai Kondratieff, who was instructed by Josef Stalin to create an economic model to thoroughly discredit capitalism. His views were rejected by Stalin, though, who wasn’t pleased that Kondratieff’s Wave demonstrated an inevitable upsurge in capitalist markets once the ebb had eased, and he was consequently stripped of his job and sent to the Gulag, where he was eventually sentenced to die.

With arguably less pressure to please the boss, numerous economists have since modified Kondratieff’s thesis, but there are still many similarities.

For instance, the consensus among the studies is that the super-cycle lasts approximately 50 years, and is very often demarcated by stages of significant technological innovation in society, such as the Industrial Revolution that began in Britain in the late 18th century, and the more familiar Information Age that began in the early 1980s.

Despite all of this research, long-wave theorists don’t curry much favour with most modern economists, who prefer to focus on much shorter-term indicators and predictors of market performance.

Being a relatively old investor, I remember the deep malaise of the investment markets in the 1970s. In fact, the memory of that experience continues to impact how I look at the world today. Likewise, people in their nineties who are unfortunate enough to remember the Great Depression still carry the lessons learned then with them. Not surprisingly, though, these watershed economic moments in history had until very recently been forgotten or ignored by most investors.

In the U.S. in 2005, the vast majority of the populace had only ever experienced house prices rising in value and, as a result, went on a credit-driven home-buying spree fuelled by the firm belief that they were making a riskless transaction. Of course, if more people had taken the time to listen to their grandparents and heeded their warnings about taking on cheap credit, we may have avoided the great real estate meltdown we’re seeing in the United States right now.

If you accept the general premise of long-wave economic trends, as we do to a degree, it’s clear to see that we’re now well into Stage One of an economic super-cycle that began sometime between the U.S. stock peak in 2000 and the U.S. housing market descent in 2005 (see “Humans vs. markets,” this page). Given the reality of the current global debt situation, and the view that it usually takes around 50 years for the cycle to complete, the probable scenario is that we still have some time to go before we even return to the slow growth period of Stage Two.

Dire as the situation may be, the reality of long-wave economics doesn’t necessarily have to spell doom and gloom for investors.

Long-cycle investing is an important view that every investor should understand, even if they don’t fully accept it. We firmly believe investors can make money in these times — but they need to act differently than they did during the long bull market run.

To take advantage of difficult markets, risk needs to be thoroughly evaluated prior to looking at any opportunity, expectations should be moderated, and leverage must be reduced.

The rules have changed pretty drastically, but an investor’s world can still be a happy place if it’s papered with good preparation and realistic expectations.