Enter the e-Depression Era..
Kondratieff Cycle
A Kondratieff Cycle or Long Wave is a continuous repetitive pattern, also observed in 1913 by dutchman Van Gelderen. The cycle shows repeated periods of ever increasing economic expansion and contraction. Kondratieff correctly observed that from the despair of depression capitalism gave birth to another cycle of expansion mostly founded on a new technology. This new technology was only partially developed in the late stages of the previous cycle. This demonstrates the historic inherent ability of free people in a market environment (capitalism) to survive.
According to Simon Kuznets' article "Schumpeter's Busines Cycles" published in The American Economic Review (1940) a Kondratieff cycle consists of four distinct phases, or distinguishable, dramatic mood changes. These mood changes reflect and determine the actions of individuals involved in an economy. The mood of the up phase is one of accumulation, expansion and the desire for new product manufacture. The mood of the down phase is one of saturation and contraction.
Revival
The first part of the up phase is associated with increasing economic activity, confidence, inflation, debt, prices and decreasing unemployment. Much effort is put into controlled growth. A booming stock market reflects confidence.
Recession
The second part of the up phase is associated with ever increasing acticity, debt, prices, inflation and confidence. At the end of this period inflation peaks just like prices. During summer an economy seems to get out of control. This is reflected in a faltering stock market.
Prosperity
The first part of the down phase is associated with declining interest rates, prices, increasing debt, business activity and confidence. During this period stock markets boom because of efficiency, worldwide price competition and globalisation.
Depression
The second part of the down phase is associated with a debt funded expansion (over production) which cannot sell it's products to a debt saturated and product loaded consumer. The massive debt implodes resulting in increasing contraction, declining prices and interest rates. When the debt problem is resolved a new birth of expansion is underway. Depressions are inevitable but healthy.
Prognostication Tool
Predicting the future course of the economy, the overall price level, the bond market and the stock market is just one feature of the Kondratieff framework. We would like to mention another very important feature. Contrary to common belief the interest rate and the stock market can either be identical twins or mirror images. During Revival both the stock market and the interest rate rise. During Recession the stock market stumbles while the interest rate goes up even further. During Prosperity interest rates fall while the stock market experiences the biggest bull market during a Kondratieff cycle. And finally Depression means a falling interest rate and a massive stock market drop. So the interest rate and the stock market alternate being friend and enemy.
Not surprisingly Joseph Schumpeter called Kondratieff's theory the single most important prognostication tool. The real life example below shows how accurately facts fit theory. Ivan Faustyn has plotted the US long bond yield and the constant dollar Dow Jones Industrials Average (price adjusted) in a Kondratieff framework. By applying Kondratieff properly one holds a very reliable long term investment model: when what to buy and how long to hold it.
Revival (1949-1966)
Out of the ruins of World War II 1949 gave birth to a new inflation/deflation cycle. The western economy was rebuild and by doing so people (re)gained confidence. This optimistic mood resulted in increased business activity and rising stock prices. Suddenly everybody realised that capitalism didn't fail. Governments and Central Bank didn't want the economy to grow too fast so they tried to control inflation and wages. The first part of the up phase peaked around 1966.
Recession (1966-1981)
A long hot summer followed. Prices skyrocketed - helped by two OPEC shocks - and so did inflation. This changed the mood dramatically which was reflected by an invisible stock market crash (we have made the crash visible by measuring it in real terms or constant dollars). Too much money, debt and capacity had been created. Inflation (the up phase) peaked around 1981.
Prosperity (1981-1999)
Inflation had caused lower demand so businesses turned their attention to efficiency: doing more with less resulting in lower prices. Global price competition increased and in order to survive businesses had to cut costs. This changed the mood to optimism once again. The stock market took off like a space shuttle. Everlasting prosperity ahead. And by creating even more debt we can now say we are experiencing a credit card economy.
Depression (2000-2009)
Winters are hard but very healthy. During such a period too much debt, money and capacity will be eliminated. Debt liquidation will change the mood and pave the way for a depression. This will be reflected in a massive drop in stock prices (90% will be lost).
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