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The Long-Term Cycle

We believe that secular, or very long-term, trends in the economy impact the nature of shorter cycles, commonly called business cycles. Two respected investors have written extensively about how this impacts the investment decision-making process and we've mentioned them before - George Dagnino and Martin Pring. Of particular interest to investors is how the longer term cycle impacts the shorter term cycles. Why? Because we make investment decisions based on the shorter cycles. Risk to every asset class ebbs and flows with the shorter cycle, but risk throughout these cycles is either muted or amplified depending on the longer-term cycle.

What Do We Mean By "Long-Term Cycle?"

The Russian economist Nikolai Kondratieff was asked (commanded?) by the fledgling communist government in the 1920s to research capitalism and show how it would eventually collapse, and was unworkable over long periods of time. Instead, what he found were 50-year mega cycles where capitalist economies (particularly the U.S.) would have the wind at their backs for half of the cycle and face headwinds for the other half. This would not be enough to destroy capitalism. Unfortunately for Kondratieff, Josef Stalin was not a big fan of his work. After years spent in prison, Kondratieff fell victim to Stalin's purge and was executed in 1938.

Joseph Schumpeter incorporated Kondratieff's work into his own research published in 1939 under the title Business Cycles. Schumpeter suggested a model in which four main cycles - Kondratiev (about 54 years), Kuznets (about 18 years), Juglar (about 9 years) and Kitchin (about 4 years) can be added together to form a composite waveform. This is essentially what Pring is doing with his KST indicator - more on that later.

For Schumpeter, the longer cycles were a function of innovation and entrepreneurship. We would categorize the long cycle as one that reflects structural inflation or disinflation. It is the battle between inflationary forces (war, government spending programs, budget deficits) and deflationary forces (innovation, productivity increases, entrepreneurship).

When we use the term "long term cycle," we will be referring to the long-term structural cyclicality of inflation vs. deflation. Many analysts and economists use the ratio between stocks and commodities as a proxy for this relationship. Obviously, if the ratio is going up, stocks are outperforming commodities and this is viewed as a disinflationary or deflationary environment. If the ratio is decreasing in value, commodities are outperforming stocks and this is viewed as an inflationary period.

Kondratieff, Schumpeter and Pring

We can look at the long-term cycle by applying an indicator that Martin Pring developed to look at the ratio between stocks and commodities. We will use the S&P 500 for stocks and the CRB Spot Raw Materials Index for commodities. We will then use Pring's KST indicator to form our own "composite waveform." While it's way too mathematically messy to describe what the KST does (and there is plenty of free information on the internet), suffice it to say that the KST sums the percentage change in our ratio over multiple time frames. We are limited by data constraints such that our analysis stretches back only to November of 1961, but the trends can be seen.
 

As you can see, we went through 20 or so years of disinflation until the beginning of the new millennium and have had inflation ever since. Granted, there was a brief reversion to inflation in the late 80s through the early 90s, but clearly the trend was for stocks to outperform commodities in this period. We are in the eighth year of what is usually a 20- or 25-year run of commodity dominance (inflation). The sources of this inflation are obvious - the war in Iraq and chronic budget deficits.

Many people are confused as to why a war is inflationary. Economist James Grant explains, "[War] is always wasteful no matter how just the cause. It is cost without income, destruction financed (more often than not) by credit creation. It is the essence of inflation." Of course, Grant does not make the point (but we will) that sometimes inflation is a small price to pay for liberty and/or safety. Still, war is inflationary.

What This Means to the Investor

Look at the chart above for the period 1996 until 2000. The long term cycle was going straight up, without so much as a blip. However, not pictured is the fact that we had two full business cycles in this timeframe.

Each business cycle (also referred to as a Kitchin cycle) lasts, on average, four years. Each long term cycle lasts about 50. Simple math would inform us that every long term cycle consists of about 12 business cycles. There are normal and natural periods of cyclical inflation in every business cycle. But when the long term trend is disinflationary, cyclical inflation will be relatively low and short-lived. Conversely, when the long term trend is inflationary, the phases of the business cycle that normally experience cyclical inflation are more pronounced and last longer. Our investment plan should incorporate the impact of secular forces on the business cycle.

Conclusion

Some investors use the term "Long Wave" as a mystical force outside the understanding of mankind. All we can do, we are told, is follow the wave. Elliot Wave theorists are in this camp. They tell us what’s going on, what to expect, but they cannot explain why the waves seem to work out as they do. We don't buy that. If Elliot waves exist, their cause is rooted in the cyclical nature of the behavior of man, and therefore, his economy. Specifically, political forces work increase and then decrease restrictions placed on the entrepreneur. They also move between periods of war and peace, and lax budgeting and belt-tightening. All of this results in a long-term, secular trend in inflation. Knowing this gives us an advantage as we map out our investment plan for whatever the business cycle gives us.