Higher Oil Prices Ahead? Here’s What I See.

Understanding  economic cycles – from boom to bust, recovery to recession – can
help investors and traders be better positioned in the markets.  The longest of
these economic  cycles, the Kondtratiev wave, has turned higher and predicts
long-term strength in the world economy, sustained rising oil and commodity
prices, more severe military conflicts and the continued rapid adoption of
communications technologies.    

Economist Joseph Schumpeter categorized business cycles into several categories:
Seasonal, Kitchin (3 years), Juglar (10 years), Kuznets (20 years) and
Kondtratiev (54 years).  Currently, the “Long Wave” or Kondtratiev cycle is
having the largest impact on financial markets.  While traders and investors
might roll their eyes at the usefulness of a 54 year cycle, staying on the
"right" side of the long wave trend can enhance everyone’s returns.  

In studying economic or technical indicators, I find it helpful to go back to
the original source to get a first hand understanding of the material.  Nikolai
Kondtratiev’s work "The Long Waves In Economic Life," which was published in
1926, is a fascinating piece of research because of its prophetic ideas as well
as its methods of analyzing economies.   Kondtratiev drew upon interest rate,
coal, and iron prices as far back as 1780 to develop his observations.  

In the following analysis of the Kondtratiev cycle, I have also quoted Marc
Faber’s "Tomorrow’s Gold" extensively because he has done an excellent job in
directing investor’s attention back to the existence of economic business
cycles.  However, I think he errs in one key judgment — he states that the
Kondtratiev wave is still in the downswing. 

Other analysts and economists are espousing the idea that the world is entering
a Kondtratiev “Winter," or down wave, which will be marked by the coming
financial apocalypse.  Analysts have also used the Long Cycle to predict lower
stock prices.  Both these interpretations present a distorted picture of the
long wave and what it means for the financial markets.  Kondtratiev never used
stock prices in his analysis and his "Long Waves" paper never mentions "seasons"
of the business cycle.   

The following lists Kondratieff’s five observations and conclusions –

1)  “Our investigation demonstrates that during the rise of the long waves,
years of prosperity are more numerous, whereas years of depression predominate
during the downswing.”

If you look at US economic growth since the 1970s you might believe that this
observation is incorrect since the US economy has grown steadily and suffered
relatively few severe recessions.  However, as Marc Faber writs in “Tomorrow’s
Gold,” after the 1973/74 recession in the United States, the world has
experienced more severe recessions and relatively weak recoveries. 

“We had, after 1981, a depression in Latin America that lasted until the late
1980s (a depression combined with high inflation), a relatively severe global
recession in 1982, the Japanese economic downturn after 1990, the post-communist
economic collapse in Easter Europe and Russia, anemic growth in Europe following
the 1991 recession and, more recently, first the extremely intense economic
downturn in Asia, and in 2001, the slowest growth rate for the global economy in
30 years”.

The 1998 Asian financial crisis marked the end of the Long Wave downswing from
which the world emerged in 2002.  Rather than an economic Apocalypse, I believe
the world is experiencing an economic upswing of historical proportions. 
China’s and India’s rapidly growing economies, the surging Eastern European
economies, and the steady growth in the United States all point to a strong
worldwide economy.  While many economists will disagree that the United States
is experiencing an economic upswing, the low unemployment rate, steady wage
growth and healthy corporate profit expansion are indications that the economic
recovery is not as weak as many economist think.   

2) “During the recession of the long waves, agriculture, as a rule, suffers an
especially pronounced and long depression.”

Marc Faber makes a convincing argument that energy has taken the place of
agriculture as the driver of the economy and therefore should be relied upon as
the market for the beginning and end of the Long Wave.  Again, from "Tomorrow’s
Gold" 

“Whereas wheat, corn and cotton were the most important commodities in the 19th
Century, crude oil is now by far the most important industrial commodity in
value terms and as a cost factor in industrial societies.”

Therefore, if we replace agricultural prices with oil prices in Kondtratiev’s
analysis, we can see that energy commodities have truly been in a price
“depression” during the past 20 year downswing.   Aside from the spike in 1990
because of the Iraq war, oil was in a basing pattern for the greater part of the
1980s and 1990s. 

3) “During the recession of the long waves, an especially large number of
important discoveries and inventions in the technique of production and
communication are made, which, however, are usually applied on a large scale
only at the beginning of the next long upswing”

This is probably the most enlightened of all of Kondtratiev’s pronouncements. 
If 1974 to 2003 represented the down wave of the Long Cycle, the development of
the Personal Computer and Internet fall right into Kondtratiev’s timeline of
communication innovations.  If you take a world-wide view, the adoption and
application of the Internet have only truly just begun.  Innovations such as
Voice Over Internet telephony will most certainly be applied on a grand scale
over the upcoming decade.

4) "At the beginning of a long upswing, 1) gold production increases as a rule,
and 2) the world market for goods is generally enlarged by the assimilation of
new and especially of colonial countries"

It is clear that both these observations are currently being fulfilled.  They
are further signs that the Long Wave has bottomed and is currently in a new
upswing.

First, gold production has increased along with the price of gold.  Gold
bottomed from 1998 to 2002, right in line with the Kondtratiev wave, and has
been in a strong bull market ever since.  According to the long wave, gold
should remain a good investment for the next decade. 

5) "It is during the period of the rise of the long wave, i.e. during the period
of high tension in expansion of economic forces, that, as a rule, the most
disastrous and extensive wars and revolutions occur. "  

I’ll quote Marc Faber one more time since he states his case succinctly: 

“It is interesting to note that the French Revolution, the Napoleonic Wars, the
European revolutions of 1848, the Crimean War, the American Civil War, the
Franco-Prussian War, the Russo-Japanese War of 1904, the First World War and the
February Revolution in Russia all took place during the rising wave of the long
cycle.  An exception was the Second World Ware, which took place right at the
end of the downward wave of the third cycle or the very beginning of the fourth
cycle….However, since the downward wave began in 1980, we have had only
contained confrontations that did not have  worldwide economic impact.”

Several conflicts have the potential or already have had a “worldwide economic
impact." The war against terrorism and Al-Qaida falls into that category.  In
addition, China’s assimilation of Taiwan, conflicts with North Korea, and Iran’s
nuclear ambitions could all spark  the next World War.  Already numerous
governments stand on one side or the other of these conflicts and, as these
relatively minor infractions escalate, the world could face “disastrous” wars as
Kondratieff suggests.  Rather than dismiss violent escalations, as investors
have already become prone to do, these conflicts need to be monitored much more
closely in the upcoming years.  

Despite the fact the Kondtratiev never mentioned how the long wave directly
affects stock prices, investors and traders can infer several themes from his
ideas.  First, the world is experiencing an upswing of economic activity which
should make recessions shorter and booms longer.  Second, commodity prices and
inflation will continue to experience an upswing for the next decade.  Third,
investors should favor companies that are transforming Internet technology into
real world applications.   Finally, investors should closely monitor escalating
world conflicts for signs that might begin to affect equities negatively.  

Please email me (tneuhaus@imva.net) if you would like a translated copy of
Kondtratiev’s "The Long Wave in Economic Life".