Thursday, March 27, 2008

Secular Trends Are the Single Most Important Factor in All Investing

27 March 2008

One retirement project I have given much though to is offering guidance to young people about investing for their future.

What would I tell them?


Secular trends are the most important factor in all investing.

Everything else is secondary to this primary fact.

The broad markets are a good (or at least acceptable) place to invest for the longer term during two secular "seasons." Spring and autumn are rewarding seasons during which to invest for many years in general equities. But we must be cautious and selective during the recessionary summer season, and stay almost entirely out of the broad markets during their winter season. Few investment advisors warn their clients about these simple but vitally important secular trends.

I hope you have grasped that I am not talking about the earth's seasonal cycles as it revolves about the sun. Rather, I am referring to the fabled Kondratieff Cycle, named for the persecuted Russian economic theorist, Nikolai Kondratieff.

Economists debate the validity of Kondratieff's theoretical constructs and their application. Obviously the world has changed a great deal over the past century. What is difficult to dispute, however, is that broad multi-decade trends drive the markets, and the Kondratieff model, whether wholly right or wrong, certainly offers a perspective for thinking further about the types of factors that give rise to these patently observable secular (very long-term) trends.

From a psychological perspective, an obvious driver of cycles that may repeat over 50-70 year time frames is that no human can learn them by living through them in a lifetime (this observation is particularly applicable to the adult portions of our lives).

For most of us, our entire lifetime will represent more or less a single secular economic cycle. No matter how much we may learn through study or even through interviews with members of previous generations, we cannot know what it will feel like to live through
each stage of the cycle until we pass through it - probably once only for each stage - in our own lifetime.

In my perhaps limited experience, I have found the best discussion of Kondratieff's ideas in Marc Faber's book, Tomorrow's Gold.

Another book to look at might be Ed Easterling's Unexpected Returns: Understanding Secular Stock Market Cycles. I have ordered but not yet read this book. It comes highly recommended by John Mauldin, an advisor whom I deeply respect. I'll read this one and let you know!

In brief, the markets tend to climb, or at least to maintain stability, during periods of genuine economic growth. However, economies are driven by human behaviour, and our species is prone to excesses in thinking and behaviour that result in accumulating unresolved economic imbalances on a cyclical basis.

Most often, these problems are attributable to irresponsible monetary policy, during which the money supply is allowed to increase out of all proportion to economic productivity. During such late episodes of excess in our multi-decade economic cycles, debt accumulates and capital is increasingly misallocated or "malinvested" in unproductive assets.

In our present era, we have abandoned the gold standard, and accepted an unprecedented level of government intervention in economic activity. To state it briefly, the more governments intervene in the economy, the worse the situation grows.

These accumulating contradictions tend to go unnoticed during the expansionary spring and even the recessionary summer season, as these gentler seasons precede the parabolically accelerating "autumn" phase of the Kondratieff Cycle. However, the combination of an inflated money supply (excess liquidity) and the increasing misallocation of capital (no chief executive is worth $65 million - or more - per year, nor does Miami need that many condos!) results inevitably in perilous economic imbalances that cannot be corrected by any form of government economic intervention, "stimulus package," etc.

In our current situation, we now have, as evidence of our deeply imbalanced economic system, what Bill Fleckenstein has termed the "merger" of the US Federal Reserve Bank with the J.P. Morgan Chase and Bear Stearns investment banks. The Federal Reserve has literally agreed to take on and guarantee the lowest quality mortgage "unbacked" securities of Bear Stearns, accumulated during that bank's heyday of recklessness. While indebted nominal homeowners - too numerous to rescue - are left to suffer the natural consequences meted out by what little remains of the free market system, Wall Street investment banks are deemed "too big to fail," and so are rescued with uncounted billions in taxpayer dollars.

Permit me to state here and now that the "rescue" of Bear Stearns at this time offers the most certain evidence yet that we have reached a point of no return in our present economic cycle.

Such developments, against a backdrop of an accumulated $48 trillion of US public and private debt, are a certain warning that Kondratieff winter is on its way, if not already upon us.

This is the season during which investment in general equities is simply unwise, but so-called "counter-cyclical investments" may fare very well, the foremost among these being gold, the precious metals generally, and - during parts of the winter season - commodities.

What is happening here is not that commodities are increasing in value, but that money is reassuming its actual value against things that are real. That is, our national "reserve" banks can print money endlessly, and have in fact been doing so throughout the Kondratieff autumn season. But when winter comes, the excess money is assigned its true value against real goods.

The winter season is certainly dangerous and destructive. Globally, it is characterized by rapid redistributions of capital which fuel competition for scarce resources involving "new players," resulting in increased risks of destructive human behaviour of all kinds, including war. However, winter is also the season of "creative destruction" (a phrase coined by the economist Joseph Schumpeter), when malinvested capital is abandoned, and wiser investment strategies ultimately win out... eventually leading us into a fresh and new spring season.

A commentator who understands broad cycles well is Jay Taylor. I would like to refer you here for Mr Taylor's recent review of where we stand within the context of broad economic cycles. (I have borrowed three charts from Mr. Taylor for my present blog entry, but recommend that you go directly to the source for a full exposition of their meaning.)

Kondratieff winter is here. Take caution, as it is only beginning, and spring is a decade or more away. It is certainly now a season of "global cooling" in the international equity markets.

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