Palmerston, Kondratieff and Me. Long waves in British financial markets.

The Victorian statesman Lord Palmerston once observed of the Schleswig-Holstein question that it was so complex that only three men had ever fully understood it. One of them had gone mad, the second had since sadly died, and the third was himself – but it was so long ago that he had completely forgotten the answer.

Sometimes I feel as if the long waves that drive capitalist development have also, like the Schleswig-Holstein question, only ever been understood by three men. The first, Nikolai Kondratieff, disappeared long ago into one of Stalin’s Gulags, never to be heard of again. The second, Joseph Schumpeter, has long since passed on. The third is myself, and my only published analysis of it was in The Age of Illusions more than 30 years ago.

Actually, I’ve undertaken much research since then, not with a view to publication, but rather to apply the analysis as a framework for trading in the securities markets. It worked, thus reinforcing my confidence in the existence of the long waves that Kondratieff first identified 90 years ago.

The secrets to success in surfing the long wave are threefold: firstly, to recognise that it exists; then, to anticipate its movement going forward; and finally, to take a position to ride it and avoid being overwhelmed and submerged.

Going through each in turn:

1. Recognising the wave. Conventional wisdom as taught in academic textbooks and finance courses is that capitalist development is a process of incremental change within an inherently stable system. Kondratieff and Schumpeter realised that the real world doesn’t work like this. Market economies have no natural tendency to equilibrium. As Schumpeter wrote in Capitalism, Socialism and Democracy, “The capitalist economy is not and cannot be stationary. Nor is it merely expanding in a steady manner. It is incessantly being revolutionized from within by new enterprise or new methods of production or new commercial opportunities” which sweep away existing market structures in what he termed a “gale of Creative Destruction”.

2. Anticipating the movement of the wave. We are currently in the downswing of the Internet Revolution – the fifth long wave in the UK since the Industrial Revolution. The upswing of the Internet Revolution lasted from the late 1980s to 2007, driven by major innovations including the mobile phone, laptop computers and the worldwide web. As the upswing gathered pace, imitators keen to emulate the success of entrepreneurs like Steve Jobs and Bill Gates entered the market, driving a speculative bubble fuelled by lax monetary policies. The bubble fed on itself in a reflexive process (in George Soros’s phrase), pushing asset prices ever further from their economic values particularly in Internet-related businesses and property, until they crashed during the international financial crisis of 2007–09. We are now in the downswing of the Internet Revolution, which will evolve in two phases. The first phase is Recession, when poor investments made during the final speculative bubble and the loans that financed them are progressively purged from the economic system. The Recession will be succeeded by a Recovery, as insolvent enterprises are liquidated, surviving enterprises consolidated, and new enterprises emerge.

3. Investment positioning through the long wave. In general, the long wave upswing tends to be inflationary, while the downswing is deflationary or disinflationary. So the upswing is generally positive for equities, whose prices rise in an inflationary environment. But it is bad for bonds and other financial assets whose nominal value is fixed and whose real value falls as the general price level rises. Conversely, the long wave downswing is generally bad for equities but good for bonds.

This has been the story since 2007: Equities have suffered while bondholders have prospered. When the Internet Revolution approached its peak back in March 2007, the FTSE 100 Index stood at 6300. Today, 8½ years later in mid-October 2015, it stands at…..around 6300. At the risk of stating the blindingly obvious, equities as an asset class have gone absolutely nowhere during the Recession phase of the current long wave. In fact, in real terms, they have fallen significantly in value, as over the same period the UK Retail Price Index has increased almost a quarter from 210 to 260.

By contrast, bond prices have shown significant gains over the period. The yield on the benchmark 10-year UK gilt stood at 5% in March 2007. Today, it is just 1.9%. As bond yields have fallen, bond prices have risen.

At some point, as Recession metamorphoses into Recovery, one would expect bond prices to fall and yields to rise, but only slowly and by modest increments. In such circumstances, bonds as an asset class may continue to outperform equities. In any event, with the UK inflation rate currently at 0%, the yield of 6½% offered by the eighth bond acquired for the High Yield Bond Portfolio appears attractive, being 4½% higher than the 10-year gilt yield. Its details are as follows:

Issuer: Enterprise Inns plc
Coupon: 6.375%
Maturity Date: September 26th 2031
Payment Dates: 6-monthly on March 26th and September 26th
Offer Price: 99.85
Running Yield (at Offer Price): 6.38%
Yield to maturity (at Offer Price): 6.39%
Nominal Amount: £1,000
Cost: £998.50 + £3.59 accrued interest + £20 commission = £1,021.09

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