The Kondratiev Wave

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Why should an obscure economist liquidated as part of Stalin's purges in the 1930s be relevant to today's generation of stockmarket investors?

To get the answer needs a bit of historical perspective. Stockmarket investors have often paid great attention to economists who developed ideas about cycles. The most common assumption is that markets move in advance of major economic trends. That much is self-evident. Most think the main influence is a distinctly identifiable short-term business cycle that runs for five to 15 years.

But the ideas behind the Kondratiev wave are radically different.

Born in 1892, the Russian economist Nikolai Kondratiev suggested that there were much longer underlying cycles of boom and depression. He argued that they could last as long as 40-60 years and that they were linked to innovation and social changes, rather than economic causes.

Kondratiev studied at the University of Saint Petersburg. His initial work as an economist was in the field of agricultural economics and statistics, and on the important problem of food supply. A few days before the October Revolution in 1917, at the age of 25, he was appointed Minister of Supply in the last Kerensky government.

After the revolution he devoted himself to academic research and developed his theories of cycles. He travelled widely in the West and was a widely respected figure among fellow economists.

Kondratiev cycles do not necessarily apply universally. The theory goes that they tend to be cycles that govern the leading economy of the day and world trade. In the present day context that does perhaps mean they are applicable - albeit in different ways - to the USA and perhaps to China.

When have these cycles happened?

Kondratiev fans in the West reckon that the Industrial Revolution can be considered as one wave. It stretched from around 1780 to 1840. There was a second 60-year wave between 1840 and 1900, based around the expansion of railways and foreign trade.

The third Kondratiev wave of recent times runs from 1900 to 1950, with the Great Depression forming the trough in the middle of the period, marked by exploitation of oil, the development of means of mass communication, and the increasing importance of equity markets. Another wave arguably runs from 1950 to 2000 in the US in particular. This was based around the development of computers, the internet and mass air travel.

Some have dismissed Kondratiev's ideas, not least because there has never been unanimity about when particular waves started and finished. Modern economists tended to think that the events that kick off long-term cycles are more random in nature. But recent work on the nature of innovation and the way it tends to 'bunch' - one innovation spawning another - has supported his thesis.

The true significance of Kondratiev's writing did not become apparent until Russian-speaking economists were able to look at his original texts. Previous inaccurate translations had led to misunderstandings about his work. In particular Kondratiev drew a distinction between 'cycles' and 'waves', terms to which Kondratiev had assigned different meanings. Early translations of his work failed to make the distinction.

The Russian reckoned that the expansion and contraction of credit had a significant effect on cyclical behaviour. Some theorists also believe that Kondratiev cycles are linked to wars and revolutions. These typically occur at the starting point of a new cycle. More broadly there is also a link between cycles and the waxing and waning of a dominant power in the world. So the credit crunch, 9/11 and the subsequent conflicts in Iraq and Afghanistan, and the rise of China to the status of an influential global economic power give these ideas contemporary relevance.

The notion of long cycles of this nature also ties in to some degree with the stockmarket theories advanced by Ralph Elliott, deviser of the Elliott Wave. They also chime with those of the economist Joseph Schumpeter, who was regarded as the most eloquent advocate of the idea of business cycles and how they occur.

Kondratiev's ideas did not make him popular with the Soviet authorities. He fell from grace when he predicted correctly that the West would recover from the Great Depression. He was arrested in 1930 at Stalin's behest, was sent to a labour camp in 1932 and executed in 1938. He and the value of his work were finally rehabilitated and recognised in Russia in the late 1980s.

Peter says

Kondratiev's ideas beg a very important question for investors. If the last Kondratiev cycle ended in 2000 and the cycles individually last for 40-60 years, what message does that hold for the immediate and longer term outlook for the markets? If we recognise 2000 as a Kondratiev peak, at least in stockmarket terms, do we face a 20 to 25-year downturn before economic conditions start to improve.

There are a number of troubling portents. The arguable waning of the US and Europe and economic powerhouses in favour of China and other fast growing emerging markets, the threat of terrorism, global warming, the continuing issues over credit markets and the value of sovereign debt, the sharp rise in the gold price all suggest a period of economic strain consistent with a downturn in a Kondratiev cycle.

If you accept Kondratiev's ideas, it could last for another 10 years before some form of innovation or powerful change prompt a recovery in the leading economy of the day and a revival in world trade.

If so, it's arguably too soon to think of buying equities: parallels with 1930s America might be closer to the mark. High inflation or prolonged deflation could be equally likely outcomes. The benign middle ground of the so-called 'Goldilocks scenario' and the investments that prospered in it could be a thing of the past.