And its impact on the Indian Stock markets and Asset markets. The 70 year financial cycle surrounding business cycles.

25 FEB 2010    www.indiacharts.com 

Ever since I started studying the wave theory I have been exposed to the Kf cycle. It has taken me long to understand the context in which the cycle is to work because originally it appeared more like a study of inflation and deflation, and most of us think inflation is defined as a rise in prices. EWI and Robert Pretcher have made the point amply clear enough that changes in prices of goods and services is a by-product of inflation and deflation. Inflation refers to the expansion of monetary supply through printing of currency or through the expansion of credit or debt in the economy. Deflation therefore is the reduction of credit and debt or money supply. Before I shows you some charts here is some background.

N.D.Kondratyev noted that once economic activity stats expanding the financial system starts to expand. Business ideas needing to grow look out for funding or money for their activities and this forms the beginning of the Kf cycle. Credit is used to fund expand and grow business existing and new. But as the need to grow and compete grows man starts using debt to profit from the expansionary trends rather than new ideas. This greed causes bubbles. At some time debt becomes so big that it cannot be financed or serviced any more and defaults start to happen and a deflationary cycle starts. Deflation continues to most credit is destroyed and it takes years to restore confidence for the whole cycle to start again. The expected time span of the cycle is between 60-70 years. 

This cycle has become the object of concentration of many of the prophets of doom since the 90s as they have been predicting the end of a 70 year cycle that started for the US in 1935-49 after its last known deflationary depression. That its such a long term cycle many were too early to predict it and this bubble ended up being bigger than many in the past. The reason for this is that a bubble in credit/debt can continue as long as there is cheap finance available to keep funding or refinancing the existing debt. Once a lot of debt has already been built up to avoid the unwinding process you would always try to hang onto it by finding new financing options. The bursting of a bubble would occur due to natural consequences once options run out as they did in 2007 for the US, but they can also be burst by social or ecological factors like war, famine, earthquakes, volcanoes or something that is big enough to overwhelm the current level of economic activity making debt default the only option. So the US went into deflation in 1929 when its debt to GDP ratio was 140-160%, in 2007 it went up to 400%. Different countries around the world have deflated at different levels of debt, and a lot depends on the domestic and external environment. Today India's debt to GDP is above 100%[public+private] and not many want to accept the possibility of deflation in India because we believe that debt can be refinanced from the high savings like Japan has done for years, to keep the deflation from causing an economic depression. However the global economic environment is not favorable anymore and its effects in a globalised economy cannot be ignored. If savings are diverted to finance credit of the government than industry might get started and vice versa. If interest rates are lowered a lot then inflation becomes a risk, unless cheaper imports are available [read strong currency]. So lots of room for imbalance.

The Kf wave also needs to be read in the context of the Elliott Wave Principle, the 5-3 pattern at that degree of trend. Recent research by EWI on socionomics shows how the wave patterns of the stock market are associated with social trends. And it is the social mood that detremines whether economic activity will expand or contract as people feel better or worse about themseles. So the Elliott wave pattern reflects economic activity that is the lifeblood of an expanding or contracting Kf cycle over 70 years. Therefore a deflation becomes more severe once it starts as social mood turns negative and social behaviour foces us deeper into a corrective mode. It forces new change to correct the mistakes of the past before another positive cycle can emerge and it shows up in a bear market in the form of a 3 wave decline.

Now that's a lot of theory so here are some charts. And what is happening to India!

The first chart I am showing is that of the Sensex picked up from Vivek Patil's reports as it back dates the Sensex based on the RBI index and the FE index. This chart gives us more than 70 years of data to fit the Indian Kf cycle. The Kf cycle discussed by Ian Gordon is often discussed in the form of 4 seasons to explain how it is unfolding, and they are like this.

The Kondrateiff seasons and India

Kf Spring - Spring represents the birth of an economy which for India would have started a little before  or around Independence. Spring is the bull market during which the economy grows on new found growth prospects to exploit all its resources. Interest rates start on a low base and trend higher as demand for money grows to fund growth. Prices of assets commodities and labor expand. For India the time up to 1990 would represent such a period. GDP compounded at 6% during this period.

Kf Summer - Summer is when the economy reaches full bloom. All resources are being exploited and the expansionary phase of the past results in visible price inflation catching up with wages. To control it, interest rates move up substantially often slowing down the economy. Price inflation will appear to have been controlled and interest rates can go lower again. 1992-2001 represents such a period in India. 1966-1981 represents the same for the US. For those who have been following the market for the last decade you will remember how analysts were often comparing the 70's Dow chart with the 90's India chart to predict how the Dow then took off later and went up 10 fold over the next 20 years [during the Kf Autumn]. Well India went up 8 times since 2001 in 7 years. What I want to highlight is that in terms of the Kf cycle they were comparing the same state of markets [Kf summer]. The outcomes therefore were also similar, but time wise one lasted much longer. There is a belief therefore that India's bull market that started in 2001 is going to last for decades and we are seeing a temporary halt right now, however the size of the bull market is often ignored. Time was smaller in India because we quickly went from a closed to open economy and are doing a very fast catch up job with lost time. In terms of wave structure too if you see the chart above wave 3 was the longest however wave 1 was a small bull market relatively, and therefore wave 5 equals wave 1 in size and that is good enough. India's debt to GDP was just over 50% by the end of the Summer]

Kf Autumn - The myth that inflation is under control is what kicks off the Autumn. This feeling of control allows for monetary action to start again. Note that this is the only time when lower interest rates are associated with rising asset prices. During spring interest rates start on a small base and expand slowly as the economy expands, demand for finance leads interest rates. During Autumn rates are lowered to kick start economic activity and the belief that prices can be kept under control allows for credit based bubbles to reach full scope. Falling rates push all asset prices up from equities bonds and real estate to possibly commodities and wages. As credit levels expand exponential nurturing debt with cheap finance is the essence of keeping the Autumn bubbles alive. But as discussed above they will eventually burst. 2001-2010 is the Autumn for India. In terms of credit 2010 appears like the right time of the cycle to end, though from a stock market perspective it can be debated whether the 5th wave based on Elliott waves ended in 2008 or 2010. It differs between Sensex and Nifty. India's debt to GDP had crossed 100% and is now close to 130%.

Kf Winter - As always winter will come. The most painful period as bubbles burst causing economic upheavals and hardship. Fear and distrust force reduced lending activity despite lower interest rates. Quality debt is back in vogue. The process of unwinding of debt before another cycle starts can take from a few years to decades depending on the degree. The U.S. deflation from 1929-1949 took 15 years for debt, but stock markets bottomed in 1934, i.e. in 4 years. However a grand super cycle occurs when a 5 wave rally of one larger degree occurs. This means after 3 consecutive Kf waves in a country it completes a larger degree 5 wave rise lasting 210 years and will correct/consolidate for a longer period. In the U.S. 1720-1784 is shown as the Grand-Supercycle degree wave 2 by Robert Prechter in his book "Prechter's Perspective". That was 50-60 years of depression/consolidation. Since then US has been in a Grand supercycle degree wave 3 till year 2000. Wave 4 could potentially be as large in time. But for countries like India that are in their first Kf cycle since independence and things are not so bad. Yes I think India will see its own Kf winter, i.e. deflation, however after 2-3 years once it completes a supercycle degree wave 2 correction, a larger degree supercycle wave 3 bull market lasting 70 years can emerge. This is when decoupling will happen for India and maybe China. The recent 2010 Indian budget has started talking about reducing the fiscal deficit and that is a deflationary trend signal. How debt gets reduced may vary from cycle to cycle. Bubbles can be pricked internally through tightening or externally through events not in our control.

India's biggest strength that will eventually bring us out of this mess is our demographics. A young population is willing to take hard steps and suffer the pain needed to quickly move ahead. Ageing populations in the west and Japan prefer not to suffer pain and postpone it as far as possible which will make them take much longer [20 years for Japan already]. Now here is a look at the current picture of the Elliott Wave structure for the Sensex for the last decade

Elliott Waves and the Markets

I have already explained that 2001-2010 was the Kf Autumn, within this the 5th wave of the stock market advance from 2001 ended in 2008 after which it is technically in a bear market. However some sectors like Autos and IT are completing their 5th waves in 2010 as the B wave in the Sensex is forming. If you have been an Indiacharts follower then you would know that I was originally counting the fall in 2008 as a 5 wave decline. At some point I choose to follow the W-X-Y-X-Z structure as it allowed me to truncate the bear market at 8000 on low sentiment readings. My expectation then was of an X wave upto not more than 12500. However we have a B wave that is much larger. That alternate played its role then and allowed me time to judge whether my original counts that have longer term bearish implications are valid and whether economic behavior is fitting. Now its more clear that decoupling is a fad. Its possible only after a deflation. It takes a new model of growth to emerge may be new technologies that solve the worlds problems or make it more productive. All said and done the original wave structure of counting the 2008 bear market as a 5 wave decline has not been violated and the falling volumes and bubble in small caps is a clear signal that the recent Jan high is a wave B top of a supercycle degree bear market. Wave C of the bear market therefore will be another 5 wave decline and has already started. Wave 1 [or I of 1] has formed since Jan and a wave 2 rally is in progress. Wave 3 would take us far lower than the recent lows. Wave C would be at least equal to wave A giving the Sensex a target of 6432. This itself may sound impossible today as known fundamental theory practiced cannot predict it as it does not encompass socionomics [or socio-economics], mass psychology and social mood, or financial cycles like the Kf wave. However wave theory states that bear markets often travel up to the wave 4 low of the previous bull market at one lower degree under consideration. Now wave 4 of the 2001-2008 bull market was at 4227, but wave 4 of the 70 year bull market shown in the first chart above is at 2596. These targets appear absurd today but coincide with 1.618 times A [at 4715] and 2.618 times A [at 3193] as potential targets if C was extended.

I don't know whether to say we should expect such low levels but the Elliott Wave Principle suggests it and till the market proves it wrong it might be better to be prepared for the above scenario till a better one is clearly emerging. Right now investors should be holding cash and protecting their cash in safe banks FDs or Central government securities. Buy dollars to hedge against a depreciation of the rupee if you have access to currency futures. And wait for a great investment opportunity that lies at the end. If you are a trader capable of building shorts they would be profitable. At some point of time once gold prices are much lower you might want to also own gold. At some point in future the governments around the world will again attempt to spend their way out of deflation and those attempts at inflation can cause commodity prices to rise or hyperinflation in some economies. Then one should own some gold. But right now its too early to buy.

Alternative and More thoughts : based on feedback

Now like I said the forecast even at A=C is bad enough and frankly for most readers hard to believe. So lets discuss what alternates have been thrown at me. The most common one is that India because of its high savings rate and public sector will be able to keep fueling its expansion for several years and we may get a few more bubbles to possibly new highs before we can enter a corrective Kf winter like period. Before I discuss this lets look at this chart taken from Citigroup Global markets Asia Pacific report.

Now let me be very clear that I am not being an economic analyst. Technical analysis and the Elliott Wave theory form the basis of any forecast. So what is the role of the Kondratieff wave? While studying supercycle degree elliott wave counts, the knowledge of the Kf wave allows for economic forecasting based on a non linear model. So what I am most convinced about is the wave Count discussed above and that the Kf cycle of 70 years coincides with the 5-3 supercycle trend of markets. In this context what I would expect is that attempts to reflate the economy with spending could slow down Wave C into a larger time wise 5 wave decline where wave 2 of C would be another strong rally that will try to retest the recent highs. But since wave B is over its going to be difficult to do more than that. Extending the Kf Autumn into more bubbles is theoretically possible but needs a positive external environment and no external shocks. So for all our strengths and better demographics we are weak in many areas such as technology, food security, dependence on rain gods, threatening neighbors and a non-global currency. One look at the chart above tells you that in a world that is already in trouble over debt we rank only next to Greece. OUCH! but economists will tell you its not that bad because we have domestic savings to finance it. All the same we need to service our debts and that's a cost that will slow us down. From today's Economic survey I recalculated our Debt to GDP ratio which was over 100% last year based on rough estimates. It is now close to 135%. Government debt is at 45% with states and off balance sheet items at 25% and banking sector credit to commercial sector is at almost 65% so that adds up to 135%. In Greece the problem is not just savings but that its part of the Eurozone and cant do the kind of creative financing we still can. So just the idea that we can take the risk of growing on debt is not good enough anymore the question is whether its worth the risk and will it bear fruit before some external threat pricks it. Right now the wave structure tells me that it shall not be possible to extend this debt cycle any further...unless if 17700 is crossed then I would be wrong. I have also been questioned about the 70 year period. Its not an exact period but its between 50-70 years that in the past has taken for the full Kf cycle to play out. You have to study the stages of the credit cycle in more detail to figure that out. Again is it still possible that we are only in wave 2 bear market of a multi year bull market that wont go below 11500? Its possible but till there is evidence of that, the risk of a Kf winter is worth keeping note of and waiting for it to be ruled out.