Stealth Phase

Those who understand the new fundamentals realize an emerging opportunity for substantial future appreciation, but at a substantial risk since their assumptions are so far unproven. So the “smart money” gets in, often quietly and cautiously. This category of investor tends to have better access to information and a higher capacity to understand it. Prices gradually increase, but often completely unnoticed by the general population. Larger and larger positions are established as the smart money start to better understand that the fundamentals are well grounded and that this asset is likely to experience significant future valuations.

Awareness Phase

Many investors start to realize the momentum, bringing additional money in and pushing prices higher. There can be a short-lived sell off phase taking place as a few investors cash in their first profits (there could also be several sell off phases, each beginning at an higher level than the previous one). The smart money takes this opportunity to reinforce its existing positions. In the later stages of this phase the media starts to notice and those getting in are increasingly “unsophisticated”.

Mania Phase

Everyone is noticing that prices are going up and the public jumps in for this “investment opportunity of a lifetime”. The expectation of future appreciation becomes a “no brainer” and a linear inference mentality sets in; future prices are a “guaranteed” extrapolation of past price appreciation, which of course goes against any conventional wisdom. This phase is however not about logic. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Fairly unnoticed from the general public caught in this new frenzy, the smart money as well as many institutional investors are quietly pulling out and selling their assets to eager future bag holders. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep the appreciation – “the game” – going. The market gradually becomes more exuberant as “paper fortunes” are made and greed sets in. Everyone tries to jump in and new investors have absolutely no understanding of the market, its dynamic and fundamentals. Prices are simply bid up with all financial means possible, particularly leverage and debt. If the bubble is linked with lax sources of credit, then it will endure far longer than many observers would expect. At some point statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.

Blow off Phase

A moment of epiphany (a trigger) arrives and everyone roughly at the same time realize that the situation has changed (like the Road Runner Coyote realizing he is about to fall after walking on thin air for a few seconds). Confidence and expectations encounter a paradigm shift, call it a reality check, not without a phase of denial where many try to reassure the public that this is just a temporary setback and that anyone saying otherwise does not know what he is talking about. Some are fooled, but not for long. Like a directionless herd many try to unload their assets to a greater fool, but takers are few; everyone is expecting further price declines. The house of cards collapses under its own weight and late comers (commonly the general public) are left to hold the bag while the smart money has pulled out a long time ago. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged bag holders go bankrupt, triggering additional waves of sales. There is even the possibility that the valuation undershoots the long term mean, implying a significant buying opportunity. However, the general public at this point considers this sector as “the worst possible investment one can make in his life”. This is the time when the smart money starts acquiring assets at bargain bottom prices.

I asked Dr. Rodrigue for his opinion on whether the current markets are in the “return to normal” phase or the “return to mean” phase.

My assumption concerning the stock market is that we are in the “return to normal”. It is not because that the contraction is taking place at a slower rate that one should declare that “the recession is over”. There is quite a lot of desperation so the market appears to cling to any news that is not horrible with a positive spin.

The next shoe to drop is linked with the commercial sector that has overinvested and malinvested, fooled by the debt fueled consumption binge that was the real estate bubble (if debt is defined as present consumption at the expense of future consumption, then it can be assumed that there will be much less consumption than expected in the future). You should see the blood bath that is currently taking place in the maritime shipping industry; gigantic capacity coming online at the same time the demand is dropping sharply.

Once the “stimulus” will be spent, both financially and politically, and that people will see it for what it was – a macroeconomic fraud – then there should be a another downside until we reach the “return to the mean phase”. One can also wonder about the unfolding pension crisis as the baby boomer generation enters retirement age with limited savings and depleted assets (real estate and 401k/RSSP). A question I am asking myself these days is how all of this will be defaulted on, particularly defined benefits plans?

Thanks to Dr. Jean-Paul Rodrigue for taking the time to share his thoughts and research with The Canadian Finance Blog. His theroies show a possible outcome for the economy that isn’t being discussed much as stock markets move higher.

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Kondratieff noted that capitalist economies have long waves of boom and bust, that he described similar to the seasons in a year.  However, for presenting his work to Stalin showing that capitalism will always return, he was imprisoned and then eventually executed.

The four seasons in The Kondratieff Wave are:

• Spring (25 years) – Inflationary phase with rising stock prices and increased employment and wages.
• Summer (3-5 years) – Stagflation phase with rising interest rates, rising debt and stock corrections. Imbalances lead to war.
• Autumn (7-10 years) – Deflation phase where falling interest rates lead to a plateau and stock prices increase sharply.
• Winter (3 year collapse and 15 year readjustment) – Depression phase with stock and debt markets collapsing and commodity prices increasing.

Source: www.chartingstocks.net

So what does all this mean? I found this chart very interesting, especially in today’s economy. I’d like to thank a reader, Dave in Calgary, for emailing this to me. Of course, it’s debateable whether winter is behind us and we’re back into spring… or are we currently in autumn, with winter still to come?

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On Monday, Trade Minister Stockwell Day repeated this claim in the Penticton Western News, writing  “I’m not kidding. The recession is over… Last week, after pouring over all the numbers he was able to declare, not on a whim but based on economic fact that the nasty ‘R’ word no longer applied to Canada.”

But then this Tuesday, when Finance Minister Jim Flaherty was asked if the recession is over he said ”No, I think we will have to look back as we always do and look at this quarter. There are good signs that the economy has stabilized, and there are the beginnings of a recovery. And I wouldn’t put it any stronger than that.”

Transport Minister John Baird had a similar statement on Wednesday, “What we want to make sure of is that we don’t pop out the champagne just yet. There’s a lot of Canadian families that are still feeling the pain of the economic times that are going around the world.”

I prefer Mr. Flaherty and Mr Baird’s cautious statements, especially with the jobless rate at an 11 year high and EI payments at their highest level since Statistics Canada began tracking in 1997.  More importantly, being too much of an economic cheerleader might lead to another crash if, 3 months from now, the projection turns out to be incorrect. Ultimately, these mixed messages will not help a nervous stock market or a fragile consumer confidence.

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