The Business Cycle and the Economic-Confidence Model
In separate research works on our Economic-Confidence Model published since 1979, the complete and detailed historical review stretching back several centuries will provide the in-depth analysis of this model for those interested in more serious study. The primary purpose of this discussion is to present an overview combined with a practical guide as to how to implement this model into your investment and/or business decision making process.
Understanding the business cycle is extremely important to successful trading, investment, and corporate strategic planning. Paul Volcker, former chairman of the Federal Reserve, stated that the business cycle frequency amounts to a duration of 8 years. Research at Princeton has revealed a similar duration of 8.6 years, but on a more dynamic scale.
The overall structure of the Princeton Economic-Confidence Model is based on an 8.6 year business cycle. This 8.6-year cycle builds in intensity to form long-waves of economic activity measuring 51.6 years. This should NOT be confused with the long- wave of Kondratieff whose work revealed an average long-wave of 54 years. Kondratieff’s work, conducted during the early part of this century, covered a period of slightly less than 150 years. At that time 40% or more of the total civil work force was employed in the agricultural sector. Therefore, the primary input used in Kondratieff’s model was the commodity sector. Today, agriculture accounts for only 3% of the total civil work force and the service sector now employs nearly 70%.
While the world waits for the Kondratieff Wave to predict the next Great Depression, the reality of the situation is quite different. The major high in commodities during the early part of this century took place in 1920 followed by the low in 1932. Precisely 54 years after 1920 provides a target of 1974 while 54 years from the 1932 low yields the target of 1986. In fact, 1974 was the major high for many commodities as 1986 was a major low. The Kondratieff Wave has come and gone and the commodity sector indeed experienced a massive deflationary wave. By 1986, only 50% of the number of farmers remained from the peak in 1974.
No one in their right mind would develop a model based on pork bellies and then claim that it’s capable of forecasting the stock market. Nevertheless, those who write so much about Kondratieff’s work are doing precisely that! If Kondratieff were alive today, he would have chosen the service industry to base his model upon rather than commodities, since services now represent the lion’s share of the economy.
Long-wave economic theory did not begin with Kondratieff. It has actually been around for centuries. Kondratieff merely captured most of the publicity during this century. We offer as one proof of this statement an illustration of a most curious chart which was published in the Wall Street Journal on February 2, 1933 with the following caption:
“The above chart was sent to the Wall Street Journal by Edward Rogers of Detroit. Mr. Rogers states that it was found in an old desk in Philadelphia in 1902. The original drawing was much discolored. The desk was of a pattern that indicated it was at least 40 years old.
“The author of the chart is unidentified and the circumstances lead Mr. Rogers to believe that possibly the chart was made during the Civil War or before. It is submitted to Wall Street Journal subscribers for what it may be worth.”
Under the circumstances, the Wall Street Journal could not have commented on the accuracy of the chart. At that point the chart, on the surface, had predicted the past brilliantly, but what about the future? The bottom of the depression had been reached according to the stock market in 1932. However, since this factor was not clear, even at the time of publication in 1933, the Wall Street Journal was not in a position to make a qualified statement. Even though this chart accurately had pointed to all the ups and downs in the past, it could have been a forgery or a hoax that only time would reveal.
Today we have hindsight to provide us with an honest review of this chart that the most cynical skeptic cannot dispute. We know that this chart, constructed by some unknown 19th century economic explorer, was published by the Wall Street Journal during 1933 and cannot be a hoax concocted for today. Looking at the performance of this chart since 1932 yields some interesting information.
The year 1932 was indeed the bottom the Great Depression as well as the stock market. But 1934 was the real bottom in the emotional confidence of the people as they began to look toward Roosevelt for hope in his famous New Deal. The 1938 peak predicted by the chart was fairly accurate. The economy reached its peak during late 1937 to early 1938. From there, the actual bottom of the 1949 recession occurred in 1951. The chart predicted the bottom of the next recession for 1968 at which time there was a bottom of a less severe recession. The chart called for the next peak to come in 1975. In this case it was off slightly since the peak came in 1972. Then the chart predicted another decline into 1979 followed by another peak in 1983. In truth, the recession bottomed out in 1977 and the economy peaked in 1981. The chart continued to point to the next bottom in 1985.
We must admit that while not perfect, the errors tended to be less than 1 year from the actual economic events. Careful analysis of the mathematics behind this forecast from the 19th century reveals that the author made a few errors. Nonetheless, this forecast from the past illustrates that others were looking for the key to the business cycle long before 20th century man.
Another famous believer in long-wave theory was Joseph Schumpeter, a professor at Harvard. Schumpeter devoted his life to explaining long-wave theory and in the process emerged with his own Theory of Innovation. Schumpeter saw Kondratieff’s long-waves corresponding to man’s economic evolvement. For example, one wave could be attributed to the development of the railroad. That invention allowed the West and east coasts in the United States to be connected, thereby expanding the marketplace for goods and services. This enabled the East to become the center for manufacturing while the West flourished in agriculture. As prosperity unfolds, competition increases. Eventually, the peak is reached due to over-competition that results in lower profit margins. Lacking a new major innovation to allow the economic expansion to continue, the economy begins to slow and eventually a correction takes place. The wave of the 1920’s could easily be attributed in part to the development of the automobile.
Others, such as Rostow, a professor at the University of Texas, have also sought to explain Kondratieff’s long-wave. At MIT you will find another group including Jay W. Forrester who has also dedicated his life to understanding long-wave theory. At MIT they take every fundamental event and public decision and input this into their computer models.
At Princeton we have taken a different road. Our 51.6 year long-wave is not based on any of the works mentioned here, other than an agreement in the general theory that long-waves exist. We have named our model the “Economic-Confidence Model” because our research has shown that all long-waves of economic activity are NOT the same. There is a cycle of different activity in long-waves themselves. We have found that in one 51.6-year period the underlying confidence of the community may reside heavily within the public (government) sector and the private sector will have a certain degree of skepticism attached to it. The next long-wave of 51.6 years will be exactly the opposite, showing confidence moving away from government and toward the private sector. This alternating confidence of the people is caused by the excesses of each sector.
For example, during the mid 19th century, people became very skeptical about government and didn’t even trust its currency. This gave birth to the term “greenback” which referred to the only “backing” being the green ink on the reverse side of the note. To inspire the acceptance of unbacked paper currency, there used to be a schedule of interest payments on the reverse. Currency had become merely a strange form of circulating bonds.
The long-wave that resulted in the Great Depression was a wave of “Private Confidence” as people believed more in the virtues of the private sector. This high concentration of private confidence results in strong stock markets and great expansion. When it reaches its point of maximum entropy or excess, the correction begins. Due to the losses that take place, confidence then turns to government as its savior—in this case Roosevelt.
Confidence can be determined by simply monitoring capital movements. During public waves, capital is comfortable to reside in government bonds, whereas during Private Waves, capital begins to look more at diversification into stocks, commodities, business, and real estate. We have entered a new Private Wave of confidence as of July 1985. This is why the stock market continued to make new highs beyond 1986 when the bonds peaked. It is also why the ’87 crash took place, because volatility is always higher in Private Waves than in Public waves.
Many of our observations of this alternating confidence was based not merely on market activity, but on the newspaper analysis of events. Several specialized works have been published which are available through our book department for those interested in a deeper background on this subject. The titles are “The Greatest Bull Market In History” and “The Economic-Confidence Model.” Both offer a detailed account of historical events and how they correspond to this model.