I’ve added another chapter to my article on Kondratieff wave. I’m reproducing this chapter below.

Let see the relationship between stocks and bonds in different phases of Kondratieff wave. I will define the Spring and Summer periods of the Kondratieff wave as the inflationary context (1949-1981) and the Autumn and Winter as the deflationary context (1981-201?).

First of all let separate corporate bonds and government bonds. The yield of corporate bonds is composed from inflationary issues and credit risk issues. The yield of Treasury bonds are composed from inflationary expectations and some geopolitical issues, but mostly it’s just about inflationary expectations.

The relationship between corporate bonds and stock market is easy. When yield spreads are widening, the stock market will drop – immediately or with some delay. When yield spreads are tightening back the stock market is bullish or is about to become bullish. That’s pretty much it.

The relationship of Treasury bonds and stock market is much more interesting.

In inflationary context of Kondratieff wave stocks and bonds are moving in the same direction. In deflationary context stocks and bonds are moving in opposite directions

Why is that? In inflationary context the main problem is, you guess it, the inflation. So when the economic expansion is maturing the inflation heats up and bonds are turning bearish. The peak of inflation requires a violent credit tightening from the Feds, which is producing the economic contraction and bear market in stocks. When bonds are finally turning bullish it usually means that the Feds can finally relax the credit and money supply and the stock market will signal that the next economic expansion is underway.

In deflationary context it’s all different. Then the main problem is deflation, not inflation. The inflationary phase of the economic cycle is pretty relaxing and does not threaten the economic growth that much. People don’t even understand why the Feds are fighting that inflation when the things are so good. So the booming commodities and stagnating Treasury bonds are not bearish at all. New unprecedented heights of the oil prices are coincident with new heights of the stock market. That was not the case back in 1970s.

But things become quite different when treasury bonds are becoming bullish. In deflationary context it is signaling that the happy inflationary period is over and the ugly deflationary period is about to start. The stock market will not drop right away as all the classic books written during the inflationary context tell that rising Treasuries are bullish. But that’s wrong, which comes as a surprise.

The bear stock market in the deflationary context is very ugly, much more ugly then in the inflationary context. The reasons for that are:

  1. In the inflationary context the inflation itself is adding to the stock prices, as money get cheaper. The stock market falls 15%-30% and it’s pretty much it
  2. In the deflationary context the bull market of ultra-safe Treasuries is soaking up money from everything, from the stock market, commodities market and real estate market. When the safest possible instrument is so bullish – why would you risk your money in the stock market?

So I don’t expect the 2007 bear market to be gentle, bad things are coming soon. What I’m expecting?

If the S&P500 index will drop 46% and revisit the 2003′ resistance at 775 I would call it an optimistic scenario. It’s not that bad, not bad at all. The rally back up from that level could be pretty impressive. That will be the good point to load utilities and all good large-cap value stocks.

The more pessimistic target is 435, the good support level back to 1994. This would translate into pretty ugly 70% decline – this is as bad as it can get.

Tighten your seatbelt. I did 🙂