Long Valuation Waves

Long valuation waves are the secular bulls and bears of the stock and commodity markets. The theory is that due to fundamental (for the last century at least) reasons, stocks and commodities become approximately inversely more or less expensive over long 30-40 year waves. General valuation measures such as p/e help indicate which stage of a long valuation wave the market is in and also what sort of returns you may expect from stocks or commodities.

This is of interest to me because my investment strategy is value based and long term, i.e. I don’t like to buy or sell more than once a year and I expect to be investing until I drop dead.

Currently my knowledge of these waves only scratches the surface but here’s the gist:

1. Let’s say that currently we have the capacity to provide all the commodities that the world needs. Commodity prices are low because of that and so investing in new capacity is very limited as it isn’t profitable and we don’t need it.

2. Population grows, standards of living rise, partly because of low commodity prices. This increases demand.

3. Gradually this increase of demand, over a period of years, begins to strain the current capacity to supply the commodities. Miners, farmers and others start to make more money and begin thinking about buying more land to plant crops or dig more mines. However, these things require big injections of capital so the producers don’t try to increase capacity straight away, they wait until they are sure that it’s worth it, i.e. until commodity prices are high.

4. Producers start to build new mines, farm more fields and pump more oil. However, it can take years to get new mines up and running, and the same goes for oil and food production (although less so for food). During this phase commodity prices are very high and this hurts other sectors of the economy as consumers have less spare money to spend on things other than food and fuel, and the other things also cost more because of raw material costs. The rest of the economy starts to make their use of commodities more efficient or just cut back on their use due to the high costs.

5. Eventually the producers do increase supply. At the same time the consumers are consuming less (or not increasing demand so fast) because of high costs. The producers can now supply enough commodities to consumers and prices drop. Prices keep dropping as people don’t want to invest in decreasing assets and also as it becomes obvious that supply exceeds demand.

6. We are now back at stage 1. All of this took 10-20 years to go from stage 1 to stage 5, then there may be another 10-20 years at stage 5 as money flows into other areas of the economy (technology or housing for instance) which very gradually increase demand for commodities again.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

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