The third law of physics is: For every action, there is an equal and opposite reaction. That’s why I study cycles.
But with so many cycles, the key is to identify which ones are important to whatever you are measuring or trying to profit from.
That’s why, when the bubble from late 2002 to late 2007 was not nearly as strong as my earnings and demographic indicators suggested, I knew there had to be another important cycle showing itself.
That led to my discovery of the Geopolitical Cycle in early 2006. It is the second in my hierarchy of cycles, as it is not as fundamental to the economy as the Spending Wave. Predictable demographic cycles that impact housing and inflation are just more important…
But the Geopolitical Cycle still has a major impact on investor psychology. When a war, oil embargo, or major terrorist event comes along and wrecks a positive economic cycle, investors sound the alert!
This can severely impact price-to-earnings ratios (P/E) on the same earnings trends for stocks. The P/E ratio can vary from five to 44 times — though more typically eight to 25. Still, that’s a huge deal!
The Geopolitical Cycle shows that our global environment is favorable for 17 to 18 years, followed by an adverse period that lasts the same amount of time. This chart shows how that relates to P/E ratios on stocks:
That’s a stunning correlation. When the geopolitical environment is favorable, P/E ratios rise. When it’s not, they fall.
Think about the adverse cycle we are presently in: 2001 to 2019. How does that compare to the favorable cycle from 1983 to 2000?
Hmm, let’s see. From 1983 to 2000, almost nothing went wrong in the world. Sure, we had a little 100-hour-long war in Iraq… but we didn’t meddle with their regime, beyond kicking Saddam Hussein out of our ally, Kuwait.
But ever since 9/11, it’s been one geopolitical crisis after the next! We’ve had two major failed wars in Iraq and Afghanistan… one civil war and Arab Spring after the next… and now we have ISIS which has proven to be even more evil than Al Qaeda, and they’re still growing.
And let’s not forget Russia, which took over Crimea and threatened to invade Ukraine… the sanctions we’ve placed on Iran and strong concerns over their nuclear program… Boko Haram, which has terrorized Nigeria and allied with ISIS… and most recently Saudi Arabia, whose band of Arab nations has bombed Yemen, hoping to invade after a coup there — but not if their Shia enemies in Iran have anything to say about it!
During the favorable cycle, we had the combination of the strongest demographic phase in modern history and the mainstream emergence of the Internet create the highest P/E ratios ever, at 44 times.
But P/E ratios have not been anywhere near as high since. That’s despite favorable demographic trends into late 2007, and unprecedented QE and stimulus into 2015.
Why? Geopolitical risks have only risen since 9/11 and investors are scared out of their wits!
We’ve seen the same thing happen during the past two full geopolitical cycles as well:
- 1914 to 1929: The last great bubble boom and the sudden emergence of automobiles
- 1930 to 1947: The Great Depression and World War II… enough said!
- 1948 to 1965: known as the “Happy Days,” with no major geopolitical events except the Cuban Missile Crisis in 1962
- 1966 to 1982: OPEC oil embargos, the Vietnam War, and the Cold War rip apart the geopolitical environment
The bottom line is this: The Geopolitical Cycle bears the greatest impact on the P/E ratios of stocks, with the Spending Wave and Innovation Cycle as secondary measures. The fact that the P/E ratio can fall off a cliff when the cycle goes from positive to negative shows that!
Newton’s third law abides… what goes up, must come down.
P/E ratios fell the most after the extreme peak in 1929. But they got even higher in early 2000…
What does that tell you?