I wrote in an earlier article this week entitled "Bonds and Gold" of the relationship between interest rates and the K-wave, pointing out that persistently low or declining rates are an earmark of the final portion of the K-wave (known as "runaway deflation" or hyper-deflation). I'd like to follow up on that article with some more salient observations about the current K-wave and its potential impacts on the U.S. economy and financial structure.

The interest rate situation is really the pivot of the deflation argument. In fact, of all the various financial indicators, interest rates show the most historical consistency for reflecting the true rate of inflation and deflation. Despite the currently prevailing myth that gold is strictly an "inflation hedge," gold and certain other commodities can actually rally in a climate of runaway deflation as they did through the better part of the 1930s.

In the 1930s, unilateral default was the rule rather than the exception. This despite the fact that commodity prices rallied quite vigorously from about 1932 to 1937. The general economy remained persistently weak through that doleful decade known as the Great Depression. Yet there are distinct differences between the times then and the financial situation today. What are those differences? Consider the following:

1.  In 1929 when the stock market peaked before the Great Crash of '29, the K-wave itself was still peaking while the 120-year Master Cycle (which had previously bottomed around the year 1894) was still rising. It was the 40-year cycle (a component of the 120-year cycle) which, more than anything, was a major catalyst to the crash.

2.  Even in the Depression Era of the 1930s the U.S. economy had certain things in its favor, namely, the still rising 120-year cycle and a K-wave bottom that was still some 15-20 years away.

3.  For the first time in many generations, the U.S. economy has absolutely nothing (in cyclical terms) in its favor. All of the major long-term cycles in the 120-year cycle series have peaked: the 120-year cycle peaked in 1954, the latest 60-year cycle peaked in 1984, the 30-year cycle peaked in 1999. On top of that, the following cycles are still declining: the 10-year cycle, the 8-year cycle, and the K-wave itself (typically 50-60 years in duration). With all these long-term cycles leaning, as it were, against the financial/economic structure we can expect an extremely bumpy ride in the years immediately ahead.

Now let's turn our attention to what has become a critical component of the U.S. economy and growing debt situation -- the real estate bubble. Back in March in my forecast for the second quarter I wrote concerning the leading indicator for real estate in the U.S., the Morgan Stanley REIT index (RMS):

"Here's a fact worth pointing out about RMS: for the 8 or so years this index has been in existence the 100-day/200-day moving averages have been in a bullish configuration (i.e., 100-day MA above 200-day MA, both averages rising) for close to 5 of those 8 years. The averages got out of their bullish alignment in mid-2002 and have been unaligned ever since, but as you can see from the...chart the 100-day MA is threatening to penetrate back above the 200-day MA, which would send a bullish signal. This would put RMS in line to challenge its previous peak of approximately 470 (RMS currently near 450). And what would such a bullish signal spell out for the broad U.S. real estate market? Obviously that the bull market in housing isn't over just yet. This alone could keep the economy propped up for a while longer."

This bullish moving average crossover signal was accomplished last month and RMS has been rocketing higher ever since. Looking at the completely history of this index it is clear that the final "blow-off" phase of the bull market in real estate equities (and by extension, real estate) is now underway and I note that the RMS chart has traced out a clear-cut five-wave Elliott Wave pattern with wave 5 currently underway. I predict that real estate prices will reach their peak by the first quarter of 2004 and that the real estate crash will get underway next year. And since the U.S. consumer has most of his or her eggs in the real estate basket, this will be the real catalyst for deflation. I've stated for the past couple of years that real estate is the proverbial "last Indian standing" and the only thing keeping consumer confidence up and preventing the average American from completely losing faith in the financial system.

Speaking of real estate bubble, I personally experienced something the other day that really brought home to me the enormous proportions this bubble is taking. Stepping into the local bank to make a deposit, I was accosted by a bank official who was taking a "customer survey." I politely consented to fill out the questionnaire (even though I despise such polls as an invasion of privacy) and was surprised to discover that the "survey" was nothing more than a cleverly-disguised promotional for the bank's mortgage and home-lending services. Basically, the bank (a well-known U.S. lending institution) has taken to practically handing out home loans to prospective home buyer (including first-timers) and is literally "taking to the streets" to get people to take on a 30-year mortgage.

I interpret this as a move of desperation on the part of the major lenders who are doing everything in their power to not only keep the real estate bubble pumped, but more importantly, to keep the overall economy afloat via credit inflation. But as Ludwig von Mises teaches us so eloquently, this game of continuously expanding credit and adding debt onto debt can only go on for so long before it collapses of its own weight, bringing hyper-deflation.

Speaking of deflation, newsletter veteran Richard Russell had this to say in a recent edition of his venerable Dow Theory Letters:

"I believe we're on the edge of a very dangerous deflation. I have listed the reasons why I think deflation is in our future...China and Asia with their low wage scales and exporting deflation. Discount chains like Wal-Mart and Target are retail forces for deflation. The Internet is a mighty force for deflation, in that it allows consumers to check the price of anything anywhere at any time of the day or night and find the best price. Over-production in almost every area from cars to computers. Over-loads in debt in the cities, counties, states, corporations and among consumers. Rising unemployment and concession in wages (as per the airline personnel). Rising trend of bankruptcies, both corporate and individual. Huge levels of unfunded debts on the part of corporations."

Concludes Russell, "I take these deflationary trends very seriously. A trend in deflation will [hurt] the debt-laden U.S. economy, in that deflation renders debt much more difficult to service."

Back to the K-wave. I asked friend and fellow market analyst Samuel "Bud" Kress recently his take on the K-wave and how we'll know when the current economic K-wave has finally bottomed. Since we obviously can't predict in advance exactly when the K-wave will bottom (the bottom is only konwn in retrospect), I wondered what his criteria was for discerning the bottom. You will remember that the K-wave (named after Nikolai Kondratief, who first posited the idea of a 50-60 year economic long wave). The K-wave also closely corresponds to the biblical "Jubilee Cycle" of 50 years, although technically the K-wave isn't really a cycle -- as its name suggests, it's a "wave." An economic long wave is distinguished from a cycle in that its duration from trough to trough is not precise and can be extended or contracted via manipulative efforts on the part of governments or central banks.

Bud and I discussed the possibility that the U.S. government will attempt to extend the K-wave as long as possible to keep it from collapsing the economic system. K-wave expert Ian Gordon also subscribes to this theory and points out that K-waves can sometimes last as long as 70 years when serious government/banking efforts are made at manipulating it. According to Bud's understanding of the K-wave, the previous one bottomed in 1949-1950 and the current one should theoretically bottom in 2004-2005. So here's what Bud had to say: "Keeping in mind that we don't actually know in advance when the K-wave will bottom, we'll know the bottom has come when we see an increase in month-over-month monetary growth as measured by M-3, and an increase in inflation as well as an increase in corporate earnings for at least two back-to-back quarters."