May 2008 – Brooke Allen

ThreePhaseTheory — The graph depicts four indices for six years on either side of a peak. They are: BLUE : Dow Jones Industrial Average (center: September, 1929), YELLOW: Japanese Nikkei 225 Stock Index (Center: December, 1989), GREEN: Nasdaq 100 Stock Index (Center: March, 2000), and RED: S&P/Case-Shiller Home Price index for Miami (center: May, 2006… ending November, 2007)

Experience has convinced me that there are three phases to the economic cycle:

Phase I – A period when it seems that everything you do succeeds

Phase II – A period when it seems that nothing you do succeeds

Phase III – A period when success depends on what you do

If you’ve studied the Roaring Twenties, Japan in the 1980s, the Dot.com bubble of the ’90s, our current housing market[1] – or even a gravity propelled roller coaster – then you know the slow climb of Phase I deserves to be the scariest for the worst is yet to be.

If what you are doing is working well you then you might convince yourself that you don’t need to learn anything new or do anything differently. You might be seduced into believing that it is wise to mortgage your future for an even more wonderful present. Fact is; these are the best times to save for bad times.

Eventually a hill will be crested that leaves nothing but a cliff in sight and if there is another hill in the distance the fog will be too thick too make it out. Phase II has begun.

During these times people have no trouble feeling fear and remorse but those feelings do them no good. If you’ve lost a job, you might conclude that no equivalent one exists to replace it, and you might be correct. People will switch from mortgaging their future to scrimping to make ends meet. Since no investment seems to pay a return, they stop investing and since nothing they do seems to work, they stop doing anything. These are symptoms of depression, both economic and emotional.

Eventually there comes a time when your investments do begin to pay off and success does depend on what you do. This is the beginning of Phase III.

How well your investments perform in Phase III depends on what you invested in during Phase II. You might object that during Phase II many people no longer have resources to invest. But, they have clear title to a brain and they own their own time. If nothing you do pays a current dividend then there is no opportunity cost to investing effort and time honing old skills and learning new ones.

The degree to which your efforts pay off depends on what you are capable of doing. What you are capable of doing in Phase III depends on what you were doing during Phase II.

Consider the story of how my grandmother and how she found amazing opportunity in the Great Depression that would have never presented themselves during normal times. You can read that story here: https://brookeallen.com/2008/04/01/great-depression-great-grandfather-great-grandmother/ and if you do then what follows will make more sense.

Out of necessity, my grandmother had become a real estate agent in the early 1930’s during a bad time to be one. Homes didn’t begin moving until the economy turned around, but when it did, she had mastered her craft, she had the prospects and she was on the job. Within seven years they owned a spectacular house of their own free-and-clear whereas had they used their meager savings to buy a house in 1928 then by 1937 they would be about 9 years into a 30 year mortgage and my grandmother would still be without a career — assuming, of course, they didn’t lose everything to the bank as did so many of their peers.

My grandfather kept his job at the United Press by volunteering for multiple pay cuts. Things didn’t open up for my Granddad until the environment improved, but when it did, he was there in the office with needed skills while others were still waiting things out.

If, during Phase I, you avoid having too high an opinion of yourself or too much confidence in the future but instead continue to evolve your skills and save for Phase II, then you will be better able to weather and adapt to hard times.

If, during Phase II, you continue to invest in yourself and work for the benefit of others even though your efforts are not immediately rewarded, then you will be in the best position to prosper when Phase III inevitably begins.

If you follow, believe in and espouse this Three Phase Theory, then:

During Phase I you will have been labeled a contrarian and a pessimist.

During Phase II you will have been thought a fool for working so hard without reward.

However, during Phase III, when prosperity seems to shine on you before others, you will be heralded as a genius and visionary.

It is what you do when it seems that nothing matters that determines your success later when you discover that it does.

[1] Note: The Yellow line (Japanese market) is the best illustration of my theory since Phase III doesn’t go down as far and is flatter after it stops rather than “bounces.”

I lived in Japan for Phase II and although the Japanese government tried to manipulate the market. I believe they succeeded in engineering a soft landing but they didn’t manipulate the market for a recovery, which I believe is wise.

In the 1920’s and 30’s (the Blue line) the market ran up just as much in the Roaring 1920’s as it did in Japan in the Roaring 1980’s. But the USA then fell more than Japan in the next few years and then government interventions helped with a recovery.

The Dot-Com bubble of the 1990’s was a bigger bubble than in the 1920’s and the collapse that started from the high in 2000 was more severe. While, in the lingo of so-called analysts, the collapse was a “correction” and the recovery from the low was due to “over-shooting” I believe the truth is that the so-called recovery is the beginning of another Phase I bubble rather than what some people call a “consolidation” and what I call Phase III.

If you want to experience the the the Red Line (Case Schiller Real Estate Index adusted for inflation) as a literal roller coaster ride then look at the Real Estate Roller Coaster video published in April, 2007. You can see it here: https://www.youtube.com/watch?v=kUldGc06S3U

This article was first published in May, 2008 in a publication called International Family Magazine that is now defunct. It is reproduced here with changes made over the years to correct typos and improve readability but the graph and the text describing the theory are unchanged from the original.

I formulated the theory in the 1980s and used it professionally and personally every since. At that time I was employed by Merrill Lynch in NY from 1986-87(Phase I) and kept my job through 1988-90 (Phase 2). Then I moved to Japan with Merrill and worked during Phase II there. I returned to the U. S. A. in 1993 during the depths of recession and bought a house for cash, which turned out to be perfect in retrospect since I timed Phase III within a few months of its beginning.

I was running a hedge fund during the dot-com bubble burst in 2000 and because of this theory we flourished when many peers went belly up. Like my grandparents we own two houses free-and-clear (one for weekday use near a good school and another in the country). There is no way we’d buy real estate during during what is obviously the beginning of Phase II.