Thursday, June 11, 2015

Spotting Turns in Market Cycles

This is the hypothesis I’m working under. To the well-read there’s nothing new here, and lots of market players probably already look at the world this way. But it took me a while to piece it together, as schools don’t teach this and you don’t get this type of stuff from reading Warren Buffett. 

First though, I want to address a common misunderstanding of credit and growth.

An Essential Point about Debt and Growth

I was reading an old economic report from Goldman Sachs by Andrew Tilton. In that report there is a sentence that stood out with its clarity of thought.

“…the growth rate of spending is related to the second derivative of credit – accelerating credit can fuel an increase in growth, but credit cannot accelerate forever, and when it begins to decelerate there will be a negative impact on spending growth.”

Everyone knows that spending growth can be driven by changes in credit – duh!? But that’s actually not exactly right. It’s really the second derivative of credit. There’s a subtle but incredibly important difference here - one that most people have a hazy understanding of (including myself until recently). That lack of clarity shows up when people talk about the world’s high level of debt, and they say something like this: “You can’t cure debt with more debt. Forget about actually pay down debt, how about just stop borrowing for a start? Is that too much to ask?”

Let’s walk through this with a simple example. Let’s simplify and say the whole nation is just one person. Let’s say I want to buy some fancy car for $100k. I don’t have the money, so I borrow $100k and buy. GDP for that year is $100k. Next year though, if I don’t do anything – not paying down debt or increasing debt), GDP naturally goes down to $0! In order to keep GDP flat, I’d have to borrow another $100k to buy another car– doubling my debt just to have 0% GDP growth.

This is what Goldman means by spending growth being related to the acceleration (2nd derivative) of credit, and not just changes (1st derivative) in credit. That is the tyranny of debt addiction. GDP growth could go negative just from people borrowing less than before (in the above example, say I only borrow and spend $50k in year 2, then GDP is down 50%).

Per Federal Reserve data, U.S. total credit market borrowing (SAAR) was $2,472bn in 4Q14. GDP was $17,701bn for the same period. So new borrowing contributed to ~14% of the GDP. If everyone stops borrowing, GDP would take a 14% hit. We would have massive unemployment and social unrest.

That’s just not an option. So the sensible way to “deleverage” is not to decrease the level of outstanding debt in absolute terms. But rather to INCREASE debt at a slower rate, and try to increase income at a faster pace, so that both debt and GDP increase in absolute amounts, but the ratio of Debt/GDP declines. In this sense, we have no choice but to “cure debt with more debt”


So what does that have to do with investments? In my last post I mentioned Kostolany’s explanation of how liquidity drives broader markets. But he gave little guidance on when that would happen. Ray Dalio though, has a framework on the typical deleveraging processes and when central banks need to provide liquidity to the market. Combining the two frameworks should us a better sense of credit cycles and turns in the equity market.

I read Dalio’s writings on credit cycles a long time ago but did not understand it completely. Turns out understanding the above dynamics of debt and GDP growth was the missing piece – particularly the “why” behind various government’s alternatives. I went back and re-read his stuff and everything became clearer this time around.

In his paper “An In-Depth Look at Deleveragings”, Dalio mapped out the typical steps to deleveraging. In the first phase of deleveraging, debt growth either decelerates or turn outright negative, and countries attempt to cope via some form of austerity. Debt to GDP ratio will go up mostly because of declines in GDP. In the second phase, austerity and resource transfer reached its limits, and central banks are forced to pull the monetary policy lever and pump some liquidity into the system.

That’s when the stock market will take off despite the weak economy. The increased liquidity mostly goes to juice up the financial markets first, since people still lack confidence in the real economy.

So here are the big picture steps: Watch out for countries that are in the start or middle of deleveraging. Ideally you find a country that had explosive growth in Debt/GDP ratios and then a subsequent deceleration of debt which triggers a deleveraging cycle. Follow that deleveraging cycle and wait for central bank to print money – that would be time to play the stock market.

Appendix: Where is the U.S. in the Cycle?

Where is the U.S. in the long term cycle? The blue line in the chart below shows nominal Debt/GDP levels. The takeaways are 1) the U.S. went on a debt binge starting late 1970’s, so it’s possible that much of our GDP growth the past 40 years are just a debt fueled mirage. 2) The Great Financial Crisis was the first time we deleveraged to any material extent since the 1940s’. 3) Despite the deleveraging since 2008, debt/GDP is still at an extremely high level. 4) the pace of deleveraging has slowed and we actually have signs of re-leveraging.

My data does not go back to show the Great Depression. But per Dalio’s data, Debt to GDP went all the way from 155% in 1930 to 252% in 1932, then down to 168% in 1937. That’s a much greater swing of leverage levels – one that probably contributed to the rise of Hitler and World War II.

Given the still high level of debt and the deflationary forces of any potential deleveraging, as well as the already high P/E levels, I have to agree with the common notion that equity markets are in for long years of low returns ahead.

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