Now Its Open, Now It Isn’t
As investors, it is important for us to understand that markets are affected by developments in a lot other areas in the investment world such as economies, businesses and investor behaviour. But, markets are more severely affected by developments in one area above all else. I'm talking about the credit available or lending behaviour in the economy. This is also known as the credit cycle. And this post is going to talk about why the credit cycle in the economy has such a strong bearing on where the markets go, and how the credit cycle brings about fluctuations in the markets and the economy as a whole, at a particular point of time. It will also touch upon why we need to pay attention to the credit cycle and it's movements, and how we can use these movements to our advantage.
Before delving into the main subject of this post, we first need to understand the pattern of movement of most things in the investment world such markets, economies, businesses, investor behaviour and yes, even the credit cycle. The movement pattern that one can observe in most of these fields is similar to that of a pendulum swinging about its own arc. Now, if we were to observe the movement of a pendulum, we would see that it usually swings from its mid point to one extreme point in its arc. And the momentum from this swing usually pushes it back to the mid point and further to the other extreme point in its arc. For a better understanding, look at the diagrammatic representation given below.
So, as should likely be clear from the representation given above, the pendulum spends very little time at its mid point and most of its time at its extremes. And this is no less true for various aspects in the investment world and the markets themselves. The markets are made up of, and driven by people who are capable of being swayed by emotions. This sees markets spending much more time at its extremes than it does at its rational midpoint. And one of the major factors that causes extremes (both positive and negative) in the markets and the investment world, is the credit cycle.
Understand first, that credit and the availability of money in the financial system is the lifeblood of the economy. If money is abundantly available, the economy grows and does well. If money is scarcely available, the economy slows down and it may even come to a standstill. The interesting thing is, the availability of money and credit in an economy is like a window that can be wide open in one instant and slammed shut the next. So availability of money does not stay stable and constant for long periods of time. But that is not the issue here. The issue is that the credit window opens up and money becomes more readily available and accessible when the economy is doing well. To call this an issue and a concern may sound counterintuitive at first glance, but look at it this way. In the financial world, if someone is willing to provide cheap capital and easy money, they will find many more borrowers who will borrow buy and build - often without discipline, and with serious negative consequences. And at the positive extremes of market cycles, lenders and providers of capital (i.e banks and financial institutions) are eager to lend as much as possible, as quickly as possible. This causes them to turn a blind eye to concepts such as risk and prudent lending (meaning lending only to those borrowers who are capable of paying back their dues). Ultimately banks and financial institutions become ever more than willing to finance projects of lenders who don't deserve to be financed in the first place. This ultimately leads to capital destruction and stunts the growth of the economy. And this is only obvious. When the cost of capital exceeds the returns that are generated on that capital, the most likely outcome is that there will be no return OF capital. For example, assume I avail a loan at an interest rate of 8% annum and put that money into an investment that yields just 6% per annum. In such a case I would be losing 2% of my capital per annum, because the returns generated by my investments would not be enough to match or outstrip my annual interest payments.
In fact, in most cases, over permissive providers of capital aid and abet financial bubbles. This is justified even more by the fact that an analysis of every economic or financial crisis in the past, would show that a lender or a financial institution is invariably involved in some way, shape or form. Take for example, the Global Financial Crisis of 2008, where the collapse of Lehman Brothers, one of the largest investment banks in America was at the centre of the crisis. Or more recently in 2018 in India where we needed to have Infrastructure Leasing and Financial Services (IL&FS), a leading financial services organisation saved and restructured in order to avert a crisis that had already started brewing.
In other words, the easiest way to understand the lending cycle in the economy is as follows : Prosperous times lead to increased lending, which leads to unwise lending, which creates huge losses and in turn ends the period of prosperity. And when that happens, markets and the economy come to a screeching halt. Lenders who until now were more than willing to part with their funds, suddenly make them available to a selected few who are backed by a spotless reputation. And even when funds are made available to them, they are made available at a premium and the money comes with a number of highly restrictive conditions attached. All of these factors combine to wreak havok in the minds of investors, causing them to display a lack of emotional and behavioural fortitude, and run for cover.
Having understood how the credit cycle works and the repercussions it can have, let us now understand what we can take away from the action in credit cycles as investors. We must first understand that superior investing comes not from buying the best assets, but from buying them when the price is right, the risk is low and the potential returns are high. And this is possible only when the economy has come to a halt and everyone around is losing their sanity envisioning a future where doom is imminent. In other words, the greatest investment profits and bargains pop up when capital is scarcely available in the economy, because it is only at such times that nobody would want to participate in markets. And everybody refrains from participating in the markets at such times because they would be convinced that there is no hope for their money and investments. This in turn allows asset prices to fall to dirt cheap levels, thus increasing their potential returns exponentially.
At the same time investing in an asset or a field into which everyone is throwing money mindlessly is a fool proof formula for financial disaster. Also, there is a belief among some investors that money can easily be made in the markets using borrowed funds irrespective of the cost of such funds, when markets and credit cycles are at their positive extremes. This is one of the biggest examples of a departure from sanity and rationality. Because, the thumb rules governing every market cycle are as follows : the greater the boom - the greater the excess in the upward direction - the greater the eventual bust. So the more reckless we are with our investments during good times, the more we will suffer during bad times.
In the end, when making investments, we must worry less about the economic future and more about the ease with which capital is available in the economy. Because the greater the ease with which capital is available, the more likely we are to abandon caution and be reckless with our investments and lose money on them. Therefore, we must always pay close attention and be attuned to developments in the credit cycle and the impact those developments have on the markets. Doing this will not tell us what will happen next. But it will allow us to think systematically and draw inferences which would tell us what is more likely to happen and what is less likely to happen next. And this in itself, would give us a great advantage on our investment journeys.
