A Primer on Cycles
The word “cycle” is one of the most widely used terms in economics and investing. Cycles are also one of the few things you can count on in any investment landscape and are among the most influential forces on dramatic changes in securities prices.
Most people just think of the stock market when they think of a cycle, but there are multiple different cycles working in concert that should be considered on their own and together when assessing where we as investors might stand in a market cycle.
I’m not an economist, and I’ll never try to predict where the current cycle is going, or how far. I do think it’s helpful to study characteristics of past cycles to observe where we stand and prepare the best we can.
Most of the material that follows comes from the ideas in one of my favorite books, “Mastering the Market Cycle” by Howard Marks along with his various memos over the years. In the book, Marks discusses the different types of cycles, how they interact, and the best ways to benefit from them. Here I’ll focus on the cycles that are relevant for most investors and draw some conclusions from each.
The Economic cycle
The foundation on which all cycles are built is the economic cycle, primarily comprised of GDP growth. The U.S. economy generally grows low-single digit percentages each year with 4 or 5% growth being a great year and modest contraction representing the occasional recession. Economic growth is largely fundamental in nature and is driven by measurable factors like birth rates and productivity gains across all labor force participants. Each year, hours worked and output per hour (productivity) are measurable and do not change widely year-to-year, resulting in reasonably steady overall economic growth.
The Profit Cycle
The cycle in corporate profits is the next layer built upon the foundation of the economic cycle. Company profits deviate more than underlying economic growth because of one reason – leverage. Leverage takes two forms, operational and financial.
Just about every business has fixed and variable costs. Businesses with higher levels of fixed costs earn higher profit margins as revenue increases as those fixed costs are spread across higher revenue levels. In other words, more dollars drop to the bottom line when revenue increases than if costs were strictly variable. This is called operating leverage and it’s one primary reason why corporate profits grow and shrink to a greater magnitude than revenue and GDP.
The second form of leverage is financial leverage, or debt. Businesses that are financed partially with debt experience the same effect as operating leverage as debtholders occupy a senior position compared to equity investors. This means that any losses are born by equity holders until the equity is totally wiped out, at which point debt holders would take losses. It also means that when profits are rising equity holders enjoy the upside gains whereas debtholders simply receive the same agreed upon interest payments. Financial leverage is just another fixed cost used to finance a business that magnifies gains and losses just like operating leverage.
Some businesses profits are very responsive to small changes in economic activity. Luxury items, commodity prices, and “big ticket” items like homes, cars and vacations can experience extreme swings in demand given small changes in economic levels. Other items fluctuate far less, like medicine, food and beverages, and haircuts. This dynamic is another contributing factor to why some businesses profits swing more than underlying GDP.
The dynamics of corporate profits, economic growth, industry sector, and leverage are highly imperfect but roughly right as the economy ebbs and flows.
Despite the effects of leverage, corporate profits in aggregate still deviate relatively modestly year-to-year. So why do securities markets soar and crash with great regularity (both inter and intra-year). Consider the last three years alone:
In December of 2018, the stock market fell 11% – the worst December since the great depression.
In 2019, stocks rose more than 30%.
In early 2020, stocks fell 30%, only to end the year up 18%.
Obviously, the underlying value of corporations in America did not swing nearly as widely during these periods.
If the economy and corporate profits generally oscillate between “pretty good” and “not so hot”, why do securities markets seem to oscillate between “flawless” and “hopeless”? It largely boils down to psychology and availability of credit.
The Psychological and Attitudinal Cycle
Economic trends underpin investor sentiment. At the beginning of a cycle, positive economic developments lead to increased optimism among market participants. This leads investors to increase tolerance for risk and demand correspondingly skimpier risk-premiums (i.e. they’re willing to pay more for stocks and other securities). The reduction in risk premiums and increased demand for risk assets causes prices to rise.
This process repeats as more economic good news rolls in. Investors gain confidence on the backs of rising prices, retail investors watch their friends get rich, and more capital flows into securities markets. Eventually, the focus shifts away from not losing money to a myopic focus on further gains. As Marks observes, the greatest harbinger of risk, and subsequent declines, is widespread risk tolerance and high degree of investor comfort with risk. If this doesn’t sound familiar in certain parts of the market today, then I’d have to argue we are looking at things through a different lens.
Most market participants are wired in such a way that the more prices rise, the better they feel. This is of course backwards and as valuations incorporate rosier assumptions risk is higher and prospective returns are lower. As we’ve written before, this doesn’t require “getting out”, moving to cash, or other extreme actions when markets have risen appreciably. It does at times warrant more caution and careful selection of investments.
The psychological cycle eventually reverses and the positive feedback loop that worked in investors favor on the way up is perpetuated in the other direction on the way down. When economic data eventually turns less rosy (or some unforeseen outside shock like a pandemic arises) prices fall. Investing quickly becomes associated with loss, especially for new investors who have not invested during a downturn, or who don’t understand what they own. Avoidance of further pain becomes more important than missing out on potential gains. No investments offer an adequate margin of safety for many investors, and they simply get out because they can’t stand the thought of watching their portfolio decline further. It’s at times like this when risk is lowest and prospective returns are highest across asset classes. Unfortunately, most investors are worry warts at times like this and refuse to deploy capital at the best time.
The takeaway from studying the attitudinal cycle is that investing successfully over the long term is not about being optimistic or pessimistic, it’s about being skeptical. Skepticism means exercising caution when optimism is excessive but also exercising optimism when caution is excessive.
The Credit Cycle
People tend to think about equity cycles and bubbles, but as Marks says, “the slammed-shut phase of the credit cycle probably does more to make bargains available than any other single factor”. It’s thanks in large part the credit cycle that exacerbates moves in securities prices far in excess of the underlying business fundamentals.
The credit cycle is another way of describing the availability of credit, or debt, to businesses and individuals. Why is this so important?
Credit is one of the most essential ingredients for companies and economies to grow. When the capital market is closed, it is hard for most to finance growth and spending of all kind grinds to a halt.
Second, credit needs to be available to refinance loans coming due that can’t be repaid in one balloon payment, which is almost always the case. If debt is due and it can’t be rolled over, bankruptcy is on deck.
Further, corporate assets are usually long in nature – investments in R&D, infrastructure, machinery, goodwill, etc. – take years to produce earnings. They’re often financed with shorter term debt because rates are the most attractive, known as “borrowing short to invest long”. This usually works well as long as the credit window is open, but it means the debt has to be rolled over frequently. When the credit window shuts and short-term borrowing can’t be rolled over, it spells trouble for those without strong balance sheets and exacerbates swings in securities prices.
It’s for these reasons credit is so important, but why does the credit window tend to open and slam shut instead of gradually opening and closing? The answer can be traced back to psychology.
Perhaps nothing causes fear to spread faster in financial markets than a closed credit window, which is why when economic clouds darken and lenders begin to tighten modestly, the availability of credit disappearing can become a self-fulfilling prophecy. In summary, difficult business conditions cause capital markets to tighten, tight capital markets have a negative impact on businesses, which causes the credit window to tighten further, and so on until before you know it no one is willing to lend and even the most credit worthy borrowers have trouble finding credit. This happened in 2008 and again, briefly, in March of 2020.
Just like the other cycles, it’s at the moment the credit window is shut that the best bargains appear and investors can shift to full aggression. Much of our portfolio is in non-cyclical businesses at present, but we keep a “wish list” of somewhat more cyclical businesses we hope to buy at fire sale prices (just like last March) the next time the credit window slams shut – and there will be a next time.
Real Estate Cycle
The real estate cycle shares many of the same elements as other cycles: positive returns in areas of the real estate market lead to optimism and increased activity. Increased activity fuels rosier assumptions, greater assumption of risk, and shrinking risk-premiums for new developments. Lower demanded risk premiums mean higher asset prices and greater risk-bearing. This continues until things go too far and prices rise too high, when a correction occurs.
The major differentiating factor in the real estate cycle is the long lead time that development projects take. Large real estate projects can take years or even a decade plus to plan, design, evaluate environmental impacts, zone, and build. Market conditions can change rapidly in the meantime. When a downturn occurs it can take years for improved demand to sop up the excess supply that was built up during boom times, putting extreme downward pressure on real estate prices and perpetuating the downward cycle.
In the 1970’s, steel skeletons littered Los Angeles when the developers enamored with the 1970’s boom initiated projects just before the early 1980’s economic contraction hit. Many real estate developers went bust and buildings stood unfinished for years. There were some beneficiaries. Investors and lenders who avoided lending on the riskiest projects based on too positive of assumptions withstood the real estate bust. When the dust settled they were able to purchase busted developments for pennies on the dollar, leading to strong investment returns when demand returned and the excess supply was finally absorbed.
The Market Cycle
Each of the cycles described above come together in the equity markets making it easier to understand why the stock market, and individual stock prices, can do crazy things over short periods of time.
In summary, equity markets move drastically more than the economy as a whole and underlying corporate fundamentals because of the influence of various forms of leverage and psychology.
A simplified cycle might progress as follows over the course of several years. The economy is growing modestly, and corporate profits are improving slightly faster thanks to operating and financial leverage. Wall Street and the media report mostly good news and investor sentiment improves. The stock market rises, drawing in more buyers as they see others making money. Big ticket purchases begin to pick up, home prices rise, and commercial real estate development demand increases.
In response to increased demand for credit, banks provide looser credit with lower rates and relaxed covenants. This in turn feeds greater demand for credit, and more competition between banks. Credit expands throughout the market, including in retail investors taking on leverage to buy increasingly expensive stocks. At this point everyone assumes everything will get better forever and stocks and other assets only go up (sound familiar?). Risk is now high in areas of the market.
Eventually, corporate profit growth slows, or goes negative. Media reports turn pessimistic, and markets weaken. Marginal sellers outnumber marginal buyers and investors become depressed. The negative cycle of selling feeds on itself and markets decline more. Real estate developers begin defaulting on abandoned projects and highly leveraged companies are forced to restructure or go bankrupt as the credit window suddenly slams shut. Investors are only focused on avoiding further losses and “get out” as the stock market craters. Now is the time for aggression when it seems risk is omnipresent and pessimism dominates optimism. Things gradually improve and buyers reenter the market and the cycle starts again.
Takeaways
The reason I study these aspects of cycles is two-fold. First, as investors its not our job to predict the general market or economy, but it is our job to prepare. Understanding how investors and lenders are behaving in the stock, credit, and real estate market can provide clues as to where we stand and how much optimism is baked into security prices. It helps direct the level of caution or aggression at any given time and how we position our portfolio.
Second, the same aspects of general cycles can be applied to individual securities. Even if the general attitude in the market is sanguine, investors often unreasonably punish individual businesses or overemphasize risks by discounting stock prices too heavily due to short term challenges. I view these as a cycle within an individual business and you can find any number of these situations at any given time.
There’s a lot more to cycles than what I’ve described. I think of this as a primer to the various cycles, how they interact, and how to spot signals that may help with risk positioning. For those interested, I’d highly recommend Marks’ book that expands on each of these areas, and more, in lucid detail.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.