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Being Attentive To Cycles
This section is primarily from the November 20, 2001 memo “You can’t predict. You can prepare.”
Remember that just about everything is cyclical.
Two concepts we can hold to with confidence:
- Most things will prove to be cyclical.
- Some of the greatest opportunities for gain and loss come when other people forget rule #1.
When people are involved, results are variable and cyclical.
When things are going well, people spend more and save less.
Trends create the reason for their own reversal.
Success carries within itself the seeds of failure, and failure the seeds of success.
The Credit Cycle:
The credit cycle deserves special attention for its inevitability, extreme volatility, and ability to create opportunities for investors attuned to it.
The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.
The credit cycle process:
- The economy moves into a period of prosperity.
- Providers of capital thrive, increasing their capital base.
- Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
- Risk averseness disappears.
- Financial institutions move to expand their businesses – that is, to provide more capital.
- They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.
When this point is reached, the up-leg described above is reversed.
- Losses cause lenders to become discouraged and shy away.
- Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
- Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers.
- Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
- This process contributes to and reinforces the economic contraction.
Cycles are self-correcting. Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.
Investors overvalue companies when they are doing well, and undervalue them when things get difficult.
It is dangerous when the market is at record highs, to reach for a positive rationalization that has never held true in the past.
Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.
Jeremy Silva
Jeremy Silva lives near San Francisco with his wife and son. He is a writer, blogger, and personal investor. He is passionate about education, personal development, project management, and investing. His blog has over 100 book summaries on many topics including investing, self-help, and business. You can click on the link to read some interesting book summaries on Jeremy’s website (https://jsilva.blog/book-summaries/).