The latest letter from Howard Marks of OakTree Capital succinctly describes why the business cycle can be so volatile and why crises generally occur – the mixture of leverage and psychology create broad swings like that of a pendulum.  Howard Marks describes this as follows:

“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. . . . This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the ‘happy medium.’”

But it is not just psychology that causes these wide swings.  It is the optimism or pessimism that gives investors the confidence or discouragement to use leverage:

“In “The Happy Medium,” I discussed the workings of the credit cycle in creating market extremes:

Looking for the cause of a market extreme usually requires rewinding the videotape of the credit cycle a few months or years. Most raging bull markets are abetted by an upsurge in the willingness to provide capital, usually imprudently. Likewise, most collapses are preceded by a wholesale refusal to finance certain companies, industries, or the entire gamut of would-be borrowers.”

I view the economic cycle like a battleship moving through rough seas.  It might feel volatile on deck, but the truth is that the economy is a massive, slowing moving, cyclical beast that exists on a playing field that is much larger than the one we view on a daily basis.  Marks describes how this cycle can expand and contract over time:

“Then, in “You Can’t Predict. You Can Prepare.” I described this expand-and-contract process in detail, along with its ramifications:

·   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 share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.

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 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, if anyone.

·   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.

Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled. . . .

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.

The bottom line is that the willingness of potential providers of capital to make it available on any given day fluctuates violently, with a profound impact on the economy and the markets. There’s no doubt that the recent credit crisis was as bad as it was because the credit markets froze up and capital became unavailable other than from governments.”

The effects of this cycle are much more broad:

“The section above describes how the capital cycle functions. My goal below is to describe its effect.

From time to time, providers of capital simply turn the spigot on or off – as in so many things, to excess. There are times when anyone can get any amount of capital for any purpose, and times when even the most deserving borrowers can’t access reasonable amounts for worthwhile projects. The behavior of the capital markets is a great indicator of where we stand in terms of psychology and a great contributor to the supply of investment bargains. (“The Happy Medium”)

An uptight capital market usually stems from, leads to or connotes things like these:

·   Fear of losing money.

·   Heightened risk aversion and skepticism.

·   Unwillingness to lend and invest regardless of merit.

·   Shortages of capital everywhere.

·   Economic contraction and difficulty refinancing debt.

·   Defaults, bankruptcies and restructurings.

·   Low asset prices, high potential returns, low risk and excessive risk premiums.

On the other hand, a generous capital market is usually associated with the following:

·   Fear of missing out on profitable opportunities.

·   Reduced risk aversion and skepticism (and, accordingly, reduced due diligence).

·   Too much money chasing too few deals.

·   Willingness to buy securities in increased quantity.

·   Willingness to buy securities of reduced quality.

·   High asset prices, low prospective returns, high risk and skimpy risk premiums.

The point about the quality of new issue securities in a wide-open capital market deserves particular attention. A decrease in risk aversion and skepticism – and increased focus on making sure opportunities aren’t missed rather than on avoiding losses – makes investors open to a greater quantity of issuance. The same factors make investors willing to buy issues of lower quality.

When the credit cycle is in its expansion phase, the statistics on new issuance make clear that investors are buying new issues in greater amounts. But the acceptance of securities of lower quality is a bit more subtle. While there are credit ratings and covenants to look at, it can take effort and inference to understand the significance of these things. In feeding frenzies caused by excess availability of funds, recognizing and resisting this trend seems to be beyond the majority of market participants. This is one of the many reasons why the aftermath of an overly generous capital market includes losses, economic contraction and a subsequent unwillingness to lend.

The bottom line of all of the above is that generous credit markets usually are associated with elevated asset prices and subsequent losses, while credit crunches produce bargain-basement prices and great profit opportunities.”

So you can see why this most recent cycle has been so volatile.  We have had record levels of leverage and debt across many parts of the global economy.  Part of the stabilization process in laying the foundation for the next great economic boom is allowing these excesses to clear.  If you have ever wondered why we experienced nearly 50 years of uninterrupted boom following the Great Depression look no further than this clearing process.

What I fear most about the current cycle is that we have not allowed the markets to sufficiently clear.  If that is the case you can think of the global economy like an obese man who fights to lose weight in an effort to fend off what is an almost certain heart attack.  After a multi decade binge he suffers a massive heart attack (think LTCM circa 1998).  The doctors save him by intervening, but they don’t actually help the man fix his inherent problems (dying internal organs and lack of discipline).  In the case of the economy this is global imbalances, structural flaws in the banking system and a lack of regulation.  The man vows to lose 50% of his total body weight, but after losing 20% of his total body weight he decides the process is too grueling and is taking too long.  A fast food restaurant opens up next door (hello government bailouts!).  He once again feels the need to stimulate his lust for food.  So, he binges again (think Greenspan 2001).  A new boom occurs before he ever becomes fully healthy.  Over the ensuing 7 years his body weight doubles.  He’s now 60% heavier than he was in 1998!  Of course, this is unsustainable.  His body begins to breakdown.  Before you know it he is suffering a total system failure (think Lehman brothers).  But again, thanks to modern medicine (or incessant Fed intervention) the man is once again saved.  Over the following year he loses 25% of his body weight.  It’s an arduous process and certainly not enjoyable, but it must be done.  The good news is he’s 25% lighter.  The bad news is he’s 20% heavier than he was in 1998 when he had his first setback.  Nothing has changed inherently.  He has the same failing internal organs and the same failing disciplines.   But his next binge begins from a weaker starting point and a more dangerous level. You can imagine how this story ends.

There is vast improvement off the 2009 lows.  There is simply no denying that.  The recession is over, but the balance sheet recession continues.  The economy is growing.  Our obese man looks healthier.  But is he healthier than he was in 1998?  Most certainly not.  After all, what has really changed?  Or have things actually gotten worse?  He has the same failing disciplines and the same fatal imbalances.  The cycle continues…..

Source: OakTree Capital

Cullen Roche

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