The article appearing in The Weekly Commentary last week resulted in an unusually large amount of interest. It described how the equity/credit cycle works. So, I reprinted it and developed a series of FAQ’s based upon the questions I received.
I read a very interesting discussion about how the equity/credit cycle works:
1. After a washout, valuations are low and momentum is lousy. People/Institutions are scared to death of equities and any instruments with credit exposure. Only rebalancers and deep value players are buying here. There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks. Liquidity is at a premium.
2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten. Equities may have rallied some, but the move is widely disbelieved. This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.
3. Slowly, but persistently the equity market rallies. Momentum is strong. The credit markets are quicker, with spreads tightening to normal-ish levels. Bit-by-bit valuations rise until the markets are fairly valued.
4. Momentum remains strong. Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures. Liquidity is cheap, and only rebalancers are selling. (This is where we are now.)
5. The market continues to rise, but before the peak, momentum flattens, and the market meanders. Credit spreads remain tight, but are edgy, and maybe a little volatile. This is usually a good time to sell. Remember, tops are often a process.
6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue. Some think that the problem is an isolated one, but search begins for where there is additional weakness. Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high. A few institutions and investors fail who you wouldn’t have expected. Momentum is lousy. We are back to part 1 of the cycle. Remember, bottoms are often an event (Source: David Merkel).
FAQ’s
1. Q: Does the cycle always work as described?
A: No. Unexpected events (either favorable or unfavorable), sometimes called “Black Swans”, can derail the cycle. Examples of such an event are 9/11 or adoption of the internet.
2. Q: Is this cycle widely accepted by economists?
A: This description is not universally accepted by economists because it is based upon David Merkel’s statistical observations instead of an econometric model.
3. Q: Who is David Merkel and what is his background?
A: David is a CFA (Chartered Financial Analyst) and a FSA (Fellow of the Society of Actuaries) which indicates a strong analytical capability. David appears to possess a keen insight into how to earn money without undue risk.
4. Q: Is this a signal or warning?
A: Yes and No. The equity/credit cycle matches up with The Weekly Commentary’s view which is the markets are currently favorable with the normal amount of risk; BUT, investors are warned that steps 6 and 7 are coming.
5. Q: How long will we remain in the current position within the cycle?
A: David Merkel does not predict this and it is very difficult to do so. The Weekly Commentary has been warning investors that step 6 will occur in 2015, plus or minus 2 years.
6. Q: What specific investment advice should one take from this analysis?
A: We recommend investors maintain their long term asset allocation at this time. But, investors’ portfolios must develop the ability to be nimble to reduce downside risk when steps 6 and 7 occur.
The Weekly Commentary
Observations of the current state of the stock and bond markets
