Cycles Matter.

In July, I sent that tweet because it was pretty clear that my fear that 2015 would mark the top of the #Cycle had come true.

Unfortunately, since then, the theory has continued to play out as expected and in the early days of 2016, my expectations that equities will be down more than 20% this year seem likely to be accurate.

I’ve written a bit about my theory about the credit #cycle openly on Twitter for a long time. Feel free to peruse the hashtag, but I haven’t written about it much here because it kinda sucks and is a downer.

I believe that Progress is Inevitable in the long run, and so I spend most of my time focused on helping to make that reality arrive faster.

That said, given that Cycles Matter, and many people seem interested in what I have to say about this, I figured I would write a bit about it here.

(I’ve been sharing details about my view of the markets in my Odin River newsletter since March, which I hope to make public soon).

So what do I mean by “Cycles Matter”?

default rates over time

This picture might be the important picture in the financial markets.

The simple idea it encapsulates is that as time goes on, defaults (here measured in the corporate bond market) rise and fall, and as they do, the bond markets rise and fall.

The reason this is so important is that when bond markets fall, that means that equity markets must also fall. This is based on the simple fact that equity is junior to credit in the capital structure of companies. If the value of the credit is lower than 100%, in theory that means the equity should be wiped out (of course in reality sometimes that isn’t always the case).

Since the 1990's as the credit markets have fluctuated, so too have the equity markets and in the 2000’s this led to big booms and busts in the overall economy as credit binges led to a housing boom and bust (as well as the related consumer and corporate credit booms and busts).

Prior to the last crisis, I was at Harvard doing my JD-MBA, and working for Elizabeth Warren on Consumer Bankruptcy stuff and blogging about the oncoming collapse at Paranoid Bull. At that time, it was crystal clear that housing was going to be the catalyst for the contraction and it was.

Following that crisis, the Fed intervened by saving the credit markets through reducing interest rates to zero and other measures. Thus, when I joined Paulson & Co. to do distressed investing the markets were recovering, and I “rode the upcycle” as the credit markets recovered.

During the last 7 years since 2008 as you can see in the graph, defaults have been almost non-existent as interest rates have been near zero and the economy has expanded.

This led to the great result that the U.S. Economy has recovered, unemployment has fallen, and Progress has accelerated in the form of many new startups emerging, including Artivest, which I left Paulson & Co to help build. I did that partially as an expression that I was optimistic about the long-term of Progress and as an expression of where we were at the time in the cycle — early stage companies levered to equities benefit in upcycles.

In any event, as you can see on the right hand side of the picture, defaults have started rising again and as a result, defaulted corporate bonds sold off last year, posting their worst year (negative 40%) since the last crisis.

Unfortunately, this means that the equity markets will almost certainly follow. This also likely means that liquidity more generally will become harder to come by as falling markets leads to pessimism, which leads to risk aversion and so on.

The pro-cyclicality (or “reflexivity”) of markets works in both directions and sadly as this part of the #cycle (which I call the “contraction”) accelerates, that should cause the prices of most securities to decline across markets (including many private securities, especially at later stages).

So what should you do about it?

This is the hard part and what I’ve been saying publicly on Twitter for awhile is:

Cash is a reasonable option because it avoids the volatility of the financial markets.

I wish that there was an easy answer beyond that, and I’ve been working hard since leaving Paulson & Co., to try to help upgrade the way financial markets work to provide more access to great investing (that’s why Artivest exists). It is also the long term motivation behind Odin River.

Thankfully companies like Wealthfront, Betterment, Vanguard and others have been bringing low cost investment options to people to avoid the over-priced nature of underperforming mutual funds and financial advisors.

Unfortunately, when the Cycle turns like this, I’m concerned that these passive investing approaches won’t work. The prices of securities tend to decline across asset classes when things turn, which is why I default to cash. (The other option is a portfolio that is net-neutral to net-short, which is extremely difficult to do and inadvisable to non-professional investors in my opinion; even the very best investors struggle to do this well).

The key thing to remember in my opinion is to be careful. Risk exists, it has always existed and it always will. Even governments can’t eliminate it simply because they want to — we see that in China today.

I’m sorry to be such a downer and to write about this part of it — trust me, I much prefer to focus on the bright side. I also hope this is totally wrong and this cycle is different. That would be awesome!

But some people have asked me to share this thinking more publicly and so hopefully this is helpful to some of you.

I’m glad to share more anytime (and do on Twitter probably too much :-)).

Please don’t hesitate to let me know how I can be helpful.