We are currently living in an extraordinary time. Three years back the world was shaken by a pandemic that forced people to stay inside, keep their businesses shut and mourn lost lives. With time we figured a way to gradually get back to normal. Billions of people got vaccinated. People started going out. Businesses started running as usual. But we truly did not get back to normal. Many economies around the world were still struggling to recover from the shockwave. Supply chain was disrupted. Suddenly there was surge in demand worldwide but not enough supply. Prices shot up from the bottom. Then Russia invaded Ukraine causing another major blow to the already wounded supply chain. Fuel price skyrocketed, wheat price broke record, a new kind of crisis emerged. We saw zero interest rate and record level money printing from the big economies. From there we are now experiencing inflation at a new high. Central banks all around the world are now raising interest rates at a pace never seen before to regain price stability. Now in a recent turn of events we are seeing commodity prices cooling down. It's not there yet but things seem to reverse.
These all happened in a span of two to three years. And what does it tell you? Things change. The world moves into a new sets of orders. And then it doesn't stay the same either. Nothing is permanent. In the book titled "Richer, Wiser, Happier" by William Green, I was reading the chapter on Howard Marks. That chapter is titled "Everything Changes". Howard Marks studied Japanese Literature as his minor in his undergraduate program. There he encountered the Zen concept of mujō which means impermanence. Howard Marks explained how this ancient idea shaped his philosophy of investing and life.
Howard Marks
The world doesn't move in a straight line. If it did so, it would have been easier for us to live. And for an investor, there wouldn't be any alpha to generate if everyone knew what would come next. Nobody would bother to beat the market. But the world is unpredictable. What you see now is bound to change. And if you get carried away by the euphoria of the crowd or the panic of the herd, you are most likely to get into trouble.
The world moves in cycles. With every boom there is a bust to follow. Instead of predicting the future which in and of itself is a risky venture, a better way to look at it would be to understand what the present market tells you. If there is too much euphoria, be in doubt and if there is too much panic, try to find some bargains. We may know the nature of the cycle but it's hard to know when the cycle will turn. The best course of action is to get a sense of where we stand in the cycle and deliver a response that best serves our interest.
From the book Richer, Wiser, Happier by William Green
For me to live in a world of uncertainty and to know that there are some patterns that always seem to emerge in cycles is something that gives me comfort. But it’s not easy to detect the peak or bottom of the cycle. We can only try to make sense. It requires a lot of experiences and strong sense of how the world works.
But what really is a cycle? Economies, industries, businesses - all move through a certain trend. There is an inherent secular trend embedded in all of these which we can think of as a moving midpoint. Cycle happens because economies, industries or businesses don’t move in linear fashion rather they sometimes move above the midpoint and sometimes they move below the midpoint.
When it reaches the peak of the cycle, well above the midpoint, it usually reverses to the midpoint and in most cases it doesn’t settle in there rather it moves past the midpoint and continues to move down until it finds a bottom and then it reverses upward and the cycle continues.
Take for example the private sector credit growth trend of Bangladesh. If you look at last eight or ten years of private sector credit growth, you will say the average growth rate has been on an average 13.0% which we can think of as secular trend of private sector credit growth of Bangladesh which is also very close to nominal GDP growth rate of Bangladesh. Even though it’s a short time frame for understanding cycle, you will find nature of cycle in this trend. From 2013 to 2015 the monthly credit growth was flat at range of 11-13% until it started picking up. Then in 2016-17, it went up to as high as ~19.0%, much higher than the midpoint. Afterwards, it stayed close to that level for awhile and then reversed. It dropped to as low as ~9.0% even before pandemic arrived in 2020. This low point was also far below from the mid point. And then we saw the credit growth picking up before it reversed again.
In cycle, we find a symmetry of uptrend and downtrend in terms of direction. But you will hardly find symmetry in terms of time or pace. It can either go up very slow and go down very fast or vice versa. It can stay in the uptrend for a long time and afterwards it can stay in the downtrend for either smaller or longer duration than that of the uptrend. However, there are certain characteristics of cycle that have appeared many times in history. One of the characteristics is how in cycle extreme leads to extreme.
Howard Marks
In one of the Morgan Housel’s blogpost, he talked about this phenomena of extreme leads to extreme. This phenomena is as prevalent in nature as it is in economies and businesses. One of the examples he brought on is the case of Japan’s economic slowdown. Japan’s stock market is often taken as an example of when long term investing doesn’t work. Since 1990, for three decades the market has been on a long bearish mode, a total disaster for a long term investor. Many reasonings can be made for such devastating performance of the market. But if this feels like an extreme event for an economy, what about the period before the slowdown started for Japan. The Nikkei, Japan’s prime index for stock market, increased 400-fold from 1950 to 1990, an average annual return of more than 16%. The extreme event in the post-1990 is preceded by another extreme event but on the opposite side of the cycle. Here not only one event following another event in the cycle but in many ways one event causing another event in the cycle. This is another characteristics of cycle.
If we go back to our example of private sector credit growth of Bangladesh, we can see how one event caused another event. When the credit growth was at peak, most banks exhausted their fund and to make additional lending they would need to push up the deposit growth. But that didn’t happen immediately. Moreover, aggressive lending deteriorated asset quality. So, many banks started taking it slow. Central bank also intervened to arrest high credit growth as too much money supply was putting inflationary pressure. The result was obvious. Credit growth started declining. Here, in the cycle not only an event was followed by another event but one event made the other event possible.
But why is it that in cycle when something reverses to midpoint doesn’t stay at the midpoint? Often the answer has to do with psychological swing of market participants. When a particular trend stay in picture for sometime, most market participants embed that trend in their expectations ignoring the long term average. They get carried away by what’s happening at the present moment and stay ignorant of the midpoint. And it leads the event to go past the midpoint until it loses pace and gravity of midpoint pulls it back. John Kenneth said, “Cycle’s clout is heightened by the inability of investors to remember the past.” He used the phrase “extreme brevity of the financial memory” as the cause that keep market participants from recognizing the recurring nature of these patterns, and thus their inevitability.
John Kenneth Galbraith in A Short History of Financial Euphoria
If the nature of cycle is such a reappearing phenomena, how can we understand cycle better?
People can better recognize a pattern if they are familiar with the pattern beforehand. Hence, those who have gone through more cycles will always have edge over those who are too young to experience significant number of cycles.
Can you make up for the lack of experience with any other practice? Reading history and reading widely can be another way to understand. Many events that we are experiencing now happened in the past. This is not the first pandemic human kind experienced. This is not the first time a war happened that put a disruption in the global supply chain. Reading history and understanding the sequences of events can help us understand the cycle we are going through better. Also, reading widely helps. Any principle that appears in different disciplines can have stronger implications in our lives. Understanding nature can give us answers to many problems in businesses. Understanding psychology can help you detect the biases others have and if you are any different.
Things will always change. Uncertainty always remains. That’s the reality we have to deal with. How can we be antifragile so that we don’t break when crisis hits and survive until next opportunity arrives? There are certain ways the world works that have some pattern that you can familiarize yourself with. Nature of cycle is one of them. It won’t solve all the problems, but it may give you some edge over the market.
Sources (mentioned below):
1. Mastering the Market Cycle by Howard Marks
2. Collaborative Fund Blog
3. Richer, Wiser, Happier by William Green
4. A Short History of Financial Euphoria by John Kenneth Galbraith