The Calculation That Broke The Market

Numbers surrounds us. Analytical minds, like you and I, know this to our core and it is probably one of the things that drives us to do what we do. Sometimes we can get a bit carried away though. When it comes to investing and the markets, this can be increasingly dangerous. What I want to show you now is how a simple calculation can lead to hundreds of years of boom and bust business cycles.

It goes a little something like this. Let’s say person X want to buy a $30,000 car. They have the 30k in the bank so they could buy the car for cash, but they have a clever idea. Using a little numbers they see that they can finance the car at let’s say 2%. They know that they could invest that 30k in the stock market and earn let’s say 8%. Over time they will make a net 6% on their money over the cash purchase case. So, they decide to take the finance option feeling they have made a sophisticated decision and used their numbers knowledge to dupe the market.

On the surface, the analysis looks sound. Indeed this same analysis is used by millions on a massive scale. Fortune 500 companies justify taking out loans to invest in their companies using this same idea. Billions and possibly trillions of dollars of business decisions are made using this as a basis. MBAs, news channels, and high touting academics will regard this analysis as the sign of a sophisticated financial landscape in which we make sound business decisions. To understand where this leads us we must talk about what economists call “The Credit Cycle”.

The Credit Cycle

The credit cycle is very well documented and understood across all levels of the financial industry. To explain how it works I want us to take a trip through the cycle using are example above of person X.

So person X has made their decision to finance the 30k car. Now person X gets married and is looking to put down some roots. Since the sophisticated thing to do is the finance your assets and invest in the market, they take out a 200k mortgage on a 240k house. Let’s also say that person X makes $80k per year at their job. This is a good picture of what the majority of the middle class looks like. So like person X there are millions of other people and businesses that are making similar decisions. Now this surge of new credit into the economy creates the making of a boom time. As credit is available more and more people have access to assets that they normally wouldn’t have access to. All of these asset prices begin to rise. As consumer spending is strengthened businesses begin to flourish. As businesses flourish investors flock to the stock markets to get a piece of this growth and stock prices begin to rise as jobs are being created. With more people employed this means more people that now have access to credit to get a piece of the middle class life. This creates a boom in the market and a soring of all asset prices. The people who have borrowed money to invest are thrilled as they see great returns on their portfolios and interest rates are low. Many articles will be written about the endless growth in the markets for years to come. How the growth in asset prices will never end and people should do all they can to buy more assets.

There is something that I didn’t mention about the simple calculation above. Looking at the calculation it has no bound on how much to borrow to invest. Person X could have chose 50k instead of 30k. But why not a million? Why not 2 million? This is where risk begins to play a part. When you take out a loan on something and invest the capital in the market you are inherently taking on risk. The person’s or business’s risk tolerance will determine how much they are “comfortable” with taking on. Notice that word “comfortable”. Is that an exact word? No, it is based on how someone feels. So there is no good way to determine how much leverage (which is what we call investing using debt) is too much. This is key to the next part of the cycle.

As this growth time is in full effect people truly begin to believe it will last forever. This induces them to start taking on more debt, which is adding more risk. Eventually something begins to happen. First, a small subset of people will begin looking around at all these asset values and wonder if they are really “real”. Houses that used to cost 200k a couple years ago are now selling for 400k. But no matter, everything is still going up so they just shrug it off. Soon more and more people will begin to realize that something is wrong. Then there is a trigger.

For different times in history it was different things and it is almost impossible to know what the trigger is, but all of the sudden people begin to wake up. They look around them and see assets that are massively overvalued and have been driven up using an ungodly amount of credit. So some people begin to start selling. Prices all of the sudden begin to flatten. The people that had that bad feeling in their stomach know that the game is up so they start selling. Soon prices begin to fall, fast! Before people know what is happening the markets are in a mad panic. Prices are falling faster than anyone expected. Fueled by mass pandemonium all the people that have gone into debt to purchase those assets are starting to sweat and get worried. Since people are worried, they generally stop spending as much money because they know their household is at risk due to how much debt they took on. As consumer spending drops, business profits begin to flatten and fall. Investors, who are also in fear of losing their assets, begin to flee to “safer” investments. Money flees the stock market at rates that are truly hard to get your head around. Some people will try to short sell the market which further accelerates the drop. This causes more falls in asset prices. Companies begin to try to deal with lower profits due to less consumer spending, so they begin laying off workers among other things to lower their cost structure. The unemployment rate begins to skyrocket. As families grip with the reality that they no longer have any income coming in and they have all the debt bills to pay they begin to get desperate. Soon people are starting to get underwater on their debt meaning the debt they have out on their assets (cars, houses, etc.) is more than what the assets are worth. In a moment of desperation, people just try to sell their assets at whatever price they can to alleviate the damage or they go bankrupt. Businesses that have taken out too much debt begin to go bankrupt, as they no longer can support the leverage. Distressed assets are being sold at extremely low prices driving down the prices of all the assets in that class.

Person X is sitting there with a financed car and house. In the beginning it all seemed like a great idea, but who knew it would all come crashing down... When the stress becomes too much they are forced to sell out their portfolio to cover the debts securing any losses up to that point. This means they bought high and sold low. The exact opposite of what you want to do in investing. It is a truly dark time for them. Afterwards they will say things like “the stock market just isn’t for me” and “the economy just took me out”.

We are in a full out recession. The massive crash leaves a nation devastated. Governments try to swoop in to save what they can, but usually are unsuccessful or make it worse.  Slowly over time people begin to rebuild. They say necessity is the mother of invention. With desperation all around them, trailblazing entrepreneurs, artists, scientists, and engineers begin to create. Slowly over time things begin to settle. As real economic growth happens people begin to find jobs. Consumer spending starts to reestablish. Businesses begin to see growth again for the first time. This leads people to believe that we may be out of the crash. This means people begin moving back into stocks. Stock prices slowly start to tick up. As investors stay hungry for more growth credit becomes available again and the cycle goes on and on forever.

Do We Learn From Our Mistakes?

The short answer is no. My theory is that it all comes back to the simple calculation we started off with. That is what makes this cycle go on and on. It repeats itself for a couple of reasons:

1.     Leveraging debt to invest leads to instant gratification.

2.     The social pressure is too great to disobey it.

When person X financed the car and put their money in the market they probably saw some instant gains. This fuels what psychologists call the Self-serving Bias. It is that if you do something and are successful, people tend to attribute it to skill. If you do something and are unsuccessful, they tend to attribute it to chance. There is a saying that the worst thing that can happen to you in gambling is that you win. It is because this will fuel you to attribute it to skill and more than likely set yourself up for big losses. I will write more about this in later posts.

Secondly, there is a huge social pressure here in America for people and businesses to use debt. We see it all around us. It is just regarded as normal. Combine this with the ability for people to perform the simple calculation above and conclude that credit is good then you can see we are destined to repeat our mistakes over and over again. Well, most of us that is…

Short Circuiting The Credit Cycle

What if there was a way to short-circuit the cycle? What if there was a way for people to buy low and sell high? Indeed there are some truly clever people have figured it out.

Let’s look back at the situation with the car that we started out with. Let’s say we have person Y who is facing the same situation. They want to buy the 30k car and have 30k in the bank. But instead this time they decided to buy the 30k car in cash. They instead decided to simply save what they would pay in car payments and invest that instead.

Person X and everyone else will scoff at them. “OMG, how unsophisticated. Do they not know how to do math?” Indeed they will be to odd ones out of the bunch. When it comes time to buy a house person Y decided to buy a bit smaller and pay it off as soon as they can again investing what they would pay in mortgage payments. This will really set the person Xs off. “Paying off you mortgage?! Not taking the tax credit?! You are truly an idiot.”

Now lets look at where person Y is. They have a paid for house and a paid for car and they are investing a large person of their income every month. They also have built up an emergency savings. Even large companies such as Amazon, Apple, and Bed, Bath, and Beyond run debt free. Many other companies run their businesses with large amounts of cash and short term investments compared to their liabilities. It my theory this is in part to appease the leverage enthusists who are ranting and raving about the need to borrow from atop their high horse. Now lets go through the cycle.

Fast forward to the top. Person X feels on top of the world, but soon things begin to change. As we travel through the cycle person X begins to become increasingly worried. They start to worry if they will be able to make their payments. Person Y is also seeing their asset values fall. But person Y followed some simple rules to begin pulling out cash when the market started to fall. They wanted to "keep their chips on the table". They are sitting with no debt and an emergency fund saved for this very reason. They are ready. As the world falls into the darkness of the crash, person Y goes hunting. As person X is forced to sell his assets at depressed prices due to the downward pressure of his leverage, person Y is there to buy.

We are seeing this right now in the oil companies. While some companies are having to sell their oil assets at a distressed price, balance sheet strong companies are looking to buy them for a discount.

This is where we separate the masters from the students, the wheat from the chaff, and the pros from the amateurs. The pros understand the cycle. They understand that the cycle repeats itself. The pros know that the calculation is misleading. They are the truly clever ones that have learned to have a great respect for our human nature to know they are susceptible to it's downfalls. They have taken measures to guard their portfolios from themselves. The pros know that there will come a time when fear is all around them and assets will start to go on sale. The pros will buy the assets from the amateurs. They will short-circuit the cycle.

One of the greatest things that a true analytical mind can learn is when using numbers can create clarity and when using numbers is causing more harm than good. To truly understand that is the difference between the academics and the practitioners. Between the amateurs and the pros.

Why Few Can Do It

Even though the cycle has repeated itself many times we have never learned from our past. This is because human nature never changes. People are emotional beings and their emotions can make them do the wrong things at the wrong times. To put this simply, not everyone can be a pro.

We all know the pros names: Warren Buffet, Ray Dalio, Carl Icahn, etc. Yet so many refuse to believe they are susceptible to the same tendencies that everyone else is. We want to believe that we are better. That we are can tame ourselves. That those things don’t effect us. Oddly enough, those thoughts make them the most in danger of following the same path because they do not have a respect for the power of the human mind. The true analytic and professional knows this power.

In the coming weeks I will be posting on exactly how to create a system that protects you from yourself. I will be giving you all the details you need to know to begin immediately. I will be doing it all for free. Please join the email list below to stay on top of the posts and make sure to share this with your analytical friends. Next I will be going into exactly how we are hard wired to suck at investing. If you have any feedback please send it to me at Joshua.bird@younganalyticalmind.com! Until next time!

Resources

Wikipedia: https://en.wikipedia.org/wiki/Credit_cycle

Video by Ray Dalio: https://www.youtube.com/watch?v=PHe0bXAIuk0