Peddling the Credit Cycle by David Merkel, CFA of The Aleph Blog
Starting again with another letter from a reader, but I will just post his questions in response to this article:
1) How much emphasis do you put on the credit cycle? I guess given your background rather a great deal, although as a fundamentals guy, I imagine you don’t try and make macro calls.
2) What sources do you look at to make estimates of the credit cycle? Do you look at individual issues, personal models, or are there people like Grant’s you follow?Mohnish Pabrai On Low-Risk Opportunities And The Recycling Sector
In his book, The Dhandho Investor: The Low–Risk Value Method to High Returns, Mohnish Pabrai coined an investment approach known as "Heads I win; Tails I don't lose much." Q3 2021 hedge fund letters, conferences and more The principle behind this approach was relatively simple. Pabrai explained that he was only looking for securities with Read More
3) Do you expect the next credit meltdown to come from within the US (as your article suggests is possible) or externally?
4) How do you position yourself to avoid loss / gain from a credit cycle turn? Do you put more emphasis on avoiding loss or looking for profitable speculation (shorts or quality)
1) I put a lot of emphasis on the credit cycle. I think it is the governing cycle in the overall economic cycle. When some sector of the economy finds itself under credit stress, it has a large impact on stocks in that sector and related areas.
The problem is magnified when that sector is banks, S&Ls and other lending enterprises. When that happens, all of the lending-dependent areas of the economy tend to slump, especially those that have had the greatest percentage increase in debt.
There’s a saying among bond managers to avoid the area with the greatest increase in debt. That would have kept you out of autos in the early 2000s, Telecoms after that, and Banks/Finance heading into the Financial Crisis. Some suggest that it is telling us to avoid the junior energy names now — those taking on a lot of debt to do fracking… but that’s too small to be a significant crisis. Question to readers: where do you see debt rising? I would add the US Government, other governments, and student loans, but where else?
2) I just read. I look for elements of bad underwriting: loosening credit standards, poor collateral, financial entities focused on growth at all costs. I try to look at credit spread relationships relative to risks undertaken. I try to find risks that are under- and over-priced. If I can’t find any underpriced risks, that tells me that we are in trouble… but it doesn’t tell me when the trouble will hit.
I also try to think through what the Fed is doing, and think what might be harmed in the next tightening cycle. This is only a guess, but I suspect that emerging markets will get hit again, just not immediately once the FOMC starts tightening. It may take six months before the pain is felt. Think of nations that have to float short-term debt to keep things going, particularly if it is dollar-denominated.
I would read Grant’s… I love his writing, but it costs too much for me. I would rather sit down with my software and try to ferret out what industries are financing with too much debt (putting it on my project list…).
3) At present, I think that an emerging markets crisis is closer than a US-centered crisis. Maybe the EU, Japan, or China will have a crisis first… the debt levels have certainly been increasing in each of those places. I think the US is the “least dirty shirt,” but I don’t hold that view strongly, and am willing to be challenged on that.
That last piece on the US was written about the point of the start of the last “bitty panic,” as I called it. For a full-fledged crisis in US corporates, we need the current high issuance of corporates to mature for 2-3 years, such that the cash is gone, but the debts remain, which will be hard amid high profit margins. Unless profit margins fall, a crisis in US corporates will be remote.
4) My goal is not to make money off of the bear phase of the credit cycle, but to lose less. I do this because this is very hard to time, and I am not good with Tactical Asset Allocation or shorting. There are a lot of people that wait a long time for the cycle to turn, and lose quite a bit in the process.
Thus, I tend to shift to higher quality companies that can easily survive the credit cycle. I also avoid industries that have recently taken on a lot of debt. I also raise cash to a small degree — on stock portfolios, no more than 20%. On bond portfolios, stay short- to intermediate-term, and high to medium high quality.
In short, that’s how I view the situation, and what I would do. I am always open to suggestions, particularly in a confusing environment like this. If you’re not puzzled about the current environment, you’re not thinking hard enough.
Till next time.