Risk appetite is the mother's milk of capitalism.
– Paul McCulley, Managing Director, PIMCO
If Wall Street were more like Sesame Street, this week would be brought to you by the letter "L," for layoffs.
Job cuts dominate the headlines. Sprint (S) is gutting 8,000 jobs; Phillips (PHG), 6000; Home Depot (HD), 7,000. Caterpillar (CAT) is axing a whopping 20,000 jobs. And that's just the tip of the iceberg.
On Monday of this week alone, Bloomberg reports, 77,000 job cuts were announced. 2009 is shaping up as a bloodbath – more than 150,000 pink slips have been handed out thus far.
And yet stocks are hanging in there, at least for now. This week's news of Pfizer's (NYSE: PFE) $68 billion buyout of Wyeth (NYSE: WYE)– the biggest pharma deal in close to a decade – shows that some areas of the market are still primed for making deals.
If markets always moved down on bad news and up on good news, things would be a lot simpler. But that's not how it works. Sometimes the market shakes off bad news and chooses to go higher. At other times, it's the good news that doesn't get any traction.
How to make sense of it all?
Behold the Accordion
It's a simple truth to say that markets move in cycles. Most traders and investors, though, don't have an intuitive sense of just how powerful that truth really is.
Take volatility, for example. You can get a snapshot of the volatility in a stock by looking at the ATR, or Average Trading Range. Over extended periods of time, volatility tends to expand and contract like an accordion. Things start out mild... then they get wild... then they turn mild and the cycle starts again.
The same is true of long-run economic cycles. If you step back and study market history, you can see how powerful a phenomenon this cycling affect is.
It's one thing to grasp the general concept of cyclical activity in markets over the years. It's another thing to cultivate a gut-level understanding of it. If you want to do this, two good books that come to mind are Money of the Mind by James Grant and Devil Take the Hindmost by Edward Chancellor.
The full title of Grant's book is Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken. It's a big book. If you have an interest in credit cycles, you may well find it fascinating (as I did). If not, you might find it dry as dust.
Either way, it's very helpful to understand the nature of long-term credit cycles – the way credit flows tend to expand and contract, again like an accordion, over long periods of time.
Of Booms and Busts
The full title of Chancellor's book is Devil Take the Hindmost: A History of Financial Speculation. This book is more fun because it focuses wholly on panics and crashes.
Did you know that markets have been booming and busting ever since the days of Ancient Rome? If you read Hindmost, you'll get a better sense of just how entrenched these cycles really are. For the intelligent speculator, a grasp of market history is a powerful thing.
Market history is probably the most effective inoculation one can have against recency bias... the dangerous tendency to assume that the near-past represents the way things have always been and always will be. Anyone who marches boldly into the future without a clear-eyed understanding of the past is a candidate for being made a fool of.
Two Basic Variables
For most traders and investors, the trouble with top down, macro-level type analysis is how complicated it can get. When it comes to sussing out the big picture, the average observer has trouble knowing where to start.
When a problem is fearsomely complex, the best thing you can do is take Thoreau's advice: "Simplify, simplify, simplify." At the same time, though, one should remain aware of Einstein's advice: "Things should be made as simple as possible, but not simpler."
In your editor's humble opinion, it is a reasonable simplification to reduce all big-picture market movements down to the interplay of just two variables: credit flows and risk appetite.
Credit flows relate to the availability of capital. Remember the accordion concept? Over time, credit flows tend to expand and contract with great regularity. The markets move to an extreme... reversion to the mean kicks in... and then the pendulum swings to the other extreme, and the cycle reverses itself.
Don't be intimidated by the abstract nature of the term. At root it's all about borrowing and lending. For example, just think about how easy it was to get a mortgage or a business loan in 2006. The banks were literally giving money away, on ridiculously easy terms. Now the pendulum has swung so far in the other direction, even borrowers with perfect credit histories and wonderful track records can't get loans.
This cycle, writ large over the decades, is the cycle that leads to boom and bust in markets too. Another way to think of it is to imagine credit as a great flowing river. When times are flush and money is cheap – like when Greenspan lowered interest rates to 1% and held them there for over a year – the river gets wild and strong, threatening to overflow its banks. When times are hard – like now – the riverbed is cracked and dry. Once-mighty flows are reduced to a sickly anemic stream.
Risk appetite relates to "animal spirits" and the willingness to speculate. "Animal spirits" is the term John Maynard Keynes used to describe the willingness of investors and businessmen to go forth and make bold moves.
Again, risk appetite expands and contracts like an accordion over time. At the height of the most recent housing and credit bubble, you had speculators snapping up no-doc loan properties three or four lots at a time and private equity firms angling for leveraged buyouts in the tens of billions.
At one point, investors were "reaching for yield" so aggressively that shoulders threatened to pop out of sockets. Now risk appetite is so diminished that investors would rather own government bonds at zero interest than high quality corporates paying double-digit yields with a long-term default risk near zero.
The Market Quadrant
These two factors, credit flows and risk appetite, drive the entire market cycle. They are intimately linked. In a big picture sense, virtually all other factors can be distilled down to their impact on these two things.
This is a useful simplification because it helps us get a handle on the broader complexities. Trying to get a bead on a dozen variables is a real headache. Two variables, we can work with.
To create the "Market Quadrant" – which I have drawn on a piece of scratch paper below – all we have to do is look at the interplay of credit flow and risk appetite.
The Market Quadrant has four sections because there are four different "states" in which the two variables can exist.
For the sake of simplification, we are only focused on the directional trend of the two variables. Credit flows "up," for example, means that available credit is increasing, the accordion is expanding, the river is getting stronger, and so on. The same goes for risk appetite. The periods of transition – i.e. when credit flow peaks and starts to downtrend – are represented by transitions between the four states.
Now let's look at each of the quadrants in turn, so you can see how it works.
Quadrant I: Credit Flows up, Risk Appetite Up
Quadrant I is by far the most bullish state. When credit flows and risk appetite are increasing simultaneously, that is the time to be aggressively long.
The last time we saw Quadrant I conditions was after Greenspan took interest rates down to 1% and held them there for over a year. The super-stimulus from the Federal Reserve successfully staved off the after-effects of the dot-com bubble by inflating a new housing bubble. As money got cheaper and home prices sky-rocketed, the whole world rejoiced.
Quadrant II: Credit Flows Up, Risk Appetite Down
In Quadrant II, credit flows are still rising but risk appetite has peaked.
Wall Street tends to push everything too far. When the investment banks get hold of a good thing, they will whip it and drive it until the last dog dies. As valuations hit their peaks, risk appetite starts to wane even as the credit still flows.
We saw this in the late days of the private equity boom. In their rush to cater to Blackstone Group (BX), KKR (KFN) and the like, banks had agreed to lend out tens of billions to the private equity kingpins on incredibly lax terms. By mid-2007, it was clear the private equity boom had peaked – as evidenced by Steven Schwartzman taking Blackstone public in the summer of 2007. That was the high in terms of risk appetite as smart players started walking away from the game... but it took the banks a little longer to wise up.
Quadrant III: Credit Flows Down, Risk Appetite Down
Quadrant III is raging bear territory. This represents the toughest combo of all – when credit flows and risk appetite contract simultaneously. In Quadrant III you get the double whammy as profits fall and loans dry up. Indebted consumers and businesses find it harder to make a buck as everyone pulls in their horns, and the once-virtuous leverage cycle turns vicious.
We saw the mother of all Quadrant III cycles in the second half of 2008. For the first time in living memory since the 1930s, credit flows and risk appetite vanished into thin air... leading to a graphically brutal result.
Qudrant IV: Credit Flows Down, Risk Appetite Up
Quadrant IV is the recovery period in which markets slowly begin to heal. It is here where bear markets run their course and the stage is set for a new bull.
To put it another way: if Quadrant III can be compared to Mr. Market falling down the stairs, Quadrant IV is the point at which he gets up and dusts himself off.
It is important to note that, in the aftermath of Quadrant III, risk appetite tends to return first. Animal spirits can creep back into the markets even as credit flows continue to look bad and the news continues to disappoint.
Why is this true? Simply because markets are forward-looking mechanisms. The stock market is meant to discount the future, not the past. So if things continue to look ugly here and now, but the forecast is for a clear general improvement six months from now, then equities can start chugging higher even as the headlines look bleak.
The $64,000 Question
And so, with the above in mind, here is the $64,000 question: have we made it to Quadrant IV or are we still in Quadrant III?
If we are in Quadrant IV, then risk appetite and "animal spirits" should steadily rise as the markets anticipate global recovery in the second half of 2009. If we remain in Quadrant III, however, then the lows in terms of credit and risk appetite (apart from index lows) have not yet been reached.
There is no way to answer this question directly, as certain factors are yet to be determined (like what the new administration does, for example, and how global stimulus efforts play out). But as we watch closely, we can take the Market Quadrant into account and adjust our trading and investing strategies accordingly.