We can officially add the US personal savings rate to my list of late cycle indicators. For those of you keeping score at home, others include really rich high yield valuations and really, really silly bond issues. Oh, and don’t forget the worst leveraged loan covenant quality on record. There is a lot of commentary out there about what the equity market might do over the next few years but considerably less on the credit cycle. Apparently the steady erosion of covenant quality in the leveraged loan market does not make for riveting CNBC programming.
Readers may recall that I believe the credit cycle, and its attendant indicators, are the best signposts for where we stand in the economic cycle. Credit has a habit of leading the equity market. In the financial crisis era, credit began showing cracks in 2007, while the equity market didn’t wake up to the severity of the issues until later in 2008.
So whenever I am trying to understand where we are in the cycle, I am looking at credit markets first and then everything else.
A couple more reasons for that:
- It is easy and intuitive intuitive to compare the yield to maturity on risky debt to one’s hurdle rate for risky investments.
- Spreads of risky debt over Treasuries of equal maturity are a great indicator of how investors are pricing more equity-like risk.
- Covenant quality is a “squishy” qualitative measure of trust in the financial markets. As an investor, you want to put capital at risk when trust is low and protect capital when trust is high. When investor trust levels are high and capital is plentiful, companies are able to do things like issue PIK bonds subordinated to other PIK bonds so they can pay insiders a dividend. (See “really, really silly bond issues” above)
I am not a fan of “all in” or “all out” market calls. Timing calls are really tough to get right and can be extremely destructive to a portfolio if they result in repeated whipsaws (selling out of the market at low prices and having to buy back in at successively higher prices). I am, however, a big fan of thoughtfully paring risk when the market is not rewarding you for bearing it.
So what does any of this have to do with the personal savings rate?
The Wealth Effect & Its Deleterious Impact On Investors’ Risk Preferences
The Wealth Effect is super easy to understand. As risk assets perform well, people feel wealthier. After all, their net worth is growing along with the value of their portfolios, their homes and, in all likelihood, their paychecks. They therefore begin to spend more of their disposable income, and take on more debt. Because they feel wealthier, they take more risk.
The problem with the Wealth Effect is that it is about the most pro-cyclical behavioral bias you can imagine. The Wealth Effect literally drives people to lever up their personal balance sheets and fritter away their free cash flow at the worst possible time–that is to say, when the market is offering very little compensation for taking on incremental risk. You aren’t just overextended. You are highly levered and overextended. Such a posture transforms even modest financial shocks into cataclysms.
This is what Buffett is driving at when he says: “be greedy when others are fearful and fearful when others are greedy.”
The advantage of approaching asset allocation through the lens of whether the market is offering a premium or demanding a discount for risk is that it obviates the need for price or return-based timing calls. Frankly I can’t believe more people don’t think along these lines.
I suspect there are two main reasons:
- If you are managing Other People’s Money it can be very difficult to act counter-cyclically for a whole host of business reasons.
- Greed.