BlueMountain Capital: Procyclicality And Its ExtremesVW Staff
BlueMountain Capital investment research for the month of June 2018, titled, “Procyclicality And Its Extremes.”
Imagine a bike race. You are in the middle of the pack. The sun is shining and the road is flat and smooth. The pace is brisk but steady. Legs move in unison, almost as if choreographed. There is camaraderie in competition. You feel great and pedal hard.
The road slopes down and the peloton picks up the pace. The speed of the bikes and the sound of the wind amplifies a surge in adrenaline. You notice others are pedaling even faster, trying to accelerate. Some rise from their seats, swaying their handlebars from side to side, seeking to push the pedals harder. The thrill of the chase and the motivation of competition inspire you to do the same. Riders jockey for position. Soon, disarray replaces order. You start to think that the pace and proximity may be unwise but the intoxication of the moment keeps you from slowing down.
A rider at the front of the pack swerves just enough to touch the wheel of another bike. Riders crash, toppling those who follow. You are ensnared in a giant and unstoppable cascade that seems to unfold in slow motion. A jumble of bikes and bodies end up on the road, broken and bruised.
You gather your wits and peer down the road. It is clear, flat, and empty. But no one gets up. Everyone is dazed, scared, and traumatized. You hear a rider approaching who had kept a sensible distance from the pack, not caught up in the herd. She dodges the fallen riders and sails down the road alone. As she disappears beyond the horizon you realize she will win the race.
A few of the fallen riders gradually rise and resume pedaling. You get back on your bike, cautiously and gingerly, and start riding as well. The riders are now hesitant and wary. They maintain a safe distance from one another and are hyper-alert to the slightest sign of danger. Funny, you think to yourself, when everything seemed great we all went too fast and were reckless in retrospect. But now that the road is clear and flat, we are going a lot slower than the
Funny, you think to yourself, when everything seemed great we all went too fast and were reckless in retrospect. But now that the road is clear and flat, we are going a lot slower than the conditions justify. We have collectively lost our spirit. You chuckle at the pun: The pack took the cycles to an extreme and the winner avoided the extremity of the cycles. And so it is with markets.
The history of markets teaches us that we have financial cycles. At some times, asset prices reflect a great deal of optimism. Think of the dot-com stocks in the late 1990s or the housing market from 2002-2007 (see exhibit 1).
At other times, prices reflect fear. For example, exhibit 2 shows the difference in yield between corporate bonds rated Baa and Aaa by Moody’s. This difference reflects the extra compensation that investors demand for low investment grade versus high investment grade bonds. The spread soared to 70-year highs at the peak of the financial crisis in late 2008, four times higher than it was just one year earlier.
This report discusses procyclicality, and especially its role in bubbles and crashes in financial markets.
In economics, procyclical variables move in the same direction as the overall economy: Consumers, businesses, and investors are bold when economic conditions appear strong and timid in the wake of weakness.
Procyclical behavior need not be reckless or irrational. Some procyclical behavior is warranted because there is more opportunity when the economy is strong than when it is weak. As a result, “the debate about the procyclicality of the financial system is therefore more subtle” than an assumption of trend-reinforcing behavior, according to a report by the Federal Reserve Bank of New York. The question is whether or not the fluctuations are a justifiable result of changes in fundamental values.1
In other words, in an upswing, we should ask whether asset prices reflect what Alan Greenspan called “irrational exuberance.”2 And in a downswing, we should ask whether prices reflect “irrational despair.”3
Unfortunately, investment managers who try to remain prudent during a bubble lose assets to those who are more aggressive and temporarily more successful. Jim Cramer, an investor and television personality, captured this in a speech he delivered in February 2000, immediately prior to the peak of the Nasdaq Composite Index: “If we use any of what Graham and Dodd teach us, we wouldn't have a dime under management.”4
But successful long-term investors are able to avoid both irrational exuberance and irrational despair, which enables them to take advantage of the extreme behavior of others. As Warren Buffett, the chief executive officer and chairman of Berkshire Hathaway, says, “Be fearful when others are greedy, and be greedy when others are fearful.”5
Article by BlueMountain Capital
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