The biggest question for investors is are we in a boom or a bust?
Each bust sets the stage for a new boom. It is cultivated with low-interest rates, easy monetary conditions, and a negative outlook. They say Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria. So, have the seeds of the new boom been planted or are we still in the bust part of the cycle? To answer this question is to understand where to invest assets; whether to be defensive or cyclical.
Boom and bust cycles are inevitable. They describe an expanding business environment and then a contracting one. To understand that this is how the cycle works, helps investors to understand how to invest their money. During the boom part of the cycle, risk assets outperform. During the bust part of the cycle, defensive assets outperform. Investors can use this cycle to create wealth over time.
Boom and bust cycles can be defined by money and credit supply. As money and credit supply expand, a boom cycle is fed. As growth in money and credit supply level offs and decreases, a bust cycle occurs. Long term investors understand that this cycle takes place every 7-10 years and take advantage of busts to buy cheap assets.
Here is a graph of total assets of the US Federal Reserve System:
You can see that big jumps in money supply as we have seen, usually, sow the seeds of the next boom cycle. The risk here is that Central Banks have moved too soon and not allowed for the normal bust cycle to occur. The bust cycle while associated with pain such as rising unemployment, unrest and a negative wealth effect also has the function of cleaning out weak companies. Allowing those weak companies to survive due to easy monetary policy not only creates zombie companies but also stifles innovation and efficiency. I believe that it means that the next bust cycle will be more painful because the medicine this time around has not been taken.
For most investors, it feels like a topsy-turvy world. On one hand, Covid-19 cases are rising and the final economic impacts are yet to be seen. Market signals seem scrambled with central banks and governments stepping in to support economies on an unprecedented scale. The usual cleanout of inefficient companies has not occurred and zombie companies are thriving. On the other hand, money supply has clearly started to rise and that should mean that the seeds of the next boom have been planted.
The biggest risk to the sharemarket and the business cycle is that Central banks and governments withdraw support too quickly or the support falls short of expectations.
Here at Burman Invest, we view that market through three lenses. The first is part of what is explained above and that is through looking at the business cycle. The second lens is through looking at what is happening in companies and the third aspect is timing.
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