Cody Willard: Boom times are here but cheap capital is not

The only thing we know for sure in the summer of 2007 is that it is a great time for the economy and the broader market. Whether you take a 25-year or five-year view of the economy, we are in boom times. But if the idea is to buy low and sell high, then it’s important to recognise we’re certainly in the “high” part of the spectrum. And, given how good the economy is and how far the world’s financial markets have run, it would be prudent to pay attention to the turn in the world’s ability to access capital. Stocks go up when companies increase earnings and earnings can only rise in a credit-driven world when capital is cheap and easily accessible.

The great bull market and economic expansion of the last quarter century have coincided with two events; a decline in US interest rates and the personal computer/ internet-fuelled explosion in capital distribution outlets. While the direction and impact of interest rates have been clear-cut (a lowering of the cost of capital), PCs and access to the internet have made it easier for individuals to access and deploy capital.

But the credit cycle has turned. We’ve undoubtedly seen an inflection point come and go in the longer-term credit cycle during the past couple of years, as the Federal Reserve took real rates back up above zero and ended its steady rate cuts. The US cut real interest rates – interest rates less the inflation rate – to below zero and was flooding the world with money. But the rate at which that money flooded the world was greater than the rate of US economic growth.

And that means access to capital got about as “good as it could get” during this cycle. Put another way, capital can only get more expensive and harder to come by. The fact is that earnings growth has been slowing for the past couple years, and that hasn’t stopped the ongoing bull market. Earnings are still rising, right? And stocks go up when earnings increase, right? You can ignore conventional wisdom that focuses on the “slowing of earnings growth”.

But you cannot ignore the changed credit cycle. Corporate and consumer access to capital peaked when the long-term direction of interest rates turned, as rates clearly bottomed out during the past couple of years. I’d like to think that the capital cycle could turn positive again, and it’s possible.

In the past couple of years, the former strength of the US dollar relative to the developed world’s other centrally controlled currencies meant the Fed could cut or raise rates as it wanted to, depending on the domestic economy. That the dollar remains weak in spite of the Fed jawboning inflation and hinting about raising rates leaves the Fed with a tough choice: stimulate the economy with lower rates and see the dollar collapse or let the credit cycle play out, entailing real economic and stock market pain.

Unfortunately, the culmination of that 25-year boom of economic expansion and reduced barriers to capital didn’t end until it had flowed all the way down to the low-income consumer segment of the US economy. Yes, the subprime excesses that are now unwinding were the top of the multi-decade credit cycle that’s now turned.

There is an old investing adage – often mistakenly attributed to Nathan Mayer Rothschild – that one should “buy to the sound of cannons, sell to the sound of trumpets”. When I launched my hedge fund in October 2002, cannons could be heard in the form of 30 per cent unemployment in telecommunications. It is five years since these cannons were audible, and investors should heed the possibility of their return. Stick with long-dated calls and puts while the premiums are still cheap. Most of all, don’t be greedy by getting levered up in the summer of 2007 when the credit cycle is working against you. The endless multi-billion dollar private equity deals, dotcom parties in Silicon Valley and long waiting list for micro jets sound like trumpets
blaring.

Cody Willard is a hedge fund manager at CL Willard Capital. www.codywillard.com