THE INCESSANT DEBT CYCLE
Published: May 2022 First Edition- May 2022 MRP. - Rs. 270
Copyright 2022 © Johann Da Silva by KHWAAB PUBLICATION Near SRP office, Aashiana road, Adityapur, Jamshedpur Jharkhand-831013 Contact no. – +91 8986634758 E-mail:
[email protected] Website: www.khwaabpublication.com Printed in India
2
THE INCESSANT DEBT CYCLE
Copyright © Johann Da Silva All Rights Reserved.
This book has been published with all efforts taken to make the material error free after the consent of the author. However, the author and the publisher do not assume and hereby disclaim any liability to any party for any loss, damage, or disruption caused by errors or omissions, whether such errors or omissions result from negligence, accident, or any other cause.
While every effort has been made to avoid any mistake or omission, this publication is being sold on the condition and understanding that neither the author nor the publishers or printers would be liable in any manner to any person by reason of any mistake or omission in this publication or for any action taken or omitted to be taken or advice rendered or accepted on the basis of this work. For any defect in printing or binding, the publishers will be liable only to replace the defective copy with another copy of this work then available. 3
THE INCESSANT DEBT CYCLE
I dedicate this book to my family, grandparents, and friends for all the love and never-ending support. All my professors at SS Dempo and my teachers at Don Boscos who laid the best foundations for my growth and prosperity. Arjun and Suraj my mentors at Milestone Financial Consultants and to Neville, Joshua, Roger, and Ambar who have been of constant support and guidance to make me the man I am today.
4
THE INCESSANT DEBT CYCLE
A beginner’s guide on the cycle of debt, inflation, interest rates, and common stock valuations
5
THE INCESSANT DEBT CYCLE
INTRODUCTION The stock market over the years has been a gold mine and a ticket to freedom for so many individuals. Yet it will come as a shock to know that 90% of people who invest in the stock market, lose money. For the longest time I never understood why stocks fluctuate so much in the short and intermediate term. After undertaking some research I understood that a major reason for it’s fluctuation is the stock market cycle or rather, the debt cycle. The most unfortunate part is that today there are very few books that put forward a simple explanation of this cycle’s working because of how complex it’s working is. In my opinion there are two major company segments in the market. The Cyclical company and the non cyclical company. There are plenty of authors, books and videos that guide amateurs on how to invest in non cyclical companies but very few on guiding investors on investing in cyclical companies. This is simply because it is easier to devise strategies on non cyclicals rather than cyclicals. It is also much easier to understand non cyclical businesses in view of the consistency in performance that these companies usually manage to achieve. In this light I have written this book. Not to tell you how to invest in cyclical companies but more so to educate you on the working of the main factor that drives cyclical companies and that is “The Stock Market Cycle”. This book has been written to explain a complex stock market cycle to you in the easiest way possible and all in under twenty pages. This book will therefore help instill a good foundational understanding of the cycle to you which I believe will help you take more informed decisions as a result of it.
6
THE INCESSANT DEBT CYCLE
The book is broken down into 3 major parts that cover the basic working of debt in the economy, the impact of the debt cycle on stock valuations and lastly the psychology that runs behind it. I hope this book will act as a guide for you when the cycle turns and help you forecast possible market scenarios in the times ahead.
THE FOUNDATIONS “You can’t build a great building on a weak foundation” - Gordon Hinckley THE BIRTH OF THE ECONOMY: THE TRANSACTION As Ray Dalio said “An economy is not a complicated thing, it just has a lot of moving parts but the basic is there’s a transaction.” Imagine you went to the market to purchase an apple. Let us assume that the cost of the apple is 20. You therefore have two options here, you either pay 20 upfront or you take the apple and promise to pay the vendor on a future date. An economy is the product of such transactions that occur in it.
Each transaction consists of two sides. The buy side and the sell side. The buyer has two options: To either hand in money or take 7
THE INCESSANT DEBT CYCLE
the product/service on credit. This credit is also called debt. When you take a product on credit you’re indebted to the vendor on a future date. Similarly in the economy, companies have two options while making transactions: Either to pay for raw materials directly with cash or take on debt or credit. The total money spent in the economy is therefore the sum of the money spent and debt spent. This money spent determines the progress of an economy. CASH SPENT+DEBT SPENT= TOTAL MONEY SPENT Gross Domestic Product (GDP): One of the best measures of the progress of an economy lies in the GDP. The GDP is the value of all the final goods and services produced in an economy. When the spending in an economy increases, companies will also manufacture more to meet this demand. Therefore, when more is produced the value of all final goods and services also increases and this causes GDP to increase indicating growth in the economy. The opposite is true when spending reduces, it causes GDP to drop. Transactions are essential to keep the economy moving. The markets consist of all the buyers and sellers coming together and making transactions with one another for something similar. For eg. Fish market, Stock market etc. Now it’s important to understand that for a transaction to be complete, the buyer and seller must both come to an agreement and for this both parties need to gain. If there is no gain to both parties there would be no will to accept the terms of the agreement.
8
THE INCESSANT DEBT CYCLE
9
THE INCESSANT DEBT CYCLE
THE FUEL OF THE ECONOMY: DEBT Debt forms the majority of the money that is circulated in the economy. Most transactions are the result of atleast one side getting it’s purchasing power from debt. It includes two parties: The lender and the borrower. The borrower wants to undertake an activity he can’t afford like purchasing a car or starting a business and the lender wants to use his excess reserves to make more money by earning a return on the amount lent out. This return is earned through interest on the amount lent out. Debt therefore helps bring about a gain to both parties and thus the acceptance of the agreement to form a successful transaction. It transfers money from those who have excess to those who are in need of it. Borrowers agree to pay the amount they borrow (also called principal) along with interest on that amount. The interest is the gain the lender makes for lending money and taking on the risk of default by the borrower. When borrowers agree to repay and lenders accept it, debt is created. This is what debt is all about. THE BACKBONE OF THE ECONOMY: ASSETS AND INCOME Borrowing leads to spending which turns into another person’s income. When income is higher it drives a person to borrow more because he now feels richer and has a better capability to service the debt. Lenders prefer to lend out to those parties that have a higher income because the risk of default in such cases is lower. Creditworthy borrowers have two important characteristics, good assets to put down as collateral and a good income which facilitates the ability to repay the debt in due time. Collateral: Collateral refers to any asset the lender has accepted which acts as security for the loan given out. If the borrower 10
THE INCESSANT DEBT CYCLE
defaults, the lender has the right to sell this collateral to recover the bad debt. Income and debt becomes essential in the creation of assets because it goes towards the purchase and generation of assets. If income and debt drop, it will affect the creation of assets. As borrowing, income and money circulation in the economy rises, it drives asset prices higher because now the economy is willing to purchase assets at a higher price. As the value of assets rise, it increases the creditworthiness of the economy because there is now greater value in collateral put down. The opposite happens when borrowing and spending reduces. It causes asset values to drop and this reduces the creditworthiness of the economy. Lenders then cut down on debt given out. More borrowing= More spending=More income= More assets=Higher creditworthiness= More Borrowing=More spending This relationship between spending and borrowing turns out to be nothing but a cycle and is the leading cause of economic swings. Debt drives the economy because when the borrower borrows money, he spends it in the economy and this fuels economic activity. It allows us to consume more when we acquire it and drives us to consume less when we repay it. Economies with increased debt have increased spending and hence more volatile cycles.
11
THE INCESSANT DEBT CYCLE
THE HEART OF THE ECONOMY: DEMAND AND SUPPLY Demand is mainly understood from the perspective of the consumer. It refers to nothing but the want for a product or service in the economy. However, it isn’t just the want of a product in isolation that drives demand, it is also the willingness to spend at that given price. When coupled together, price and willingness to spend at a given price is what drives demand. There will be no demand if there is no willingness to spend at a given price.When the price of a commodity rises, it reduces the willingness to spend by the consumer because the consumer now needs more money to purchase the same good. Conversely, the reduction of price of a
commodity will increase the willingness to spend and demand as a result. Supply on the other hand is looked at from the perspective of a supplier. It refers to the production and supply of a product or service in the economy. Like demand, it isn’t just the production of the commodity that drives supply but also the willingness to sell at a given price. When coupled together, price and willingness to 12
THE INCESSANT DEBT CYCLE
sell at a given price is what drives supply. When it comes to supply, the feasibility and profitability of a given price becomes the core variable for determining the price of a commodity. If the price does not cover cost undertaken to bring the commodity or service into existence and reward the supplier of it reasonably, it would discourage the supplier from going ahead with the supply
at that given price. When the price of a commodity rises, it increases the willingness of the suppliers to supply at that level because the supplier will now earn more at that given price. Conversely, the decrease of the price of a commodity will reduce the willingness to sell at that given price because the margin and income of the supplier is now lower.
13
THE INCESSANT DEBT CYCLE
THE PULSE OF THE ECONOMY: INFLATION Inflation refers to the increase in the general price levels in the economy. Inflation erodes the purchasing power of money. To understand inflation we must first understand the two phases of the debt cycle: a. The expansionary phase b. The contractionary phase
Expansionary Phase In the expansionary phase, spending continues to increase because of more debt being easily available. This higher spending leads to an increase in price levels because suppliers are now aware that there are higher income levels in the economy. These higher income levels drive higher demand since there is a greater willingness to spend at even higher price levels. This gives businesses the opportunity to increase prices. Thus the increase in price levels cause inflation to rise in the expansionary phase.
14
THE INCESSANT DEBT CYCLE
15