The premise of the concept of a credit cycle is that in equilibrium, the return on capital is equal to the cost of capital. If the difference between the return on capital and the cost of capital is positive and growing, equity prices will rise. If the gap is shrinking, equity prices will decline. The author tests an investment approach based on the credit cycle concept.
More than 100 years ago, Swedish economist Knut Wicksell developed the concept of a credit cycle. In equilibrium, the return on capital is equal to the cost of capital. If the return on capital exceeds its cost, there will be great demand for credit and an economic boom will follow. This concept provides the underpinnings for an investment strategy that is focused on the gap between the return and the cost of capital. If this gap is positive and growing, equity prices will rise. If the gap is shrinking, equity prices will decline.
To implement this approach empirically, the author uses the return on the corporate sector’s invested capital as a proxy for the cost of capital and the five-year moving average of five-year government bond yields as a measure of the funding cost. The strategy of switching into equities when the gap is widening and reducing the equity exposure in favor of government bonds when the gap is narrowing is backtested for the period of 1986–2011. With this strategy, the average real return of close to 9% for U.S. assets exceeds the return available from either equities or bonds alone.
How Is This Article Useful to Practitioners?
The author suggests a simple model for the allocation between equities and bonds that rests on reasonable theoretical foundations. The challenge for every practitioner will be to develop robust and consistent empirical proxies for both return and cost of capital. Certainly, the five-year moving average of five-year government bond yields as a measure of the funding cost will not appeal to every investor.
As the author points out, it is always possible to find models that provide outsized returns using past data. For that reason alone, the use of any one model as the basis of asset allocation decisions cannot be recommended. But the theoretical foundations are interesting, and studying the relationship between funding cost and return of capital should provide valuable insights into the state of the credit cycle.