Lesson 4
Why Cycles Exist
Markets aren't random walks. They follow credit cycles with predictable phases. Your job is to identify where in the cycle we are: early expansion (buy risk assets), mid-expansion (ride the trend), late cycle (reduce risk), recession (preserve capital, prepare to buy). The cycle doesn't care about your feelings — learn to ride it.
If productivity grows steadily, why do economies boom and bust? The answer is credit.
Ray Dalio's key insight: Credit creates cycles. Here's the mechanism:
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Credit Expansion: When lenders are confident, they extend more credit. Borrowers use that credit to spend. More spending = more income for others = more confidence = more lending. This is a self-reinforcing boom.
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The Catch: Borrowing pulls spending forward from the future. Today's spending boom means tomorrow's debt servicing burden. Eventually, income growth slows while debt payments keep coming.
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The Turn: At some point, debt servicing eats so much income that new borrowing stops. Spending falls. Others' income falls. Confidence drops. Lending contracts. This is a self-reinforcing bust.
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The Bottom: Eventually, debts are defaulted, restructured, or inflated away. Balance sheets repair. Lending confidence returns. A new cycle begins.
This happens in short-term cycles (5-8 years, recessions) and long-term cycles (75-100 years, paradigm shifts). The short-term cycle is the business cycle. The long-term cycle explains the Great Depression and potentially where we are today.
Cycles aren't random. They're driven by the mathematics of credit: borrowing creates booms, debt servicing creates busts. Understanding this gives you an edge over everyone who thinks markets are random or believes 'this time is different.'
Check your understanding
Lesson Quiz
Quiz Check
According to Ray Dalio, what is the fundamental driver of economic cycles?
Quiz Check
If banks aggressively expand credit, what will happen to the yield curve (T10Y2Y) (short vs long-term rates)?
Quiz Check
It's 2018. Banks are aggressively loosening lending standards, credit growth is accelerating, and the Fed is raising rates. What phase of the cycle are you in?
Quiz Check
You observe: Fed funds rate is high, credit spread (BAMLH0A0HYM2)s are wide, loan defaults are rising, banks are tightening standards. What should you do with your portfolio?