The End Game: Part I

Last week, I wrote that the US election was almost irrelevant to investors in the grand scheme of things. Today, and this week, I would like to try and justify that claim.

Markets have been all over the place, sinking 10% in the run-up and catching it all up in the week of the event. But zoom out to a multi-year or multi-decade view, and this fades into insignificance.

Drawing on learnings from names like Howard Marks, Warren Buffett, and Russell Napier, as well as lessons humanity has learned through folklore such as Aesop’s fables, Greek mythology and Harry Potter, I would like to demonstrate three the three parts of the big picture.

How we got here, where we stand today, and how it all could end.

This is The End Game.

Deadulus ran forwards towards the ocean, sweeping his arms up and down as he did so. With a whoosh he zoomed forward, rising into the air. Icarus copied his father; suddenly he found his feet were no longer on the ground… he was in the air… he was flying!

He couldn’t believe it! As he looked down at the sea Daedulus and Icarus below, his heart fluttered with excitement. It was as though his body was weightless. The wind whistled against his ears. He felt like a bird!

Higher and higher, faster and faster he flew! Suddenly, Icarus realized he could hardly see his father. He had flown so high his father resembled a small dot below him.

At the same time, he noticed a feather drift past and float downwards towards the sea. And then another… and then another.

Too late Icarus realized his wings were melting. He had flown too close to the Sun. With every desperate swoop of his arms, more feathers fell and soon his arms were almost bare.

Down and down and down went Icarus…

Source: Pinterest

The world has never moved in straight lines.

Life always balances out, but it is not always balanced. Things sway around a centre point or trendline. Empires rise and fall, companies dominate and then are disrupted. Politicians come and go.

And markets are no different. It’s a truth embedded in human nature, in our psychology. From Daniel Kahneman and Amos Tversky through to Howard Marks and Morgan Housel (whose excellent book The Psychology of Money we looked at last Friday), human psychology drives irrational behaviour in the markets.

The efficient markets hypothesis, which believes that prices are a fair reflection of all publicly available information, has been proved to be a fallacy time and again.

Market cycles are eternal, they are inherent, and like a pendulum, they swing from extreme to extreme.

The clearest way to see this is with Warren Buffett’s favourite metric, measuring the market capitalisation of the all-encompassing Wilshire Total Market index, against the GDP of the US.

If markets were efficient, this chart would look very different:

Source: GuruFocus

You can see the market is sometimes undervalued relative to GDP, and sometimes overvalued. It has never stayed above or below the green line forever. And when it returns to it, like a pendulum, it often swings right past without stopping, moving from one extreme to the other.

The herd mentality of investors oscillates between greed and fear, and that is clearly seen in the above chart.

This has been especially true in the last two decades.

The many-headed monster

 In the story of Hercules’ 12 labours, he faces the hydra, a snake-like water monster with many heads. Each time you chop one off, two more grew in its place.

The last two decades of American central bank policy have been oddly reminiscent of this, as mistakes have been compounded by doubling down on the policies at fault.

In Evergreen Gavekal’s e-book series “Bubble 3.0: How Central Banks Created the Next Financial Crisis” (written 2017-2020), CIO David Hay outlines why that’s the case.

Their first error was in overreacting to the bursting of Bubble 1.0 (tech) in the period from 2002 to 2005, which led to an extreme rise in housing prices.

This led to the housing market crash and banking crisis in 2007-2009.

The Federal Reserve, and other central banks the world over, then doubled down. Interest rates were lowered to record levels, and money was printed to buy financial assets (“quantitative easing”), to stimulate capital markets in the hope of “trickle down” economic effects. This has not worked.

It has led to the longest financial asset bull market in memory, while wages have stagnated.

Thus, the balance sheet assets of the central banks correlate concerningly tightly with the share of assets held by the bottom 50% in the US.

Source: Crescat Capital

 As a result, the stockmarket is now more out of reach for the average worker than ever before:

Source: Finbold

 Looking back to last Friday’s book review of The Psychology of Investing, we can see evidence for Morgan Housel’s view in the above chart.

He said expectations were set after WW2 of broad and evenly distributed wealth gains, and the disappearance of that reality after the 1970s is why we are seeing cries of “this isn’t working for me any more” across the world – from Brexit to Trump.

It’s all relative, or is it?

Finally, I’d like to look at the mechanics of how the policies of the Fed have directly led all financial assets to be incredibly overvalued, although they may seem to be fairly priced relative to one another.

Borrowing heavily from his latest memo, here is Howard Marks explaining why the Fed’s actions have led to mathematically higher prices, as well as greedier investor behaviour.

On 3 March, the Fed lowered the fed funds rate from 1.50%-1.75% to 0-0.25%. This is the base rate which influences all other interest rates.

The first effect is stimulative. Everything that requires financing becomes more attractive, because the cost of capital is lower. Monthly payments for mortgages or cars become cheaper, as does taking on debt for companies. Companies, households and governments all take on more debt when rates are lower.

A fear of missing out on low rates gives people a reason to act now.

Second, lower rates increase the discounted present value of future cash flows. Discounted cash flow (DCF) calculations are widely used to quantify the potential returns from investments.

Thirdly, a low risk-free rate brings down demanded/expected returns all along the capital market line. Investments other than government bonds generate higher returns as a trade-off for higher risk. This is called the risk premium.

When rates are lower, the demanded returns from other assets – high-grade bonds, defensive equities, aggressive equities, high-yield bonds, and private equity – all decline, because they are priced relative to the risk-free rate.

If US ten-year government bonds are offering 9%, then high-grade bonds have to offer 12% to entice investors to buy them. If US ten-year Treasuries are at 0.25%, then only 3.25% is required to get investors interested – if not lower.

Yields are inversely correlated to prices, as the yield is the fixed coupon payment of the bond as a percentage of the price, so when the price goes up, the coupon falls relative to it.

That means that as the risk-free rate falls, other bond yields fall, and prices go up. This has been happening consistently since the early 1980s.

This has a knock-on effect all along the risk curve, because as bond prices go up, equities look cheap relative to bonds, and then aggressive equities look cheap relative to defensive ones, and soon even private equity looks cheap relative to everything else.

Just two weeks ago, the US Department of Labor agreed to permit pension funds to include private equity funds in American pension (401k) funds.

Fourthly, lower expected returns (caused by lower interest rates) lead to higher valuations, because of the earnings yield.

The earnings yield is the inverse of the price-to-earnings (P/E) ratio. If US Treasuries yield 3%, a 6.5% yield might be demanded by investors for investing in the S&P instead. The S&P offers that yield when earnings represent 6.5% of its price. A 6.5/100 earnings yield (earnings-to-price ratio) is logically equivalent to a 100/6.5 P/E ratio.

A 6.5% earnings yield is equivalent to a P/E ratio for the S&P of 15.4, the post WW2 average.

If Treasuries yield 1%, as many do today, the same equity risk premium requires an earnings yield on the S&P of only 4.5%. This translates to a P/E ratio for the index of 22.2, a 44.4% increase in the price.

That’s is how, logically, falling interest rates automatically push stock prices higher. You can see how this has pushed bond prices and stock prices higher simultaneously, for the last 50 years:

Source: Koyfin

These four points combine to create a powerful force. Together, low interest rates and low prospective returns encourage risk tolerance and reaching for return.

People who got a certain return in the past expect to be able to continue to do so, and thus they move further down the risk curve in order to achieve that return.

Two examples are pension funds moving into private equity, and income investors using quality stocks as a replacement for bonds.

In these ways, low rates make risk aversion a challenging thing to practice, and risk-taking much more palatable, perhaps even professionally necessary.

All of these factors go a long way into explaining both the high prices and the high levels of greed and FOMO (fear of missing out) present in the market today.

Add in that the Fed has reassured investors that it will ride to the rescue at the first signs of trouble, and the result is that investors can always look beyond short-term trouble to better times.

 Marks finishes, “Thus, today… most assets are offering expected returns on everything that are fair relative to their expected risk, relative to everything else. But the prospective returns on everything are about the lowest they have ever been.

This is a crucial point, because everywhere you look, people are offering justifications for why prices can keep going up and up. But the truth is that greed will always find a justification for higher prices.

Joining the dots

It’s time to pull it all together, and figure out how we got to where we are, with US markets breaking record highs in the middle of a global recession and pandemic.

The rampant inflation of the 1970s forced a change of tactics from the Fed which began cutting interest rates by too much during crises, and not raising them enough afterwards.

After 2008, it also began printing money and buying financial assets to stimulate markets economies. As a result, indebtedness has increased. It’s no longer with the banks though. It’s mainly with corporates and governments.

That is why we are at the stage where bond yields are at all-time lows at the same time as stocks are at all-time highs. Both have experienced mind-bending, five-decade bull runs.

Meanwhile, average workers are being priced out of these financial gains, leading to a widening of gaps in society.

With all of the above factors gaining momentum, markets are headed for a reckoning.

Like all cycles, they cannot go on forever. Market cap cannot exceed GDP forever. Valuations cannot go up forever. Debt burdens cannot grow forever.

In such an environment, it has never been more important to be on top of your savings and investment. And with so much peril swirling about, it’s crucial now to have the best advice.

Charlie Morris has managed money for 30 years. He ran billions of pounds at HSBC, and his multi-asset approach has never been more valuable for retail investors.

As is our way here out Southbank Investment Research, we are sharing his work with you in a unique format.

Right now, with the end game approaching, having Charlie in your corner has never been more important. He can guide you through, using his wealth of experience and City-leading know how.

I can’t recommend it enough – more details coming soon.

All the best,

Kit Winder
Editor, UK Uncensored

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