The End Game – Kit Winder 2020 – markets, valuations 11-2020 The End Game: Part 1,2,3 – by Kit Winder

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. …”…

The End Game: Part II

Kit Winder

Well, I said that the election wasn’t that important, and I was right. Not because I was right though, but because genuinely good news arrived on the vaccine front.

While the vaccine may offer feelings of a return to normality and a fresh start, in the financial markets it’s a different story.

On Monday we looked at how cycles drive everything, how central banks are tripling down on policies which exacerbate market distortion, and how lowering interest rate drives both mathematical and psychological reasons for prices to rise, and investors to get greedier.

Today, I want to look at how financial markets have responded to lower interest rates in ways which have made them more fragile.

When we have football manager José Mourinho advertising trading platforms to millions of football fans, and when there are drunk guys in bars (this was in August) shouting at me about why Tesla is the best investment ever, we are surely in the final phase of the end game.

So I ask, what are the biggest threats to your wealth today, that no one is talking about?

In people who suffer from some form of memory loss, it’s common to forget that you have a problem remembering things.

Thus, it can be mind-bendingly confusing when you can’t remember something, and are told that you’ve actually forgotten a lot of things.

Sometimes, an entire week, month, or life has slipped your mind.

Given that reality is a construct of the human mind, and that we are mostly a collection of memories and experiences, I always think that being told of things that happened to you that you can’t remember must be deeply terrifying, mind-bending moments.

The reality you believed in is no longer the same.

Like a member of a cult entering the real world for the first time, the fundamental underpinnings of your world collapse. The truths you held dear are gone – in fact, they were never true at all.

In Peter Pan, this comes into play as the Tinkerbell effect, in which belief creates reality. Children need to believe in fairies in order for Tinkerbell to recover.

Some things just exist only because people believe in them.

Today, financial markets are suffering from the Tinkerbell effect. And when cracks and chasms begin to appear, I fear that the effects will be similar to the feelings of amnesia sufferers and cult escapees.

The power of politics and passive flows

The reason I argue that the election doesn’t matter is that the US is divided. It has problems that a single president cannot fix.

The same is true of the vaccine. It can only mask the deeper issues for a while.

Through policy and central bank actions, society continues to widen. Perhaps the vaccine will accentuate that.

In the 1990s, Bill Clinton brought in a rule on executive pay which put a ceiling on CEO salaries. But not bonuses and stock compensation, so now that’s all they do. They grant themselves options and buyback shares with debt to boost the stock price – a subversion of free markets in many ways.

The reason buybacks are so important is because of the flow of capital. If there is always a big buyer of a stock (in this case, the company itself), then dips are quickly bought, lowering volatility and pushing prices higher and higher, year after year.

And because growth attracts incremental capital (investors look to buy into things which are going up), this becomes a self-reinforcing cycle.

Capital flows have become one of the most crucial determinants of investment returns in recent years, because of this self-reinforcing element. And not just because of buybacks.

Let me explain.

The last decade has witnessed the rise of passive investing. Michael Green of Logica Capital is the leading exponent of the view that passive investing is distorting the markets, and that flows are more important than valuations now.

Source: Isabelnet

Passive funds are exactly that – they are execution machines, buying the underlying stocks in proportion to their size in the index, at any price.

The more they buy, the better the underlying shares do, and because flows go in proportion, the largest companies get bigger and bigger.

The big US tech stocks, as the biggest and best performers in this bull market, have been the top beneficiaries.

The better passive does, the better they do, and the better they do, the better passive does.

The flows continue.

Stockmarket participants have spun a very powerful narrative that the Federal Reserve will save us, and like Tinkerbell, the power of their belief has made it true. But there are other forces at play, and if their belief should crack or waver, there could be serious trouble ahead.

This passive investing feedback loop of doom is enticingly powerful on the way up – however, it will be equally powerful on the way down. For now though, it sucks more and more money in.

It reminds me of that famous quote, which says that “the stockmarket’s goal is to inflict the maximum amount of pain on the maximum number of participants”.

For just as passive strategies like ETFs will buy at any price on the way up if someone puts money in, they will also sell at any price when someone takes their money out.

As long as net flows into passive funds are positive, everything winds upwards, like the right-handed honeysuckle in Flanders and Swann’s romantic ballad (the fragrant honeysuckle spirals clockwise to the sun…).

That’s how we have ended up here, with valuations nearing their highest points ever:

Source: Crescat Capital

And earnings yields (earnings as a percentage of price – the inverse of the price-to-earnings ratio) are near multi-decade lows:

Source: Multpl

But this week we have caught a glimpse of what happens when the trend does reverse. Here’s Facebook, Google, Netflix and Microsoft (blues), vs Shell, Lloyds and Southwest Airlines (reds).

Source: Yahoo Finance

The loved become the unloved.

This reversal is a whisper of what is to come, a truth which is buried in the wisdom we all learn as children.

Don’t fly too close to the sun, blessed are those who are poor, the higher the pedestal.

The market moves in cycles, and those cycles are exacerbated by human emotion.

We stand now, near the end of a two-decade bull market which began with the Fed’s response to the tech bust. The debt burdens faced by companies and governments are no longer sustainable. Corporate debt-to-GDP ratios are at all-time highs across the globe.

To resolve the debt burden, there is only default, or inflation.

To get from one side to the other requires crossing the stormy seas, and passing through a revolving door.

And Chris Cole puts the “vol” in revolving.

His work has shown how there are trillions of dollars in the financial markets today that are betting on volatility staying low or falling.

The last two years have seen market crashes turn ugly. They have been violent, like the Vol-maggedon incident in February 2018, and the crash earlier this year.

That’s because, in a similar way to portfolio insurance in the 1987 crash, funds which balance risk according to how volatile things are, are forced to sell risky assets (equities, high-yield bonds, etc) when volatility spikes.

This itself leads to a downward spiral, as selling begets selling. Volatility begets volatility, and round and round it goes.

Do you see now, how things are geared up? Markets are being driven by feedback loops, as falling volatility and rising flows into passive investing have pushed things up and up.

Markets are in the thrall of a cultish leader, and when these trends reverse, as they inevitably must, there will be hell to pay.

Source: Barron’s

It will be a terrifying moment when the pillars of that world view come crashing down.

With such a setup, I would say that it has never been more important to seek professional financial help.

The End Game: Part III

Kit Winder

“A Hare was making fun of the Tortoise one day for being so slow.

“Do you ever get anywhere?” he asked with a mocking laugh.

“Yes,” replied the Tortoise, “and I get there sooner than you think. I’ll run you a race and prove it.”

The Hare was much amused at the idea of running a race with the Tortoise, but for the fun of the thing he agreed. So the Fox, who had consented to act as judge, marked the distance and started the runners off.

The Hare was soon far out of sight, and to make the Tortoise feel very deeply how ridiculous it was for him to try a race with a Hare, he lay down beside the course to take a nap until the Tortoise should catch up.

The Tortoise meanwhile kept going slowly but steadily, and, after a time, passed the place where the Hare was sleeping. But the Hare slept on very peacefully; and when at last he did wake up, the Tortoise was near the goal. The Hare now ran his swiftest, but he could not overtake the Tortoise in time.”

This, and other stories, teach investors the virtue of patience, which will be crucial in the final phase of The End Game.

So far this week, inspired by the Grant Williams podcast series, we’ve been discussing ‘The End Game’.

It’s been a battle, trying to achieve two things.

Firstly, that we are somewhere. And secondly, that we must get to somewhere else.

Where we stand, and how we got here, were discussed in Part I on Monday and Part II on Wednesday.

We are overburdened with debt, over-reliant on central banks, and that financial asset prices are too high, causing social divisions which are getting worse. Good luck, Joe Biden…

But why must this end?

Markets are cyclical, swinging around points of equilibrium, never settling in balanced positions but never straying too far (or too long) either.

I also want to describe how we as investors should approach the coming transition from one phase to the next – as the saying goes there is no such thing as bad weather, just the wrong clothes.

There are two main relationships which must always come back into balance.

They are the size of the stock market (market capitalisation) compared to GDP, and the size of the debt pile relative to GDP. The debt can be government debt, corporate, or household, or a combination of all three, depending on the situation.

Corporate debt to GDP is currently at all-time highs, and so is market cap to GDP:

Total US Market Cap/GDP
Source: GuruFocus

The variation of market cap around the line of GDP is created by the combination of financial engineering and human emotion that we investigated on Monday.

Market cap cannot stray too far from GDP though. It must eventually return to the point of equilibrium. Either market cap must fall back in line with GDP, or GDP must catch up.

It’s important to remember that there are two ways in which balance can be restored.

Firstly, through a deflationary crash – essentially, stock prices fall far enough that market cap is cut down into proportion with GDP.

This is what happened in the tech bust between 2000-2002, as you can see below:

Performance of S&P 500 (blue) vs US GDP (red)
Source: Koyfin

Alternatively, GDP growth can outpace the stock market, while stock market prices stay flat.

This is more like what happened between 1968-82, when inflation took hold.

A fourteen-year bear market took place, but it was in valuations more than prices – which ended up roughly where they started.

Performance of S&P 500 (blue) vs US GDP (red)
Source: Koyfin

In our current situation with market cap to GDP nearly at 175%, the highest recorded level ever, those are the two methods of escape.

Price deflation, or GDP inflation.

In the former, standard portfolios lose money in a very obvious way, as prices decline fairly rapidly.

In the latter, the loss is more subtle. 1968-82 so a 0% share price return on the S&P 500 over a fourteen-year period.

If you are within thirty years of retirement, such a period with no positive returns would be truly devastating, forcing you to work longer or live more frugally.


There is a similar story with debt to GDP levels, and two pretty similar routes from where we are today, to where we end up once The End Game has played out.

Let’s look at a few different debt metrics.

Globally, corporate debt to GDP (not including banks), is at all-time highs:

Source: Reddit

And global government and corporate debt both just jumped in the wake of Covid-19, with the onset of massive fiscal and monetary stimulus.

Just look at America’s government debt as a % of GDP – it’s back at WW2 levels (over 100%) and forecast to rise plenty more in the years to come:

Source: The Economist

Again, this is a relationship which must come back into balance eventually.

Debt moves in grand cycles – something Ray Dalio is pretty famous for if you’d like to read more. You can see the first one building up to World War II, but incredibly we have now surpassed the debt levels, relative to GDP, that were reached back then.

Debt also moves in cycles.

Too little, and growth suffers because people can’t afford to invest in new machines, employees, advertising and other things for growing their businesses.

Too much, and growth suffers, because the interest burden grows too much, overpowering a business’ profits.

Sadly, after a crisis, as debt helps to rebuild growth and confidence, people take it too far. Convinced by recent history that the economy is healthy, people take on more debt and more risk. As businesses do so, competitors are forced to do the same. And on it goes.

When a country, or in this case most of the world, is overburdened with debt, two choices are once again available.

One is default, which is akin to the deflationary crash in asset prices we described earlier.

It is a sudden stop, a shock, a crash.

Corporates and governments simply say they cannot repay their debts, and start again (but with lower trust and higher future borrowing costs).

Throughout history, a second option has more often been chosen – inflation. The EU may struggle here, as nation states no longer control their own currency, so cannot print money.

If you can generate inflation, your debt burden will slowly fall in real terms.

So again we have two options – one which is very sudden and very painful, and another which is slower and much subtler.

This is the End Game.

Two problems, two solutions.

Overvalued stock markets, and overburdened governments and corporate sectors.

A stock market crash, with a wave of defaults, or inflation slowly reducing the real value of the debt, and quietly stealing away your real returns.

The hare, or the tortoise.

We cannot know which way things will go. …”…