In today’s Exponential Investor…
- How passive investing has distorted markets
- How markets became more concentrated and overvalued than ever
- How the assumption of safety is the riskiest belief of all
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.
In my newsletter for UK Uncensored on Monday (The End Game: Part I – click here to read), I looked at how cycles drive everything in, 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.
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:
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.
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.
All the best,
Editor, UK Uncensored