Albert Edwards: "The Trend Is Your Friend Until It Hits A Bend"
Even as GDP "surprises" Goldman Sachs to the upside, courtesy of some inventory build that only the government is seeing, and which completely skipped all the regional Fed reports, the market continues being stuck in an "sideways is up" mode, where any major economic upside surprise is a solid case for the Fed finally raising rates (yeah right). Yet the markets continue being on a good news is good news and bad news is even better news, roll.
So as we digest the GDP report, here are the latest observations from Soc Gen's Albert Edwards, who is not sharing any of the optimism generated courtesy of Goldman's 24-hour GDP reveral call.
One of the key conclusions from our late-1996 Ice Age thesis was that once the bubble burst, the close 35-year positive correlation between equity and bond yields would break down. This relationship had persisted for so long that it had become ingrained in investor psychology.
The 35-year period could be divided into two phases. The 1982-2000 equity bull market had largely been driven by PE expansion (not profits), which in turn had been driven by lower bond yields and lower inflation. Conversely, in the dismal years, the Dow went sideways for 17 years between 1965-82 as profits growth was wholly offset by multiple compression - driven this time by higher bond yields and higher inflation. Indeed, throughout this 35-year period, ?bad? economic news was generally good for equities as it drove bond yields lower and PEs higher. Equities had only a very loose relationship with the profits cycle.
We knew though from Japan that in a post-bubble world, once bonds and equities had decoupled, that the equity market would mirror the economic and profits cycle. And so, despite Japan?s structural equity bear market, one could enjoy numerous 50%+ rallies if one invested as the cyclical lead indicators bottomed out. Conversely one should have ALWAYS sold when these same lead indicators peaked out. After recent massive cyclical gains in equities, that extremely dangerous topping out phase looks as if it has begun (see below).
We have long advocated that in a post-bubble world, investors could participate in explosive upside equity rallies driven by decent economic data and an underlying improvement of
profits. We saw many of these rallies in the Nikkei over Japan?s lost decade. And even if one
believed, correctly as it turned out, that each 50% rally would wither away, it would be simply daft not to participate in these policy-induced cyclical rallies.
Hence the explosive rally in the equity markets this year should not have come as a surprise to our readers. The cyclical indicators after all turned up around December time (for the ECRI
and the Conference Board) and a touch later for the OECD leading indicator (see chart below). But, having flagged up so strongly that one should tactically become a buyer of equities onthe upturn of these indicators, I failed to follow my own advice! To be perfectly honest, as the market powered ahead, I, like so many others, waited for the pull-back that never arrived. Do I feel like a grade 1 moron? Yes, I most sincerely do. Should I be beaten mercilessly to within an inch of my miserable life? Definitely.But I remain convinced we are still in a structural bear market and that this economic recovery rests on such shallow foundations that it will be washed away by the first moderate wave.
Many clients and salespersons point out though that lead indicators, including the ECRI,
suggest instead that a traditional V-shaped recovery might unfold with 10%-plus quarterly
GDP advances just over the horizon (see chart below).
And some observations on cyclical feedback loops that impact the thinking of both consumers and analysts:
I could be mean of spirit and point out that many of these proprietary lead indicators do actually include the equity market itself and so buying equities because the lead indicator is rising may be an entirely circular argument; but I think that is wrong. Indeed the tendency of analysts to upgrade their eps forecasts has been a pretty good sign a real economic recovery is underway (see chart below). My colleague, Andrew Lapthorne, monitors these data closely on a weekly bottom-up basis (as opposed to the top-down data below) and publishes these regularly in the extremely useful Global Equity Market Arithmetic document which comes out first thing every Monday morning ? link. This is worth getting.
If in the Ice Age, post-bubble world, the equity market is far more connected to the cycle (see chart below), we should be very aware of possible cyclical turning points. They say the trend is your friend until it hits a bend. Beware, we may have just hit one.