"Brace For A Stock Market Accident", GLG Chief Investment Officer Warns

Tyler Durden's picture

Authored by Jamil Baz (CIO, GLG), Originally posted at The FT,

Brace For A Stock Market Accident

Profits and leverage are locked in a deadly embrace

There is a time-honoured tradition in statistics: whipping the data until they confess. Bullish and bearish equity analysts are equally guilty of this practice.

It would seem that statistical conclusions are merely an ex-post justification of a long-held prior belief about equity markets being cheap or overpriced. Clearly, consensus, notably among sellside analysts, is bullish. I present the bullish view before discussing a bearish counterpoint.

Who can blame the equity bullish consensus? Earnings yields – a proxy for real equity yields – stand at comfortably high levels. For example, the forward earnings yield on the S&P 500 is 8.3 per cent.

Contrast real equity yields with real bond yields: with the US Consumer Price Index at 1.7 per cent and the nominal Federal Reserve funds rate at 15 basis points, real bond yields are at -1.55 per cent.

The difference between equity and bond yields – also known as the equity risk premium – is therefore close to 10 per cent. This is way above the 4-5 per cent premium required by investors to own equity, and therefore indicative of an ultra-cheap equity market.

There are two reasons why this consensus is misguided. First, because it uses dubious metrics. It is wiser to use a long-dated real bond yield because equity is a long-dated asset.

And forward earnings yields are misleading for well-documented reasons: analysts’ earnings consensus forecasts are known to be wildly optimistic; in a bid for juicier equity and call option compensations, managers encourage their accountants to inflate earnings numbers; and earnings are partially squandered by managements as they seek to prioritise growth over profitability.

So it is probably a good idea to use dividend-based – as opposed to earnings-based – equity valuation models. Unlike earnings, dividends do not lie.

Second, because consensus disregards leverage. Profits and leverage are linked (in a deadly embrace, it turns out). If deleveraging is yet to happen, then earnings growth can only be headed south.

So what if you trust dividends more than forward earnings? In a simple dividend discount model, the real equity yield is the sum of dividend yield and real dividend growth. The S&P dividend yield is 2.15 per cent. The real dividend growth has been historically 1.25 per cent.

The real 30-year yield is 0.4 per cent. Using these numbers, the equity risk premium is now 3 per cent, less than the premium level deemed acceptable. But we are not done yet, as we have not factored leverage into our equation.

Enter Michal Kalecki, a neo-Marxist economist who specialised in the study of business cycles and effective demand. Mr Kalecki showed that profits were the sum of investments and the change in leverage.

In the current environment, the implications of this equation are clear: in G7 economies, total debt is at a record 410 per cent of GDP. And this is excluding the net present value of social entitlements and healthcare expenditures, which is larger than the total debt.

Because leverage stands at unsustainably high levels in advanced economies, it should fall substantially over the long term, affecting profits negatively.

It can be assumed conservatively that the total-debt-to-GDP ratio needs to fall by 100 per cent before the debt position becomes sustainable in advanced economies. This would bring the US back to 1995, when the profit-to-GDP ratio was 45 per cent lower.

We can value the S&P under the following scenario: dividends fall by 45 per cent over a zero-growth period of 10 years. Then they resume their real growth of 1.25 per cent per year. Again, assuming a real yield of 0.4 per cent and a required risk premium of 4.5 per cent, fair market value is only one-third of current market levels.

Leverage is hence the fly in the ointment, begging the obvious question: when does the deleveraging take place? Answering this question is tantamount to timing the next major bear market. It is, of course, futile to predict a date, but as economist Herbert Stein used to say, if something cannot go on for ever, it will stop.

It is increasingly obvious that governments will take no active step towards deleveraging unless they are under the gun. But there are institutions and mechanisms that will trigger deleveraging, namely: Basel III, the bond market, default and, rarely, courageous politicians.

Inflation can also help delever, except in economies where social entitlements are inflation-indexed.

In the short term, it is clear that central banks need to entertain the illusion of viable stock market valuations by pulling rabbits from a hat. But as high-powered money reaches ever higher levels, the probability of accidents looms large.

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The Gooch's picture

"the probability of accidents looms large"

Unstoppable force, meet immovable object.

LetThemEatRand's picture

Entropy, meet central control.  Laws of nature have a tendency to win, eventually.

Unprepared's picture

Chaos, meet nuclear winter.

THX 1178's picture

Pride, meet downfall.

"Hello, old friend."

SilverTree's picture

Virginia Wants to Mint Its Own Coins HOUSE AGREES TO SPEND $17K ON A SPECIAL PANEL


ACP's picture

I'm surprised ZH hasn't thrown this out there as part of a possible stock market "accident":


EnslavethechildrenforBen's picture

stock market won't crash, it never has in the past.

wee-weed up's picture

Believe me... it will be no "accident" when the stock market crashes!

Theosebes Goodfellow's picture

~"...fair market value is only one-third of current market levels."~

S&P500 @ $1511.29 / 3 = $503.76

Feces, meet impeller.

jeff montanye's picture

while some might say so, i don't think the author meant what he said below.  a better way would have been to note that leverage needs to fall from 410% to 310% of gdp, about 25%.  

"It can be assumed conservatively that the total-debt-to-GDP ratio needs to fall by 100 per cent before the debt position becomes sustainable in advanced economies."

trebuchet's picture

S&P500  @1550,   meet  Shorty

Freddie's picture

Drones killing American citizens.  Bullish!  Should be good for a 350 point rally in the Dow.

Hope and Change.

zero deception's picture

to Rand, Yes, they do but I wont be alive for theat specticle and neither will you.

LetThemEatRand's picture

That's what "they" are counting on.  Probably true but maybe not.

zero deception's picture

And you think I'm the one that's batshit crazy.

Deacon Frost's picture


May I remind everyone;



Last updated: 11/12/2009 09:59:24


In real terms, the ZSE is the best performing stock exchange in the world. The Zimbabwe Industrial Index up some 7399% since the January 2007 and 12 000% over twelve months is three times in excess of the increases in consumer prices.


The reason why we continue to recommend investments on the ZSE is because the market is reflective of the deteriorating economic conditions in Harare. Increasingly, the only means for the government to fund itself has been money-supply growth. The stock market is the primary beneficiary of the fresh money. Fresh money enters the economy first through banks and other financial entities who may invest it in shares, or lend it to others who buy shares.

The relative stock market outperformance relative to general prices of other goods such as food or clothes will continue as long as this monetary process is allowed to continue. Regardless of the temporary crash, by the end of this year, the ZSE is on course again to being the best performing stock exchange in the world as long as the government continues with its affinity to print money.


SMG's picture

Which is why although these articles are informative and correct, have so far had no bearing on the market and do not really do anything to predict where the market will actually go.   With measured printing they can keep this going for, I suspect, at least 2-3 more years, until the hyperinflation (complete loss of faith in the currency happens).   

May you live in interesting times.  -Chinese curse

MisterMousePotato's picture

I have been thinking about this a lot. Are not both of the following statements true?:

1. The Fed and the US government will do anything and everything (and I mean that in the strongest literal sense) to prop up the stock market. Otherwise, pension funds, public and private (but especially public) are utterly bankrupt overnight. Obviously, anything and everything includes (at a minimum) printing money and giving it to others to buy stocks, if necessary. There are even some on this website who have made a compelling case that such is already being done.

2. The Fed and the US government are actively undertaking debasement of the dollar to monetize debt and to keep the system from outright imploding quickly. Again, I have read enough articles and commentary here that I am persuaded that this has already begun, and, further, that this policy will be pursued until the very end.

I am aware that there is what appears to be a disconnect between the economy and the market; viz., the market no longer reflects the underlying economy or fundamentals of any particular company or sector, but instead is being manipulated to enrich certain individuals, prevent utter pension and system collapse, and to give the appearance (via television sound bite talking points) of normalcy or better.

Nevertheless, given the certainty of the two policies mentioned above, is it not impossible that the market will decline in any significant manner (at least nominally), and likely will provide growth commensurate with real inflation for some period of time (which may well prove to be longer than my remaining days here on Earth)?

Really, it seems like the big questions are:

1. How long? When?

2. What will prove the harbinger of real decline?

3. Will manipulation and support include all stocks (including Facebook, Netlix, Amazon, and their ilk) or just some? How to identify those that will enjoy the most support the longest?

On the other hand, a stock market 'accident' would provide the Sandy Hook needed to grab everyone's pension dollars for their own protection. ("If it's to protect our kids, I'm all for it" a la http://abclocal.go.com/ktrk/story?section=news/local&id=8971311)

tenpanhandle's picture

The notional value of all stocks is just that, notional. 

Common_Cents22's picture

All it will take is another good drop for the government to make a pitch to take over 401k's/private retirement/private pensions.   They already floated a trial balloon saying in a market decline they'll reimburse part of the loss to your portfolio if you hand it over to them.

Watch for this topic to come around again soon, if and when, watch out because you know there will be a major market decline.

They will be running out of taxing power soon, knowing they'll kill the host too quickly, and/or treasury refi's getting tougher and tougher.

TrumpXVI's picture

Good analysis, MMP, and I don't necessarily disagree, but the stock market will be moved, I believe, by action at the margins.  If and when one or two of the larger hedge funds decide to cash out this will probably cascade.  The Fed can prop things up (maybe indefinitely), but that is very different from stopping a run once that has started.  There are real dangers here and I wouldn't put any of my resources into this equity market.  It's not that people aren't making money, it's the risk/reward that turns me off.

MisterMousePotato's picture

Why do you think that a large hedge fund or two withdrawing from the market would have a greater effect than the loss of the retail investor?

TrumpXVI's picture

Because the hedge fund guys are the market' "experts".  The retail investor isn't, he represents the "dumb" money; nobody follows the retail investor or copies what they do or cares what they do.  But if a couple of big hedge funds decide to take profits I think that other hedge fund managers will follow and then institutional money managers will want to run, too.

vamoose1's picture

thats  so  good    i   fiddle  it  a  bit  and  call  it   cultural entropy    but   entropy  it  most  certainly  is

    WELL   HURRY  UP   FOR  FUCKS   SAKE   lets  get   rocking

Ah  entropy     if  only  we  knew  thee  and  your  relentless  timetable    just   hurry  the   jesus  up   we  are   getting  old   here

Matt's picture

What happens when an immovable object meets an unstoppable force?


westboundnup's picture

Bust a deal, face the wheel.

LongSoupLine's picture


At $85 fucking billion a month, the only accident is in fucking Krugman's fucking pants.

Fuck you Bernanke and your middle class destroying fucking bubbles, you shit stained fucking asshole.

Falconsixone's picture

Need money for Cyborgs, the price went up for red ones.

willwork4food's picture

Krugman & Bernanke. Such nice Jewish boys.

tenpanhandle's picture

$85 fucking billion only pays for gas and oil.  Accident is when the tires fall off.  Will happen.

bobthehorse's picture

I predict the DOW will climb to 30,000.

Why the fuck not?

The whole thing is rigged.


ultimate warrior's picture

Bullish fat finger trades.

zebra's picture

the market will only top when ZH runs out of bad news..

derek_vineyard's picture

i heard tyler might be getting bullish

New_Meat's picture

"There is a time-honoured tradition in statistics: whipping the data until they confess."

In the U.S. we used to call this 'torturing the data' but that term is no longer in vogue.  We can kill the data, but we can't "torture" them.

- Ned

traderjoe's picture

The market is broken. Since everything is now planned, there are no 'accidents'.

There will not be a crash. There will be war first, and then hyper-inflation later.

At least you get free drinks in Vegas.

SheepleLOVEcheddarbaybiscuits's picture

I agree there will not be a crash for at least 1.5-2 yrs, but then there will be a crash in epic proportion equalling 1929. All of this will be on the liberals hands, and they will burn. 11% inflation is not hyperinflation. Look back over your history, the wars come after the crashes......the only wars that come before the crashes are civil wars.

zero deception's picture

I dont agree with a word your saying. What will happne with 100% certantly is that the stock market will sore on news f BH O'Bamsa's getting caug red-handed with a sixteen year old… boy. Then a comet will destroy NYC den of evil a cesspool of perdition to rival anchient Rome. Then the mutton business will introduce a capita tax on the sheep and those who cant pay the bill will be sent to the neirest fema resort. Good luck. Nobody escapes in tack.

Whiteshadowmovement's picture

Sorry to take you out of your apocalyptic trance but where did you learn to spell? Is it home schooling or the public education system thats responsible for this?

Hate to be a dick about it but its "soar", "ancient", "nearest", "in tact" etc..

Dr. Engali's picture

I think maybe he's had a bit to drink. Either that or he's having a hard time coming down from the last hit of acid.

zero deception's picture

I was riffing off the previous poster in case you didn't notice dummy.

Dr. Engali's picture

Oh my bag. It was hard to tell since you haven't made an intelligent comment in the entire time you've been here. In case I don't see you post tomorrow happy 6th week birthday.