For years, the so-called experts laughed at SocGen's Albert Edwards who not only steadfastly claimed that his "Ice Age" thesis is in play with central bank intervention only kicking the can - something that no longer works as Deutsche Bank so poignantly explained when it begged over the weekend for no more "easing" - but that once the realization and revulsion to artificially inflated markets hits, the "S&P will fall 75%" as he predicted in mid-January and we duly noted.
But while the pundits were laughing, they have been surprisingly quiet lately. Why? Because it appears that Albert may have the last laugh after all.
As SocGen's "other" realistic strategist Andrew Lapthorne writes, "Maybe Albert’s crazy forecast is not that crazy after all!" Here is why:
Global equity markets continued their difficult start to the year, with the MSCI World index off 2.5% last week, leaving it down 8.4% in 2016 and 15% lower from the highs seen last May. Sadly despite these declines, equities are still some way away from “average” valuations.
Albert Edwards sees the possibility of a 75% decline from the peak if all his fears were to manifest themselves. Now many view this as an incredible and somewhat outlandish forecast, yet it is not that unreasonable in our view. For example, in the chart below reproduced from last week’s risk premia note we look at the potential downside if MSCI US & Europe were to mean revert to their average P/E since 1970. This equates to 14.7x for the MSCI US and 13.3x for the MSCI Europe based on operating EPS as defined by MSCI.
We also look to see what the decline would be if we went back to crisis reported P/E multiples, which we put at roughly 12x for the US and 10x for Europe (though both have been much lower). These types of declines would leave indices down rough 60-65% from peak, and would send leverage ratios skyrocketing.
The job of risk management is to think the unthinkable, to stress test your assumptions to even include the worst case scenario. It does not take a particularly bearish set of assumptions, say a 25% decline in EPS and an average P/E multiple, to generate significant equity market downside. Yet, we’d argue most would assign a very low probability to such an event. Surviving a crisis and avoiding permanent losses of capital are key in delivering long-term outperformance, so even if you consider such downside forecasts "perma-bear" nonsense, they shouldn’t be dismissed out of hand, especially in a world where corporates are carrying record levels of debt.
Hardly the stuff one should smile about, and yet...