Fear of overvaluation – particularly for U.S. equities – has driven far too many investors to miss the strong bull market. For market bears to be proven right, according to Albert Edwards, it will take one or more of several triggers.
Edwards is the global strategist for Societe Generale and is based in London. He spoke at his firm’s annual investment conference in London on July 9. A copy of his slides, as well as those from his colleague Andrew Lapthorne’s presentation, can be found below.
Edwards is not known for providing upbeat forecasts, but he said at the outset that he is not as bearish as usual. “I understand the competitive pressure to participate,” he said, “despite that fact this will go horribly, badly wrong.”
In 1996, Edwards forecast an “ice age” during which bonds would outperform stocks. He based this on his experience observing the Japanese economy, predicting that equity yields would rise as their prices fell, while bond yields would decline.
He noted that the U.S. equity market peaked in 2000, just as Japan did in 1989, and that U.S. stocks are still in a secular downtrend based on cash-flow yield. Edwards said the same thing happened in Japan and it continued for 10 years.
“The ice age is still intact,” he said.
The fate of the bull market
Do valuations still matter? Edwards said the U.S. forward P/E ratio is at a “considerably and extremely unusually high level,” higher than Europe and Japan. It’s not just the FANGS and technology stocks, he said. Using data from Grantham Mayo van Otterloo (GMO), he showed that the Shiller CAPE is not very dependent on the sector composition of the market, which accounts for only a small portion of the gap relative to historical levels.
Investor sentiment was missing a year or 18 months ago, he said, but now that data depicts “full-on bulls.” Using data from the American Association of Individual Investors, he showed that retail exposure is 75% in stocks (based on the ratio relative to cash) and at historically high levels. Data from Investors Intelligence shows that professional advisors are as bullish as prior to the 1987 crash, Edwards said.
“Essentially everyone has decided valuations don’t matter,” Edwards said. “But they do.”
He said the run-up to the 1987 crash was similar to the last few years. At that time, the bond yield started to rise following a period of rapidly increasing valuations. Oil had fallen but the economy recovered and was very strong, according to Edwards. “It looked very vibrant,” he said, “yet the market collapsed.”
What happened? Edwards said the dollar was falling and bond rates rose in response. The Bundesbank raised interest rates instead of helping to stabilize the dollar. The market feared the dollar would plunge and the Fed would have to raise rates, he said, triggering a recession. But market valuations didn’t support a recession.
Such a recession could be the trigger for a market pullback, he said, “or even just the fear of one.”
Another trigger could be the bond market. Two-year Treasury yields are greater than U.S. dividend yields, which he said is threatening equity valuations.
The yield curve is flattening, he said, but the market is still not expecting aggressive Fed tightening. One risk, he said, is that the yield curve flattens further along with a higher 10-year yield.
Yet a third trigger could be inflation and monetary policy. Edwards admitted he and the consensus were wrong about the bullish call on the dollar a year ago. Now the consensus is bearish about the dollar and bullish about the euro, he said.
“The Fed is composed of cowards,” he said. Since the taper tantrum in May 2013, it has gone out of its way to persuade the market that Fed funds rate will be less than 3%, according to Edwards. That makes it difficult for the dollar to rally. Every time it raises rates it goes out of its way to reassure markets. Ironically, despite rate hikes, he said, according to data from the Atlanta Fed, financial conditions are easier than prior to those hikes.
On a secular basis, he said the U.S. is in deflation, “but cyclically inflation will pick up.” Inflation could be a trigger, according to Edwards. Data from the New York Fed suggests core CPI could pick up and Edwards said this could surprise investors.
“Wage inflation was the dog that did not bark,” Edwards said, since it decelerated last year. This has been very reassuring for the market, he said, making it hard for the dollar to rally. The reason for the sluggishness in wage inflation, according to Edwards, is the persistently high level of potentially employable workers, despite the low published unemployment rate. But, he said, wage inflation could pick up.
A positive outlook for Japan
Amid his fears of a market correction, Edwards offered a positive outlook for Japan.
A big surprise has been wage inflation in Japan, he said, which has been stuck at 0.5% for two and a half years, despite a much tighter labor market than the U.S. “Japan had done fantastic things,” he said, “like getting women into the workforce – the one part of Abe’s policies that did work.”
Nominal income growth nominal is about 2%, he said, despite slow wage growth. Consumption has been running way ahead of income, unlike in the U.S., according to Edwards.
“There is a real case that consumption growth in Japan will accelerate very rapidly,” he said. Its GDP growth is at 2% and could increase, he said, which would be a surprise to the markets.
“Profits are rising as is the stock market,” Edwards said.
The big macro disappointment has been the Bank of Japan’s (BoJ’s) failure to hit its inflation target. Inflation is picking up everywhere else in the world, he said. But due to the BoJ pinning rates at zero, if inflation increases, real rates will decline and consumption will increase further.
Of all the central banks, he said Japan and Switzerland have been most aggressive. The BoJ’s balance sheet has already started to decline, he said, indicating that it is stepping away from its purchases of 10-year Japanese government bonds.
“A lot of major trends start with Japan,” Edwards said. “This could be very significant.”
But if the BoJ tightens, he said the yen could strengthen instead of its recent weakening.
“If you are looking for surprises and shocks that trigger a great unwind,” Edwards said, “it could be Japan tightening.”
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