Much to the chagrin of some folks out there who recently bemoaned the fact that bearish analysts are “still talking,” Albert Edwards is back.
In his latest tri-weekly weekly (and as we’re fond of reminding you, that is not a contradiction in terms, because if there’s anyone who can put something out once every three weeks and still call it “weekly,” it’s Albert), Edwards begins by taking a trip down memory lane to a time when actual wolves were allowed in the conference room.
Oh, how times have changed. In today’s world, characterized as it is by “stifling health and safety strictures,” you can’t bring carnivorous pack animals into meetings with very “serious” people anymore.
In fact, you can’t even bring figurative “wolves” around very “serious” people anymore because in today’s market, what counts as a “serious” person is someone who plows everything indiscriminately into index funds when valuations are stretched to historical extremes.
That kind of egregious lack of regard for anything that even approximates responsible value investing is red meat for “wolves” like Albert (and there’s a double entendre here – people like Albert have been accused of “crying wolf”). So, on Thursday, he’s going to remind you that “valuation DOES matter” (all caps in the original).
But you wouldn’t know it to talk to clients. Here’s Albert:
Despite my bearish (or is it wolfish) howling, virtually no clients think the denouement will come any time soon and that the equity bull market should have at least 12-18 months left to run. Most can see nothing on the immediate horizon that might burst this bubble.
Before discussing a couple things that could catch the ebullient bulls off guard, Edwards reminds you of the similarities between vol. control funds/ CTAs/ risk parity and Portfolio Insurance (with the latter being a bad word). We and others (including JPMorgan’s “Gandalf” Marko Kolanovic) have variously discussed those similarities and the potential for those strats to deleverage into a falling market, exacerbating an already bad situation. Throw in the potential for an inverse and levered VIX ETP rebalance to supercharge a vol. spike and you’ve got a “doom loop.” Let’s go to Edwards again, recalling Black Monday:
I remember it as clearly as if it were yesterday – actually I can’t remember yesterday. Of course the machines took over the selling in the form of Portfolio Insurance programmes, but speaking to my colleague Andrew Lapthorne, he reminds me we also have similarly pro-cyclical ‘doomsday’ vehicles today with so much money being run by volatility targeting, risk parity and CTA/trend following quant funds.
Another thing Edwards remembers like it wasn’t yesterday is that “the record 25% ‘Black Monday’ October 19 decline was due to a horrendously expensive equity market suddenly confronted with the fear of recession.” Sorry CNBC anchors-turned asset managers: equity valuations matter.
“Could the same happen again?” Edwards asks, before answering himself as follows: “of course it could.” And not only could it happen again, “it could happen tomorrow” (save the damn date):
It could happen tomorrow given the extreme expense of US equities and the near universal consensus of a continued acceleration in the economic cycle despite the Fed also in the midst of a tightening cycle. As the excellent David Rosenberg of Gluskin Sheff points out, of the 13 post war Fed tightening cycles, 10 have ended in unexpected recession.
But at these extremes of equity valuation it might not even be an actual recession that produces the next precipitous equity bear market, but the fear of a recession, however misguided that fear may or may not be.
“The only thing to fear, is fear itself.”
So what could change the market’s expectation of steady economic growth? Well, an overly hawkish Fed, for one thing. But also, what happens if wage inflation finally does show up? Here’s Edwards:
Wage inflation has been the dog that didn’t bark this year – or indeed the wolf that didn’t howl. Wage inflation actually slowed this year against the expectations of some naysayer commentators (ie me) of an acceleration (and yes I do mean an acceleration rather than a rise). But it was notable that in the September payroll release, average hourly earnings jumped sharply to 2.9% – a high for this cycle (see chart below).
What if that’s not a hurricane-related anomaly? Or, more poignantly, what if it becomes a trend and catches everyone (including the Fed) behind the curve? “If for whatever reason it is not an aberration and the Phillips Curve is reasserting itself, similarly high wage inflation data in the months ahead could cause a rapid reappraisal of the pace of Fed rate hikes,” Albert notes, adding that “at these high equity valuations, that could really scare investors.”
In that scenario – i.e. if everyone begins to anticipate a faster pace of rate hikes – yields would rise and so would the dollar and here’s what happens next:
The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve. In that scenario yields would jump sharply higher across the curve, but especially at the short end and the dollar would soar.
Well if corporate profit growth is helped along by a weaker dollar, then a soaring dollar would be a headwind:
So a reappraisal in the market’s expectations on the pace of Fed rate hikes, perhaps because of higher than expected wage inflation data, would likely trigger both a rise in yields along the length of a flattening curve and a resumption in the dollar bull market. When the equity market is ridiculously expensive and priced for profits perfection, these events (or indeed as in 1987, the FEAR of these events) could prove catastrophic for QE inflated equity markets.
Oh, and don’t forget that in credit, spreads have become completely detached from leverage or, in other words, the market is not punishing poor discipline:
And that’s not even the half of it. There’s much, much more in the full note.
Of course if you’re the type of person who thinks that being bearish (or “wolfish”) is now akin to heresy and that people like Albert are “Gollums” (as some folks have recently suggested), then feel free to go ahead and keep buying at valuations that don’t make any sense.
But I’ll tell you what: if this all ends in tears, a lot of the people who have mistaken the effects of central bank largesse for their own investing acumen are going to end up looking pretty damn silly in retrospect. And my guess would be that you won’t hear from those folks for a long time after the inevitable correction.
Meanwhile, Albert is going to keep delivering his weekly dose of reality – every three weeks.
