SocGen’s Albert Edwards is off to Jamaica, where he goes every year to “absorb large quantities of sunlight” and hang out with the ghosts of Marilyn Monroe and Winston Churchill.
But before he sets off on that “annual imperative” which helps “head off the creeping Seasonal Affective Disorder that results from living under the grey skies of London during the winter months”, he spent some time explaining how, according to a new working paper from the Bank of England, some version of the “Ice Age” dynamic has been at work not just since 1996, but in fact for the last 800 years.
You can read that paper for yourself, or if not, there’s a small chance we’ll get around to writing something about it later this month. More germane (maybe, although the “Ice Age” was about as “germane” as “germane” gets during the August bond rally) is Albert’s discussion of profits and valuations.
As regular readers know, we’re neither bullish nor bearish – we fancy ourselves neutral, a stance that drives some folks crazy, but which allows us to weigh in objectively and thereby makes it far easier to write from sunup to sundown. It’s easier to describe the world as it is (or at least appears to be) than it is to bend reality to fit a narrative and otherwise beat the facts into submission.
And yet, over the past month, it’s been difficult to avoid adopting a bearish-sounding tone given the relentless run-up in equities. This month’s under-the-hood action has made it even more difficult given what’s in the driver’s seat. “As equity markets make new highs every day/week, there is a defensive undertone”, Morgan Stanley said Monday.
You could write that off to a simple reversal of a reflation trade that simply got too extended in December and will eventually reassert itself, especially if the econ improves. But whatever the case, January has so far been characterized by bouts of renewed bull flattening in the curve and equities action that suggests investors are no longer as confident in the reflation story as they were just three weeks ago.
At the same time, the push to fresh highs on benchmarks has the broad market looking stretched and multiples suggesting too much optimism is baked in, especially at a time when earnings growth has flatlined and indeed gone negative.
Edwards touches on all of this in Tuesday’s note.
“The equity market may have rallied on the back of ‘not-QE4’ as the surge in the Fed’s balance sheet is commonly described, but irrespective of whether the equity market’s surge is due to Fed liquidity or not, [stocks] are in effect discounting a surge in the real economic data and in corporate profits”, he writes.
It’s possible, Albert admits, that “the Fed’s balance sheet expansion can sustain equity market gains well in excess of any potential profits rebound”. But that’s not the point. Rather, the point is that “for certain, investors have bet that weak economic and profits data is a mid-cycle pause”.
What comes next is highly interesting and, frankly, cries out for an explanation.
Albert has previously noted a parallel with the tech bubble, specifically as it relates to long-term earnings expectations as measured by IBES. That parallel broke down recently, or at least according to the color and charts he provides.
“Analysts in the late 1990s were simply driving up LT eps forecasts to reverse engineer their discounted cash flow models so as to justify maintaining their Buy recommendations for Tech, Media and Telecom stocks already on ridiculously high PE multiples”, he reminds you. Once the bubble burst, those forecasts collapsed because “there was no need to pretend anymore”.
In the right-pane, you can see what looks like a wholly anomalous explosion in the ratio of the forward multiple and long-term EPS growth expectations. Here’s Albert:
The recent swing in analysts’ long-term eps forecasts was most curious. Increasingly high PE valuations (17x+) had taken the ratio of the 12m forward PE relative to analysts LT eps growth expectations (the PEG ratio) to a new record high of 1.7 at the start of 2016 (right-hand chart above). Analysts therefore raised their LT eps projections from the start of 2016 onwards, bringing the PEG ratio back down, until it collapsed below 1.0 when the market slumped 20% at the back end of 2018. Curiously since then a slump in the LT eps series through 2019 has combined with a surge in the equity market to send the PEG ratio to a new record high of 1.8!
Yes, “!” indeed.
To reiterate our brief assessment from above, that right-hand chart “has some ‘splainin’ to do”, (to quote Ricky Ricardo) because if it’s to be taken at face value, then here’s what it might mean (from Edwards):
Does the record PEG ratio and the continued fall in LT eps estimates mean that analysts have just given up justifying historically high PEs? Does it mean that analysts have given up reverse engineering their justifications for their Buy recommendations? Is there instead a plethora of Sell recommendations on these extremely expensive stocks?
Edwards says that’s a rhetorical question, but even if you’re inclined to say there’s a good explanation that doesn’t involve a valuation bubble bursting (or a “valuation accident”, to quote Albert), then it’s incumbent upon you to provide that explanation.
“Those with long memories will remember that none other than Alan Greenspan justified the surge in the late-1990s equity market’s PE by the rise in this very LT expectations series”, Edwards goes on to write. “Greenspan actually believed that all those analysts making these high and higher LT eps forecasts independently couldn’t be wrong. He was mistaken”.