‘Try 8X Instead’: As Market Crosses Another ‘Ice Age’ Milestone, Albert Edwards Looks Ahead

It must have been tough for SocGen’s Albert Edwards to decide what to write about on Thursday.

After all, this week found the Fed bowing to the bond market and delivering a 50bps “emergency” rate cut, the first inter-meeting move since the crisis. That decision was widely panned, and nobody is as adept as Albert when it comes to criticizing central banks.

Then again, 10-year US yields made history this week, falling below 1%, and the 30-year TIPS yield fell below zero. To say those milestones are squarely in Albert’s wheelhouse would be to grossly understate the case.

Spoiler alert: Albert chose to hold fire when it comes to lampooning the Fed.

“I’m going to suppress my natural inclination to launch a full frontal assault on the Fed’s emergency 50bp cut”, he writes. “There are plenty of others who have done that”.

Instead, he focuses on what he calls “interesting aspects” of recent market action, and “how they might pan out in the coming weeks”.

Right up front, Edwards lets you know that his famous “Ice Age” thesis is looking more and more prescient all the time. To wit:

Almost as significant as the unprecedented fall in the US 10y yield below 1% and 30y TIPS below 0%, is the decline in 30y nominal yield to below the equity dividend yield. This is another huge step in the Japanification of the US markets and ushers in the next phase of the changing relationship between bonds and equities. Equity investors are going to be disappointed Tina (There Is No Alternative to equities) has let them down.

Here’s a visual on that point:

A few paragraphs down, commenting briefly on the coronavirus outbreak and the potential for the economic fallout to burst what many see as an equity bubble, Edwards suggests that irrespective of what form the “pin” ultimately takes, the bubble was going to be popped regardless.

“The immediate cause of any recession will be attributed to the coronavirus crushing the cashflow of highly indebted and vulnerable companies”, he writes, before noting that “a day of reckoning was almost inevitable in any case”. He then says folks who cited Lehman’s bankruptcy as the proximate cause for the global economy’s collapse during the GFC were looking for “an excuse to cover up for their excess bullishness and to blame an exogenous, unpredictable event for their failings”.

I guess I would quickly note (and I don’t think Albert would mind this pseudo-pushback) that Lehman wasn’t exactly “exogenous”. It was, in many ways, the corporate personification of the problems at the very heart of the system as it existed at the time.

In any case, Albert is certainly correct (indeed, this is almost tautological) to say that “it was the extent of the bubble that was the problem, not the immediate cause of its bursting”.

He goes on to warn that the “TINA” excuse for buying stocks (i.e., “there is no alternative”) is “a dangerous trap” in the Ice Age.

Why? Well, consider this quick bit about the vaunted “Fed model”:

This widely followed valuation tool showed the ratio of 10y bond yield relative to the forward equity earnings yield (the reciprocal of the forward PE). It was widely used to inform investors when equities were cheap versus bonds. And indeed this ratio seemed very stable and useful during the 1980s and 1990s (see area inside box below), and it worked well as an asset allocation tool. But then as we predicted, it broke down as equities suffered a secular valuation de-rating versus government bond yields. I had hoped the Tina mantra had died out permanently, only for it be resurrected again in recent years like a pesky but dangerous zombie.

There’s a lot that’s compelling in that excerpt, not least of which is that by calling the Fed model a “zombie” which is both “pesky” and “dangerous”, Albert seems to suggest (i.e., by extension) that there are zombies who are merely pesky, but not wholly dangerous. That’s an interesting prospect, and a consideration which may come in handy if COVID-19 does, in fact, morph into a full-blown zombie apocalypse.

Jokes aside, Edwards reminds you that he has always (and by “always”, I mean for longer than some readers have been adults, let alone been actively trading and investing), maintained that “in the deflationary Ice Age the equity dividend yield, for example, should be higher than the bond yield just like in the early 1950s”.

The point is that for Edwards, this “is not an anomaly. It is the new (in fact old) normal”.

But, just in case it needs to be driven home any further, Albert rolls out another kind of bond/equity yield ratio for you to feast your eyes upon – namely, the equity/cash flow yield. To wit:

(I use the reciprocal of the trailing MSCI Price/Cashflow ratio). I have pulled the red line, the Japanese ratio, forward 10 years so 2000 for the dotted US line is actually 1990 for the Japanese red line. We note how the ratio was virtually the same in Japan at the peak of the 1990 bubble as it was in the US in 2000 and how the US ratio has continued to de-rate on a secular basis, more or less tracking what happened in Japan a decade before. The recent attempt of the dotted US line to break upwards away from the Japanese red line seems to have failed. If Japan remains the template, much more downside lies ahead for the US.

(SocGen)

What, ultimately, does this presage for US equities?

Well, nothing good according to Albert who, as ever, “makes up” for his exceedingly affable demeanor with exceedingly dour forecasts. I’ll leave you with one last quote:

The lesson from the recent landmark move in the 30y US T-Bond yield below the equity dividend yield is simple. If we are right and US 30y yield falls below zero, US PEs will contract from their lofty 19x forward earnings peak seen recently, especially in a likely recession. Try 8x instead at the bottom of the next recession and see where that takes us!

[Editor’s note: Edwards touches on much more than the above in his latest missive, some of which we’ll address in a subsequent post]