Monday, August 9, 2010

Société Générale's Albert Edwards: "The Leading Indicator Is Already Back Into Recession Territory And Why The Japan "Ice Age" Is Coming" (August 2010)

In February Mr. Edwards said (the bit in the quotation marks) Société Générale's Albert Edwards: "Stocks Face ‘Ice Age’ Drop as Indicators Peak..." Euro to $1.25; We're all Doomed.
He (and I) got the direction of the euro correct, it eventually hit an intermediate low with a 1.18 handle. The "We're all doomed" part, time will tell.
More Albert links below.
From ZeroHedge:
Albert Edwards reverts to his favorite economic concept, the "Ice Age" in his latest commentary piece, presenting another piece in the puzzle of similarities between the Japanese experience and that which the US is currently going through. A.E. boldly goes where Goldman only recently has dared to tread, by claiming that he expects negative GDP - not in 2011, but by the end of this year. After all, if one looks beneath the headlines of even the current data set, it is not only the ECRI, but the US Coference Board's Leading Index, Albert explains, that confirms that we are already in a recesion. If one takes out the benefit of the steep yield curve as an input to the Leading Indicator metric, and a curve inversion physically impossible due to ZIRP and the zero bound already reaching out as far out as the 2 Year point (it appears the 2 Year may break below 0.5% this week), the result indicates that the US economy is already firmly in recession territory. Edwards explains further: "one of the key components for Conference Board leading indicator is the shape of the yield curve (10y-Fed Funds). This has been regularly adding 0.3-0.4% per month to the overall indicator, which is now falling mom! The simple fact is that with Fed Funds at zero, it is totally ridiculous to suggest there is any information content in the steep yield curve, which will now never predict a recession. Without this yield curve nonsense this key lead indicator is already predicting a recession."

All too obvious double dip aside, Edwards focuses on the disconnect between bonds and stocks, and synthesizes it as follows: "investors are finally accepting that what is going on in the West is indeed very similar to Japan a decade ago. For years my attempts to draw this parallel have been met with hoots of derision  but finally the penny is dropping." The primary disconnect in asset classes as the Ice Age unravels, for those familiar with Edwards work, is the increasing shift away from stocks and into bonds, probably best summarized by the chart below comparing global bond and equity yields - note the increasing decoupling. This is prefaced as follows: "The reaction of bond markets is wholly appropriate given it seems we are heading into outright deflation. The increasing divergence of bond and equity market yields that has been a key plank of the Ice Age will continue (see chart below). Equities will look increasingly cheap relative to expensive bonds."

And just like in China, with time stocks will become increasingly cheaper when compared to bonds, whose intrinsic value due to their cash flow generation will make them a preferred asset. Granted, during the Japanese "Ice Age" it was not the case that the entire world was leveraged to the gills, and sovereign insolvency was a household phrase. We have certainly entered a new regime, in which excess debt makes the certainty of future coupons increasingly problematic. Although, courtesy of the reserve currency status, the US is likely insulated for the time being from an outright collapse in bond prices. But that is a topic for another time, and, incidentally, Edwards touches on it at the very end of his piece (more below). In the meantime, one thing is certain, that stock on a relative basis will become ever cheaper. As such, the recent dramatic divergence between stocks and bonds which we have been charting almost daily, presents some great entry points in an ongoing attempt to short the market on both a relative and absolute basis. For those wondering what Japan predicts for relative values between stocks and bonds, the chart below has nothing favorable to report:

Here is how Edwards captions the chart:
The de-rating in Western equities continues to rhyme in a surprisingly familiar way to what we experienced in Japan a decade ago (see chart below). Another cyclical rally has led to a temporary pause in the structural de-rating process ? just as it did in Japan a decade ago. US equities looked cheap verses bonds last year but will look even cheaper next year!
Edwards' conclusion is troubling, as it confirms an observation we ourselves have had: in its aggressive intervention to provide a basis for an accelerated sugar high, the Fed threw the monetary kitchen sink at a multi-trillion deflationary collapse. In doing so, it did in deed conceive a dramatic bounce in stocks from a fair value that is still well in the mid-triple digits. If Japan has shown anything, is that reversion to a long-term mean is inevitable. Yet its decline was gradual. Our own will likely be a mirror image of the spurt to the upside. The Fed knows this, which is why we have no entered a period where the half lives of new and improved monetary intervention will be ever shorter, in many ways comparable to the Swiss National Bank's intervention in the CHF. If the market is allowed to find its natural place without endless Fed manipulation (and not necessarily of stocks: the outright open intervention of USTs, MBS, and monetary aggregates is sufficient), the plunge lower will be severe, dramatic and instantaneous.

Which explains why on Tuesday everyone anticipates a new message of monetary loosening, regardless of the form it ultimately takes. However, it is unlikely that this will be the last, or even a material, QE phase, as otherwise prices, even those of core CPI  items, would have already risen. Alas, as deflation accelerates, and QE episodes become clustered and ever more frequent, the Fed is telegraphing that as we approach the endgame, it has little to no options left. The practial application of this be a plunge in stocks far more pronounced than the March 2009 lows. To wit:
Inflation continues to ebb away. In Japan core CPI deflation, at -1.5% is the worst on record. While in the US, the corporate sector is seeing its weakest pricing power on record ? even worse than that seen in the deflationary maelstrom during the Asian crisis (see chart below). We have consistently articulated the view that the severity of the current situation will only be appreciated when this current cycle ends in failure ? and that is not too far away. That will be the time that equities will plunge to new lows.
Will that be the end? Not at all....MORE
Matt Phillips at MarketBeat has had a half-dozen posts on the bond/equity disconnect. In mid-July there was "Time to Buy this Falling Knife: No, Says Treasurys Market":
Don’t even think about it.
That’s the message being sent by the bond markets. We’ve been harping on this for a while...
Which brought forth a comment:

  • Keep harping. When the two markets disconnect the wise man trusts what the bonds are saying, not the stock traders.
    (What’s the difference between a bond and a trader? A bond matures.)
    Turning Harry S over, I’m going to do my “On-the-other-hand” schtick. Remember the old trader’s lament:
    “As soon as you think you’ve found the key, they go and change the lock”

    Summing up markets and MarketBeat:
    “But I don’t want to go among mad people,” Alice remarked.
    “Oh, you can’t help that,” said the Cat: “we’re all mad here. I’m mad. You’re mad.”
    “How do you know I’m mad?” said Alice.
    “You must be,” said the Cat, “or you wouldn’t have come here.”
    (Alice’s Adventures in Wonderland, Chapter 6)
On August 4 the MB headline was "Should We Still Heed the Message of the Bond Market?":
Here’s a pretty stark example of the confusion characterizing the markets at the moment. Take a look at the Treasurys markets and stocks. Normally these two asset classes are like cats and dogs, oil and water, Pelosi and Bush. But in recent weeks, it seems they have been singing Kumbaya and moving together.
Since July 13, the yield on the 10-year Treasury has fallen 162 basis points as investors have continued to pile into Treasurys. (Bond yields move in the opposite direction as prices.)

Meanwhile the S&P 500 has continued to grind slowly higher by 3%. We can’t help but note that in early April, a tumble in the yield on the 10-year preceded our most recent equity correction. Of course, back then 10-year yields were flitting around 4.00%, meaning they had a lot more room to move lower.
So should we heed the message of the bond market once again?...
Which elicited:

  • Beware:
    Spurious correlations
    Frumious Bandersnatches
    Real correlations when they diverge,
    as distinct unpleasantness may be at hand
    or as the scribbler said
    “The jaws that bite, the claws that catch!”
I'm not sure how much longer I can maintain the Lewis Carroll schtick, Fortunately there are plenty of  other phantasmagorical references we can draw on.
Back to Albert, some of our favorites:
Société Générale's Albert Edwards: We are all Japanese Now (July, 2010)

May 25, 2010 
Société Générale's Albert Edwards: "Europe Is On The Edge Of A Deflationary Precipice..."

April 16, 2010 
Société Générale's Albert Edwards: "We Are Now Only One Cyclical Downturn Away From Outright Deflation"

Feb. 24, 2010
Société Générale's Albert Edwards: "Stocks Face ‘Ice Age’ Drop as Indicators Peak..." Euro to $1.25; We're all Doomed

Jan. 25, 2010 
Albert Edwards, Societe Generale: "Theft! Were the US & UK central banks complicit in robbing the middle classes?"

Jan. 11, 2010 
Société Générale's Albert Edwards on Employment and Market P/E

And the 2008 series in which he foretold the future and made some of the funniest headlines of the financial crisis:

May 8, 2008
This Week’s Advice: Canned Food, Guns and a Ham Radio
June 26, 2008
Société Générale: “We see a y-shaped global recession. We are going down before looping backwards”
September 5, 2oo8
"Meltdown"-Société Générale
September, 2008
Société Générale: Prepare for the Great Unwind, part Deux