Albert Edwards On The Selloff: “Comparisons With October 1987 Are Entirely Justified”
Last week, when equities were still blissfully hitting daily record highs, we showed the one “chart that everyone is talking about“, or if they weren’t they soon would be: the sharp, sudden disconnect between the junk bond and stock market …
… a disconnect which – as we showed at the time – was last observed in mid-August 2015, just days before the infamous ETFlash crash. Fast forward to day, with stocks suddenly hitting air pockets around the globe and rapidly catching down to junk yields…
… when this enveloping divergence between the conflicting narratives by equities and bonds was the center piece of Albert Edwards latest letter to clients. In it, the SocGen strategist highlights the ZH chart and, ever the pragmatist, wonders why it took not only stocks, but junk bonds so long to react to the steady deterioration in underlying balance sheet quality, a topic discussed most recently by his colleague Andrew Lapthorne…
… who showed that “interest coverage for the smallest 50% of US companies is near record lows, at a time when interest costs are extremely depressed and when profits are at peak.” Lapthorne’s conclusion, which echoed what the IMF said earlier in the year, “It is difficult to envisage a scenario in which this ends well.”
Albert picks up on this theme in his latest note released today, and writes that “investors are beginning to punish the corporate debt and equity of highly indebted US companies. We have highlighted consistently that excess US corporate debt is probably the key area of vulnerability that could bring down the QE inflated pyramid scheme that the central banks have created.”
To demonstrate this point, Edwards shows another bizarre “balance sheet debauchment” divergence, one between surging leverage, and record low junk bond yields, to wit:
… we think the high yield corporate bond market should have been revolting against balance sheet debauchment some time ago. That would be the normal state of things with net debt/profit ratios so very high (see chart below but note bottom-up data shows a far higher peak than this top-down Fed data but peaks normally occur as profits fall in recession).
As the chart above suggests, junk bond yields would have to be double current levels to be aligned with “fair value” as imputed by the current state of the corporate balance sheet, however with the ECB purchasing billions in corporate bonds every month, this clearly won’t happen for a long time.
Edwards also show a chart revealing why the US is unique among the major developed regions: only there has corporate debt bloated to levels last seen during the great financial crisis. As for the reason, we just discussed it earlier: all bond issuance has been used to fund stock buybacks, pushing the S&P to all time highs.
And speaking of the final frontier, i.e. equities, which are always the last to get any memo, Edwards’s biggest concern is the sheer euphoria and that various sentiment indices – such as the record expectations of higher market moves 12 months forward as per UMich – have reached extremes of bullishness which have rarely been seen. One among these is the Investor Intelligence Sentiment Survey.
CNBC reports that “the roaring stock market has professional investors riding high, so much so that it’s rekindling memories of the 1987 crash. In terms of sentiment, the difference between bulls and bears hasn’t been this high in 30 years, according to the latest Investors Intelligence reading… Investor Intelligence editor John Gray noted, sentiment readings have roughly followed their 1987 pattern. Then the bulls peaked (near 65%) with initial market highs early that year and they returned to above 60% levels months later after more index records. In 1987 stocks crashed a few months after that. A repeat of that scenario suggests potential significant danger for over the remainder of 2017!” – see see chart below. Strangely we only recently compared the current conjuncture with 1987 in terms of valuation excess combined with extreme macro and market bullishness .?
Between the recent reality check for junk bonds, and the sudden decline in equities, Edwards believes that “comparisons with October 1987 are entirely justified.” Still, there have been so many headfakes in the past 9 years, could this be just the latest one? Here are Edwards’ 2 cents on how to decide:
“the market itself can signal a top. For example, I remember in early 2000 our then Japan Strategist, Peter Tasker, warning that the tech heavy Jasdaq index had turned down sharply ahead of the Nasdaq March 2000 peak. I also remember our technical analyst pointing out the significance of the Nasdaq Composite failing to follow the lead of the Nasdaq 10 to make a new high at the end of March 2000. These proved to be early warning signs of the subsequent September peak in the S&P. In short, the 2000 bear market was clearly flagged if you knew how to read the technical and macro runes. The same was true in 2007. Is the market?s current behaviour already ringing a bell to warn investors intoxicated by risk appetite that the party is over and it is time to head to the exits before the stampede starts?”
Not to put too fine a point on it, Albert, but everyone would like to know the answer.