World Global Strategy

2 October 2008

Global Strategy Weekly

Preparing to take the plunge
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

Just in the last week, the US ISM, consumer spending (including sharp downward revisions) and durable goods orders are all now consistent with an economy plunging into deep recession. On Saturday I also take my own headlong plunge into marriage. Maybe Ill come back from honeymoon bullish, and take our equity weighting up to 80%. Maybe.

As you can see from the picture below, Im totally ready for plunge (both market and marital). James Montier, an avid scuba diver, has lent me some of his gear and I have been perfecting the art of drinking red wine via the snorkel. In these markets one must adapt. Id like to take the opportunity to thank clients for their steadfast support over many years, putting up with me even when I have been an annoyingly irritating voice in the wilderness. I know I have been a pain in the butt. Ive been very tempted in recent days to raise our recommended equity exposure considerably due to technical reasons before I disappear. The usual array of indicators suggests a strong bounce is now very possible. In addition, the S&P is sitting snugly on the bottom of the downtrend (1105 on the S&P) that started from the low of August last year. The top of the downtrend is around 1350, and a 22% rally back to this level is possible and, from a technical viewpoint, perfectly consistent with a continuation of the long bear market. But I feel reluctant to increase our equity exposure because of the imminence of rapidly deteriorating economic and profits data that we highlighted in our 4 Sept Alert (see GSW, Economic and equity market meltdown imminent). Investors have also yet to accept the destructive power of the Ice Age equity de-rating that is now fully under way. We explain inside why we see equities falling 70% from their peak as a deep recession unfolds.

Global asset allocation

% Equities Bonds Cash
Index Index neutral SG Weight

30-80 20-50 0-30

60 35 5

30 50 20

Source: SG Equity Research

Equity allocation
Very Overweight Overweight Neutral Underweight Very Underweight
Source: SG Equity Research

US UK Cont Europe Japan Emerging mkts

IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS BEGINNING ON PAGE 12

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Global Strategy Weekly

While equity investors believe that the most damaging event for their portfolios might be a deep recession, they remain comforted that any equity bear market will be moderate. After all, arent P/Es as low as they have been for 20 years (see chart below)?
US trailing and 12m forward P/E
30 30

25

25

trailing PE
20 20

15

15

10

10

forward PE
5 80 82 84 86 88 90 92 94 96 98 00 02 04 06 5

Source: Datastream

Hopes of a moderate bear market are underpinned by the belief that in recessions, falling bond yields typically allow P/Es to expand as the present value of future earnings rises. That is the natural course of events, isnt it? Well it was until the last cycle (see chart below). The 2001-03 bear market shocked investors by its severity, in large part because multiples contracted in tandem with declining profits and bond yields. Investors now seem comfortable that the unusual pro-cyclical behaviour of P/E multiples during the late 1990s bubble and its aftermath is now behind us - a one-off as bubble equity valuations deflated. And having observed that booming profits have driven P/E multiples even lower in recent years, most investors believe equities are currently cheap enough. Hence the usual counter-cyclical behaviour of profits and P/Es can resume. But what if they are wrong?
P/Es normally move in a contra-cyclical fashion
35 90 80 70 30 60

trailing eps
25

50 40

30 20

20 15

10

trailing PE
5 80 82 84 86 88 90 92 94

anomaly
96 98 00 02 04

Best Case
06 08 10 12

10 8

Source: Datastream

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Global Strategy Weekly

To assess whether the normal counter-cyclical behaviour of P/Es has resumed, one must step well back and take the long view. The tendency for short termism in this industry is well known, with increasing pressures to outperform on shorter and shorter time scales. Naming the individual trees in the wood may all be very well and comforting, but if we dont know what wood we are actually in, then incorrect strategic decisions can be made. Stepping back and trying to see the strategic wood from the cyclical trees is instructive. For between 1950-2000 we believe there were only three major structural phases of the equity market (see chart below). We are all familiar with the spectacular equity bull market since 1982-2000, but who now remembers the dismal years of 1965-1982 where the Dow went precisely nowhere for 17 years in nominal terms and collapsed in real terms?
The Dow Jones Inds (log) who now remembers the dismal years (17 years of going nowhere)
000'S 16 14 12 10 8 6 4 000'S 16 14 12 10 8 6 4

The culting of the equity

The dismal years The long Bull market

0.20 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

0.20

Source: Datastream

History books can remind us of the 1950-65 period. Equities fared well, re-rating from extremely depressed levels despite rising bond yields, as the nightmarish investment memories of the 1930s were forgotten. As the cult of the equity grew, equities established themselves as the dominant long-term investment asset class in institutional portfolios. So while we run around getting excited about short-term cyclical and technical developments, correctly identifying the secular investment environment we are in is absolutely crucial, i.e. the default asset allocation decision that might work in one 17 year period might have been totally the wrong strategy for the following 17 year period. It was around a decade ago that we developed our Ice Age thesis. We conjectured that after one last equity hurrah, the investment landscape would be radically transformed by a very low (maybe even excessively low) inflation backdrop. We believed that the long equity bull market investors had enjoyed since 1982 would come to a shuddering halt, but the bull market in government bonds would continue. This was the Ice Age. The reasoning was simple. The long bull market in equities had been driven predominately by a collapse in inflation from its early 1980s peak. This was a complete mirror image of the dismal 17 year period before 1965-82 (see chart below).

2 October 2008

Global Strategy Weekly

Forget the cycle - Long structural phases shape long-term equity returns
16

Culting of equities

The dismal years

The long bull market

14

The Ice Age

16

14

12

12

Bond yield
10 10

Equity yield
2 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2

Source: Datastream

During the 1982-00 bull market, lower inflation had led to lower bond yields which, in turn, had driven equity multiples substantially higher (falling equity yields). P/E expansion had accounted for well over half of the capital gain of equities over this period. In contrast, the previous 17 years had seen multiple contraction entirely offset earnings growth. The first step to the Ice Age thesis was, we conjectured, that with inflation already so low this engine as a driver for further multiple expansion was over. Equity prices would now only rise in line with profits - at best - producing much reduced returns. This relatively non-controversial idea was also expounded by some other strategists, It was the second stage of our Ice Age thesis that marked our view out as separate from most of the investment community. We believed in a world of very low inflation, the Ice Age would produce a secular trend towards rising equity yields whilst bond yields (and interest rates) would carry on declining. Equity valuations would enter a secular bear market which would be a mirror image of the 1950-65 period (see chart above). Among other unwelcome outcomes, the Ice Age would destroy the solvency of many equity heavy, defined benefit pension schemes. They would become caught in a vicious pincer movement of falling asset values (due to their excess equity exposure) and rising liabilities (due to the declining bond yield). As you can imagine, this was a hard story to tell at the end of the 1990s and not one which made me popular especially with the equity salesforce! For what we were conjecturing was a return to the sorts of bond/equity valuations seen in the 1950s and early 1960s (see chart above). We believed that the outlook for equity and bond yields would become a mirror image of the 1950-65 period. The Ice Age would bring about the De-culting of the equity and we would return to a period where the equity market as a whole would yield more than the bond market not a few stocks that seem to excite people currently. The reverse yield gap would return to being just the plain vanilla yield gap. Before we explore the drivers of the secular bear market in equity valuations lets see what has happened and why events in many ways closely resemble Japans experience of a secular equity bear market over the last 17 years.

2 October 2008

Global Strategy Weekly

What has happened since the late 1990s equity bubble burst? The normal positive correlation between bonds and equity yields has indeed broken down (see chart below). Cheap equities just seem to get cheaper and cheaper relative to supposedly expensive bond markets. The bulls hope this is a one off adjustment that has ended. But the Ice Age thesis calls for a lot more of the same to come.
World equity yield (average of dividend & earnings) and bond yields
8 8

Bond yield
6

THE ICE AGE

6

Equity yield
2 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 2

Source: Datastream

Of course we have seen this all before - in Japan when their bubble burst in 1990 (see chart below). So one does not need to dig into the history of the 1950s to see how this might unfold.
Japans Ice Age started when their bubble burst at the end of the 1980s
11 10 11 10

Bond yield
9 8 7 6 5 4 3 2 1 0 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

JAPAN'S ICE AGE STARTED IN 1990

9 8 7 6 5 4 3 2

Earnings yield

1 0

Source: Datastream

The comparison with Japan is uncanny. It has less to do with the economic comparisons (although those are perhaps more similar than many suppose) and more to do with how an equity market adjusts to a world of very low inflation (or deflation) combined with the anatomy of an equity bubble bursting. At the end of the 1990s Japan, like the US a decade later, was regarded as a model for a New Paradigm of strong and stable economic growth with a backdrop of low inflation. Equity multiples expanded in Japan to what seemed ridiculous levels, but at the time had all sorts of plausible explanations. The simple fact was that strong and stable growth was built upon an asset bubble that eventually burst.

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Global Strategy Weekly

Successive cycles saw Japanese equity valuations grind lower and lower, both in absolute terms and relative to bonds. The US valuation experience is not so different to Japan a decade before (see chart below, P/Es were a lot higher in Japans bubble than the US but the cash flow yield was pretty similar). The tried and tested valuation metrics that had worked extremely well in Japan began to break down as seemingly cheap equities just carried on de-rating against what appeared to be very expensive bonds. This went on and on and on. Even now the de-rating is not over with the 12m forward TOPIX P/E just falling below the S&P.
US bond/equity (cashflow yield) de-rating merely following Japan a decade earlier
1.20 1.20

1.00

cheap equities US
to get cheaper relative to bonds

1.00

0.80

0.80

0.60

0.60

0.40

0.40

0.20

0.20

Japan (led 10 years)

0 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 0

Source: Datastream

Hence we have for the last decade cautioned that we would enter a period in the western markets where traditional valuation metrics would flag up equities as incredibly cheap. But the siren strategists voices enticing investors to increase equity exposure would surely wreck portfolios. Like Odysseus sailors, stuff your ears with wax, or if you do want to listen to the bull market song, tie yourself to the mast. Indeed the voices are even more alluring than normal with The Fed Model showing equities at rock bottom cheapness relative to bonds on a 25-year view (see chart below).
The Fed Model (bond yield/ forward equity earnings yield)
1.80 1.80

1.60

1.60

1.40

1.40

1.20

1.20

1.00

1.00

0.80

0.80

0.60

vaulation support is now resistance

0.60

0.40 83 85 87 89 91 93 95 97 99 01 03 05 07

0.40

Source: Datastream

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Global Strategy Weekly

Now Im not too good with all this equity valuation nonsense (I normally leave that stuff to James and Andy), but in some ways it seems pretty simple to me. Using a discount model, a 12-month forward P/E is determined by expectations for near-term earnings and long-term (trend) EPS growth discounted by a bond yield and a cyclical risk premium (which can vary). Declining long-term earnings expectations are the core as to why in the Ice Age forward P/Es decline despite falling bond yields. Mathematically the reverse should occur but only if everything else is kept equal. The problem is, we are now in a period where long-term earnings expectations are in secular decline (and also the equity (cyclical) risk premium is rising). For this is where the bulls have got it so wrong. Yes in a world of low inflation and low bond yields, P/Es should be high, ceteris paribus. But in a low inflation, low nominal GDP growth world, long-term earnings expectations should also be low. At the end of both the Japanese late 1980s bubble and the US late 1990s bubble, expectations for long-term EPS growth rose higher and higher due to New Paradigm nonsense, mathematically justifying extremely high P/Es (see chart below). Indeed at one point in his cheer-leading for the New Paradigm, Alan Greenspan cited the IBES long-term expectations series as evidence why high equity valuations were justified. After all, surely all those hundreds of individual analysts were unlikely to be wrong. But due to collective delusion on a grand scale, they all were!
The key driver for Ice Age P/E de-rating is loss of faith with long term EPS estimates
26 19

24

18

22

17

20

Forward PE

16

18

15

16

14

14

13

12

L/T eps
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

12

10

11

Source: Datastream

And as the profits recession now deepens, multiple compression will be driven by a second wave of downgrading of long-term EPS. This is exactly what happened in Japan during their second recession during the 1990s. This time around, rather than tech, long-term expectations have risen in former cyclical sectors that have been re-designated as growth sectors due the China/Emerging Market inspired super-cycle for industrial cyclicals and commodities. But to be sure, it is notable that despite the most explosive four years of profits growth in history, long-term EPS expectations, in aggregate, have remained pretty becalmed. That is the calm before the storm. Japanese history of the last 17 years suggests that that a secular valuation bear market has a tendency to accelerate in each successive cyclical downturn, especially if we are coming off bubble valuations (see chart below).

2 October 2008

Global Strategy Weekly

The timing of these equity slumps was crucially synchronized with cyclical downturns at a time when valuation models repeatedly told investors that equities were cheap. Equity and bond yields had become de-coupled and buying into Japanese equities too early in the downturn repeatedly crushed investors. (That does not preclude the possibility huge 40%, cyclical inspired rallies - Japan regularly enjoyed these but they were interludes in the context of a long drawn out secular bear).
In Japans Ice Age, equity de-rating occurred during the economic downturn mind the gap
80 90

70

lead indicator (rhscale)

80

70 60 60 50 50 40 40 30 30

20

20

10 91 92 93 94 95 96 97 98

12m forward PE
99 00 01 02 03 04 05 06 07

10

Source: Datastream

One lesson from the Japanese secular bear market is that it is perfectly normal for investors to clutch onto new growth straws in each successive cyclical rally. Back in the late 1990s, for example, the bubble in Japanese technology valuations made the Nasdaq bubble look like a small insignificant pimple. Similarly, newly formulated hopes for growth protection from industrial cyclicals and commodities are now being shown to be pipe dreams. In the unfolding downturn, analysts will take an axe again to their estimates of trend earnings. The crux of the arguments above is that investors should be wary that equity valuations are not cheap for we may be in a secular bear market for equity valuations. A seemingly low US 12-month forward P/E of 12x (albeit with inexplicably high analysts EPS estimates) may continue to de-rate in any upcoming cyclical downturn. In a deep recession the mathematics are scary. In the last downturn, forward operating S&P profits fell 20% (peak to trough) but the S&P declined about 50% from its peak. But suppose we get the sort of economic downturn the global economy has not seen for 30 years. If profits slump 50% and the forward P/E continues to contract towards single digits, then a 70% decline in the equity market would come as a bit of a shock to those who think that multiple expansion will cushion any profits recession. One piece of evidence that the secular bear market in equity valuations is not over is seen by comparing equity prices to cyclically adjusted earnings. One of the few things I have learnt in this business is that profits cycle around an uptrend and that margins mean revert. The chart below shows how global earnings (excluding the pesky Japan which mucks up the chart in the 1990s) have begun to drop back to the uptrend line and will ultimately fall far below it.

2 October 2008

Global Strategy Weekly

World x Japan EPS versus trend (MSCI definition, log of level)

4.50 4.50

4.00

4.00

3.50

3.50

3.00

3.00

2.50

2.50

2.00

2.00

1.50 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

1.50

Source: Datastream

At the peak of the bull market, equities often look cheap, purely because profits are so far above trend (and vice versa). Hence it is better to compare current prices with the black line above. The cyclically adjusted P/E for the US (for example) has indeed declined very sharply and is now around 15x exactly the same as the conventionally measured trailing P/E (see chart below).
US trailing P/E and cyclically adjusted P/E (Datastream definition)
40 40

35

35

30

30

25

p/trailing eps

25

20

20

15

15

10

10

p/trend eps
5 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 5

Source: Datastream

The fact we have seen such a rapid de-rating - back to the lows of 2003 - is good news. The bulls, once again, will now be snorting that the bear market is over and this represents a huge buying opportunity. But is it? For putting aside the Nasdaq bubble years the market surely remains expensive. We might feel 15x is cheap because our recent memory is of valuations in the 1998-2001 period that were far higher. James tells me this is anchoring. We anchor our perceptions of what is normal by our own working experience. The cyclically adjusted P/E may be back to 2003 or even early 1990s levels, but it could fall far further.

2 October 2008

Global Strategy Weekly

James lent me the Graham and Dodds P/E chart shown below. It uses a 10-year moving average of trailing reported earnings instead of trend earnings but as you can see the shape since the early 1970s is the same as the trend adjusted P/E above. This is a very long-run chart going back to 1880. It shows that, apart from the Nasdaq bubble years, the Graham and Dodds P/E is not cheap at 22x. If we are in a secular re-rating which ends when equities are cheap, we are no-where near to bargain basement valuations yet!
US Graham and Dodds P/E (price/ 10y moving average of reported EPS)
60 50 40 30 20 10 0 1881 1885 1890 1894 1899 1903 1908 1913 1917 1922 1926 1931 1936 1940 1945 1949 1954 1958 1963 1968 1972 1977 1981 1986 1991 1995 2000 2004
40 35 30 25 20 15 10 5 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Global Equity Strategy (James Montier)

But notwithstanding that, investors in European equities might be reassured by the fact that the cyclically adjusted P/E in Europe is some 5x EPS below that of the US and much more in keeping with the experience of the lows mid-1980s to mid-1990s (see chart below). They are probably right that Europe is closer to bargain basement valuations. But the problem is if the US still has to de-rate substantially and will Europe really buck that trend in that environment? It hasnt so far. The current 12x cyclically adjusted P/E may yet be heading back to the 8x low of the early 1980s - a 30% P/E contraction. But yes, certainly I can see why long-term value investors might be becoming interested.
US and European equity price relative to trend earnings
40

35

30

US

25

20

15

10

Europe

Source: Datastream

One final point of concern that I would like to raise here before signing off, is that the decline in profits recently has been concentrated in the financials. Their huge write-offs might be biasing down headline earnings. What is going on outside of this sector?

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Global Strategy Weekly

Certainly the conventional trailing and cyclically adjusted P/E look somewhat different from the total US market valuations above the former looking cheaper but the latter looking more expensive (see chart below).
US non financials trailing P/E and P/trend EPS (datastream definition)
45 45

40

40

35

35

30

p/trailing eps

30

25

25

20

20

15

15

10

p/trend eps
75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07

10

Source: Datastream

Has the deep global downswing undermined the profits outside of financials yet? Certainly, if the analysts are to be believed, not at all. I find the fact that analysts see no slowdown next year at all in profits growth (ex financials) truly staggering.
Global equity consensus profit growth profile
2007 2008 2009

Global Global ex Financials

Source: SG Quantitative Research, IBES

5.2 12.4

3.7 12.1

16.5 12.8

But as James says maybe analysts are lagging indicators. And indeed excluding financials, trailing profits in the US are still over 20% above trend and havent even begun to turn downwards (see chart below)! That explains the table above. This is dangerous. As Andrew Lapthorne, our Quantitative Strategist, pointed out in his Global Earnings Estimate Analysis recently, non-financial profits will see a slump in the coming months. This is the main reason why I am reluctant to turn tactically bullish before I disappear for my nuptials
US total market and non-financial profits relative to trend (datastream definition)
30 30

non-financials
20 20

10

10

-10

-10

-20

total mkt

-20

-30 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

-30

Source: SG Equity Research

2 October 2008

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Global Strategy Weekly

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2 October 2008