Submitted by Thad Beversdorf – The First Rebuttal Blog
Soc Gen’s global head of research, Patrick Legland, has gone on record, according to aMarketWatch article yesterday as saying that the selloff in developed equity markets has gone too far, and he provides reasons to support his claim. First, he suggests the Chinese market rout has further to go but believes the fallout will be limited to EM and commodities. Second, Legland believes that the US and other developed nations are protected by “well-armed central banks” evident by the 3.7% economic growth and the 5.1% unemployment rate and the Eurozone’s 3 year low unemployment. Lastly, he suggests that due to central banks having created a bond market bubble bonds are no longer a safe haven and thus no longer a viable alternative to equities. I will point out that Leon Cooperman also discussed on CNBC yesterday morning the fact that there are no viable alternatives to equities anymore and so equities remain in the secular bull.
While I admire Legland’s optimism I simply do not accept his claims. They are full of tragic flaws. Allow me to colour code this for all those market ‘pros’ and PhD ‘economists’ who haven’t been able to follow the premise over the past several months.
The chart depicts that this rout has just begun. As EPS rolled over in the first half of this year, it signaled that ‘The Tide has Finally Turned‘ as I explained in a recent piece published Aug 2nd (just weeks before the selloff began). In that research piece I told readers to “prepare for an imminent equity valuation reset” and explained why it would occur. The above chart provides an explanation as if we are a 5 year old. You see a correction is not a one week market selloff that then allows for the algos to push markets to new all time highs. A correction implies there was a mistake that required fixing. The correction is market valuations coming into this year with unsustainable EPS growth projections.
Since ’08 growth in earnings has been attained in the absence of consumer demand and productivity. What that means is it must have come by way of cost cutting (i.e. operational contraction) and financial engineering (i.e. share buybacks and diverting capex to div payouts). While those are effective microeconomic strategies CEO’s use to defend market cap in the short term they don’t correct the macroeconomic issues that have made their implementation necessary. And so if the macroeconomic issues that have led to a collapse in demand don’t correct, EPS growth will.
Remember the only thing that can sustain growth in market valuations is sustainable growth in expected future cashflows, not short term spikes in EPS. The only stimuli that can sustain growth in expected future cashflows is growth in demand and/or growth in productivity, neither of which precipitated the extraordinary market valuation growth of the past 6 years. This necessarily means, as it has in every unwarranted market rise, that the spike in EPS would roll over as we’ve seen this year and continue to see today. And so the argument that P/E ratios are moderate relative to history isn’t a valid argument that they are sustainable. As EPS rolls over P/E ratios begin to spike requiring an equity valuation reset. The extent of the reset will be equitable to the size of the unsustainable EPS growth over the past 6 years. These are logical facts.
What the pundits, such as Legland, attempt to do is have you focus on the forest from an inch away.
Looks pretty good eh, but if one were to step back a few hundred yards what we actually find is a dying forest.
Let me show you the magic trick using economic data.
If we look at YoY GDP growth over a 12 month period this is what we see.
Now most of us look at the relative levels and assume things look pretty stable. However, if we step back a little and look at the same thing, YoY GDP growth, but this time over a 60 year period, this is what we see.
Now clearly we are in a secular deterioration of economic growth with the long term trendline now having moved under 2%, less than half of what it was in 1960. And perhaps more alarming is the rate of deceleration over the past 30 years. And don’t lose sight of the fact that the deceleration began subsequent to the US moving to a pure fiat currency in 1971.
But the point is that we don’t hear the Legland’s of the world ever discussing this secular deterioration and that is not a coincidence. The reason is that there is only one answer to this riddle. And the answer is not one that anyone will be happy to hear. So they prefer to have us all continue to admire the forest from an inch away and pretend that everything is as green as it always has been.
Now dear Mr. Legland (and Patrick I’m simply using you as a proxy for all those like you – i.e. the misguided), the reason that EPS growth cannot be sustainably positive, given the current macroeconomic fundamentals, is explained in the following chart.
The above chart depicts the level of real median personal income as a percentage of real consumer debt outstanding per labor force capita (i.e. real median income as a percentage of real consumer debt per worker). The implication of the above chart is critical. Three things we can pull from it is that much of the (deteriorating) GDP growth we have achieved since the early 1980’s has come only from increased levels of real consumer debt per worker (i.e. boosting current GDP at the expense of medium and longterm GDP). The second is that the median real financial condition of workers has worsened significantly since the mid 1980’s. The third significant implication of the above chart is that growth in output, EPS, and standard of living will continue to decline until the above chart finds itself in a “Correction”.
We find something very interesting in this next chart.
The above chart shows the rate on consumer credit (green line) against the median ability of each worker to pay down their consumer credit (blue line – from the previous chart). What we find is interesting because it is not intuitive. We would think as each worker’s ability to pay down debt worsens (declining blue line) that banks would require higher interest to offset the higher risk. So we would expect these two lines to move with negative correlation. But what we find is that they move together. This implies risk is being under priced. That is, risk is being priced at a level for which debt will be taken on rather than in accordance to the risk. When the price of risk can be raised it is until demand for debt declines due to workers worsening ability to pay off the debt, at which point interest rates are again lowered to again incentivize the taking of more debt.
Now the other place we see this is in US total public debt as I explained in a previous article called “Interest Rates Cannot Rise and Here’s Why“. Let’s have a look.
The chart basically depicts that in order to allow for perpetually increasing debt it is necessary that the price of risk must come down, irrespective of the inherent risk fundamentals. So let me be clear here about the data, risk has been significantly under-priced and continues to be because the system itself (designed and controlled by bankers) is incentivized by perpetually increasing debt requiring the perpetual rolling over of more debt. The flaw in this system is it ensures that growth will deteriorate over time. The data on this is simply not arguable.
Now tying this all back to the market for Mr. Legland, what it means is that subsequent to this current cycle of equity valuation reset (i.e. major selloff), some fancy new strategy (Tech Bubble was direct capital injection to equities without regard to current earnings, Credit Bubble was consumer debt fueled earnings, Credit Bubble 2.0 is operational contraction fueled earnings) will have to be implemented to again provide a mirage for investors to once again overvalue equities in the short term before that next bubble’s valuation reset. While these bubbles provide a mirage of stability in the short term they do not correct and thus exacerbate growth’s long term deterioration. That is, continuing these bubbles that we’ve seen over the past 15 years will create extraordinary compounding wealth over very short cycles for less than 1% of the population but will severely punish 90% of households over generations.
The point that I hope is sinking in is that until the incentives of capital allocation between labour and profit is corrected via intelligent policies and until the monetary system itself, which is predicated on the perpetual expansion of money supply (and thus debt) to enable banks to grow profits is corrected there can be no sustainable operational and EPS growth. And this means no sustainable growth in market valuations (bad for long term investors).
But if no new fancy strategy can be found (touch wood) after this current market repricing ends (still many, many months away) to create that mirage of valuation growth well then perhaps we can finally begin to work on the only correct “Correction”; the policies and thus the policymakers themselves. But understand the reigning lion does not give up his pride easily. One must challenge the reigning lion and then be prepared to fight to overcome such (a) pride.