In the aftermath of last week’s stunningly weak economic data the market is now beginning to acknowledge that, like last year, without a further round of QE a relapse back into economic stagnation or recession surely beckons. In the post-bubble world, economic downturns are always the most dangerous phase in the cycle – when the Ice Age blows yet another shiver of reality onto market valuations. Both equity PEs and government bond yields will make surprising new lows for a consensus totally convinced of the extreme cheapness of equities and the expensiveness of government bonds. So, this week we revisit some of our old favourite Ice Age charts to see how far advanced we are in our post-bubble long march.
Investors were given a boxer’s one/two in the jaw by last week’s super weak ISM and payroll data. We are not ones to say I told you so. Indeed let me point out that hours worked over the three months to May rose a healthy 4% annualized.
But hopes that the dreadful May employment data might be an aberration were well and truly dashed even before the report was posted. The day before that infamous payroll data was published the influential National Federation for Independent Businesses (NFIB) issues a press release stating that “After solid job gains early in the year, progress has slowed to a trickle. The two NFIB indicators–job openings and hiring plans–that predict the unemployment rate both fell, suggesting that the rate itself will rise. May’s job numbers will disappoint; meaning job creation on Main Street has collapsed.” The use of the word “collapse” doesn’t sound like erratic data to me, but something more pernicious.
The post-bubble long march to Ice Age valuations seems fully intact to the naked eye (see chart below). And as the economic gloom intensifies, this is the stage in the cycle when we need to revisit the Ice Age theme. For the Japanese experience shows that in the post-bubble cyclical recovery, the Ice Age’s impact on valuations lies dormant, only to viciously catch out unsuspecting investors as the cycle takes its inevitable turn for the worse.
The Ice Age theme is now well known. In a world of very low inflation and near deflation, equities de-rate both absolutely and relative to government bonds, which also re-rate in absolute terms. After the obscene extremes of equity valuations seen during the 2000 bubble, we have entered a long valuation bear market which should end in extreme levels of cheapness consistent with an S&P around 400. The unavoidable deep recession associated with this level (not forgetting the inevitable China bust) will drag an already ‘expensive’ bond market to even higher extremes. One of the key themes of our longer-term analysis is that at the end of these lengthy 15-year phases for the financial markets (shown below), investors believe that the current investment phase will continue indefinitely. That was not the case in 2009 and is not the case now. There is still far too much hope to call a bottom.
We know exactly what to expect. Japan has been trudging down this very long valuation path for some 20 years (see chart below). The post-bubble de-leveraging finished around 2003 and yet still onward we trudge across the icy valuation steppes with no end in sight. If western investors think we are anywhere near the end of our own deep freeze, let them think again.
One of our favourite Ice Age charts which has most perplexed clients is the one showing the bond/equity cashflow yield ratio. It shows the US is de-rating in exactly the same way Japan did a decade earlier (see chart below).
What clients found particularly surprising is that the left- and right-hand axis on this chart are on the same scale. Hence despite PEs being substantially higher in Japan at the peak of their bubble in 1990 than the US in 2000, price/cashflow ratios were remarkably similar, as were bond yields. Indeed the exact ebb and flow of valuations with the cycle have also been remarkably similar, suggesting there is a way to go yet.
We typically show just how far the US equity market is from extreme levels of cheapness using the Shiller or Graham and Dodd PE. Let us look at a similar construct, namely the ratio of prices to the trend of reported earnings (see chart below, we use the trend, rather than actual reported earnings to adjust for where we are in the cycle in a similar way to the Shiller PE which uses a 10 year moving average of reported earnings).
Aside from how much more sharply the US valuation has recovered from its 2009 low relative to Europe, one other thing clearly stands out. Investors should note how the 2001 and 2008 recessions brought about savage Ice Age de-ratings of US valuations followed by only a partial 50% recovery of the previous valuation losses during the cyclical upswing. If we are about to set out another leg in the Ice Age de-rating, the next icy ‘steppe’ in valuations could take us closer to 7x – i.e. what we would typically expect to see at the end of a secular valuation bear market. By then investors would have lost all hope as we sink into deep recession and bond yields plunge below 2%. That will be the buying signal for equities and time to offload our remaining holdings of government bonds back to the Central Banks.