soc gen global strategy [albert]

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26 August 2010

Global StrategyAlternative view

www.sgresearch.com

Global Strategy WeeklyThey laughed. Oh how they laughed.Albert Edwards(44) 20 7762 [email protected]

Global asset allocation% Index Indexneutral SGWeightEquities 30-80 60 35

Bonds 20-50 35 50

Cash 0-30 5 15

Source: SG Cross Asset Research

Global Strategy TeamAlbert Edwards(44) 20 7762 [email protected]

Dylan Grice(44) 20 7762 [email protected]

Investors cannot m ove for the weight of broker research comparing the current conjuncture inthe US with Japan a decade ago. While bond markets at least, move to discount deflation,most sell-side analysts still say the current situation is unlike Japan a decade ago. They areright. Things now in the US are much, much worse than Japan a decade ago.

Equity investors are in for a rude shock. The global economy is sliding back intorecession and they are still not even aware that these events will trigger another leg down in

valuations, the third major bear market since the equity valuation bubble burst.

This lack of awareness reminds me of reports this week that a 35 year old Polish manhadnt noticed for five years that he had a bullet lodged in his head. Like the equity market

in 2000, the Polish man had been partying too hard to notice that he had been shot. The

BBC report the police as saying "He told us he remembered having a sore head, but that he

wasn't really one for going to the doctor." link.

As the equity bloodbath of the last decade enters its final, even bloodier phase, investorscontinued optimism also reminds me of the Black Knight in Monty Python & the Holy Grail -

link. Despite being grievously wounded by King Arthur, the Black Knight makes light of his

injuries which he dismisses as a flesh wound. The vast bulk of the investment industry fails

to appreciate that we are locked in a structural bear market and about to enter Act III.

There is still too much hope about. Until the mantra changes from Equities for the longterm to Bonds at any price, we will not have completed our Ice Age journey. It has been a

difficult road for me personally for the last 14 years during which I have been laughed at and

my ideas dismissed as the attention-seeking ravings of a lunatic. But as we complete the

path set out below over year (see chart), the Japanese template of supposedly expensive

bonds outperforming supposedly cheap equities; this will feel nothing like a flesh wound.

My vision of the next year: world bonds (10y+) and equities

Source: Datastream

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

75

100

150

200

250

300

350

375

75

100

150

200

250

300

350

375

Equities

Bonds

Cash


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Global Strategy Weekly

The front cover chart shows outperformance of global government bonds against equities has

been in the order of 100% even before equities begin yet another cyclical slide. My colleague

Dylan Grice asked me if there was similar outperformance if we exclude Japan over the last 14

years. There is.

This year has already seen a dramatic flip-flop in sentiment as the market has begun to

acknowledge it is sinking into the deflationary quicksand. For this year outperformance in the

US, for example, is over 20 percentage points (see chart below).

Total return of US long bonds (10y+) and S&P com posite (1Jan 2010=100)

Source: Datastream, SG Cross Asset Research

The structural bear market has not reached the end. We have long said that the de-bubbling

process would end only when equities became very cheap and revulsion in equities as an

asset class hangs in the air like a fog.

The problem remains more of excess valuation within the US rather than Europe, but that will

not prevent the bear market hurting other cheaper markets as much. We will return to the

valuation nadir last seen in 1982 with the S&P bottoming around 450 (see chart below).

Cyclically adjusted PE (using trendline for trend earnings)


JAN FEB MAR APR MAY JUN JUL AUG

90

95

100

105

110

115

120

90

95

100

105

110

115

120

Equity

bonds 10y+

73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

5

10

15

20

25

30

35

40

45

5

10

15

20

25

30

35

40

45

US

Europe


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We still like to keep it simple. Drawing straight lines is about as simple as it gets and hence a

ruler is one of the most important investment tools to have in one s armory (they never tell you

that on a MBA program!). The bond market is still locked in a technically perfect bull market

(see left-hand chart below). The next move down is clear to me. Global cyclical failure will take

US 10 year yields down to the 1 -2% range. In our world, 10y German bunds will break

below 1% and even UK Gilts will break below 2%.

And we may be closer to outright deflation than many suppose. The Cleveland Fed produces

an alternative measure of core CPI, namely trimmed mean and median CPI. Among other

things these reduce the dominance of imputed owner-occupier rent in the core measure. On

these measures core inflation is evaporating far faster than the official measure suggests

(see right-hand chart below and link). The slide in median CPI from a 2008 peak of 3% to only

0.5% has been precipitate, especially after 10 years of relative stability centering on a 2%

rate. We are sliding closer to deflation faster than the official core data suggests.

US 10y bond yield Cleveland Fed trimmed CPI (Median) and core CPI inflation


So far the equity market has shrugged off much of the weaker data that abounds, and has not

joined the bond market in a perceptive move. The equity market will though crumble like the

house of cards it is, when the nationwide manufacturing ISM slides below 50 into recession

territory in coming months. Indeed the new orders data for August, already reported in

regional ISMs suggests the equity market is going to get some sentiment crushing data in the

very near term. But never mind the last standing optimist will tell us it is only a flesh wound!

Philadelphia and New York Fed ISM new orders (average) and national ISM headline measure


86 88 90 92 94 96 98 00 02 04 06 08 10

1

2

3

4

5

6

7

8

9

10

1

2

3

4

5

6

7

8

9

10

91 92 9 3 9 4 9 5 9 6 9 7 9 8 99 0 0 01 0 2 0 3 0 4 0 5 0 6 0 7 08 09

0

1

2

3

4

5

6

0

1

2

3

4

5

6

median trimmed

core CPI

2002 2003 2004 2005 2006 2007 2008 2009

-50

-40

-30

-20

-10

0

10

20

30

40

30

35

40

45

50

55

60

65

new orders(av of philly and NY Fed)

headline ISM

(rhscale)


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