You’re in denial if you believe that U.S. stocks are fairly valued, the Eurozone does not face a crisis or a strong dollar will support stability in the global economy. Those themes were presented by Albert Edwards and his fellow speakers at annual investment conference sponsored by Societe Generale.
Edwards spoke on January 10 in London, along with his colleague Andrew Lapthorne and Raoul Pal, publisher of the Global Macro Investor newsletter.
A year ago at the same venue, Edwards predicted a down market for equities and a weak economy in the U.S., driven by the strength of the dollar. He highlighted the instability in the Eurozone, focusing on problems in the French economy. Forecasts like those have earned him an “uber bear” reputation. But he has been right over the long term with his “ice age” thesis, which foresaw the outperformance of bonds over equities beginning over 20 years ago.
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Let’s look at what the lineup of prominent speakers said this year.
Global overvaluations driven by the U.S.
Price-to-earnings ratios are modestly high for world indices, but enterprise value (EV)-to-EBITDA ratios show exceptionally high valuations – approaching those during the dot-com era, as illustrated in the chart below:
The overvaluation is driven by the U.S., according to Lapthorne. The above chart shows the metrics for the MSCI world index including the U.S., whereas if the U.S. is excluded the EV/EBITDA overvaluation is not as extreme.
Lapthorne said future returns will be lower at some point in time based on the historical precedent. He claimed quantitative easing (QE) and corporate debt in the U.S. are the culprits. QE has driven interest rates lower, increasing the demand for corporate debt, and that has been fueling share repurchases, which increases EPS. He said that the U.S. corporate sector is overleveraged and exposed; when the market does go down, they will cut back costs and contract.
“Balance sheets have been swept away by the idea that we are going to get better growth in 2017,” said Lapthorne. He claimed that global profits were down 9% in 2016 and that, even if they went back to previous highs, the equity markets would still be priced at 19-times earnings.
U.S. corporates are underinvesting and consuming all of their cash flow after share buybacks. Lapthorne said there is no “mountain of underinvestment” in the U.S. Cash flow is decreasing, debt is increasing and is being spent on buybacks, although buybacks are declining now at a rate of approximately 9% annually.
The bulk of the cash among U.S. corporations is held by the largest 25 companies, according to Lapthorne. “Trump’s problem is corporate inequality,” he said. “The biggest U.S. companies are very profitable, but the rest are struggling.”
While QE is driving valuations up in the U.S., in Japan the effect is almost the opposite.
Indeed, the Bank of Japan’s QE has been the most aggressive among central banks. But it has used those funds to buy Nikkei 225 ETFs – essentially investing in Japan’s equity markets. That has depressed Japanese valuations, at least relative to the rest of the world:
Average profitability in Japan is high, said Lapthorne, “but the U.S. and EU are in a synchronized slowdown.”
In Japan, the median dividend is higher than in the U.S. and it has the lowest payout ratio of any developed country. In Japan, 50% of the non-financial companies have net cash.
“Japan is an interesting place to put your money,” Lapthorne said, “irrespective of what happens to the yen.”
The Italian problem
Albert Edwards began his presentation by remarking that the investment climate resembled those in 1999 and in 2006-2007, when clients didn’t want to hear a bearish story. But he had one to tell and, unlike last year, his focus was on Italy instead of France.
The main problem with the EU is unemployment, he said, which is now 9.8%. That is a seven-year low, but it masks the problem in Italy, where unemployment is 12%.
By Robert Huebscher, read the full article here.