With stocks having reached nosebleed valuations which clearly make no sense, which event bullish pundits slam as absurd, and which every single bank has thrown up on and is urging clients to sell into what has clearly been a relentless central bank bid, there has been just one justification for the stratospheric prices attained by equities: the so-called Fed model, which argues that all that is needed for stocks to be high is for them to be cheap relative to bond yields, or in other words, the lowers global bond yields are, the higher stocks can levitate, completely dislocated from fundamentals.
Naturally, it is this dislocation that has forced so many hedge funds to face the greatest redemption wave since the crisis, or throw in the towel altogether, as this particular "model" is nothing more than a economic justification for an asset bubble, in this case one inflated by central banks who have created the biggest bond and stock bubble in history courtesy of some $2.5 trillion in annual liquidity injections…
… or as we called it, a slow-motion LBO of equity markets courtesy of central banks.
But what happens when the Fed model finally breaks? For the answer we go to perhaps the most prominent expert on the Fed Model, and specifically its collapse, SocGen's Albert Edwards, who writes in a recent note that "a key plank in our Ice Age thesis was that the Fed Model, so widely adhered to by the market, would break down."
According to Edwards, the seemingly stable relationship between bond and equity yields was a recent phenomenon. Indeed prior to 1957 the US equity dividend yield had always been above the 10-year bond yield. When the strategist formulated his infamous Ice Age thesis some 20 years ago, the big asset allocation call was that the Fed Model would break down and that 10y US bond yields (which were then 7%) would fall back permanently below the S&P dividend yield (which was then 2%) ? something which he says was "a most ludicrous, extreme forecast that got me a frosty reception!"
Edwards continues:
Our Ice Age thesis in 1996 called for an end of ?the long bull market? financial era and that we would enter the mirror image of the 1950-1965 period. We were, as usual, too early and the ?long bull market? and positive correlation between equity and bond yields continued until the end of 2000. But what we expected to occur did occur eventually and from 2000 equity and bond yields de-coupled and equity yields rose (PEs fell) despite bond yields and interest rates continuing to decline. It was indeed a mirror image of the 1950-1965 period, dubbed ?the culting of equities? (see chart below). The so-called Fed Model was finally broken.
So what tipped Edwards off on the failure of the Fed Model? Why Japan of course: that experimental monetary laboratory which central bankers have abused for 30 years with disastrous results, leaving Japan on the verge of becoming a failed state: "We knew the Fed Model would break down and equities would de-rate verses bonds because we had seen exactly the same thing happen in Japan ten years before (see chart below)"
According to Edwards, the chart above is a variant of the Fed Model but uses the inverse of the price/cashflow yield rather than the price/earnings ratio and the Japan ratio has been pushed forward ten years.
What is so startling is that the scale is the same on both sides ? ie this ratio peaked out at a very similar level in the US in 2000 as it did in Japan in 1990. We consistently believed, and do still believe, that there are key lessons to be learnt from the bursting of the Japanese equity bubble, and in many ways what has happened in the US and Europe since 2000 was wholly predictable.
So what is the implication of the Fed model's breakdown? If Edwards is right, it would be staggering.
One thing we learnt from Japan is that the equity secular valuation bear market takes many economic cycles to unfold and ends when equities are ?dirt cheap?. US equities did not get dirt cheap in March 2009 at a Shiller PE of 14x – they just got cheap. To be dirt cheap they needed to half again from the 666 level they reached. But why should we have expected this process to end in 2009 as it was only the second recession from the valuation peak of 2000? Historically the shortest secular valuation bear market has taken four recessions to play out.
Or, said otherwise, it will get worse, before it gets much worse: so bad in fact, that the S&P could plunge to under 400. And it would be downhill from there:
We also learnt from Japan that each successive recession caused equity valuations to slump to new secular lows. And history shows that is exactly the case too in previous US secular valuation bear markets (with recessions shown in red on the top line above).
Alberts conclusion:
Most investors are currently neglecting the longer-term context of this secular bear market. Relying on Tina will prove disastrous. The last three years have seen equity yields re-couple with bond yields and it has beguiled investors that ?normality? has returned (circle in chart below). If I am right (and I am on occasion), this is merely a brief interruption in the secular de-rating of equities and the next (imminent?) recession will bring devastation to Tina-loving investors.
Judging by today's market collapse, Edwards may indeed be right as the TINA divorce proceeding appear to have begun.
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