December 14, 2017
Bitcoin is grabbing headlines for its twentyfold surge in the past 12 months, but it shouldn’t distract investors from a growing stock bubble.
That’s the message from Albert Edwards, the top-ranked global strategist at Societe Generale. He established his reputation as a perma-bear in 1996 with his Ice Age thesis that argued that stocks will collapse and bond values will climb because of deflation.
“The underlying profits recovery looks increasingly fragile and indeed on some key measures a rapid deceleration is underway,” Edwards said in a Dec. 14 report. “With equities over-valued, overbullish and now also over-bought, the boring old profits cycle still needs watching.”
The S&P 500 stock index has risen more than 18 percent in the past 12 months to record highs. The rally began as Republican Donald Trump unexpectedly won last year’s presidential election on a pro-business platform of less regulation, tax cuts and trillion-dollar spending on infrastructure.
In the past few months, the market has jumped with each new headline about the progress of tax reform, which includes sweeping changes to the way the federal government taxes U.S. businesses on overseas profits. The corporate tax rate likely will be cut to 21 percent from 35 percent, the New York Times reported on Wednesday after Republican lawmakers reached a tentative deal to work out differences between the House and Senate plans.
President Donald Trump may sign the bill into law by Christmas if both houses of Congress approve the plan next week.
Edwards acknowledged that valuation multiples don’t provide the best market-timing signals, so fund managers who have stayed away from overvalued stocks have ended up underperforming the market.
“Clients are forced, as Chuck Prince of Citigroup famously said, to keep dancing while the liquidity mood music is playing,” Edwards said. “Clients are no longer concerned with overvaluation; they are more concerned about timing and triggers.”
The Shiller P/E Ratio, a measure of equity prices compared with corporate earnings, currently is greater than 32 times, compared with a median value of 16 times. The valuation measure is higher than it was in 1929 before the stock market crashed and ushered in the Great Depression.
Edwards said corporate profits aren’t as strong as they appear in data such as National Income Accounts, which showed a 10 percent gain in the third quarter from a year earlier. That rate matches growth estimates of the S&P 500’s 12-month forward earnings per share.
“Yet scratch the surface and all is not well,” Edwards said. “Looking at only domestic, non-financial companies (i.e., companies selling in the U.S.), profits have barely rebounded on an economic basis (i.e., adjusting for inventory gains and putting depreciation on an economic, rather than tax basis).”
He said much of the earnings rebound can be attributed to the recovery in oil prices, which have bounced back in the past two years to boost the profitability of energy companies.
“Much of the rebound is driven by the recovery in the oil price. Excluding energy, the post-2015 profits surge is already decelerating,” he said. “And in an over-valued, over-bullish and overbought market, this profits deceleration might yet prove to be highly significant.”
Indebted U.S. Companies
Last month, Edwards warned that strong gains shouldn’t distract investors from some worrisome signs that portend of a market decline.
“Investors are beginning to punish the corporate debt and equity of highly indebted U.S. companies,” Edwards said in a Nov. 15 report. “Excess U.S. corporate debt is probably the key area of vulnerability that could bring down the QE-inflated pyramid scheme that the central banks have created.”
S&P 500 companies with solid balance sheets have risen faster than the broader market this year, while firms that carry lots of debt have barely budged, according to a chart cited in the report.
The past couple of bear markets showed early warning signs, Edwards said.
“I remember in early 2000…that the tech-heavy Jasdaq index had turned down sharply ahead of the Nasdaq March 2000 peak,” Edwards said. “I also remember out technical analyst pointing out the significance of the Nasdaq Composite failing to follow the lead of the Nasdaq 100 to make a new high at the end of March 2000.” The Nasdaq 100 was a narrower group of stocks that drove gains in broader benchmarks.
“These proved to be early warning signs of the subsequent September peak in the S&P,” Edwards said. “The 2000 bear market was clearly flagged if you knew how to read the technical and macro runes. The same was true in 2007.”