In the cacophony that is global investment strategy research, Albert Edwards and James Montier stand out as clearly distinctive voices. And not merely because of their British accents or because they’ve tended to the decidedly bearish side of the scale over the last decade or so. Despite long tenure in the rarified top echelons of the investment banking world, for many years with Dresdner Kleinwort and more recently at Societe Generale (where they are co-heads of global cross asset strategy) both have managed to retain a natural plain-spoken bluntness. Also large dollops of common sense and strong streaks of reflexive independence, which they employ in conveying their often invaluable insights on investment strategy. In Albert’s case, those spring mostly from his long experience in the dismal science of economics and in James’, from his explorations of the equally mysterious realms of behavioral neuroscience. They are, in a word, skeptics, and at this juncture most deeply skeptical of any and all notions that “the worst is over.” The recession, which has barely begun, is more likely to be deep than shallow, market valuations are hideously expensive and the -flation policymakers should be worried about starts with de-, not in-. For their reasons, keep reading, if you dare.
Yet I hear people all the time comparing valuations to the tech bubble and declaring stocks, “Cheap.” Isn’t there a neuroscience explanation for that behavior?
James: Absolutely. It’s classic anchoring. This whole habit of hanging onto irrelevant benchmarks. That’s exactly what you’re seeing. People say things like, “Well, 24-25 times Ford’s
earnings is perfectly reasonable.” That was the peak they reached in the bubble. Today, at 13
times, even if I believed the Ford earnings forecasts, which clearly we don’t, you’d have to
question whether those numbers are actually cheap. Relative to the peak in the bubble, yes.
Relative to a decent long-run history, clearly, no. That’s the problem. People have very, very
short-term memories here. We’ve got a serious myopia problem within the markets. The analysts are just in cloud cuckoo land. They keep telling us that things are going up. I do a chart
of actual earnings and forecasts, which shows that the analysts very clearly lack reality. They
only ever change their minds when there is irrefutable proof they are wrong, and then they
only change it slowly. It’s a classic pattern of anchoring and slow adjustment that we see.
Not to mention, demolish decoupling.
James: I actually have come up with a wee bit of data that shows, even if you somehow still believe in decoupling, that the emerging markets still have a huge problem: There’s an inverse relationship, historically, between economic growth and stock returns in emerging
markets. The slowest-growing emerging markets have generally generated the best stock
market returns for investors, while returns from the fastest-growth emerging markets have
lagged, because people overpaid for growth. Yet the whole reason, today, for buying into the
emerging markets and commodities seems to hinge on rapid growth in China, India, Brazil and
Russia — which I think is utter madness.
One thing I hear constantly, so you must, too, is that there’s still so much liquidity
looking for a home that the markets have to be sitting pretty.
James: We definitely hear a lot about liquidity and a lot about sovereign wealth funds. But along time ago I wrote that liquidity is the name that investors give to their ignorance, and I continue
to stand by that. When you can’t find anything else to explain what’s happening, you say it’s liquidity. You might as well say there are more buyers than sellers because it is at least as true, scientifically. A lot of what we see here is just excuses being made. A lot of it isn’t genuine monetary creation like Albert was talking about earlier is in the emerging markets context. A lot
of what you’re referring to is really the fallacy of liquidity, this idea that there’s a lot of money
sloshing around and it’s got to find a home. As our mutual friend John Hussman always points out, all you’ve got is really Paul selling to Peter. It doesn’t alter a damn thing if I buy a stock and
someone else sells it. The net amount of money entering or leaving the market is essentially zero.
Albert: What the “liquidity” everyone talks about really is, is leverage. If there’s price momentum, you want to borrow and play that price momentum — often in cyclical risk assets.
But as soon as that momentum turns, like the Roadrunner, liquidity may continue running off
the cliff for awhile, but eventually gravity takes hold. Prices re-couple with the cycle. And as
we’ve seen with CDOs, liquidity just evaporates overnight. That’s the problem with relying on
liquidity as an investment tool. It’s just basically a leveraged momentum trade, which can
explode in your face. Now, some of these private equity people are still able to raise money —
that’s what’s so amazing. But liquidity essentially can evaporate overnight, as we’ve seen with the CDO market.
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