It’s nice to know your employer has your back … even if they will only give you backhanded compliments.
In a note on Tuesday, Societe Generale’s global research team led by Andrew Lapthorne decided to look at their colleague Albert Edwards’ startling prediction that global stock markets would crash 75%.
Their conclusion? It’s not that crazy after all!
“Albert Edwards sees the possibility of a 75% decline from the peak if all his fears were to manifest themselves,” Lapthorne and his team wrote.
“Now many view this as an incredible and somewhat outlandish forecast, yet it is not that unreasonable in our view.” (The note’s subtitle? “Maybe Albert’s crazy forecast is not that crazy after all!”)
This is interesting for two reasons.
First off, it is a startling call from Societe Generale.
Markets are bad, closing in on a 10% drop in 2016, but a 75% would be a massive implosion. Lapthorne wrote that this sort of sell-off could happen if stocks revert back to their long-term average price to earnings (P/E) multiple.
For the US, this would be a return form the current level around 30.8x to 14.7x. They also computed stock downturns if P/E multiples sunk to crisis levels and if earnings per share declined 25%.
“These types of declines would leave indices down rough 60-65% from peak and would send leverage ratios skyrocketing,”Lapthorne wrote.
The second reason this is interesting is the look behind the curtain it provides into the reasons research like this is done.
Lapthorne and the team acknowledge that there is a “very low probability to such an event,” but they also back up their co-worker Edwards, who is often categorized as consistently pessimistic about the economy — a “perma-bear” if you will.
“The job of risk management is to think the unthinkable, to stress test your assumptions to even include the worst case scenario,” Lapthorne wrote.
“Surviving a crisis and avoiding permanent losses of capital are key in delivering long-term outperformance, so even if you consider such downside forecasts ‘perma-bear’ nonsense, they shouldn’t be dismissed out of hand, especially in a world where corporates are carrying record levels of debt.”
Implicit in the note is the idea that yes, the strategy team at Societe Generale recognise that Edwards’ calls are outside of the mainstream (a fact Edwards himself readily acknowledges this), but having that perspective is helpful while refining or thinking harder about their own calls.
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