A legendary Wall Street strategist lays out the stock market's 'nightmare scenario'

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Albert Edwards

• Legendary strategist Albert Edwards thinks that investors are ignoring many latent risks in the stock market.
• His "nightmare scenario" combines an acceleration in wage inflation and a hawkish adjustment to Fed rate hike expectations.

Albert Edwards thinks you're all too confident about the durability of the 8 1/2-year bull market. And he'd like to remind you that there are some major risks lurking in the shadows, waiting to strike.

He's identified the worst-case scenario for what could cause a massive stock blowout, and it ultimately involves the Federal Reserve raising rates too slowly. But that won't just happen for no reason - Edwards thinks there needs to be a surprising economic jolt.

"The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve," the legendary Societe Generale investment strategist and outspoken market bear said in a recent note to clients.

That's right, in an ironic twist, the economy could recover too quickly for the stock market to handle in its current form. And shockingly strong wage inflation could be the root cause of the whole catastrophe.

Edwards note that wage inflation has declined this year, as indicated in the chart below. He points out, however, that US average hourly earnings have jumped, and suggests that a similar jump in wage inflation could follow.

Societe Generale

Edwards says a sharp increase in wage inflation could trigger the stock market's "nightmare scenario."

"Wage inflation has been the dog that didn't bark this year - or indeed the wolf that didn't howl," explained Edwards. "High wage inflation data in the months ahead could cause a rapid reappraisal of the pace of Fed rate hikes. At these high equity valuations, that could really scare investors."

Another element of the US macroeconomic picture that could be impacted by expectations of quicker Fed tightening is the dollar. Bucking forecasts and staying surprisingly weak for much of 2017 the greenback could be due for a bullish reversal in the event of hawkish expectations. The US dollar index has fallen more than 7% year-to-date.

That would be bad news for the torrid earnings growth being enjoyed by US companies, since the large multinational corporations with heavy weighting in stock indexes have had exports boosted by a weak currency.

With all of that said, the fact of the matter is that investors have been reluctant to price that potential downside into the market. And Edwards just doesn't understand that. In his mind, current market conditions hold many eerie parallels to the 1987 stock market crash.

That most notably includes lofty stock valuations. Major US indexes are currently near their most extended levels ever, the same as three decades ago. And just like in 1987, investors don't seem particularly concerned about it.

Edwards also draws a comparison between modern-day investment methods - volatility targeting, risk parity and trend-following quant funds - and the 1987-era hedging technique called "portfolio insurance," which is frequently associated with the market crash.

In the end, Edwards himself acknowledges that his bearish views are largely contrarian. But he also points out that 10 out of the 13 post-war Fed tightening cycles have ended in unexpected recessions.

So if you are going to keep piling into stocks, and the bottom drops out at some point, don't say Edwards didn't warn you.

Societe Generale

Edwards notes that US stocks continued to rally throughout 1987, even though bond yields were rising sharply.