Black Swans, Expensive Stocks, And The Most Important Chart In The World

| About: SPDR S&P (SPY)


Things that statistically speaking should never happen are happening all the time.

The fractious political landscape greatly increases the risk of tail events occurring at a time when equity valuations are stretched.

But at the end of the day, it all comes down to China.

I think the scariest thing about the UK referendum, the refugee crisis in Europe, the growing influence of political parties that were previously relegated to the fringes, and the upcoming US presidential election, is that markets really don't need all these extra tail risks right now.

Sure, you always prefer a situation with less event risk than more, but the problem is that for a variety of reasons, tail events are happening more and more often already. That is, we're all just kind of holding our breath each and every day as it stands. We don't need endogenous political shocks exacerbating an already precarious situation.

Let me show you what I mean. Have a look at the following chart from Citi's Matt King:

Click to enlarge

(Charts: Citi)

In the simplest possible terms: things that aren't supposed to happen ever are happening all the time.

Whether it's the abandonment of the franc peg, the great bund VaR shock of 2015, or the Treasury flash crash, the existing market structure is creaky and ill-prepared to handle the dislocations created by the potent combination of parasitic HFTs and central banks. Here, for instance, is a rather terrifying chart from Nanex which depicts the more than 220 ETFs that fell more than 10% on the morning of August 24:

Click to enlarge

(Chart: Nanex)

And here's a revealing look at what happened to liquidity during the Treasury flash crash:

Click to enlarge

(Charts: Citi, Nanex)

The point: there's already a heightened risk of absurdly anomalous moves even in what are supposed to be the deepest and most liquid markets on the planet. We don't need politicians enhancing the risk of tail events.

But alas, we are living in some of the most fractious political times in recent memory, and that means coping with potentially destabilizing geopolitical outcomes.

Here's the problem: if you're going to have to deal with this type of uncertainty, you don't want to go into it long an asset class that's overextended. Especially when that asset class benefited from a perpetual central bank put for years and then, when that dissipated, corporations stepped in to fill the void with the buyback bid.

I talked about this on Wednesday from the perspective of the US economy. That is, I looked at the underlying economic data and asked whether it supported elevated multiples for US equities (NYSEARCA:SPY). The answer, I concluded, was no.

Let's take a closer look at valuations, because trust me, Brexit isn't the last or even the most dangerous geopolitical landmine buried out there, and you don't want to be long a fully valued asset class that's lost its artificial support network when some manner of black swan lands.

So first, here's another look at multiples via Credit Suisse:

(Chart: Credit Suisse)

As you can see, fully valued. And here's a particularly disturbing graphic which suggests that the smoke and mirrors factor is sitting near an all-time high:

(Chart: Credit Suisse)

Here's how CS puts it:

Operating earnings reported by US corporates, which exclude "unusual" items as defined by the corporates themselves, are unusually high relative to reported earnings as defined by US GAAP. This indicates to us that some corporates may be trying to artificially improve their earnings by classifying reoccurring costs as "unusual."

Meanwhile, the buyback effect is drying up and will likely continue to do so as the cost of capital rises...

...while debt-to-EBITDA is at its highest levels since the crisis (even ex-energy):

(Chart: Credit Suisse)

So yeah, things are looking a bit stretched as the risks pile up. The key thing to remember though, is that barring some kind of absolute catastrophe in Syria that plunges NATO into a direct military confrontation with Russia and Iran, the biggest risk out there isn't the UK or the US election. It's China and the yuan (NYSEARCA:CYB). Here's SocGen's Albert Edwards:

But there is an argument that global investors have overly focused on Brexit at the expense of other more important macro events. We believe China's ongoing stealth devaluation of the renminbi is far more important for the global economy.

Meanwhile, our attention has been diverted. China has embarked on a stealth devaluation of the renminbi. Its new trade-weighted currency basket has fallen 10% since just before its initial August 2015 devaluation (white line in chart below) and it has continued to decline since January even as the Rmb/dollar has stabilised. The Wall Street Journal has reported that this is a deliberate shift in policy. China is now exporting its deflation, and my goodness it has a lot of deflation to export.

On that note, I'll leave you with a chart which shows the spread between the onshore and offshore RMB plotted against the S&P.

It should speak for itself (hint: the dashed line is parity, the wider the spread, the more likely it is that capital is flowing out of China, and when that happens, risk sells off).

Click to enlarge

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.