Don't Wade Into The Flood Waters During A Hurricane

| About: SPDR S&P (SPY)


For whatever it's worth to you, I have some advice.

Well, it's more a metaphorical lesson.

But take heed.

For whatever it's worth to you, I have some advice: do not go to the beach in North Carolina during a hurricane.

If you make that decidedly ill-advised decision, you may end up where I did - half drunk on top of a drowned Toyota Tundra here:

Click to enlarge

But there's a metaphorical lesson in this that I think applies quite nicely to today's market. Don't wade into flood waters while intoxicated - and that's exactly what some of you are doing in the market.

We're flooded. Inundated. About to float away. And you might need to take a breathalyzer before diving in. I've shown these S&P (NYSEARCA:SPY) charts a hundred times, but I'll show them again here:

(Charts: Goldman)

Does that look like "value" to you?

But here's the thing, like the two girls I was with still trying to swim into the Kangaroo Mart to buy beer even as cars floated away, there's only one group of people keeping this whole party afloat. Well, actually two. Here's a hint:

(Chart: Goldman)

In other words, you're buying, ETFs are buying on your behalf, and all the rest is corporate buybacks. The smart money is long, long, gone. Just like the smart residents in the town I photographed above.

Now the savvy readers out there might make an argument out the ERP and the fact that compared to the paltry yield on bonds, equities look pretty good. But that's just the problem. The ERP doesn't mean anything anymore. Here's Goldman to explain:

On the surface, valuations for equities appear more attractive than for credit, as equity risk premia are high, both relative to credit spreads and relative to their history. However, estimating equity risk premia is difficult due to the low level of bond yields and uncertainty on LT growth prospects: high dividend yields (and low bond yields) could just signal lower growth. Until we see a sustained pick-up in growth, we think equities will be stuck in their 'fat and flat' range: low positive returns but continued risk of drawdowns. To unlock the ERP and drive outperformance of equities vs. bonds and credit, we need more signs of a 'reflation' scenario. Until then, we still prefer credit to equity.

Ok, fair enough. Now about that credit preference. What exactly is it you're going to buy? Especially considering the soaring correlation between stocks and bonds that's befuddled even the likes of Ray Dalio.

Well, you could buy IG credit (NYSEARCA:LQD), but you won't get much yield there with spreads trading below their 25-year median and fully one standard deviation below their quarter century average. Or you can opt for riskier credits which are a little more reasonable (yield wise). Here's a snapshot:

(Chart: Goldman)

Ok, so what about HY (NYSEARCA:HYG)? Well, as I discussed earlier (and as I've mentioned on my brand new blog), the door is slamming shut on new issuance:

Click to enlarge

(Chart: Deutsche Bank)

What do you think that portends? And here's the scariest chart of all for HY:

(Chart: Goldman)

See anything foreboding there? If not, just read the title of the chart. Now check out one last graphic:

(Chart: Goldman)

That rising correlation increases the chances that risk-parity and vol targeting strats will all be selling at once which in turn raises the chances of sharp moves to the downside especially considering the fact that they've been allowed to lever up thanks to central banks' artificial suppression of volatility.

And speaking of central banks, if you're counting on them to save us all... well, don't. On that note, I'll close with the following from Deutsche Bank:

We believe the current market equilibrium rests on a shaky foundation, which assumes the Fed is going to fail in raising interest rates in coming months and quarters, while the ECB/BOJ will remain successful in maintaining negative long- term rates in their jurisdictions, or even trying to push them further negative, thus forcing major investment flows into US rates and credit to continue. We think there is a meaningful scope for a surprise on both sides of such views, potentially more so on the Fed side in the near-term, and on the ECB/BOJ side in the longer- term.

In recent weeks, the Fed has been sending clear signals that it wants to reengage on its path to rate normalization in the remainder of 2016, while the market has continued to push against it. Interest rate forwards are pricing in less than a 60% chance of a rate hike before the end of the year, while the Fed speakers have been entertaining a possibility of more than a single hike during this timeframe. As we look out further into future, the Fed's dot plot projects seven rate hikes before Dec 2018, while the market is implying only two and a half. This gap cannot exist in perpetuity, and if the Fed decides to force the market to realign its views closer to those of FOMC, the primary impact could transpire in FX hedging costs for EUR/JPY investors in the US going even higher than they are today, making their continued inflows, if not yet holdings of US assets uneconomical. (my note: recall our many discussions of FX hedging dollar exposure)

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.