Threading a needle that will burst a bubble

US stocks levitated in recent weeks to all-time nominal highs recently courtesy of unabated debt monetization by a sugar daddy Fed that promises not to let up for some time on their draconian printing scheme. And the markets have responded in true Pavlovian form despite so many headwinds- the Cyprus default, record Eurozone unemployment, and so on. It seems the bulls and bears both agree the Fed and the other central banks are omnipotent. This type of sentiment is what one would expect at the peak of a 70 year super cycle in credit. The world is awash in debt and credit like never before as central banks attempt a high wire act of promoting growth without destabilizing the global financial system with too much cheap money. So the real question is this- is the Federal Reserve threading a needle that will one day burst the debt bubble?

History has shown that just when a prevailing worldview forms, such as universal belief the Fed will prop up the markets, it is often upended quite abruptly. New realities that hide in plain sight such as too much unpayable debt suddenly get a second look. Don’t look now but deflation is rearing its ugly head again. Global growth is slowing to a crawl despite massive monetary and fiscal stimulus by nearly all of the developed countries. Investors have ignored this and so many other fundamental problems and have chosen to bid the market higher so long as they feel that massive monetary stimulus will remain in place. Global markets surged higher in April after the Bank of Japan announced plans for monetary policy so grandiose it even surprised even the most optimistic bulls. Japan is now all in on a scale even more ambitious than the Federal Reserve. Such a scale would make even Bernanke blush with envy.

All this cheap money has helped corporate profits to peak on a log scale as they now comprise over 11% of US GDP. This number is absolutely staggering when you consider that the historical average for profits is just 4-6% of GDP and thus the 11% number represents a level several standard deviations removed from the norm. This implies that this level isn’t sustainable for an extended period. Corporations have wrung out all the efficiencies possible for this cycle and wages that have plateaued or declined for decades will begin to rise. Hence the current PE multiple of 14 is far too ambitious and this is why I argued last month that the Shiller equation of a ten year average should be used for computing the present PE multiple. Today that PE multiple would be 22-24 if measured by the Shiller method and that’s not cheap, especially considering the tens of trillions of debt hanging over the market. A PE of 5-7 sounds about right to me considering how constrained the world has become with all this debt.

It’s been quite lonely being a bear the past several months as the stocks have confounded most bears and even surprised many bulls. But I still maintain that the Kondratieff Wave theory will get its due soon as much of this debt defaults. Our theory insists that a new cycle of prosperity cannot begin until much of the excesses of the past cycle have been removed yet in fact those excesses have ballooned even further since the 2008 global financial crisis. For those who believe in K-Wave theory but feel it came and left in 2008-9 I say this- I cannot fathom that the entire pain coming from a 60-70 year super-cycle of credit could be expelled in a mere three quarters of declining stocks and GDP. Just can’t be.

The case for a market top forming today is made easier by comparing the present conditions and sentiment to other recent bubble peaks. In the spring of 2000 it was hard to find anyone who didn’t believe in the new paradigm that assumed fantastic valuations of internet technology ventures weren’t warranted or could not be sustained. Never mind that most had no revenues and were burning lots of cash. Instead investors chose to whistle past the graveyard until their bubble burst in mid March of 2000. The S&P peaked around 1550 and the index measuring those high fliers plunged over 80% in the next two years and that one NASDAQ index is now still off over 70% inflation adjusted ever since. Bubbles and ponzi schemes are nice for a little while until they’re not.

In 2007 another bubble top was formed in stocks (peaking at 1565, a tiny 1% fake-out technical overthrow from the previous high) and US home prices and the fallout from that is quite historic. Once again investors had the audacity to believe and support a ponzi scheme hiding in plain sight. The pitfalls of the securitization of the US housing market are now legendary in their foil but of course such a disaster was apparently not evident to thousands of investors who lost so much on the grand housing scam predicated on financing by those who could not afford to buy homes. Eventually the system could not find enough new buyers so when housing prices began declining in 2006 the system crashed because it was designed to succeed only upon the idea of infinite sustainable growth, a theme directly in conflict with the K-Wave theory that advocates economic contraction is needed in certain periods of the long wave growth cycle.

In the spring of 2013 and can now measure the $7 trillion in fiscal and monetary stimulus enacted specifically to levitate paper assets above their true clearing price. The US stock market continues to rise despite ever growing signals that these draconian fiscal and monetary measures have not and can not sufficiently stimulate growth here in the US or abroad. Stocks seem to rise on good news, bad news, or no news much like the peak of the bubble periods in 1999-2000 and 2006-2007. As always, cheap money from US and global central banks are the culprit and as always they promise us there are no bubbles forming and if one were to develop they would take measures to prevent any disaster.

But don’t forget that Bernanke famously promised that the sub-prime bubble was contained in 2007 and that the Fed over the years has been notorious for failing to see potential land mines hiding in plain sight. This is precisely why our website is rooted in history. Long Wave economic theory provides the optics we need to see how responding to the same patterns were so insufficient over time. Sadly most investors today are ignorant of economic long wave theory altogether and instead choose to measure the market’s arc through yesterday’s metrics such as PE multiples, etc. I suggest a worldview more replete with historical benchmarks that have proven to be very reliable over time. And the bottom line from our Kondratieff Wave theory is all too clear- there is just too much unpayable debt that has accrued in the world today that is likely to default at some point in the near future. These defaults could be enormous and very painful for investors oblivious to the pitfalls of the implications of the bigger macroeconomic picture. Perhaps it’s prudent to take this notion to heart- don’t sweat the small stuff of corporate profits but instead look out for the big stuff such as global sovereign defaults. Massive and unprecedented debt will trump everything once the dust settles on this winter cycle phase. Debt deflation and defaults from global sovereign, corporate and municipal entities are coming to the fore soon enough. I expect one day soon it will become self evident to most that a global financial system underpinned by fractional reserve central banking is a threat instead of a benefit to global growth and stability.

One important person who shares this sentiment recently took the opportunity to weigh in to the world on this crucial matter. Outgoing Japan central bank chief Masaaki Shirakawa made several comments at his final press conference after being dumped by new Prime Minister Snzou Abe. Shirakawa said there was no quick fix for taming deflation and that deploying monetary policy to induce inflation expectations was like punching air. He said the link between inflation and the monetary base has declined considerably over the years. That notion jibes very well with Kondratieff Wave theory that holds that any attempts to fight back the natural forces of deflation coming from super-cycles of credit expansion is a fool’s game.

Shirakawa was a 39 year veteran of Japans central bank and he helped Japan avoid the worst of the global financial crisis a few years ago with tame and reasonable policy directives. But now there is a new sheriff in town in Japan (Abe) who is perhaps even more radical than Ben Bernanke. He undermined BOJ political independence with incendiary comments preceding the ouster of Shirakawa and now the BOJ is printing over $100 trillion yen per year in their great experiment (gamble) to tame deflation. This policy in incredibly risky and could lead to a total panic flight of capital out of Japan for fear of a significant currency devaluation. Such a prospect is quite possible if the markets get ahead of the central banks. In that case the law of unintended consequences would be quite severe as investors in Japanese bonds could flee to protect the purchasing power of their holdings that had been perceived safe until recently.

To some extent this has already occurred as the yen has declined almost 30% vs. the USD since Abe was elected in November. Such a large move by a major currency in such a short span is unprecedented and could showcase what is to come in the coming months and years. Our readers know that I have advocated since 2011 a specific end game to this final stage of the Kondratieff Winter coming in the form of a rising yield deflationary bursting of the global debt bubble. I have advanced the idea that this trend was most likely to take place in Japan since it has in fact been experiencing a deflationary Kondratieff Winter for over two decades since 1990. In fact the era of Japan’s deflation since 1990 will be the stuff of legend one day and a prototype case study for promoting Kondratieff Wave theory into a more prominent role in college textbooks and maybe even also into federal government policies. The next cycle is likely to better heed these lessons.

Japan as a case study is very intriguing and has several features that make it the most likely market to lead a global meltdown. It is the world’s third largest economy, it floats the world’s second largest bond market at over $12 trillion and the world’s highest debt to GDP ratio among all industrialized nations. In January I suggested that Japan would be known one day as the land of the rising yields instead of the land of the rising sun. In the past few days this process may have already taken shape. On the same day in early April the BOJ made the infamous announcement to print $100 trillion yen each year the Japanese 10 year bonds rallied to all-time highs in just a few minutes.

At their peak, their 10 year bonds yielded .31 % in mid session but then a dramatic reversal took shape and they sold off to a yield of .60 that night and have remain elevated at those levels today. Such a reversal represents several standard deviations removed from the norm and tells me something is rotten in Denmark. The takeaway from this is quite grim- it appears that the capital markets are now ahead of Japan’s central bank. The tail is wagging the dog, not vice-versa. Expect more of the same here in the US and anywhere there is blatant debt monetization and currency debasement. Too much of a good thing is in fact not a good thing. Look out below when the markets figure that out, because there is so much leverage in one direction at the moment. Let’s see how that plays out.