It's The Dollar, Stupid!

August 2010 issue

View a complete explanation of the Kondratieff Wave theory

At first glance, the 7% rally in the S&P during July seems impressive. The Dow and Nasdaq averages were just as strong. In fact every thing under the sun rallied in July- Treasury Bonds, commodities, and every currency but the dollar. The risk trade was on because the USD plunged steadily all month. And who could be surprised? Since the financial crisis took hold almost three years ago the correlation between the US Dollar and all asset prices has enjoyed a correlation swell enough to make any economist blush.

Such dollar weakness also accounts for why the markets could enjoy their best performance in a year in the same month that sported the worst economic data in a year. Yet something else took hold late July that may be the driving force in the short term. St. Louis Fed Governor James Bullard recent proposed changing the emphasis of Fed policy from maintaining near zero interest rates for an “extended” period to a new form of quantitative easing targeting longer term Treasuries. The markets took delight in this new approach and extended gains in recent weeks despite a steady supply of awful economic data that was released.

But this QE 2.0 by the Fed would be a tragic mistake I believe. While it may be cheered at first (if not already priced in the market), such a move could backfire because it would signal to investors that conditions must be far worse than we believe. It could signal a classic reversal in sentiment from hope that the recovery would endure to one of heavy and continuous dependence on the government. Bull markets are not underpinned by such a fragile psychology. They are born through technical break-outs sporting high- volume, strong sector leadership, and good market internals during a period of improving social mood. At present the market lacks all of these.

Themes we have discussed before not only survived, they thrived. Among these are:

Rates are so low that stocks must be owned-

But what if rates reversed trend and went higher? Despite the Fed’s new policy, rates could actually soar given new perceptions about the Fed’s balance sheet, now already stocked with tons of toxic debt. News of the Fed buying longer term Treasuries could have the opposite effect it was intended if investors demanded much higher yields for the newly perceived risk of QE 2.0.

Delusion-

The stress tests for the European banks were an open joke sans the laughs. By only measuring the banks trading books and ignoring their longer term portfolios, they essentially ignored 90% of their exposure to sovereign debt since that is the percentage on those portfolios. They also assumed no single Euro country would ever default on their debt. Investors have forgotten that they were bailed out by the IMF with loans that must be repaid. The markets have reacted as if these were handouts instead of loans.

Ethics is replacing Power-

I don’t know where to even start here. First you have Rangel and Maxine Walters going to trial in the House- in an election year, too. Throughout the month a steady stream of miscreants settled with our regulators for fines equivalent to just a tiny fraction of annual revenue, and for that our shrewd government officials weren’t even able to get any of them to admit to an iota of guilt or wrongdoing. Here’s a partial list, just for a single month- Goldman Sachs (double-dealing with clients), UBS (abandoned their own clients in auction-rate scandal of 2008), Citibank (mislead their shareholders repeatedly over their exposure to sub-prime), Intel (ten year period of blatant price-fixing), Countrywide (too many to list), and many others earlier in the year. Many of the bluest chips in the deck are nothing more than criminal racketeers and certainly other transgressions will be played out before us for many years to come.

High Frequency Trading has distorted price discovery-

Understatement, indeed. Few investors realize just how egregious it really has become. The abysmal failure of our regulators to reign in this practice may one day be regarded as the most colossal failure of regulation in the history of the financial markets. Their purpose is so blatantly unfair yet in a world of regulatory capture it all makes perfect sense. (More on this can be found in our Taboo section).

It seems that retail investors have gotten the memo. For the past 13 consecutive weeks, since the May 6th Flash crash, stock mutual funds have seen net outflows each week totaling some $520 billion dollars. There is a growing perception that as far as the market is concerned there is nothing real in the world anymore. Trillions of capital have chased the perceived safe haven of Treasuries in recent weeks while the S&P is up 11% since early July despite being pied in the face with the reality of deflation, the double-dip, and default on a significant level of debt. The only ones now left to chase the market are the professional money managers and hedge funds who aren’t fully invested that now must chase stocks or risk losing their jobs because they have underperformed.

Moreover, the HFT’s that comprise about 80% of the market volume has an investment horizon that can now be measured in milliseconds. Hence, some very strange and unique things may occur if any serious news were to hit the tape. Such an event could also occur though an “aha” moment that resulted from a steady drip, drip of data bringing the denial that deflation has arrived to a sudden death. Every single day now we hear rancorous debate about whether deflation is possible. As they say, if it walks like a duck….

I believe the collective subconscious of investors is approaching a tipping point of realization that there are substantial structural deficiencies evident in many areas. They see an extreme bifurcation of the economy between the elite corporations and small businesses that create the bulk of US jobs. They see the stock market melt-up on ultra- low volume despite horrible economic news. And they see structural deficiencies in the execution of trading in the markets through a maze of exchanges that are now dominated by machines instead of honest brokers. So I expect very soon severe reversals in three markets that each now sport extreme sentiment levels- the dollar, treasury bonds, and the S&P. Most shorts have been squeezed out of stocks and bonds, and too many are short the dollar. Their correlation for years has just been too strong to ignore, so look for all of the markets to reverse violently this month in a trend reversal of a primary degree.