September 2010 issue

View a complete explanation of the Kondratieff Wave theory

The whipsaw that has marked the summer of 2010 continued in full force last week. The 5% decline in August was met with a sharp rally mid-week once September began as investors viewed the ISM and  Employment reports as evidence of no double-dip. In fact, all summer it seems everyone has become  so enamored about the prospects of this double-dip it seems to me we have lost sight of a much larger threat to our capital markets-a meltdown in the debt markets triggered by defaults of sovereign and municipal defaults. These are not only likely but inevitable, yet the markets now levitate as if they are neither- and that’s the great disconnect right there. Today our markets assume that Illinois and Greece won’t default, yet they will. And of course this will change everything very quickly.

Those who know the K-Wave theory know the excesses hiding in plain sight will be purged  sooner or  later. They know that bond yields will rise even if investors know economic growth will be meager or even negative. The flight to “quality” myth of US Treasuries is sure to be exposed soon as the bond vigilantes emerge from hiding. In fact, I would suspect we saw the all-time peak in Treasuries recently because yields reversed much higher last week, especially on the long end of the curve. Is this trend  were to continue it would have enormous ramifications upon all the capital markets because so many large and leveraged bets would have to be reversed. We must remember that these govt Treasury  bond markets are so much larger than the stock market that if something unexpected occurred  across the spectrum it could profoundly impact global financial markets through their exposure to financial derivatives contracts which are extremely susceptible to sudden moves in interest rates, even small ones. This is the real canary in the coal mine that I suspect will catch everyone off guard. There may or may not be a Treasury “bubble” today, yet there surely will be one tomorrow.

Another such canary is the US dollar. Although it remains the whipping boy for monetarism gone amok, it will remain the strongest fiat currency in the short term because as most counterparty contracts in the world are dollar denominated and thus cannot be so easily reversed, even if the US maintains huge deficits. The sheer practicality of unwinding US Dollar contracts is to daunting to  render the USD as anything but the strongest fiat currency in the world for the foreseeable future, yet so many have bet on the other side of that trade. This squares nicely with the notion above  regarding the perceived “sanctity” of US Treasury bonds and notes. The poof of this will be seen  when US Treasuries sell off on bad news Don’t look now, but this just happened last week when  US treasuries reversed lower last week during a period of deteriorating economic news. 

If either of the above conditions take hold to any extent, then any discussion of PE multiples, cash on corporate balance sheets, merger prospects, and the like will just be idle conversation, relegated to those who choose to insist that classic fundamental analysis actually matters. It usually does matter except in those extraordinary times when the effects of economic global super-cycles are just too daunting to ignore. We now live in those times, for better or for worse, and their implications I feel trump the standard framework upon which we have come to value or markets. Do deficits matter? 
Very soon we will see, once and for all. It seems sure some form of the Bush tax cuts will be extended and other forms of QE by the Fed and stimulus from Washington are also forthcoming. I suspect that  instead of helping us all as advertised that instead the measures give the bond vigilantes all the cover they need to dump Treasuries and upset the applecart that has allowed the Keynesian economics to become the monster that has roamed the countryside for so long. And that would be good for us all.