In Fed we trust?

March 2013 issue

View a complete explanation of the Kondratieff Wave theory

And the beat goes on. As the major US indexes approach nominal all-time highs the desperation by investors in the search for yield recently has reached epic proportions that are patently absurd. Since the beginning of 2013 investors have snapped up record levels of debt among the most credit unworthy sources including Greece, Spain and scores of risky European corporations. How does this square with Kondratieff Wave theory?

The central canon of K-Wave theory is that there are distinct patterns of long term credit super-cycles that provide a boom then bust scenario over time. We can argue that the end of the prevailing super-cycle of credit began in 2008 in many areas- consumer credit, home mortgages, and business loans. But since then another form of credit did accelerate considerably with the explosion of untold trillions in global central bank printing. They can collectively defy the K-Wave cycle for a while by granting themselves credit out of thin air through electronic keystrokes. If they had to apply for this credit like you or me they would of course be denied. Who would lend them these trillions to buy bonds at all-time highs from deeply distressed governments running unsustainable deficits? Would Amex give you a platinum card if you were a reckless spendthrift? Of course not.

Interest rates are certain to rise substantially in the coming years and the prices of all these global government bonds will decline accordingly. This certainty is now being called to light by the few hawkish members of the Federal Reserve. In the past two Fed meetings the minutes have showed a marked increase in the anxiety that several Fed members have over the Fed’d bloated balance sheet that is now over $3 trillion and rising one trillion each year. And even more remarkably, even Bernanke stated Friday that he expects long term interest interest rates to rise to over 5% in just a few years. This was the first time to my knowledge he has ever warned about rising rates or proffered a projected target.

This trend and the common sense notion that the Fed cannot print ad infinitum suggests that investors may decide to front run the inevitable and sell in anticipation of these events. So in effect market forces could essentially usurp the Fed and force their hand sooner than they want. I do expect this to happen. After all, markets have been known to price in today what is expected to happen later. The markets at present seemingly believes in Fed we trust and that easy money will be core policy for the foreseeable future. But beware of such a mantra. My belief is that once the market gets the first whiff that the Fed is beginning to gradually taper their purchases the markets won’t respond with a gradual decline. They may choose to react instead to the magnitude and duration of the “great unwind” which promises not to be so kind. I think investors today are entirely complacent to the implications coming from even the slightest hint of a bona-fide reversal in Fed policy.

As a proponent of the K-Wabe theory I believe we are now very close to a generational peak in credit and the price of paper assets such as stocks and bonds. The draconian policies of the Fed has destroyed true price discovery in markets because they have so radically tipped the scales with trillions in printing. These policies have also enabled sovereign governments to continue to amass record deficits without any pressure to enact the needed reforms to restrain runaway spending. Here in the US this is more true than ever. I see peak credit, peak corporate profits, and peak assets prices all at once present today.

There are other signs of a classic top in the markets. Insider selling is rampant with levels of selling to buying at 9 to 1 in recent weeks. The WSJ recently noted that the level of aggregate market valuations compared to GDP are among the highest ever, matched only by those levels in 2000 and 2007. We all know what then happened next. And while some argue that the current PE of 14 looks cheap that may be deceiving. The PE is 22 when using a perhaps more appropriate 10 year average constructed by Robert Shiller and that is not cheap. And also there are the divergences. Despite being a whisker away from a new all-time high in the Dow and the S&P, the Nasdaq 100 is still off 5% from it’s multi-year high last fall. You still have three major sectors that are not participating in the rally- financials, technology, and materials. You just cannot expect a new bull market to begin without substantial moves higher in all of these sectors.

There is much drama ahead. A March 27 deadline looms for the continuing resolution just to keep our government running and then the big one in mid-May- the debt ceiling. This will prove to be quite a battle and all the chips are on the line here. I sure hope they can reach an accord that is balanced and provides very large reductions in federal spending that are carefully considered and implemented over a long period. These cuts must include substantial reforms in Medicaid, Medicare and Social Security or we risk another downgrade from the rating agencies. This week Moody’s cut the United Kingdom’s AAA rating and that leaves just a few left with the top rating. More downgrades are expected for most of the troubled southern European nations whose economies continue to implode. And let’s be sure to keep an eye on three outliers that hardly anyone is talking about- Egypt, Cyprus and Argentina. All three are set to default very soon and these could provide more shocks to the global markets.

We may be entering soon a new paradigm- one more based on reality. In 2000 we all drank the Kool-aid that the internet was providing a new paradigm where company valuations were independent of revenues or profits. In 2008 we drank a different flavor in that home prices would rise forever. We’re now drinking another flavor- that easy money printing by the Federal Reserve will sustain asset prices forever. Investors may want to consider if they are indeed drinking a new flavor the same old rancid Kool-aid.