Speculation. Rampant speculation. This run in the market has to end soon, right? Right?!
Look, I’m not so sure. I have a lot to write on this topic, but not so much time. Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect. Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).
- The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap. US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital. We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
- Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds. Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
- New supply comes to the equity market, overwhelming cash available. This could come from private equity seeking to liquefy marginal asses at favorable prices. Alternatively, this could come from private equity investments that are unable to pay their debt coupons. It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
- Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.
Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.). Until then, the party can go on. I have an article being developed on this topic, but I fear it is a “next week” item.