Four Potential Market Trouble Spots

by: David Merkel, CFA

Speculation, rampant speculation. This run in the market has to end soon, right? Right?!

Look, I’m not so sure. 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 saw in the markets concerning the four potential trouble spots (and more):

  • The recycling of U.S. dollar claims from the trade deficit ends because the U.S. dollar falls enough to make imports dear, and U.S. exports cheap. U.S. 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 the under-performance of many hedge funds. The bond spread widens as risk returns to lending, and the substitution of debt for equity slows to a halt.
  • New supply comes to the equity market, and overwhelming cash is available. This could come from private equity seeking to liquefy marginal assets at favorable prices. Alternatively, this could come from private equity investments that are unable to pay its debt coupons. It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, and not that it can’t refinance a principal payment.
  • The rising inflation in countries providing capital to the U.S. forces them to revalue their currencies higher, and not keep sucking in U.S. 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 (this did not work in 1987 and rates climbed 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.