Circumference of Darkness

“As our circle of knowledge expands, so does the circumference of darkness surrounding it.”

-Albert Einstein

Yesterday was an interesting day. I woke up, sat in a 4AM traffic jam, then mentioned the word “truth” in my Early Look and proceeded to have dozens of bulls remind me that the “truth” is that the market was up for 2 days in a row and I was on the losing side of that trade. Maybe their circle of knowledge led them to believe yesterday was going to be another up day. Who knows. But after 3PM, I stopped getting their emails…

No worries boys. This is the game we all wake up to play. Every day there are winners and losers. I built this transparency platform during the crash of 2008 with you in mind. Everything I say and do is marked-to-market live on my risk management portal. Everyone knows the truth about every position I take.

For those of you who have friends who forward you our work so that you don’t have to do the right thing when no one is looking, my current short positions in the Dow Jones Industrial and SP500 ETFs are +0.49% and -0.33% for and against me, respectively.

As our circle of knowledge about Washington and Wall Street expands, citizens around the world are not only catching a glimpse under the modern day Roman Empire’s proverbial clothes, they are starting to ask some really good questions. Many of these questions boil down to investment processes – what is it that you do?

We know what conflicted, compromised, and constrained ratings agencies and bankers do. We also know what professional politicians do. But do we really know what asset managers who can’t preserve their client’s hard earned capital do in down markets? You tell me…

The scariest part about the most recent decline in the SP500 (down -10.5% from its April 23rd YTD peak) is not only the lack of respect that the bulls have for US government deficits and debts, but the “circumference of darkness” that surrounds their analysis.

Yesterday, the Obama Administration inched a step closer to telling the truth about this country’s fiscal problems. Washington finally admitted that the 2010 and 2011 estimates for the US budget deficit were too low. As a reminder, the fiscal 2009 US budget deficit was $1.4 TRILLION DOLLARS. The new estimate for 2010 is $1.6 TRILLION Dollars. Or a +14.3% year-over-year increase in debt financed deficit spending.

Importantly, the US government’s 2011 estimate for a deficit cut to $1.3 TRILLION remains tenuous at best. They have no idea what growth in 2011 will be and, as a result, will be adhering to the Buy-And-Hope model that they want America’s creditors to subscribe to when it comes to holding US Treasuries.

We continue to think that Ben Bernanke’s GDP growth forecasts for both the back half of 2010 and all of 2011 remain far too optimistic ( the Administration’s GDP forecast for 2011 is even higher!). The “circumference of darkness” comes into play when the Fiat Fools of US forecasting mismatch expectations like this versus reality.

The reality is that our Creditor (China) doesn’t believe us. You can look it up on the Chinese finance ministry’s website yourself, but upon receipt of the $1.6 TRILLION memo China stated that the US needs to “seriously consider” the structural problems associated with this Fiat Fool model and “stop blaming” others.

Our go-to-move in response to this mess is to mark-US Treasuries to-model as low as we can for as long as we can until the circle of the world’s knowledge about Washington’s Perceived Financial Wisdoms is too obvious. This morning we are seeing US bond yields begin to trade like Japanese Government Bonds, with 3-month US Treasuries yielding 0.06%!

What Bernanke and Geithner may not get is that holding US Treasury rates artificially low for an “extended period of time” actually aids and abets the blowing out of global bond yield spreads (the long ends of marked-to-market curves do just that, get marked higher). Whether you are looking at the TED spread, Levered Loan spread, or High Yield spread this morning you’ll see the same thing – the “circumference of darkness” that began to develop in mid 2008 – spreads widening…

Spain is going to try to issue almost $5 BILLION Dollars worth of 12-month debt today. The yield on that low-quality Fiat Promissory Note is 2.30% - that’s up from yielding 1.59% for the same maturity less than a month ago. Spreads on 10-year Spanish debt versus German Bunds are 209 basis points this morning versus their YTD peak of 215bps on June the 8th.

My moving from bullish to bearish will always change. Until the US addresses this Spanish looking deficit problem head on with some form of austerity measures, the biggest clean-up ahead of the Obama administration won’t be found in the darkness of our waterways – it will remain on our children’s balance sheet.

My immediate term support and resistance level for the SP500 are now 1082 and 1101, respectively.

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

Circumference of Darkness - DEF