Monday, May 28, 2012

Caution in Defense of Capital Preservation Is a Virtue As European Economic Imbalances Roil Murky Waters

I am beginning to more seriously fear a liquidation event arising from the events in Europe.  This is not a prediction, as matters may muddle through, but those of us who manage money, either our own or OPM, must think of downside risks unless we happen to be portfolio managers for a Bill Gates and handle just a small part of his wealth.  But here's the updated set-up that I'm seeing based on today's headlines, and again, this is not a prediction, just a growing sense that the odds of a discontinuous downside event have increased to a level with which I am uncomfortable. 

First, I have a similar sense that Greece has a failed economy that I had by midyeaer 2008 that the U.S.housing bust could not be contained.  As evidence I present this article from eKathimerini titled General payments freeze takes hold.  Please consider reading in full and then coming back to this blog.


Before going on to the second, let's remember that Greece has as many people as Illinois and had an economy the size of Wisconsin.  It has about as many people as Sweden.  A Greek national bankrupty has not been reserved for.  Again, my fear from a continent away is that Greece appears to have passed a similar tipping point as the U.S. housing market passed in 2008 once it became clear that the American national economy was in recession.  Shortly after that realization dawned, Fannie/Freddie were forced into conservatorship and the jig was up.  The banks could no longer pretend that their assets were worth anything close to what they were carrying them on their books at, all foreign investors closed their checkbooks, and the meltdown began.  Europe is now in recession, and there are no excess funds anymore readily available to absorb losses from Greek debt.

Second, the Spanish situation is unraveling due to recession.  The news today is that having rapidly increased the estimate of their bad bank Bankia's losses from a few billion euros to about 20 billion euros, the government is making more news:
Spain is considering using debt issued by the government or its bank-rescue fund instead of cash into the Bankia group, using a mechanism that would free it from raising the money from investors.
The government hasn’t made a decision on whether to use its debt to recapitalize the nationalized lender and will decide in two or three months, a spokesman for the Economy Ministry, who asked not to be named in line with its policy, said in a phone interview today.

This both appears to be a sign of weakness as well as dilatory.  No decision for 2-3 months?

Other news from Spain is also negative.  Spain is approaching or is on a knife's edge.  Again, my point is that general recessionary conditions turn a manageable situation into a crisis, as occurred in the U.S. in 2008.  Capital that would have been provided to tide matters over suddenly withdraws.

Now, let's turn to the U.S. stock market, which simply by approaching its 2007 highs has been about the best performer of any major global stock market on a 5-year basis.  My take is that the FaceBook IPO really does add to the public's disillusionment with the financial establishment.  It is more "in your face" (pun intended) perceived abuse of the public than something seemingly esoteric and relatively unpublicized such as the loss of customer money in the MF Global bankruptcy.

It is not only the quick collapse of the share price back to the level that the IPO was planned to have been done at, namely the low $30s per share.  It is not that the insiders increased the number of shares they sold at the $38 price.  These things happen.  I am thinking that the tipping point for the FB IPO is the credible charge that there was selective disclosure to institutional investors after the S-1 was published that FB's current pace of business was not looking as good as expected makes it difficult for the usual parties to say, well, markets and stocks go up and down.  Those who chose to buy at $38 did so.  Even assuming, as I do, that nothing illegal occurred, then even so, the charge of selective disclosure makes the FB IPO an easy target for those who want to advise the public that Wall Street exists primarily for its own good and those of its clients.  That can easily translate into:  sell stocks, who really knows what they are worth?

Major regional recessions tend to force balance sheet readjustments.  Those readjustments may be sudden, as I believe occurred after the U.S. government signaled exactly that when it acknowledged that Fannie and Freddie's assets were seriously overstated on their books.  Now the problem is centered in Europe.  European banks issue letters of credit for a large percentage of world trade.  Europe is a larger economic entity than the U.S. plus Canada.  China exports more to Europe than to the U.S.  China is already selectively canceling certain import orders.  If European economic output takes another lurch downward, look out below in China.  It will have its planned property correction going on simultaneous with an unexpected large drop in demand from Europe.

U.S. investors are relatively sanguine.  The VIX is marginally above 20.  As 2008 moved along, I identified 25 as the cutoff point between true stock market panic and relative complacency.  Until Lehman sent the VIX sky-high, that worked well. I'm back to that pre-Lehman way of thinking, thus I'm cautious about stocks, though a strong kickback rally would (as previously stated) be completely unsurprising even if lower lows await.  Even after the recent stock market decline, quants such as Jeremy Grantham and John Hussman peg the U.S. stock market as highly unattractive.  Grantham gives the 7-year prospective return from U.S. stocks as roughly prices to yield total returns only equal to inflation.  And that's with a wide standard deviation.  Meanwhile, tax-free bonds yield about as much, with much greater certainty.  So when people ask, where else can money go expect stocks, I answer three ways:  cash, tax-frees, and beaten-down emerging markets stocks, where structurally their economies are in the higher-growth phase of development.  (Plus gold and U.S. homes.)

These periods where economic output is decelerating in most of the world and declining in absolute terms in a major part of it-- are the most dangerous times for stock investors.  The European situation has brought matters to this point.  When the Russian bankruptcy roiled markets in 1998, non-Asian stock markets were in sharp secular uptrends.  The ensuing selloff was but a blip in the ongoing stock market party.  Today's charts are different.  Every major market is seeing failed rallies off the 2007-8 highs.  Another general bear market will create yet uglier charts.  Chartists who are now comforted by the SPY may then say "sell". 

In other words, 2011 may have been a softening-up year, frightening though it was- perhaps something analogous to 2007 in the U.S.  There were no recessions then other than in small European countries.  Now the U.K. and Italy have entered at least mild recessions.  France's GDP was flat the past two quarters.  Not only are these very large economies, but please remember that they help drive China's economy.  Both through that mechanism and directly, then they also drive the economies of raw materials exporters such as those of Brazil, Canada, Australia, the Gulf States, etc.
Such a possible downward economic cascade will wreak havoc on President Obama's stated goal that the U.S. would/should double exports in a five-year time frame.

In other words, Europe's economic and financial issues are large enough to drive an economic and financial markets reset similar to those that occurred when the mild U.S. recession as of summer 2008 morphed into something much worse as the balance sheet holes of the large financial institutions were revealed to be irreparable (absent the extraordinary government action that ensured).

Thus these appear to be legitimately perilous times.  Investment discipline is paramount in these times.  Reacting to the latest headline or market moves is something I am going to try hard to resist.
As Chance the Gardener said, "I like to watch".  Whether this real-life movie has a happy ending is unknown; it is like Casablanca; even the scriptwriters have not determined the final scenes.


  1. To me it's more like watching "Lost". I can't keep up with everything and every episode introduces another mystery or another threat.

  2. Yes, the media and the eurocrats have been crying 'wolf' for a long time. But as with the US housing bubble, which peaked at the end of 2005, perhaps a major bust will actually occur. The wolf may finally make an appearance. Note I am not going to focus overmuch on Europe. Just thought it's worth an occasional mention again.

  3. If the USA goes into a recession induced by Europe & China then I think inflation will be the accepted solution. But it might not work and in fact could psychologically backfire as individuals and businesses pull back to conserve and save even in the face of inflation. Totally perverse but that is how I read people and my small business clients today. Prices going up? Conserve even more is what I am hearing. Also, the underground economy is picking up in popularity; people just don’t know how to do it. Yet. There is little moral concern about the legality of it now. I am on the street. These are my headlines.

    Ride the stock market up if at all possible right now with indexes having bought between 5/21 to 5/25. Have a clearly defined reversal point if the market doesn’t rise. If the market does rise it is harder for me to see where to exit and take profits at this time and that is what I am working on. The 50 SMA may be my fall back place to exit without any other idea.