A New EU? Does Nein mean Nein?

Tuesday, August 21st, 2012

by Peter Tchir, TF Market Advisors

Is it a New EU?

Of the major players coming into June 2011, almost none are left. Attrition and elections have taken care of most of the major players. In fact, you could make a case that Merkel is really the only major player still in the same position.

I think this is important particularly for the ECB. Draghi has now had time to establish himself in his role, and get comfortable with the people at the ECB, the various central banks, and the politicians. He entered the role with a bang – a rate cut, more symbolic than anything, at this first meeting and then began the LTRO’s.

Since then, his efforts to get Spanish and Italian bond yields down have been thwarted by the markets and a deteriorating economic situation. He wants yields low and looks like he is prepared to stretch his powers to fulfill the mandate of “transmission of economic policies”.

How far is he willing to stretch? How much can he do based on that “transmission” mandate? That is the question and we need to get answers, but more and more, it looks like he is prepared to be aggressive. It may not be a completely new EU, but it has changed a lot in a year, and the ECB does look to be a new ECB.

Nein to Nein!

Germany looks more and more isolated in their refusal to play nice and even there it is becoming clear that not everyone is against the idea of money printing and aggressive actions. On top of that, Germany is “only” 25% of the EU economy. It is the single largest economy, but France, Spain, and Italy combined are much larger. Germany plays an important role, but it cannot make decisions unilaterally. Germany could in theory walk away from the EU, but the German “elites” more than anyone seem committed to trying to hold the Eurozone together. They are stubborn and have a deep seated fear of somehow once again being the ones that cause Europe to splinter.

Their voice, while important, is diminishing, and for many of them, they are looking for ways to save face as they backtrack from 2 years of causing problems. Assuming Nein means Nein is likely to be wrong in this case.

The Immediate Problems that the ECB CAN Address

Currency exit and forced redenomination has to be taken off the front pages of the newspapers. I have not seen a single paper that walks through how redenomination would work in practice. There are 100′s that talk about an event, and then a future where the currency adjustment “restores equilibrium” or some such nonsense, but they gloss over how you get to that stage. The reality is that you don’t. Not easily and possibly never. The uncertainty created will cause business to die. To die quickly and violently as no one will want any part of cross border commerce while currencies and laws are in a state of flux. This isn’t just for the weak countries. Germany will see problems as well as they face political backlash from the rest of Europe and from a strong currency. A lack of energy resources makes this reversion to old currencies and devaluation even more problematic.

While currency redenomination risk remains on the front burner, business will be slow to engage in big new projects and the risk of bank runs remains high.

Any policy that provides funds direct from the ECB to weak countries, such as the plan floated this weekend, would immediately reduce the risk of redenomination. The ECB would become the center of a tangled web, so intricate and complete it would be hard to visualize how to untangle. So the ECB CAN take redenomination risk of the table.

Budget problems in Spain and Italy need to be fixed. The ECB cannot do much to fix the overall budgets of Spain and Italy, but it CAN help. Both countries have seen cost of new money increase dramatically and are paying rates far above the ECB’s target rate for banks. That adds to the annual budget deficit as that higher interest rate cost affects current year payments. It takes time for these higher rates to influence the overall cost, but we are well over a year into the crisis and if Spain and Italy had been able to refinance all that debt 2% cheaper, it would be having an impact. The circular nature of this is vicious as well. The more Spain and Italy have to pay to refinance debt, the bigger their current deficits, and the lower their credit quality, causing rates to go higher. This is the “transmission” element the ECB is focusing on. The ECB wants (in fact needs) Spain and Italy to have low rates, and needs to find a way to get them. It will reduce current deficits and future projected deficits.

An ECB plan to support countries would take away roll risk, so not only would the countries that need money the most, be able to get it at rates in line with overall policy, but they could spend less time on how to raise money in the bond market, and more time on how to fix their economies and budgets. So the ECB program can help the budgets, it will take time, but it is real, and will also allow countries to focus on things other than bond auctions.

Constraints in both Will and Way

Throughout the crisis there have been concerns about whether the EU had the will or the way to fix the problem. Much of the conversation revolves around the “way” they can fix it. Do they have the tools? Do the treaties allow them to do what is necessary? The reality is that the “way” argument was to hide the fact that Europe didn’t have the “will” to fix things.

Now it looks like Europe might have the “will” to fix things. That Europe is finally willing to engage in a wholesale effort to support the periphery. If Europe is willing to do that, they can find ways. EFSF, while lacking in many respects, isn’t insignificant. The ECB, while constrained by its mandate, seems to have some flexibility, especially if they decide they want to push the envelope. A lack of will has been a bigger impediment to success than a lack of way, so this psychological change is important.

It is also useful to point out that so far the term “bailout” has been applied very loosely. Germany, for example has delivered very little cash to any of the countries. It has guaranteed debt that was used for the countries or supported IMF and ECB efforts to funnel money to the countries, but very little German cash has found its way to the countries as part of “bailouts”. On top of that, all nations that have received “bailout” money have continued to pay that money back. There has not been a single default on any money lent as part of the “bailouts” so Germany is actually profiting from this so far (ignoring the cheap rates they are also benefitting from).

The image of German’s dumping money on these nations just isn’t correct. So far, Germany has acted more like Rumpelstiltskin and demanded a high price for their loan, rather than as some sort of charity act that the term “bailout” implies.

Even though I believe the will is now much stronger, and there is a way, they will be careful not to be “reckless” and will embark on programs that are easier to sell internally.

What Trades Should do Well?

I like Spanish and Italian bonds, but only with maturities of less than 5 years. I think that the ECB will focus on the primary market and the short end of the curve. I think they will make money available in the 2 year range. It is long enough to offer real support, but short enough that the political opposition will be lower. I don’t exactly agree with the theory that 2 year risk is so much less than 5 year or 10 year in the case of Spain or Italy, but politicians tend to. Politicians often have a simplistic view and will take comfort in that the next 2 years are “foreseeable” and 5 years and out isn’t. It’s not true, since they can’t seem to anticipate anything 3 months out, but that is what they believe. They can be convinced to lend short term rather than long term.

I would go out as much as 5 years because any such program will be in place for awhile so even if loans are only for 2 years, there will be a window during which they are available. That will support the 5 year point. The 5 year point is also aided by bad CDS shorts and is in the comfort zone of banks.

The threat of subordination will keep the curve extremely steep. Even if the program were to be “senior unsecured” and pari passu with other debt, there would be doubt in the minds of investors. There should be concern that if things don’t work out, that non public holders would once again (like Greece) bear the brunt of the initial restructuring. So the curve should be steep as it prices in risk that any program goes away AND that bonds not part of the program would be subordinated. The ECB needs to ensure that countries have access to cheap money, but they don’t need to support the secondary market, and they don’t need to lend to countries for long term (it would be good if they did, but it isn’t necessary for the ECB’s objectives to get accomplished).

Spanish and Italian stocks, Bank stocks, and bank CDS. The best analogy I can think of is that this is like an earthquake and the “damage” will be greatest around the epicenter. So if the ECB launches on a new program, the epicenter of the earthquakes will be in Italy and Spain. The closer to the center the more benefit. Italian and Spanish banks are sitting right on the fault line and will benefit the most from this action. Companies in these countries should also see a rebound. Banks outside these countries will benefit more than companies. In many ways, the rest of the world has decoupled from the problems (DAX is up 20% YTD), but banks have been held back more than other companies because of how interconnected the global banking system is. This would extend as far as U.S. banks.

Credit Default Swaps. I continue to believe that CDS can go tighter. It will be led by bank CDS, but will be helped along as shorts capitulate. CDS has become the last bastion of “cheap shorts”. Too many investors are short, some whose primary knowledge of CDS came from reading “The Big Short”. I continue to see a lack of interest in bank hedging, and if “real money” ever decides to stop chasing the same silly bonds to the same silly yields and sells CDS instead, the gap will be ferocious. CDS spreads aren’t at the tights of the year yet, and have been stubborn these past few days (tighter, but grudgingly so). High yield bond and leveraged loans should continue to do well, but at this stage, high quality, BB type paper should be traded with a rate hedge.

Short German, French, and EFSF bonds. As the realization that your bunds aren’t about to get converted into Deutschemarks any time soon hits, these will look expensive. As EFSF is called upon to use up its remaining capacity, the supply will add to pressure to this particular entity, above and beyond the pressure on German and French yields. While I would be uncomfortable owning 10 year bonds in Spain and Italy, getting short 10 year bonds in Germany, France, and EFSF seems fine. The subordination argument that makes 10 year scary on the one side doesn’t directly translate to making it appealing on the other.

US stocks are the “dirtiest shirt” and far from the epicenter. The US has largely decoupled. We are about to start facing our own problems, and the campaign format that we will face them in, is particularly troubling. We rally because everyone in China is going to buy a iPhone despite evidence that China is having much bigger trouble than access to iPhone. US stocks will go along with the global rally, but I expect them to lag.

China. Tempting, but I’m not comfortable yet. Japan, maybe? I am working on forming a better opinion here, but suspect they will outperform the U.S. market on European action, but still underperform Europe itself.

Short, nervous, and rebalancing.

I shifted from being long to finally having gotten short on Friday. I don’t like that position right now. I will be shifting back to a more positive position. I think I will be between small short and small long, with longs continuing to focus on Spain, Italy, banks, and the credit positions mentioned above. Shorts will become more common and will be focused on U.S. markets. It is hard to be long Spain here after a 20% run from the lows, but I find that I gag less when looking at that, than other options for being long.

On the option front, I have started buying S&P September puts. I will look at increasing that position once I’m out of more of my short, but will continue to be patient as I think we will see a move higher in index values and see a drop in the cost of vol.

I will definitely be taking this morning’s fade as a chance to take off shorts and get back to a long bias.

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Tags: Aggressive Actions, Attrition, Bond Yields, Central Banks, Decisions, Draghi, ECB, Economic Policies, Economic Situation, Economy, Elections, Elites, Eurozone, Fear, First Meeting, Mandate, Merkel, Money Printing, Politicians, Tf
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Robert Kessler: Yields on U.S. Bonds Really Can Go Quite a Bit Lower

Saturday, August 11th, 2012

Complete Transcript:

CONSUELO MACK: This week on WealthTrack, why rock climbing government bond investor Robert Kessler says we still haven’t seen the peak of the generational bull market rise in U.S. treasury bonds and why other investment routes are much more dangerous to your financial health! Great Investor Robert Kessler is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Three years into an economic recovery, it sure doesn’t feel like one. We are even beginning to hear the dreaded “R” for recession word here in the U.S. A recent headline in the Financial Times read: “Blue-Chips Raise Recession Fears.” The FT reported that “estimates of revenue growth for the largest us companies are being scaled back sharply by Wall Street analysts, signaling a mounting risk that the world’s largest economy may enter recession later this year.”

It is a development we have talked about with many WealthTrack guests. Sales and earnings estimates are being scaled back by analysts and companies alike as the global outlook becomes murkier. Recession is already happening in Europe. The so-called peripherals- Greece, Spain and Italy- are there. Even mighty Germany is feeling the pressure from its weaker neighbors. Germany’s central bank recently estimated its economy had grown “moderately” in the second quarter. According to The Wall Street Journal, that’s “shorthand for growth between zero and five tenths of a percent.” Not exactly reassuring for Europe’s largest economy, which its finance minister rightly describes as the “Eurozone’s anchor of stability.”

So if global economies and company sales and earnings are slowing, what does it mean for the markets? That is a source of heated debate and both sides are being reflected in the stock and bond markets. On the one hand, investors have been buying dividend paying blue chip stocks for their dividend income and their financial strength. The S&P Dividend Aristocrats Index, which is made up of 30 companies that have consistently raised dividends for at least 25 years, has traded around record highs recently. How well will their prices and dividends hold up in a global slowdown?

On the other hand, yields on U.S. treasury bonds have extended their multi-decade long decline over the last year, lifting the prices of the underlying bonds, as global investors sought their safety and liquidity. It has also helped that Federal Reserve Chairman Ben Bernanke has clearly spelled out the Fed’s intentions to keep interest rates low. And he has reiterated time and again that the Fed is “prepared to take further action as appropriate to promote a stronger economic recovery.” As PIMCO bond guru Bill Gross put it, in explaining why he is holding 35% treasuries in his PIMCO Total Return Fund: “don’t underweight Uncle Sam in a debt crisis.”

This week’s WealthTrack guest has been overweighting Uncle Sam in his portfolios for the ten years plus that I have been interviewing him. It’s been an extremely profitable run and he is sticking with it. He is Robert Kessler, founder and CEO of Kessler Investment Advisors, a manager of fixed income portfolios for institutions and high net worth individuals with a concentration in U.S. treasury debt. I began the interview by asking him about his long standing and contrarian investments in treasuries. What is he seeing that Wall Street is not?

ROBERT KESSLER: I think Wall Street is seeing all the same things I’m seeing. We’re just really interpreting those things a little bit differently. I look at the interest rate environment that we’re in right now, and most people think that this is created by Ben Bernanke, the Central Bank, and zero is some artificial number. The fact of the matter is, zero is a number that exists all over Europe now, and, in fact, that number is negative in five, or six, or seven countries in Europe.

CONSUELO MACK: So this is zero interest rates or negative interest rates on government debt, short-term government debt.

ROBERT KESSLER: Short-term government. Actually, even longer term. In Switzerland, it’s minus .25. So people who have a lot of money, and they want to park it someplace, they actually have to pay the government to put it there. Now, we haven’t seen that before. If you look at the way Wall Street’s interpretation of that is, they’ll say that that’s totally artificial. That’s not reality. And the reality really is that big money right now doesn’t want to go anyplace with it. It doesn’t matter if it’s corporate money, where they’re sitting with trillions of dollars, or individuals. What they want to do with it is make sure it’s totally safe. And money has a real value. Most people don’t look at money properly.

Money is a commodity. Just like gold, or like grain, or corn, or anything else. To store it someplace, it costs you some money. So if you want to store it in Switzerland, they’re going to charge you a quarter of one percent. When we look at zero in the United States, to make this really interesting, and people say, “Well, where do you think interest rates really are going?” And now I really look at everyone and say, “I don’t know. But they certainly could go negative,” meaning that the whole treasury curve, which is two-year, five-year, ten-year, thirty-year, all of that curve could all go down to zero. And everyone thinks there’s so much out there to buy. Look at all those treasuries. Come on. We have so much debt. Someone has to support it. What actually is there is, if I don’t want to sell my treasuries and you don’t want to sell your treasuries, there aren’t that many treasuries. And that’s why rates really can go quite a bit lower.

CONSUELO MACK: I know that you hear from other people on Wall Street. And if someone on the other side were looking at you and saying, Robert, okay, so interest rates are at zero. Short-term interest rates are at zero. Investors have other choices. Zero is not a good rate. That’s what they’re saying. It’s not a good return. Therefore, even Ben Bernanke, who is keeping short-term interest rates at zero, which is a reality, and is saying that, I’m going to keep interest rates at zero probably through 2015, if not beyond; even he is saying the reason that I’m keeping interest rates so low, one of the reasons is I want people to invest in risk assets. I want people to go and buy stocks and, you know, finance the economy, where they get a higher return. I’m going to make investing in treasuries so unattractive that I want them to buy something else, and, therefore, help the economy.

ROBERT KESSLER: In the environment we’re in, which is a deleveraging, deflating environment, a real return on money may actually be negative, meaning that if inflation actually goes negative, one percent is a pretty good return. And the only reason all of this is happening is because there’s no demand in the marketplace. And as much as Japan tried to do something, you can’t create that demand. And that’s exactly what Ben Bernanke’s talking about. He’s saying, “If I get these rates low enough” … there was a Swedish experiment, which is interesting, when Sweden had a very difficult time, the Central banker said, “You know, we ought to think about going negative.” Imagine that. The rate overnight won’t be zero. It will be minus 50.

CONSUELO MACK: Right. So I pay you for the privilege of owning a Swedish government bond.

ROBERT KESSLER: A half of one percent. That will certainly induce everyone to go buy something else. And the answer is, when there’s no demand from the private sector, I don’t care how much money you produce, I don’t care how much you print- if the private sector doesn’t want to borrow it, you have no marketplace. We have what we call no velocity. No movement of money. So that’s the environment we’re in. And as to what an investor needs to look at, is not what the real return is on a treasury against inflation from last year, but where will it be next year. And next year looks like we’re going to be looking at, if not deflation, certainly lower prices.

CONSUELO MACK: Let’s talk about kind of, there are different things that you’re looking at. So one of the things that Wall Street would say is that, you know, number one, inflation isn’t going to continue to go down, because, like, it never does for any length of time, and, therefore, at least in our recent experience, and all our models are predicated on the fact that we’re going to get some inflation, and with all the stimuluses the Fed is doing, central banks around the world are doing, we will get inflation. You’re saying, no, the reality is we’re in a deflationary environment, and, in fact, you know, we’re not going to get inflation for a long time. Why?

ROBERT KESSLER: Let me give you the Japan example. The Japan example is a very good example, because we claim in this country that we would never do what Japan did.

CONSUELO MACK: Right. No one wants to be a Japan. That’s the blanket statement everyone makes.

ROBERT KESSLER: We are doing exactly what Japan did. And interestingly enough, in 1997, that’s seven years after the deep recession/depression hit Japan, an administration came in, 1997, and said, we’ve got to contract the economy. We’ve got too much stimulus out here. We’ve got to tighten things up. That will make things better. The rates on the ten-year in Japan at that point were around two percent. Within a year or two they dropped to .8, and the deficit went straight up, even though everyone wanted to bring it down.

And the reason was, you can tighten everything up, but again, if there’s no demand and people perceive that prices are coming down, cash looks very good. And now we’re talking money. And money is really important, because money takes on a tremendous value in a deflating economy. If you’re a gold bug, the argument is inflate, inflate, because that’s a terrific thing to happen. All of this stimulus is going to cause inflation. And, in fact, in this kind of an economy, it doesn’t matter what stimulus you put in, because stimulus only works if someone wants to spend the money. And the fiscal side of it, which is the government side of it, right now, looks like, as we get into the fiscal cliff that people love to talk about, the fact is that will be very contractionary on the economy. So I would argue that if we get into that position, you will see rates go even further down.

CONSUELO MACK: One of the realities that you’ve identified at Kessler Investment Advisors as well is that zero interest rates can stay zero for a long time, or go lower for a long time.

ROBERT KESSLER: I think in this particular case, there are so many people who keep saying we’ve never seen this before. We’ve never seen this exact same thing, but we’ve seen this before. And I suspect that interest rates will stay extraordinarily low until we get out of this balance sheet problem of individuals getting rid of some of the debt. It’s 25% of homeowners are underwater. You have this huge unemployment problem, and the number that came out today, the Philadelphia Fed Index, actually had an employment number that would suggest, in this month coming up on the employment news, that employment could go negative again. Now, if you stop and think about that, the argument has been quantitative…

CONSUELO MACK: You mean job growth could go negative.

ROBERT KESSLER: Job growth will go negative. If you stop and think about how serious that is, we’ve had quantitative easing one, quantitative easing two, and probably something more. None of that has helped. And it’s simply because money is going no place. And the people who have it are buying whatever sovereign they feel safest in.

CONSUELO MACK: So Robert, another reality that you have identified at Kessler Investment Advisors is that instead of what Wall Street is telling you- I’m going to make you money, and that the traditional investments that make money, like stocks, that have over the last, you know, 40 years, whatever it is, in the post-World War II period- that, in fact, that investors are saying, “No. No. No. You don’t understand. My first principle is I don’t want to lose money.”

ROBERT KESSLER: We have an enormous number of investors leaving the stock market now and going into fixed income. Obviously, they feel that that’s too volatile, and that slow transition is probably going to continue for some time. But the concept of an investor saying, “I don’t want to lose money,” it usually means I want to make a lot of money, but I don’t want to lose any money. And you have to be able to explain to make a lot of money you’re going to be at risk to lose a lot of money. I would suggest the big problem we all seem to have is we can’t distinguish between a savings account, your pension account, your IRA, and an investment account.

CONSUELO MACK: And you’re saying it’s very important to differentiate between your investing and your savings. What’s the difference?

ROBERT KESSLER: The purpose of a savings account, as we all grew up, and we saved something, is to know it will be there. So, obviously, the return isn’t important. It’s the return of the money. And so I look at a savings account or a pension account, you cannot lose there. And that’s why I’ve suggested for years that you buy a zero coupon U.S. Treasury, meaning that the treasury will pay off in a certain period of time, because you have to have that money. That’s a savings account. An investment account is, have a good time.

The odds are, these days, for the last ten years, no one has made any money in the stock market unless you happen to buy at the right time, sell at the right time, and buy… and none of us do that. We’re all random buyers, so we all make mistakes. So the average person really doesn’t distinguish between those two pockets of money, and I would suggest that’s becoming very relevant now, because suddenly, if you look at the average homeowner, let’s take the homeowner, you have a decrease of $7 trillion in the value of what they had over the last two, three, four years. $7 trillion. An enormous amount of money. And if you look at their median net worth of that same homeowner, it’s gone from $126,000, that’s the average person, down to 77. That means they lost 39% of their money, of what they really thought they had. So all of these questions become extremely relevant if we talk reality, and I think that’s what we should be talking.

CONSUELO MACK: The fact that rates are coming down all over the world gives fuel to the argument on the other side, and that is, I can’t tell you how many people have told me that somewhere around 60% of the companies in the S&P 500 now are offering dividend yields that are greater than the yields on the ten-year Treasury note, and this is a once-in-a-lifetime opportunity.

ROBERT KESSLER: And they should. And they should, because everyone has done terrible with all of these companies. So they should give you some of your money back. But the best argument I can use is that these are the same companies that don’t know what to do with the cash they have, and they’re not out there buying any other companies. There are mergers going on, but they’re not spending the money. So if they’re not spending the money, what are you spending the money for? And then at the same time, there are no big dividend payers. There are no big cap stocks that are not going to be affected by a global deterioration in the economies that we’re looking at. They all will be. And if the stock market comes down, which I suspect it probably will, they’ll come down, too.

What do you care if you’re getting 4% if it drops 40%? That is the risk you take. So you think, well, this is a terrific deal, because in the long term, four percent looks good. It doesn’t look that good if you go back to 2008. You had an AT&T that was paying a very nice dividend, and it dropped 47%. I don’t think that’s what you want. And so I suspect that if you didn’t want any of the other stocks, you probably don’t want those stocks either.

And, again, I’m back to the subject, you do not want to lose money, because in an economy where prices are coming down, there’s tremendous opportunity. Everyone thinks that I’m being pessimistic about this. If you have money, and the price keeps coming down, the money gets more and more valuable. That’s why people are parking it where they think they can get it back, which ends up being in sovereign debt or good sovereign debt.

CONSUELO MACK: So Wall Street would say this is an example of extreme pessimism, and the times of extreme pessimism are when you make the most money by buying the securities that everyone else is shunning.

ROBERT KESSLER: But that has to be the excuse that we use, otherwise you wouldn’t buy anything from Wall Street. It’s a silly argument. We’re faced with a real serious problem in this country, as it is in Europe, but in this country, especially right now, because we have a disorganized kind of Congress, we have a situation where no one can get together on what to do, and I suspect there really is a reason for that. No one knows what to do. You can take this side, or you can take this side. It really doesn’t matter. The net result is, there are no simple solutions, and we’re certainly not going to get one, from what I can see.

And so this thing is going to linger, and the question is, do you need a crisis to begin to really try to solve this? Maybe that’s what happens. Maybe you do get a crisis. But this is not being pessimistic. I’m just telling you what’s happening. And the only reason we can make money in this market is because we really don’t care about what anyone else says. The key to this market right now is to follow whatever your own instinct is. If you don’t understand it, and it doesn’t make sense, and you can’t sell your house, and all the terrible things that we all know are happening, happen, well then, why do you want to go out and buy stocks? I mean I’m not doing this just because I want to hit the stock market. But this is a very serious period of time, and I don’t think people are treating it as serious as they should.

CONSUELO MACK: So most investors, most individuals, in their retirement savings, have gone the traditional route, and they certainly do not own a lot of treasury securities. So what are you advocating? That they basically, you know, liquidate, pay the taxes, everything, and put them into treasuries? I mean, you know, what are our options?

ROBERT KESSLER: I’m going to do the same thing I did last time you were kind enough to have me on the show, I think, at the end last year, and I said, go out and buy long-term 20-year, that’s a good thing to do, zero coupon U.S. Treasuries. They will yield about 280, 2.8 percent. Nothing terrible about that. In the last six months, since I’ve said that, they have returned 11%.

CONSUELO MACK: In six months.

ROBERT KESSLER: In six months. Better than the stock market and everything else. I will make the assumption that 280, 275 is not a terrible return. If you have this opportunity that I’m talking about, that rates actually come down, because if rates come down, a lot of people feel that 30-year, 20-year treasury will come down a point; if they come down a point, then you make 25% return. Worst-case scenario? You’re making 280. Not so terrible. That’s your retirement fund. That’s your serious money.

As far as the other money goes, I would be in this wait-and-see attitude. I’m really not trying to be pessimistic, and I know it sounds pessimistic, when I’m saying negative things, but those negative things are happening regardless of what I tell you. They’re happening in Europe. And this doesn’t even count the fact that we could have an oil disruption. We could have all the usual things that seem to be on our plate all the time. So sure, I think for a retirement fund, right now I’d be out buying all the treasuries I could get my hands on. I mean, but I think when you talk about the investment money, the money that you have to invest, I think you want to stay very, very cautious.

CONSUELO MACK: All right. Very cautious at this point. So the One Investment for long-term diversified portfolio is?

ROBERT KESSLER: I would say zero coupon treasury, if it’s a retirement fund. If it’s in a retirement fund, there’s absolutely– there’s no issue about time. You’re keeping it for a long period of time. But the other money that you have is money that really has to be put to use now, and you don’t want to waste it. It’s not going to be there necessarily 20 years from now. It’s money you’re going to invest in. Well, I can’t find anything to invest in. So keep it in cash. I know I’m kind of escaping by saying that, but I don’t think there’s anything wrong with cash.

CONSUELO MACK: So, you know, you said earlier in the interview that you’re really not a pessimist, that you’re actually an optimist. So what are you optimistic about?

ROBERT KESSLER: I think that people needed to go through this change in attitude towards how they spend money, what they think of money, and that change is taking place. There’s a realism coming into the marketplace. I think that makes for a better country, and that makes for a better people in the end. It doesn’t mean it’s easy, and it doesn’t mean this is going to be a very comfortable change. But it will probably be, as it usually is, for the better. What we don’t want to see is some serious kind of crisis that makes it worse.

I think the problems in the United States are solvable, if we can get a Congress to probably do something together. There are things to do here. But you can’t have 20 million people without a job, 45 million people on food stamps, and a bunch of people without healthcare, and then say, “Well, we don’t really have any problems here, and I think we should buy some stocks.” I think that attitude is exactly the wrong attitude. I think the problem becomes you have to pick up demand, and there is no demand in our system right now, and with good reason. People are pessimistic.

CONSUELO MACK: So what is it going to take to turn around demand?

ROBERT KESSLER: I don’t know. I don’t know. It’s a process. And the process is this horrible deleveraging, this pay down the debt, and people have to consciously understand when you pay down the debt, you’re increasing the value, in this case, of the currency. Because remember, the currency can buy everything cheaper. The U.S. dollar is the place to be. I’m very optimistic about the dollar. I think that’s a great place. I think the treasury market looks terrific here. That is the country. In between, there are problems that have to be solved.

CONSUELO MACK: Well said. Robert Kessler, thank you so much for joining us from Kessler Investment Advisors. And we will have you on again, you know, in a year, and see how you’ve done, as you have done extremely well over the last seven years on Wealth Track. So thanks for joining us again.

ROBERT KESSLER: Thank you. Thank you for having me.

CONSUELO MACK: At the conclusion of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. As we did last week, we are recommending a book for summer reading. This one is the choice of guest Robert Kessler. It’s called The Great Depression: A Diary . It’s by Benjamin Roth and it was published by his son in 2010, many years after his death. Roth’s diary is a compelling and eye opening account of the Depression seen through the eyes of an ordinary middle -class American. You will recognize the policy debates about inflation, skepticism towards big government, and worries about too much stimulus, that as Kessler says were “prevalent, recurring, and in the end, all wrong.” You can make up your own mind.

I hope you can join us next week for a shocking discussion about the cost of investment fees. According to our two guests- legendary financial consultant Charles Ellis, who is exclusive to WealthTrack, and top financial advisor Mark Cortazzo- fees are much higher than you think. They’ll tell us how to fight back. If you would like to watch this program again, please go to our website, wealthtrack.com. It will be available as a podcast or streaming video no later than Sunday evening. And that concludes this edition of WealthTrack. Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.

Copyright (c) WealthTrack.com

Tags: Blue Chip Stocks, Blue Chips, Bond Markets, Consuelo Mack, Earnings Estimates, Eurozone, Finance Minister, Financial Health, Financial Times, Global Economies, Global Outlook, Government Bond, Recession Fears, Robert Kessler, S Central, U S Treasury, U S Treasury Bonds, Wall Street Analysts, Wall Street Journal, Wealthtrack
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“Did Somebody Repeal The Laws Of Mathematics?”

Sunday, August 5th, 2012

From Grant Williams’ latest Things That Make you Go Hmmm

Remember late-2010? When Spain wasn’t a problem, but merely a potential problem? I do:

(FT, November 17, 2010): For some of the world’s biggest hedge funds, typically regarded as the savviest traders in the market, there is now one big question facing the eurozone: what is going to happen to Spain?

While Europe’s politicians are grappling with the crisis unravelling in Ireland, hedge fund managers are already turning their attention to the issue of how – and if – a peripheral crisis in Ireland could leap via Portugal and Spain to become a systemic crisis for the eurozone as a whole.

“The Irish problem will be contained,” says Guillaume Fonkenell, chief investment officer at Pharo, one of Europe’s biggest and most successful macro funds, which specialises in trading on macroeconomic events and trends. “For us contagion is the issue … If the market loses confidence in Spain, then all bets are off. Spain is too big to bail.”…

Back then, the general opinion was that if the contagion spread to Spain the game was over because there wasn’t enough money with which to bail out an economy the size of The Kingdom of Spain. I’m not sure exactly what happened— maybe I wasn’t paying attention—but suddenly, almost two years on and in an environment where even the rich nations of Europe are seeing an undeniable slide towards recession, there is no talk about Spain being ‘too-big-to-bail’ anymore.

Did somebody repeal the laws of mathematics?

Presumably, if the contagion reaches Italy that would be OK too now, I guess.

As it first hit the headlines as a potential problem, Spain made a presentation to potential investors that highlighted how strong the country actually was despite the conjecture amongst market participants. The presentation is highly educational and can be found in full HERE, but as a taster, here’s one particular slide that caught my eye:

Oh, to hell with it… here’s another:

Some opportunity.

* * *

Full letter:

Hmmm 05 Aug 2012a

Grant Williams
Portfolio & Strategy Advisor at Vulpes Investment Management Private Ltd
2 Battery Road #26-01, Maybank Tower Singapore 049907
http://www.vulpesinvest.com/

Tags: Bets, Chief Investment Officer, Conjecture, Contagion, Enough Money, Eurozone, Grant Williams, Guillaume, Hedge Fund Managers, Hedge Funds, Kingdom Of Spain, Macroeconomic Events, Market Participants, Mathematics, Paying Attention, Pharo, Politicians, Recession, Systemic Crisis, Taster
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Rethinking Asset Allocation (PIMCO)

Wednesday, July 18th, 2012

by Curtis Mewbourne, PIMCO

• Asset classes are likely to be affected by the situation in Europe and, more broadly, by high debt levels in developed countries. The related political debate about austerity vs. growth is also critical.
• Fixed income investors should note whether countries control their own currencies and can monetize their debts. Those that can may be greater inflation risks. Those that cannot may be greater credit risks.
• These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes.
• We encourage investors to broaden their opportunity sets, for example, looking more closely at emerging market government bonds. They also may consider assets such as real estate and commodities, which may partially replace traditional domestic equities.

Navigating the global landscape these days is tough. Macro risks range from uncertainty about the future of Europe to mixed messages about the U.S. economy – not to mention a host of concerns about indebtedness, policy and politics.

In the following interview, portfolio manager Curtis Mewbourne discusses how investors can approach asset allocation in such an environment and over the longer term.

Q: What are the most critical factors likely to affect asset classes over the next three to five years?
Mewbourne: Investors need to monitor the situation in Europe, whether they are directly invested there or not, because of the systemic implications of a potential shock to Europe’s banking system or sovereign debt. The eurozone has the second largest economy and the largest banking system in the world, and the slowdown that we are already seeing in emerging market growth is partially driven by slower demand for goods and services from Europe.

More broadly, asset classes are likely to be affected by high debt levels in Japan, the U.S. and other developed countries as well as the related political debate about the trade-off between austerity and growth. Unemployment levels remain elevated in many countries, partly as a result of austerity measures.

These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes. For example, European equity markets in some cases are at the lowest levels in years, and, as a result, investors may be questioning the notion that European equities provide reasonable returns above inflation – a key point for pension-fund managers and other investors.

Similarly, the low policy interest rates that central banks are implementing around the globe contribute to government bonds in several countries trading at very low levels. These low yields create an asymmetric return profile: There is not much room for further price appreciation, while concerns about possible future inflation could lead to significant volatility and price declines. For fixed income investors, it is critical to understand whether bonds have credit risk, inflation risk or both. Countries with their own currencies have more flexibility to print money and monetize their debts, and hence typically have more inflation risk and less credit risk. Countries that do not have the ability to print their own currencies have the opposite. This largely explains the divergence between Europe and the U.S./U.K./Japan in terms of government bond yields and knock-on effects on risk premium valuations.

Put simply, nominal government bonds and traditional equity investments, at least in the case of Europe, have not performed in the way that investors have expected and likely may not perform according to textbook expectations going forward.

Q: Will we see more convergence – or divergence – in the behavior of asset classes?
Mewbourne: It depends on which asset classes we are talking about, but there are a few high level themes that are relevant to understanding how asset classes may behave. Very high global debt levels and unconventional monetary policies mean that balance sheets are more levered and the global economy is more vulnerable to policy changes. Under such conditions it is likely that certain macro factors, such as policy changes, will affect many asset classes in roughly the same way at the same time. Over the past few years, we have seen periods of heightened correlations between regional markets as well as between previously uncorrelated asset classes.

This is not set in stone. In some cases capital will move from one area to another, or fundamental economic differences will lead to divergence of asset classes. We have seen that recently in currency markets where there has been a large shift away from emerging market currencies and into the U.S. dollar.

Q: PIMCO has talked about the emergence of credit risk in the sovereign market. How will this affect portfolio construction?
Mewbourne: As I was saying before, fixed income is an asset class that has become quite different from textbook explanations. For example, five to seven years ago it was a reasonable decision for a European citizen saving for her child’s education to invest in government bonds, counting on a low probability of principal loss, little volatility and a modest return. Fast forward to today, and government bonds in many European countries have behaved quite differently than expected. The clearest example is the loss of principal on the restructuring of Greek bonds; but also prices of other European sovereign bonds suggest higher probabilities of potential losses. In all, the expected volatility, risk and returns on such bonds have changed, and therefore they likely play a different role in investors’ portfolios.

This shift is a challenge for certain institutional investors, such as insurance companies and some banks, whose business models or regulatory requirements require high-quality bonds with low probability of principal loss and low volatility.

Q: Staying with the topic of risk, what are some other risk factors investors should be managing, and how should they go about doing so?
Mewbourne: Investors need to think about the potential loss of principal on bonds of overly leveraged countries and companies. They also need to think about the loss of purchasing power from inflation as a result of central banks pursuing very low interest rates. When interest rates are lower than inflation, the resulting negative real yields eat away at investors’ purchasing power.

Given the issues that we have discussed, the time they need to spend thinking about and focusing on political risks has increased significantly, and they need to increase significantly their efforts in understanding and factoring such risks into their investment decisions.

Q: Let’s talk about opportunities: Are there new or emerging opportunities that investors should be thinking about? And can you offer some insights into alternative ways for investors to capture these opportunities?
Mewbourne: Markets are still healing from the major financial dislocation of 2008 and 2009 and, in a sense, the recovery creates opportunities in many areas for investors to identify and take advantage of attractive risk-adjusted returns. This requires a very active focus, as those opportunities can be in sectors that have become more credit sensitive and require more resources to review.

For example, in the non-agency mortgage market in the U.S., investors need to understand the underlying loans, a process that can take considerable time and knowledge but also lead to some very good opportunities.

Another example is the U.S. municipal bond market. That asset class has become much more credit sensitive and requires much more credit focus, but investors can really benefit from rolling up their sleeves and doing their credit research.

Also, the heightened market volatility that we expect in the years ahead can lead to greater risks but also opportunities during periods in which investors look to exit the same strategies at the same time. Given the geopolitical landscape, we expect overshoots in currency and commodity markets to result in buying opportunities.

Q: Ultimately, what are the key things investors should be thinking about or doing in their portfolios, considering PIMCO’s secular outlook?
Mewbourne: As risk and return characteristics transform, our view is that investors need to transform the way they think about using asset classes. We encourage them to broaden to the greatest degree possible their opportunity sets, for example, looking at emerging market government bonds as a replacement for some more traditional developed market government bonds.

Developed market government bonds have become riskier in some respects, and emerging market bonds are becoming less risky, and in cases where they pay a higher rate than inflation, they may be less risky both in terms of credit risk and the risk of purchasing power erosion.

We also encourage investors to broaden the type of financial instruments they consider. While they need to appreciate the risks of different instruments, they may benefit from investments in areas such as real estate and commodities as part of overall portfolio construction, and those areas can replace some of the roles that traditional domestic equities have played in the past both in terms of expected returns and volatility.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Tags: Asset Allocation, Asset Classes, Austerity, Banking System, Critical Factors, Debt Levels, Domestic Equities, Emerging Market, Eurozone, Global Landscape, Government Bonds, Indebtedness, Inflation Risks, Investor Expectations, Market Volatility, Mixed Messages, Other Developed Countries, PIMCO, Political Debate, Portfolio Manager, Sovereign Debt
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U.S. Equity Strategy: A Mid Year Update

Thursday, July 5th, 2012

prepared by Ryan Lewenza, CFA, CMT, Senior Vice President, U.S. Equity Research,
TD Waterhouse, Portfolio Advice and Investment Research

Mid-Year Update

- In the “risk-off” environment seen for much of Q2, small caps and technology were hit the hardest, with the Russell 2000 Index and the Nasdaq Composite Index down 3.83% and 5.06%, respectively. The defensive telecommunications, utilities, and consumer staples sectors outperformed, gaining, 12.63%, 5.46%, and 2.11%, respectively. The cyclical sectors underperformed with financials down 7.27%, energy off 6.53%, and information technology declining 6.96%. While Q2 was a more difficult trading environment than Q1, it is important to note that the S&P 500 Index (S&P 500) is still up 8.31% year to date.

- Europe continues to be the most significant risk to the global markets, with news from the region largely driving the volatile day-to-day price action. Greece, with its potential to default (again) on its debt and possible exit from the eurozone, remains front and centre. However, the focus is quickly turning to Spain, whose economy at US$1.4 trillion is nearly 5 times larger than that of Greece.

- The key question is whether the eurozone debt crisis will escalate further, and push the global economy into a recession. Unfortunately the problems are largely political, making it difficult to predict one way or the other. All of this uncertainty bears a defensive posture at this time.

- Looking at simple P/E ratios, equity valuations look quite reasonable, and even cheap in certain areas of the market. However, with the prospect of slowing earnings and increasing global risks, we believe stocks will be hard pressed to see any significant P/E expansion, and therefore maintain our S&P 500 year-end price target range of 1,290-1,340, which assumes a year-end P/E target range of 13- 13.5x.

- Stepping back from the day-to-day market gyrations, we believe the S&P 500 will continue to trade range-bound between 1,200 and 1,400 through the summer, as the markets weigh the negatives of the European debt issues and slowing growth, with the positives of still healthy corporate earnings, reasonable valuations and supportive monetary policies.

- With the heightened risks we recently

- upgraded consumer staples to overweight from market weight.
- We continue to recommend an overweight in health care.
- Our sole cyclical overweight position is the information technology sector.
- The energy, utilities, telecommunications and industrials sectors remain at market weight.
- Finally, we maintain our underweight recommendation for the financials and consumer discretionary sector.

The complete report is available for reading or download in the slidedeck or at the link below:

US Equity Strategy Q2 12

Tags: Consumer Staples, Debt Crisis, Defensive Posture, Economy Into A Recession, Equity Research, Equity Strategy, Eurozone, Global Economy, Global Markets, Global Risks, Investment Research, Market Gyrations, Nasdaq Composite Index, Portfolio Advice, Price Target, Russell 2000 Index, Senior Vice President, Small Caps, Target Range, Td Waterhouse
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We’re Not In Wonderland Anymore, Alice… And The True Greek Debt/GDP Ratio Of 421.7%

Wednesday, June 13th, 2012

From Mark Grant, author of Out of the Box

We’re Not In Wonderland Anymore, Alice!

“You may call it ‘nonsense’ if you like,” she said, “but I’ve heard nonsense, compared with which that would be as sensible as a dictionary!”
-The Red Queen

Greece Through the Looking Glass

With all of the talk of Greece leaving the Eurozone and forfeiting the Euro as its currency; what if it does not? That, my friends, is now the question. The current estimation of Greece’s GDP is $308.3 billion. All of the debt of Greece, direct, derivatives and guaranteed is $1.3 trillion giving the country an actual debt to GDP ratio of 421.67%. You may recall all of the talk, all of the pandering words spit out by the IMF and the European Union that the new austerity measures would take the Greek debt to 120%; all nonsensical and a nonfactual expression of a very fantastic and fairy tale imagination. If someone has actually stepped through the looking glass I suspect it is Christine Lagarde. Perhaps she is Alice’s granddaughter? In my estimation she must have eaten some of the cake because her reputation has dwindled as she and Greece fell down the rabbit’s hole.

“There comes a pause, for human strength will not endure to dance without cessation; and everyone must reach the point at length of absolute prostration.”

-Lewis Carroll

Since those false exclamations the economy of Greece has, in fact, shrunk like a grape in the process of becoming a raisin. Austerity has had an effect of the Greek economy, that much is true; it has caused it to whither like an autumn vine on a dead oak tree. Not only is the economy in decline by -9.6% but the expenditures are exceeding the budget by $2.5 billion each and every month; it is a sinkhole, a vast expanse of quicksand where anything and everything is going down. With a population of 10,768,000 the people of Greece could not pay the debt they have accumulated if they stood on their tiptoes and spat Euros at the sun. The current situation is, without doubt, an impossible contrivance that could have been avoided, was not avoided, and there is no way to climb the wall of this financial cliff without, in one way or another, blowing up the wall.

“The time has come”, the Walrus said,
“To talk of many things:
Of shoes — and ships — and sealing wax —
Of cabbages — and Kings —
And why the Sea is boiling hot —
And whether pigs have wings.”

-Tweedledee

The pig could be bright blue, her lipstick could be of the shiniest shimmering red, her wings could put those of the Angels to shame and still she could not fly. If Greece decides to say in the Eurozone then the question will shift to whether Europe will allow her to remain. After the elections Greece will be required to cut another $30 billion from its expenditures. This will cause a decline of about $50 billion in its revenues which will take its GDP down to around $260 billion and the debt to GDP ratio will be a whopping 500%; say it ain’t so but it will be just that number if no new debt is added which is an impossibility at this point so that the calculation will be even worse. Then the burden has shifted from the European banks and insurance companies as they handed the Greek debts to the ECB, the EIB and the IMF so that the very institutions that could have back-stopped Greece are already full of Greek debt and therefore dead in the water.

“I know they’re talking nonsense,” Alice thought to herself: “and it’s foolish to cry about it.” So she brushed away her tears, and went on as cheerfully as she could.

I have always said that Greece will not depart until the money spigot is turned off. Therefore Greece will hang around as long as she can but the moment is coming and coming soon when Germany and the rest will say that since Greece is not keeping its part of the bargain that it cannot play any longer in the sand box. They may demand repatriation through the Bank for International Settlements. They may try and keep the Greek assets pledged at the ECB as an offset to the sovereign and municipal debt which will never get paid back but it will not just be consequences but carnage when this point is reached as even the ECB itself will have to be recapitalized by the other nations in Europe as the Greek default overwhelms its equity capital. The Greek banks, one way or another, are history and their debt will only be useful as certificates to be hung on some office walls as a reminder of lessons that should have been learned and were not. Greece is now a “dead man walking” and the execution chamber is primed and ready. The only remaining questions, really, are who is going to flip the switch and at what time.

“The horror of that moment,” the King went on, “I shall never, never forget!”

“You will, though,” the Queen said, “if you don’t make a memorandum of it.”

Make a memorandum of what is passing before your eyes and do not forget it!

Copyright © Mark Grant

Tags: Austerity Measures, Christine Lagarde, Eurozone, Exclamations, Fairy Tale, Gdp Ratio, Granddaughter, Greek Economy, Human Strength, Lewis Carroll, Looking Glass, Mark Grant, Oak Tree, Prostration, Quicksand, Raisin, Red Queen, Sinkhole, Tipt, Vast Expanse
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May Rout Leads to June Rally (Edwards)

Sunday, June 10th, 2012

On April 6th, just after US stocks touched a high for the year and climbed to within 10% of the all-time high set back in October 2007, we wrote:

“The market will do one of three things over the rest of the year:

Trade flat for the next 9 months – not likely.
Surge into a “buying panic” as investors finally jump back into stocks, which would leave the market up 20% or more by year end.
Plummet as some exogenous event (like last year’s Japanese tsunami or the Greek credit crisis) cause investors to retreat to cash once again.”

We got three “exogenous events” in May:

• Greek credit crisis resumed, with Greece likely to exit the Eurozone this summer.
• JP Morgan Chase lost $3 billion on Credit Default Swap trading.
• The FaceBook “FacePlant”.

And on June 1st, the Labor department reported a minimal gain in jobs, which has economists worried anew about the United States returning to recession.

So from the high on April 2, to the low on June 1st, US stocks sank 9.9%. Unfortunately, human nature focuses more on losses than on gains. Stocks remain 81% above the March 9, 2009 low, and 18% above the October 3rd low. But as we saw today (best one day return of the year,) universal bearishness tend to lead to outsize upside returns.

Many, many questions from our clients:

What is going on with Europe?

As we have said many times, the Europeans spent 30 years building to the current situation, and it will take at least a decade to straighten things out. The situation in Greece is the “canary in the coal mine.” Greece is an artificial country cobbled together by the US and Great Britain at the end of World War II to prevent the Soviets from getting warm water naval ports on the Mediterranean. As of 2010, Greece had about the same GDP as Maryland, now probably 20% less. The country has three important industries: agriculture, tourism and shipping. These industries did not generate enough cash flow to purchase what Greeks wanted to buy, namely, German cars and dishwashers. Germans were anxious to keep exports booming, so helpful French and Italian banks stepped in to lend money so that Greeks could buy German exports (and build super-highways and other modern infrastructure.) The bankers felt confident in making loans despite the Greek national tendency to not pay taxes because a.) the loans were denoted in Euros, not some trashy third world currency like the Drachma and b.) scores of hedge funds were willing to write Credit Default Swaps on Greek debt (more on CDS below.) The bankers did not consider that their purchase of CDS did not eliminate their risk in buying Greek debt. It only transferred that risk from a junky country to junky hedge funds, which, as history has shown, tend to close shop when a payment is owed.

Over the last two years, bankers, governments, hedge funds and the Greek people have played “hot potato” as to who ultimately takes the loss on tens of billions in Greek debt. Thus, time and again a “deal” is declared, which is replaced by another deal a few months later, and another and another. The latest deal will most likely be rejected by a new Greek Parliament elected June 17th, 2012 and Greece will exit (or be forced out of the Euro.) 50% of young Greeks will emigrate over the next 3 years as unemployment remains in the +20% range.

The real threat is that Spain (the 12 largest economy in the world, ahead of Texas but behind California) goes next.

Is Greece the next Lehman Brothers?

No – two distinctions:

Lehman was central to the world banking system, Greece is peripheral to the Eurozone. When Lehman failed so did AIG. Merrill Lynch, Morgan Stanley, Goldman Sachs, Barclays Bank and Deutche Bank were right behind. Only a miraculous intervention by the US Treasury and Federal Reserve to payoff AIG’s liabilities in CDS (there’s that word again!) saved the day. As of now,

Greek debt has already been written down by 75%.

Lehman was there Friday afternoon and gone Sunday afternoon, leaving its counterparties no time to react. Is there any investment manager in the world who hasn’t expected to Greece to fail for a year now?

What is a Credit Default Swap?

Once upon a time, managers of bond portfolios believed it was their job to adequately evaluate the credit quality of their bond investments and diversify accordingly. Then, in the mid 1990′s, JP

Morgan bankers created a nifty bond put option. In the event that an issue failed, the writer of the put option would pay the buyer of the put option the difference between the issue price (par) of the bond and any residual value of the bond.

Tags: 9 Months, Agriculture Tourism, Coal Mine, Credit Crisis, Credit Default Swap, Dishwashers, Eurozone, Exogenous Event, Exogenous Events, Faceplant, German Cars, Greeks, Human Nature, Jp Morgan, Jp Morgan Chase, Labor Department, Plummet, Rout, Soviets, Warm Water, World War Ii
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Europe’s Currency Crisis: A Look at Possible Scenarios (Michel)

Friday, June 8th, 2012

by Tatjana Michel, Director, Currency Analysis, Schwab Center for Financial Research

Key points

• A Greek exit from the eurozone has gone from “unthinkable” to a distinct possibility. Years of steep economic decline and unsustainable public debt have increased the odds that the country will once again default on its debt and possibly return to the drachma.
• A Greek default/exit would present risks to the European banking system, could cause a severe downturn in the Greek economy and might trigger contagion that spreads to countries like Spain, Ireland and Portugal.
• The European Central Bank and other institutions theoretically have tools to lower contagion risk, but may lack the time and political will to use them.
• Ultimately, the exit of one country from the euro could lead to the exits of other countries and a breakup of the euro as it’s currently known.
• We suggest investors limit exposure to European bond markets and the euro, both of which are likely to experience more downside.

The May 6 elections in Greece ousted the party that had negotiated and agreed to the bailout package offered by the European Central Bank (ECB), International Monetary Fund (IMF) and European Commission (EC). This group, often referred to as the “troika,” provided bailout funding to the Greek government so that it could cover its debt payments in exchange for a promise that the country would bring its budget deficit and debt down by reducing spending and raising taxes. Greek voters have effectively rejected the agreement because of the negative impact that spending cuts have on their economy, which is already in deep recession. No party won a majority in parliament in the May elections and a coalition could not be formed. Therefore, new elections are scheduled on June 17.

If the new government insists on renegotiating the terms of the current bailout plan, new talks with the troika will have to take place shortly after the election. If there is no agreement, the troika could decide to deny Greece its next chunk of bail-out money, which would likely lead to a default on Greece’s sovereign bonds.

Greece needs to form a new government and reach an agreement with the troika before it runs out of money in July 2012. If they reach an agreement, Greece is likely to stay in the eurozone but would need to stick to the new austerity plan to continue receiving aid.

Greek opinion polls show elections are wide open

According to recent poll results, the June 17 elections are wide open and could very well lead to a government that meets Europe’s terms for keeping Greece in the euro. However, it could also put in power a coalition government that’s firmly against austerity—positioning Greece for an exit from the euro.

Scenario 1: Coalition around New Democracy keeps Greece in

Although traditionally powerful Greek political parties like the Pan-Hellenic Socialist Movement (PASOK) and New Democracy (ND) have seen their influence wane in recent years, ND has been catching up with the anti-austerity Coalition of the Radical Left (SYRIZA) party since May 6. Should ND be able to get the upper hand in the June 17 elections, it would increase the likelihood of an agreement with the troika.

Source: Greek Ministry of Interior
*PASOK (Pan-Hellenic Socialist Movement), ND (New Democracy), DISY (Democratic Alliance), KKE (Communist Party of Greece), LAOS (Popular Orthodox Rally), SYRIZA (Coalition of the Radical Left), DIMAR (Democratic Left), ANEL (Independent Greeks), XA (Popular Union). ** Projected estimate of vote tally, after disregarding all blank votes and absentees, and after adjusting for the “likely votes” of “undecided voters.

Scenario 2: Coalition around SYRIZA precipitates Greece’s exit

SYRIZA, on the other hand, has denounced the current austerity plan. Party leader Alexis Tsipras believes Greece can stay in the euro and continue receiving money while cutting austerity measures—something Germany and other creditors probably aren’t going to like. If SYRIZA gains control, it would likely make the negotiations with the troika difficult and increase the risk of a Greek default and exit.

Tags: Bailout Package, Bailout Plan, Budget Deficit, Contagion, Currency Analysis, Currency Crisis, Debt Payments, Distinct Possibility, Drachma, Economic Decline, Elections In Greece, ETF, ETFs, European Banking System, European Bond Markets, Eurozone, Greek Economy, Greek Government, International Monetary Fund, International Monetary Fund Imf, Public Debt, Troika
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Treasuries Currently Overbought: Relative Performance of Stocks vs. Bonds

Thursday, June 7th, 2012

by Tiho Brkan, The Short Side of Long

Topics Covered

• Global economic data worsening towards a recession
• Treasury Bond sentiment is extremely optimistic

Overview

The selling pressure has stopped. It seems that the S&P 500, Crude Oil and Gold are now recovering somewhat. Sentiment reached extreme negative levels on all of these asset classes over the last couple of weeks. 30 Yr Long Bond has paused its vertical rise on top of extreme bullish sentiment, while the US Dollar posted a reversal also due to extremely bullish sentiment. It seems we are entering a period of mean reversion but the bottom line still remains the same: investors have been selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino. At the same time, Asia and especially China is slowing down meaningfully. Nothing has been done, announced or hinted by authorities yet and risk off trades are very crowded.

Economic Data

Last week was one of the worst ever data release weeks for the US economy. Out of 21 releases throughout the week only 1 was better than expected, 2 came in at their estimates and a staggering 18 releases (including the important employment figures) all came in below economist expectations. I am pretty sure that the authorises, politicians and central bankers around the world are watching this with a magnifying lens right now. The question is what will they do next and will it even matter?

The overall Developed Markets Citigroup Economic Surprise Index has completely collapsed in recent weeks, so it should not be surprising at all that Bonds have outperformed Stocks again in the first half of 2012. While majority of analysts, economists and investors continue to put all of their faith towards the Federal Reserves ability to re-stimulate the economy through further QE, contrary to that I personally think it will not have too much of an effect, apart from a short to medium term sugar high rally without any new highs. In other words – a bear market rally!

Economic data is negatively surprising economists, not just in the US, but all over the world including the darling favourite of the investment world – Emerging Markets. As we can see in the chart above, the Emerging Market Citigroup Economic Surprise Index has completely collapsed for the first time since 2008 and with it GEM equities plus the global economic barometer – Dr Copper. This leads me to believe that not all is well in Asia and especially China.

While I believe all risk assets are currently oversold and due for a rebound, if the weakness continues again in repaid fashion, it will most likely lead me to a conclusion that we are entering a global recession. Chinese equity market, the Shanghai Composite, is still struggling to break upward. While this is a very bad sign, I am still willing to give it a bit more time to prove itself, as it struggles with a cluster of resistance points around 2,400 to 2,450 level. However, a proper breakdown will most likely signal a hard landing scenario for the Chinese economy. The crisis started in the US in 2007 and spread to the EU, but if we move towards a Chinese hard landing scenario, the final economic crash will most likely occur in Asia, where the boom has created over capacities in all economies from Indonesia to Korea and Australia.

Equity Markets
Nothing new to report.

Bond Markets
The second part of an article is a slight conundrum to the first part above. Here I focus on overbought Bond prices and extremely bullish sentiment that accompanies this assets. Therefore, one major problem when discussing a possibility of a recession, from a contrarian point of view, is that majority of market participants are already overweight Bonds as a fear trade. So the question is, if things get worse, will these safe havens go even higher?

Focusing on the current outlook, be it German Bunds or US Treasuries, prices have gone almost vertical in recent weeks and yields have dropped to 200 year plus record lows. While the uptrend is still intact for the 30 Yr Long Bond and the bull market is still posting new highs, currently the Daily Sentiment Index is showing readings of 97% bulls as of Friday last week. These types of readings usually do not offer too much further gains and most likely signal that we could at least suffer a correction / pullback from current levels.

This view is also confirmed by the Mark Hulbert service of tracking Bond newsletter exposure recommendations. Consider that at present, Bond newsletters are recommending 40% plus long exposure towards this asset class. This a very dramatic switch from March 2012, where these same “gurus” were recommending 40% net short exposure (and got it completely wrong). Historically, readings of 40% plus on each side have been very extreme and usually signalled that Bond prices reversed in some type of a counter trend rally.

Personally, I do not own any bonds in my fund, because I think they are a major major major major bubble! To led money to the US government at 1.5% over the next ten years is a total robbery when adjusted for true inflation figures, in my opinion. Therefore, I am waiting to short these assets, together with the Japanese Yen, at some time in the future.

Having said that, that does not mean prices cannot go higher from these levels, as overvalued bubbles can turn into manias and totally insane buying frenzies. Remember Nasdaq in 1999? Therefore, I am still reluctant to call a final top on the Treasury bull market, until the final EU crisis resolution and some type of a major default occurs to create a capitulation.
Currency Markets
Nothing new to report.

Commodity Markets
Nothing new to report.

Credit Markets
Nothing new to report.

Recommandations

• Summary: my further action depends on political and central bank intervention. During market panics, authorises also panic. It is not until they start to panic, that they actually do something about current problems, which usually take form of some type of reflation policy. However, weak action will make me reduce my longs substantially and rebalance my portfolio towards net short exposure. Italy and Spain are once again moving towards the edge of the cliff, which is a real worry while Asia is now in a meaningful slowdown.
• I still own SPY Calls purchased in middle of May, and today I purchased some more Calls on the SPY ETF. I do not own any other equity positions in my portfolio.
• I also still own SLV Calls purchased in middle of May, and I also added to that by buying some more SLV ETF positions today (only a small trade). I am also still holding onto that core Silver position from late December 2011 bottom at $26.
• I bought a very small position in Agricultural commodities through RJA ETF today. I’m expecting the Agricultural bull market to resume eventually (best fundamentals of any asset class right now). But, I haven’t done anything major just yet.
• Other assets on my watch list for some shorter term bullish rebound trades include Australian Dollar (FXA), Russian / Brazilian equities (RSX & EWZ) and Continuous Commodity Index (GCC).
• It is too early to talk about shorting anything yet, as I am waiting for a market rebound first.

Tags: agricultural, Asset Classes, Brazil, Bullish Sentiment, China, Citigroup, Crude Oil, Economic Data, Economists, Employment Figures, energy, ETF, ETFs, Eurozone, Federal Reserves, Gold, Magnifying Lens, Mean Reversion, New Highs, Qe, Recession, Relative Performance, Stocks Bonds, Tiho, Time Asia, Treasuries, Treasury Bond, Vertical Rise
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Our House: Is the United States the Best House in a Bad Neighborhood? (Sonders)

Wednesday, June 6th, 2012

June 4, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The June 1 employment report was a dud, but other economic reports were a bit rosier.
• The eurozone debt crisis and slowing global growth remain the greatest risks.
• A muddle-through economy continues to be the most likely path.

I won’t try to put lipstick on the pig that was last Friday’s May jobs report, but I will try a little lip gloss. Somewhat lost in the mire of the dire reaction to the report were several other more-positive readings on the economy. That’s testament to the likelihood that there are many more drivers to today’s malaise than just jobs growth, or lack thereof. It seems clear we’re in the midst of the third consecutive mid-year economic slowdown, driven by similar forces, most dominantly the eurozone debt crisis.

Questions about recession risk are as rampant now as they were last fall, but I remain in the camp that believes we will avoid one in the short-term. Part of the reason is not rosy: as the saying goes, if the plane never got off the runway, a crash is much less likely. It’s the “blessing” and the curse of a muddle-through economy. I wouldn’t bet the farm on a recession being avoided and I have as cloudy as crystal ball as anyone, but that remains my view.

First, the lip gloss

The weakness in the employment report was largely across the board. Payroll employment was up a meager 69,000, about half the consensus expectation, while the unemployment rate ticked up a tenth to 8.2%. The weakness was largely concentrated in three areas: business services, leisure and hospitality, and construction.

The weakness in construction probably reflects a “give-back” from the exceptionally strong, warm-winter-weather period in the beginning of the year. The other two segments tend to see their hiring lag movements in energy prices, and given their surge during the first four months of this year, the weakness is not terribly surprising. The good news is that energy prices have plunged since then.

There are some other caveats, too. The household measure of employment, from which the unemployment rate is derived, showed an increase of 422,000 and an increase in the number of participants in the labor force. The latter explains why the unemployment rate ticked up, but may also show some increased confidence about landing a job. However, it also points to expiring unemployment insurance benefits, which is forcing some participants back into the labor pool.

It’s not all bad

We also know that many of the leading indicators for job growth remain healthy, including:

• Employment components of the Federal Reserve’s regional manufacturing surveys
• Hiring plans, sales, profits and jobs-hard-to-fill at multi-year highs
• Jobs-hard-to-get at multi-year lows
• Job openings (JOLTS survey) at a four-year high
• Average hours worked at a 20-year high
• National Federation of Independent Business plans to hire at a cycle-high

Friday also brought the latest Institute for Supply Management (ISM) manufacturing index, which registered a reading of 53.5—still well above the 50 reading that separates an expansion from a contraction, and consistent with economic growth remaining comfortably above recession territory. On top of that, the new-orders component of the ISM index (both the index overall and the new orders component are key leading indicators) is not only at a cycle-high, but the “prices paid” component, measuring inflation, has collapsed in the past month. As noted by Wolfe Trahan, the best US gross domestic product (GDP) readings have generally come in the wake of large declines in inflation. And stocks generally do well when leading indicators of growth (new orders) are stronger than inflation pressures (prices paid).

Wall of worry is back

Sentiment has also improved markedly over the past month, thanks to May’s weakness. When I last wrote about sentiment in early April we highlighted the market’s elevated risk of a correction due to overly-optimistic sentiment (a contrarian indicator). As you can see below, that sentiment has reversed and is approaching territory that’s usually supportive for stocks. But frankly, I’d feel better if sentiment got even more pessimistic. We may need to see a little more capitulation before the market can find its legs.

Enough Pessimism?

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 29, 2012.

Manufacturing renaissance

Longer term, we remain optimistic about the prospects for both the US economy and stock market relative to the rest of the globe. As I’ve noted consistently, we have a “renaissance” story unfolding here in the United States; particularly within manufacturing and domestic energy. Housing is also becoming a major tailwind (more to come on that in future reports.)

I got back from a trip to China 10 days ago and my conversations in Hong Kong and Shanghai largely supported my view that even in the face of a “muddle through” economic-growth environment, from which this country is unlikely to exit any time soon, there are bright spots worthy of attention. In fact, maybe tellingly, nearly everyone with whom I had a conversation was more pessimistic than the consensus about China’s growth prospects but more optimistic than consensus about US growth prospects. And this was the sentiment of both local Chinese as well as US ex-patriots with business in China.

Tags: Bad Neighborhood, Blessing And The Curse, Charles Schwab, Chief Investment Strategist, China, Crystal Ball, Debt Crisis, Dud, Economic Reports, Economic Slowdown, Employment Report, Energy Prices, Eurozone, Global Growth, Last Friday, Liz Ann, Muddle, Payroll Employment, Senior Vice President, Unemployment Rate, Warm Winter Weather
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