Albert Edwards: “The Eurozone Crisis Will Get Much, Much Worse” And “The ECB Will Print”

Thursday, October 27th, 2011

Anyone expecting that the events over the last 24 hours will have changed the persistently negative outlook of one of the original skeptics, will be disappointed. The SocGen strategist falls back to that old time-tested principle in complicated situations: math and logic. His summary of events released this morning: “The increasingly frenzied attempts of eurozone governments to persuade financial markets that they can draw a line under this crisis will ultimately fail – even if this week’s measures bring some short-term relief. I have minimal confidence that governments can turn this around within the confines of the eurozone project. You might be surprised though that I feel more bullish! Why? Both Dylan and I have come to the view that the ECB will be forced, by events, to monetise debt in the GIIPS and beyond. And if investors believe the governments in Spain and Italy are bust, then Germany, France, and not forgetting the UK and US, are far, far worse.” To be sure, we may see a brief respite as we get the traditional post-TARP knee jerk reaction, only for markets to digest the sad reality of the situation in the proceeding 48 hours. And what will that imply? To Edwards, it will be nothing short of the realization, that even with €1 trillion (or more), the ECB will have no choice but to commence outright monetization as well. And the real question will be whether or not “Germany, will leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?”

Looking at the macr Edwards, first points out the unsustainable fiscal picture at the “other” countries, assuming one applies the same logic to them as to Italy:

Italy never “enjoyed” a boom to suffer any bust. And on many measures, including reputable attempts to take account of off-balance sheet liabilities, Italian public sector debt fares well on cross-country comparisons (see chart below). These off-balance-sheet liabilities will now increasingly become visible to all. Who then will be really bust?

The complexity of Europe is only exacerbated by the feedback loop with a recessionary America:

Regular readers will know we like to use leading indicators. These have been weakening for some months in the US and elsewhere. We have not highlighted the Economic Cycle Research Institute’s (ECRI) weekly leading indicator for some time, although it is as weak now as it was last year. But, unlike last year, this time around the ECRI have put out a rare recession call – link.

Lakshman Achuthan, the ECRI’s COO notes that they made the recession call only after an array of economic indicators showed a “pronounced, pervasive and persistent” downturn consistent with a recession. “By contrast, in the summer of 2010, when some market bears interpreted the decline in one of the institute’s indexes as a signal that a recession was in the offing, the institute said the pattern pointed not to recession, but only to weakness.” (Does he mean me? Surely not!) The last time we entered a recession with unemployment this high was back in 1937 (see right-hand chart above). This is indeed a crisis.

 

Analyst optimism on profits has also slipped sharply recently (see left-hand chart above, optimism defined as EPS upgrades as % of all estimate changes). We find the change in optimism (dotted lines in both charts above) is a good leading indicator for the official leading indicators (see right-hand chart above). This signals continued weakness ahead.

But enough about the rest of the world. The ticking time bomb in Europe is and has always been Italy, and specifically its horrific governance structure.

With Italian 10 year bond yields once again pressing towards 6% in recent weeks, they are definitely still in the eye of the storm. The trigger for this  was back in early July, when Italian Prime Minster Berlusconi turned on his well-regarded Economy Minister. Reuters reported on 8 July that “Speculation is growing that Italy’s Economy Minister Giulio Tremonti – credited with shielding the country from the eurozone debt crisis – will soon be forced out of government, which would further raise the heat on Italian bonds… Tremonti overcame cabinet resistance to push through a tough austerity programme last week, but now looks increasingly isolated and appears to no longer have the full support of Prime Minister Silvio Berlusconi.

“He thinks he’s a genius and everyone else is stupid,” Berlusconi said in an interview with Repubblica daily on Friday.”He is the only minister who is not a team player,” Until this untimely outburst, Italian bonds yields had consistently traded below Spanish yields by about 75bp (see chart below). Now they trade at a clear 50bp premium, with yields once again pushing up close to 6%. Belgium, without a government to speak of (an advantage?), but also suffering from a very high government debt/GDP ratio, has by contrast managed to keep below the market’s crisis radar. Italy has been ill-served by its politicians for dragging the country to its knees unnecessarily. It could/should have escaped this debacle.

Albert concludes that “the real issue is Italy’s incredibly low productivity growth (see top right-hand chart above). Hence, having been in excess of 2% yoy in the late 1990s, Italy’s trend GDP growth rate is now barely positive on Vladimir’s estimates (see left-hand chart below) and investment in people is poor (see right-hand chart below). The near-zero trend rate of growth means that Italy simply cannot grow its way out of its debt and will remain highly vulnerable to market shocks.”

Furthermore, when looking at the present, one must not ignore the future, and the future hinges on a demographic crunch: “As populations age and unfunded liabilities increasingly appear on the balance sheet, all governments are effectively bust. Reinhart and Rogoff in their book This Time is Different: A Panoramic View of Eight Centuries of Financial Crises – (link) show that there is no magic public sector debt threshold that determines when a crisis hits. It happens when the markets decides it is time to happen.”

And going back full circle to the most recent events, Edwards redirects to a new and interesting question: not whether this bailout attempt will succeed: it won’t; not whether the ECB will be forced to step up to the plate and monetize: it will, but whether or not Germany, after being once again overruled by Europe will say enough, and leave the eurozone.

Dylan and I feel more optimistic about the medium term. The current eurozone talks will not solve this crisis and it will get worse – much worse. But we would agree with the well known eurozone commentator, Paul de Grauwe of the Leuven University, who wrote “Everyone needs the ECB to step up to the plate. The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the eurozone.

The ECB will have to choose between its two most cherished ideals: the euro or its hard money principles. Notwithstanding some legal issues to get around and Germany being outvoted, we think the impending threat of a euro break-up will force the ECB to begin printing money, very reluctantly joining in the global QE party. Let’s be clear – neither Dylan nor I view ECB monetisation as a “solution”. Indeed its actions will mirror those of Rudolf Von Havenstein, president of the Reichsbank in the early 1920s. He kept printing because he was scared of the mass unemployment that would ensue if he stopped – link. The question for me is not if the ECB will print, but rather will Germany leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?

In other words, as we have been saying for over two years, the fundamental question boils down to whether the opportunity cost of being part of the eurozone and funding the entire continent is greater than the loss of returning to the Deutsche Mark and abandoning the implicit peg which has kept the country’s “currency” about 50% lower than its fair value since 1999. Last night’s decision will bring the answer that much closer.

Tags: Balance Sheet, Bonds, Confines, Debauchery, ECB, Financial Markets, Frenzied Attempts, Germany France, Italy Italy, Knee Jerk Reaction, Macr, Math Logic, Monetization, Negative Outlook, Off Balance Sheet Liabilities, Old Time, Outlook, Respite, Sad Reality, Skeptics, Strategist, Trillion
Posted in Bonds, Brazil, Markets, Outlook | Comments Off

UBS Quantifies Costs Of Euro Break Up, Warns Of Collapse Of Banking System And Civil War

Tuesday, September 6th, 2011

Any time a major bank releases a report saying a given course of action is too costly, too prohibitive, too blonde, or simply too impossible, it is nearly guaranteed that that is precisely the course of action about to be undertaken. Which is why all non-euro skeptics are advised to shield their eyes and look away from the just released report by UBS (of surging 3 Month USD Libor rate fame) titled “Euro Break Up – The Consequences.” UBS conveniently sets up the straw man as follows: “Under the current structure and with the current membership, the Euro does not work. Either the current structure will have to change, or the current membership will have to change.” So far so good. Yet where it gets scary is when UBS quantifies the actual opportunity cost to one or more countries leaving the Euro. Notably Germany. “Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. ” It also would mean the end of UBS, but we digress. Where it gets even more scary is when UBS, like many other banks to come, succumbs to the Mutual Assured Destruction trope made so popular by ole’ Hank Paulson : “The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.” So you see: save the euro for the children, so we can avoid all out war (and UBS can continue to exist). The scariest thing, however, by far, is that for this report to have been issued, it means that Germany is now actively considering dumping the euro.

Executive summary:

Fiscal confederation, not break-up

Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries can not be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such a move.

The economic cost (part 1)

The cost of a weak country leaving the Euro is significant. Consequences include sovereign default, corporate default, collapse of the banking system and collapse of international trade. There is little prospect of devaluation offering much assistance. We estimate that a weak Euro country leaving the Euro would incur a cost of around EUR9,500 to EUR11,500 per person in the exiting country during the first year. That cost would then probably amount to EUR3,000 to EUR4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.

The economic cost (part 2)

Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR1,000 per person, in a single hit.

The political cost

The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.

A little more on that particularly troubling last point:

Do monetary unions break up without civil wars?

The break-up of a monetary union is a very rare event. Moreover the break-up of a monetary union with a fiat currency system (ie, paper currency) is extremely unusual. Fixed exchange rate schemes break up all the time. Monetary unions that relied on specie payments did fragment – the Latin Monetary Union of the 19th century fragmented several times – but should be thought of as more of a fixed exchange rate adjustment. Countries went on and off the gold or silver or bimetal standards, and in doing so made or broke ties with other countries’ currencies.

If we consider fiat currency monetary union fragmentation, it is fair to say that the economic circumstances that create a climate for a break-up and the economic consequences that follow from a break-up are very severe indeed. It takes enormous stress for a government to get to the point where it considers abandoning the lex monetae of a country. The disruption that would follow such a move is also going to be extreme. The costs are high – whether it is a strong or a weak country leaving – in purely monetary terms. When the unemployment consequences are factored in, it is virtually impossible to consider a break-up scenario without some serious social consequences.

With this degree of social dislocation, the historical parallels are unappealing. Past instances of monetary union break-ups have tended to produce one of two results. Either there was a more authoritarian government response to contain or repress the social disorder (a scenario that tended to require a change from democratic to authoritarian or military government), or alternatively, the social disorder worked with existing fault lines in society to divide the country, spilling over into civil war. These are not inevitable conclusions, but indicate that monetary union break-up is not something that can be treated as a casual issue of exchange rate policy.

Even with a paucity of case studies, what evidence we have does lend credence to the political cost argument. Clearly, not all parts of a fracturing monetary union necessarily collapse into chaos. The point is not that everyone suffers, but that some part of the former monetary union is highly likely to suffer.

The fracturing of the Czech and Slovak monetary union in 1993 led to an immediate sealing of the border, capital controls and limits on bank withdrawals. This was not so much secession as destruction and substitution (the Czechoslovak currency ceased to exist entirely). Although the Czech Republic that emerged from the crisis was considered to be a free country (using the Freedom House definition), with political rights improving relative to Czechoslovakia (also considered to be a free country), Slovakia saw a deterioration in the assessment of its political rights and civil liberties, and was designated “partially free” (again, using Freedom House criteria).

Similarly the break-up of the Soviet Union saw authoritarian regimes in the resulting states. Of course, this was not a change from the previous status quo, but that is not the point. The question is not how a liberal democracy develops, but whether a liberal democracy could withstand the social turmoil that surrounds a monetary union fracturing. We lack evidence to support the idea that it could.

Even the US monetary union break-up in 1932-33 was accompanied by something close to authoritarianism. Roosevelt’s inauguration was described by a contemporary journalist as being conducted in “a beleaguered capital in wartime”, with machine guns covering the Mall. State militia were called out to deal with the reactions of local populations, unhappy at what had happened to the monetary union (and specifically their access to their banks).

Older examples are less helpful, as they tend to be more akin to fixed exchange rate regimes under a gold standard or some other international monetary arrangement. Nevertheless, the Irish separation from the UK, or the convulsions of the Latin Monetary Union in Europe (particularly around the Franco-Prussian war in 1870 and its aftermath) saw monetary unions fragment with varying degrees of violence in some parts of the union.

Writing in 1997, the Harvard economist Martin Feldstein offered a view that seems to be somewhat chillingly precognitive. He said “Uniform monetary policy and inflexible exchange rates will create conflicts whenever cyclical conditions differ among the member countries… Although a sovereign country… could in principle withdraw from the EMU, the potential trade sanctions and other pressures on such a country are likely to make membership in the EMU irreversible unless there is widespread economic dislocation in Europe or, more generally, a collapse of the peaceful coexistence within Europe.” (emphasis added).

As for what happens if UBS, and the Euro Unionists lose the fight for the euro:

Our base case for the Euro is that the monetary union will hold together, with some kind of fiscal confederation (providing automatic stabilisers to economies, not transfers to governments). This is how the US monetary union was resurrected in the 1930s. It is how the UK monetary union, and indeed the German monetary union, have held together.

But what if the disaster scenario happens? How can investors invest if they believe in a break-up, however low the probability? The simple answer is that they cannot. Investing for a break-up scenario has not guaranteed winners within the Euro area. The growth consequences are awful in any break-up scenario. The risk of civil disorder questions the rule of law, and as such basic issues such as property rights. Even those countries that avoid internal strife and divisions will likely have to use administrative controls to avoid extreme positions in their markets.

The only way to hedge against a Euro break-up scenario is to own no Euro assets at all.

Alas, this will be the final outcome. Unfortunately trillions more in taxpayer capital will be lost before we get there.

In the meantime, enjoy as UBS just unwittingly announced the final countdown for the EUR.

xrm45126

Tags: Banking System, Civil War, Collapse, Consequences, Fame, fiat, Fiat Currency, Fragmentation, GDP, Gold, Hank Paulson, International Trade, Libor Rate, Monetary Unions, Mutual Assured Destruction, Opportunity Cost, Polity, Recapitalisation, Skeptics, Straw Man, Ubs
Posted in Gold, Markets | 1 Comment »

‘You Need This Dirty Word, Euro Bonds’ (George Soros Interview)

Tuesday, August 16th, 2011

This week’s Outside the Box is in the tradition of showing the other side of the argument. Normally, anything George Soros says or does politically has my blood pressure up about 20 points. Yet, I posted another piece of his today in Over My Shoulder – and then ran across this longer piece from Der Spiegel. Note this is from a dedicated Europhile wanting to save the euro. He succintly outlines what must be done if it is to be saved, and does it as well as anyone. (I know that among my readers there are both likers and haters of Soros, but as an observer of markets he is to be respected. And this is an article in which his acumen is in evidence.

I refer you to last week’s regular letter (one of my more important ones: http://www.johnmauldin.com/frontlinethoughts/the-beginning-of-the-endgame) and also to the Outside the Box piece I passed on from Michael Lewis, in which he points out that to survive, the rest of Europe must learn to behave more like Germans. This is the great objection of the euro-skeptics, since the rest of Europe does not want to be like Germans. But Soros is right to some extent when he says, “There is simply no alternative. If the euro were to break up, it would cause a banking crisis that would be totally outside the control of the financial authorities. So it would push not only Germany, not only Europe, but also the whole world into conditions very reminiscent of the Great Depression in the 1930s, which was also caused by a banking crisis that was out of control.”

We find ourselves in a binary world. Either Europe goes to a fiscal union with the various countries losing control of their budgets, or the Eurozone breaks up. As I recently wrote, we must not underestimate the commitment of the European elites to do whatever it takes to hold their project together. Neither must we underestimate the ability of voters to change their leaders. This is a very volatile situation with far more implications than our subprime problem.

I continue to say that a euro crisis will lead to a recession (or worse) in the US. Attention must be paid. Soros lays out the Euro-elite agenda. I suggest you read.

Your euro-skeptic analyst,

John Mauldin, Editor
Outside the Box

********

Der Spiegel Interview with George Soros

‘You Need This Dirty Word, Euro Bonds’

In a SPIEGEL interview, billionaire investor George Soros criticizes Germany’s lack of leadership in the euro zone, arguing that Berlin must dictate to Europe the solution to the currency crisis. He also argues in favor of the creation of euro bonds as a way out of the turbulence.

SPIEGEL: Mr. Soros, we currently see a global banking crisis, a currency crisis and a sovereign debt crisis. Has the financial dilemma become too big to handle? How can politicians on both sides of the Atlantic be expected to solve such a multitude of crises?

Soros: The politicians have not really tried to fix any crisis; they have so far tried only to buy time. But sometimes time actually works against you if you refuse to face the relevant issues and explain to the public what is at stake.

SPIEGEL: Are you talking about the Germans? Many experts think Chancellor Angela Merkel has been particularly hesitant to address the euro crisis.

Soros: Yes. The future of the euro depends on Germany. This is the point I really want to drive home. Germany is in the driver’s seat because it is the largest country in Europe with the best credit rating and a chronic surplus. In a crisis, the creditor always calls the shots. Sure, this is not a position Germany or Chancellor Merkel ever desired and they are understandably reluctant to embrace it. But the fact is that Germans are now in the position of dictating to Europe what the solution to the euro crisis is.

SPIEGEL: Why should Berlin embrace that idea?

Soros: There is simply no alternative. If the euro were to break up, it would cause a banking crisis that would be totally outside the control of the financial authorities. So it would push not only Germany, not only Europe, but also the whole world into conditions very reminiscent of the Great Depression in the 1930s, which was also caused by a banking crisis that was out of control.

SPIEGEL: What, then, needs to be done to fight this crisis?

Soros: I think there is only one choice. It is not a question of whether Europe needs a common currency. The euro exists, and if it were to break apart, all hell would break loose. Germany has to make it work. To make it work, you have got to allow the members of the euro zone to be able to refinance the bulk of their debt on reasonable terms. So you need this dirty word: “euro bonds”. But when you study what it involves to have euro bonds, you really have a problem because each European country remains in control of its own fiscal policy, and you have to rely on the country to meet its financial obligations.

SPIEGEL: Germans hate the euro bonds idea. They fear that under this scenario they will ultimately need to bail out everyone, even large nations like Italy.

Soros: That is why you need to establish fiscal rules that will ensure the solvency of every member. This should make the euro bond acceptable to German voters. Europe needs a fiscal authority that has not only financial but also political legitimacy. The difficulty is agreeing on the rules. Unfortunately, Germans have some funny ideas. They want the rest of Europe to follow their example. But what works for Germany can’t work for the rest of Europe: No country can run a chronic surplus without others running deficits. Germany must propose rules that other countries can also follow. These rules must allow for a gradual reduction in indebtedness. They must also allow countries with high unemployment, like Spain, to continue running cyclical budget deficits until they recover.

SPIEGEL: More and more economists, especially in Germany, would like to see Greece leave the European Union. Do you consider that to be a viable option?

Soros: I think that the Greek problem has been sufficiently mishandled by the European authorities that this may well be the best solution. Europe, the euro and the financial system could survive Greece leaving. It could survive Portugal leaving. And the remainder would be stronger and more easily managed. But the financial authorities have to arrange for an orderly exit in order for the European banking system to survive it. That will cost money because the European banking system including the European Central Bank has to be indemnified for its losses. Depositors in Greek banks also need to be protected. Otherwise, depositors in Irish or Italian banks will not feel safe.

SPIEGEL: Is the current crisis even worse than the one in 2008?

Soros: This crisis is still the continuation of the same crisis. In 2008, the financial system collapsed and it had to be put on artificial life support. The authorities managed to save the system. But the imbalances that caused the crisis have not been removed.

SPIEGEL: What do you mean?

Soros: The method the authorities rightly chose three years ago was to substitute the credit of the state for the credit in the financial system that collapsed. After the failure of Lehman Brothers, the European financial ministers issued a declaration that no other systemically important financial institutions would be allowed to fail. That was the artificial life support; it was exactly the right decision. But then Chancellor Merkel stated that such support would only be granted by each EU member state individually, and not by the European Union.

SPIEGEL: That undermined the concept of a strong European response to the crisis. Has that been the biggest mistake so far?

Soros: That Merkel statement was the origin of the euro crisis. It shattered the vision that the EU will protect the euro in a joint effort.

SPIEGEL: Where will the current crisis stop? Even France now seems to be threatened by a financial meltdown.

Soros: Of course it is spreading. Markets fear uncertainty. Germany has to realize that it has no alternative but to defend the euro. The longer it takes, the higher the price Germany will have to pay.

SPIEGEL: You have been very critical of how the crisis has been handled by governments. Many European citizens, however, blame speculators like you for their attempts to bring down the euro. Huge hedge funds like yours have waged massive bets against the European currency over the past year. And in recent days, several European countries have even imposed temporary bans on short selling, bets on falling share prices.

Soros: You are confusing markets and speculators. At the moment, the biggest speculators are the central banks because they are the most important buyers and sellers of currencies. Hedge funds have definitely been supplanted by central banks. Markets expect the authorities to produce a financial system that actually holds together. If there is any hole in that system, speculators will rush through that hole.

SPIEGEL: That sounds very noble. But in reality, speculation makes any crisis worse. Look at the credit default swaps (CDS) market where speculators can bet on a further decline of currencies and economies. How can that be helpful?

Soros: Of course, speculation will always make a crisis worse. If there is a weak point, it will expose it. And you are right, the CDS market is a very dangerous instrument and I think it should not be allowed. I am one of the very few people who argue that the CDS is a dangerous instrument because it is so lop-sided in favor of a negative outcome.

‘You Can Count on China To Back the Euro’

SPIEGEL: Do you think the European Central Bank is part of the solution or part of the problem when it comes to the dealing with the euro crisis?

Tags: Acumen, Banking Crisis, Binary World, Der Spiegel, Dirty Word, Endgame, Euro Bonds, European Elites, Eurozone, Financial Authorities, George Soros, Germans, Great Depression, Haters, Infrastructure, Likers, Losing Control, Michael Lewis, Skeptics, Spiegel, Volatile Situation
Posted in Infrastructure, Markets | Comments Off

Bob Janjuah’s (Nomura) Latest Outlook

Thursday, July 14th, 2011

via ZeroHedge.com

The latest big picture observations from one of the original skeptics: Bob Janjuah.

Bob’s World – Vigilantes bite back

The themes I have been highlighting all year certainly seem to have played a major role in driving markets over the past two weeks:

A. The bond vigilantes did their job with respect to Italy. While Greece, Portugal and Ireland are, in my opinion, insolvent nations that need debt relief or restructuring, it seems clear to me that the market does not want to attack Italy out of any speculative spite. As long as the sensible fiscal policies of the last decade are further built upon, I am confident Italy can exit the eurozone debt crisis in acceptable health.

B. The 8 July jobs report told investors all they need to know about the weakness in DM growth. I am very confident that both DM and EM growth will only get weaker as H2 unfolds. But in the near term I think a combination of a “fudged” US debt ceiling agreement, more talk of stimuli in the form of QE3, a genuine push by most Italian policymakers to back Mr Tremonti and implement the required fiscal adjustment, and a little more of the Q2/Q3 Japan bounce, will together be viewed, at the margin, positively by markets. But I would expect this to be only a short-lived reprieve.

Therefore, in terms of markets:

A. Although I think the current risk-off phase could last a little longer in the very short term, for the latter half of July and heading into August I am bullish and favour another risk-on phase. In this coming risk-on phase I expect to see over late July and August my S&P targets are 1350/1370, with a possibility of a bigger move to 1440. And 1250/1220 S&P remain my bear alert levels.

B. Over a Multi-Week/Multi-Quarter horizon, I remain bearish and risk-off, as outlined in my previous note. I have high conviction on this call.

C. Any surprise will likely come from the US rather than the euro zone and centres on the risk of no deal being reached on the debt ceiling. If that becomes the market consensus over the next few weeks, then my 1250 and maybe also 1220 S&P bear alert levels should come into play. I think USD and USTs would rally if the debt ceiling deal were not to materialise. The knee-jerk reaction may be to sell USTs and USD, but no deal on the debt ceiling would I feel ultimately send a very positive message to the bond vigilantes that the US is serious about getting its fiscal house in order. Risk markets on the other hand would likely see such an outcome as ultimately very negative, as uber loose policies have been and are the main support and driver of risky asset valuations. At this juncture, however, I see a short-term fudge as the more likely outcome.

Bob Janjuah

Tags: Big Picture, Conviction, Debt Ceiling, Debt Crisis, Debt Relief, Euro Zone, Favour, Fiscal Adjustment, Fiscal Policies, Horizon, Last Decade, Nomura, Policymakers, Q2 Q3, Reprieve, Restructuring, Skeptics, Spite, Stimuli, Tremonti
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Sentiment Moderates as Market Finds Some Footing

Monday, February 28th, 2011

The comments below were provided by Kevin Lane of Fusion IQ.

The markets found their footing a bit late late last week after three days of selling.  The stabilization occurred in and around key moving averages (the 50-day on the NASDAQ and the 40-day on the S&P 500).  Two factors we noted during this recent run-up still persist; investor fund flows continue to find their way into equity markets and anecdotal sentiment is still doubting and not embracing this rally. That said, measured sentiment also has moderated as seen in the chart below from the American Association of Individual Investors (AAII), which shows bulls have fallen from north of 60% to 36% as of yesterday. It’s hard to have big corrections when liquidity flows are in and sentiment remains skeptical. While logically it may make sense that the markets need to correct, I found out a long time ago, and the hard way, that markets don’t care what we think. Rather they march to their own drums and most times the obvious and logical trade is the wrong trade.

Additionally, markets only correct when trading successes seduce investors into thinking the game is easy and they have it all figured out. This overconfidence lends itself to over-commitment on the long side via leverage, until investors exhaust their buying power. Markets don’t go down when everyone is sourcing for short trades or when the loudest voices in the crowd are the skeptics. Moreover, it also takes persistent distribution to turn the tide from up to down and, other than Tuesday, so far the sellers have only been a one-act (one-day) show.

For now, as uncomfortable as it may be for some, the trade is still up. It you are fully invested and with positions that are significantly lower in cost basis, then firstly, congratulations, and secondly, sit just back and relax.  For those who fit the former description your job at this point is to make sure you have good trailing stops or hedges in place for when the correction does unfold.

The greater risk awaits those who are underinvested (or net short) and adding new positions with at the money or slightly in or out of the money cost basis.  We say there is more risk simply because the S&P 500 is up 24% from the August 2010 lows, just a mere six months ago. As legendary hedge fund manager David Tepper of Appaloosa stated on CNBC just a few weeks ago, any time the market has a big rise there is simply more inherent risk because prices get more expensive.

So, for the latter group of investors, the trick is simple; keep searching for setups on new money positions that have good upside potential (however you measure that, i.e. fundamentally derived targets, point and figure objectives or the next overhead resistance levels) but with limited drawdown risk (i.e. the difference between cost and stop loss/exit point).

Now that we have talked strategy a bit, let’s take a look at some of the markets’ technical levels. As seen below, the S&P 500 found support in the 1,302 to 1,295 support area (red lines). This level also coincided with the index’s up-trend line (green line). Any close below yesterday’s low would open up risk to the next downside support near 1,270.

As seen below, the transports had much more damage done on the sell-off than broader markets, by scoring a false breakout above their previous peak only to rapidly fall back below (purple line) the previous peak.  Subsequently the transports dropped below 5,000 and bounced off support in the 4,960 to 4,910 area (red dotted lines). At this point we view the weakness in the transports as an inverse trade to the rise in crude and  not a buckling economy. Either way, any drop below this recent support level would be a negative on the transports.

To wrap up our mid-morning missive, the trend is up until proven otherwise and a few % points sell-down from the highs are not proof enough to get your bear claws out yet. Before we do that we first need to see how the indices regroup from the recent sell-off and whether they can muster news highs or fail to do so. Then we would need to see a few days of distribution like Tuesday but only with more frequency and persistence.

To use an analogy, when hunting big game it’s better to travel in a pack than be a lone wolf and right now the lone wolf is the one searching for a top.  Wait for more evidence to appear before turning negative and only join the hunt when the pack (the sellers) are in full force.  If you deviate from the strategy you will continually get nicked.

Source: Kevin Lane, Fusion IQ, February 25, 2011.

Tags: Aaii, Act One, American Association Of Individual Investors, Bulls, cost basis, Drums, Footing, Hedges, Iq, Leverage, liquidity, Moving Averages, Nasdaq, Overconfidence, Power Markets, Sentiment, Skeptics, Successes, Trailing Stops, Voices
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Technical Talk: What to do? What to do?

Wednesday, January 19th, 2011

The comments below were provided by Kevin Lane of Fusion IQ.

“If you don’t create change, change will create you.” Mahatma Ghandi

This remains the million dollar question as there are plausible arguments for both the bulls and the bears. The bears will argue that geopolitical risks (the PIIGS) still exist, inflation is coming on fast and bullish sentiment is rampant. Bulls will counter that there are more skeptics than exuberant cheerleaders, that the economy is finally gaining traction and that earnings will continue to improve. They argue this will lower valuations even if the market climbs a bit more here. The hard part is deciphering which opinion is correct as we can see validity in both arguments.

Thus the current market environment creates a double-edged sword. In one respect, if we are in the midst of a melt-up, it is hard not to stay exposed (invested) and fully participate. On the other hand, if we are in the last turn (about to correct) in the market’s game of musical chairs, it would stink to get caught without a chair! If you are not worried about either of these scenarios you’re not properly game planning for risk management

That said, the pros are the trends for three key bellwether indices; the Transports, the Banks and the S&P 500 remain up and intact, though this morning’s action in Citigroup (C) may cap the momentum in the banks for a while. Additionally, and as mentioned before, the economy is finally gaining some traction on the job creation front. The cons are the market is very overbought, measured sentiment (not anecdotal) is a bit overbullish, and inflationary pressures in basics such as food and energy are ramping up.

So how does one play this game, given the confusing but equally plausible messages being sent by the market? Well, first we need to differentiate between older-dated holdings and new money. Older-dated holdings are easy as we make the assumption, given the market run-up since 2009, that the cost basis on these positions are markedly lower than present prices. In this case it is easy to just keep raising stops and let the market take you out on a correction.

The harder question to answer is what to do with new money or cash on the sidelines. Here we suggest a more cautious approach as we do believe, given the divergences developing between internals and market price momentum, that a correction is coming sooner rather than later. Thus we suggest being extremely selective when putting on new positions and keep stops very tight and, more importantly, honor them if triggered.

Below we see the current technical setup for the S&P 500 Index. As can be seen the Index is approaching 1,300, which is its next test of overhead resistance (gold line) and a solid round number that psychologically could stop the market. A target above that would be near 1,330, which represents the upper end of the present bullish channel the index is in (purple lines). On the downside, near-term support comes into play near 1,275 with more solid support near 1,250 (upper red dotted line).

So, in the end you’re left with either trying to anticipate the correction (proactive) or waiting for more evidence it is actually under way (reactive). The former would be done by seeing the widening divergences between price and momentum indicators and continued rise in bullish sentiment, while the latter would wait for a few days of aggressive selling where down volume and decliners swamp up volume and advancers. It is a pick-your-comfort-level strategy. Some like to be anticipatory; however, in doing so you run the risk of leaving the table before dessert is served. Others like to be more convinced; the risk here is you can get stuck with the bill! In the process you can give back quite a few basis points waiting for more evidence to unfold.

The bottom line is there are always varying degrees of risks and rewards. Sometimes one is so much greater than the other that decisions are very easy. However, other times such as the present, it is not as clear. That said, we believe at present there is heightened risk, thus we remain long but underinvested and are deploying new money at present levels only when very enticing risk/reward setups occur. With the tape running it can be very easy to be pavlovian and triggered into impulsive decisions. However, investing takes the patience and cunning of a lion, knowing when to pounce and when to conserve energy. The time to pounce is when the likelihood of the kill is the greatest and stacked in your favor, and right now we just don’t see it that way.

However, as we all know, things change very rapidly nowadays and if more evidence appears to change the outlook we will change with it. In the interim we’ll keep eyeing the unbiased data for additional clues that will help tip the risk/reward scale in a more decisive direction.

Source: Kevin Lane, Fusion IQ, January 18, 2011.

Tags: Bullish Sentiment, Cheerleaders, Citigroup, Citigroup C, Current Market, Dollar Question, Double Edged Sword, energy, Gaining Traction, Gold, Inflationary Pressures, Job Creation, Mahatma, Market Environment, Midst, Musical Chairs, New Money, Plausible Arguments, Risk Management, Skeptics, Validity, Valuations
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China’s Currency Move a Success

Wednesday, July 21st, 2010

by Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors.

When the Chinese government changed its currency policy last month to allow appreciation of the renminbi (Rmb), skeptics like New York Times columnist Paul Krugman called the move a lame ploy to placate U.S. and European critics ahead of the G20 summit.

It appears this judgment may have been too quick and too harsh.

The renminbi gained 0.70 percent against the U.S. dollar in the first couple of weeks after it was unpegged from the dollar. That works out to an annualized rate of about 15 percent—a monumental move in the currency world.

In fact, CLSA’s Andy Rothman says that the policy change has been so effective that Beijing will actually have to curb renminbi appreciation to keep it at the annual target rate of 5-7 percent.

Rothman points out that the immediate appreciation is far higher than the average monthly rate seen in the 2005-2007 period (chart), when the renminbi’s exchange rate was last allowed to float.

The soft U.S. job market has been focusing blame on China for the decline of American industry, but Rothman reminds us that the U.S. manufacturing sector has been shriveling for more than half a century – from 23 percent of American workers in 1949 to 16 percent in 1989 (when Chinese imports were still “insignificant”) to 9 percent today.

The Chinese government has much higher aspirations than being the world’s factory of cheap goods. This year we’ve seen the government raise minimum wage requirements across the country and move to improve labor conditions.

This is all part of a longer-term plan to move up the manufacturing food chain and build a stronger base for domestic consumption. A stronger renminbi that enhances the purchasing power of both Chinese importers and the average citizen fits well into that vision.

Tags: Chief Investment Officer, Chinese Government, Chinese Importers, Chinese Imports, Currency Policy, Domestic Consumption, Frank Holmes, G20 Summit, Half A Century, Manufacturing Sector, New York Times, New York Times Columnist, Paul Krugman, Period Chart, Purchasing Power, Rothman, Skeptics, Target Rate, U S Global Investors, York Times Columnist
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Gold Is The Decade’s Best

Sunday, December 27th, 2009

By Frank Holmes
CEO and Chief Investment Officer

Happy holidays wishes to all, with a special season’s greetings to the permanent gold skeptics.

The decade that ends next Thursday is on track to be the worst in recorded history for the U.S. stock market—worse than all of the many boom-and-bust cycles of the 19th century, worse than the Great Depression-era 1930s, worse than the recession-plagued 1970s.

The S&P 500 opened the decade at 1,469.25 on January 3, 2000. When the market closed on Christmas Eve, the S&P 500 stood at 1,125.46—with four trading days left in the decade, the index’s annual performance over that span is negative 2.6 percent. The Dow Jones Industrials has lost about 1 percent per year over the same period, and the Nasdaq Composite is down a whopping 5.9 percent annually. When adjusted for inflation, the 10-year returns for these indices are even lower.

Meanwhile, what about gold?

The chart above from Bloomberg tells the story—a $100 investment in gold when the market opened on January 3, 2000, was worth about $380 as of this week (data through December 21)—that’s a total return of 280 percent and an annualized return of 14.3 percent. Gold stocks (as measured by the XAU Index) have also had a good decade, climbing 9.4 percent annually.

Commodities (as measured by the S&P GSCI Enhanced Total Return Index) posted average gains of 13.6 percent per year over the period, driven mostly by rapid economic growth in Asia and elsewhere in the developing world.

There are many commentators out there who see no value in gold and who denounce it as an investment at every opportunity. They are certainly entitled to their opinions, but it’s hard to argue with the numbers over the past 10 years—investors on average would have been better off with a gold allocation than having no exposure.

We consider gold a legitimate asset class, and for that reason, we consistently suggest that investors consider a maximum 10 percent allocation to gold-related assets—half in bullion or bullion ETFs and the other half in gold equities—and that they rebalance each year to capture the swings.

What the next decade will bring for gold? Who knows. But we do know one thing—those who held gold for the past 10 years will have a happier New Year than those who listened to the perma-skeptics.

Tags: Annualized Return, asset class, Boom And Bust, Bust Cycles, Chief Investment Officer, Christmas Eve, Commentators, Commodities, Developing World, Dow Jones, Dow Jones Industrials, ETF, ETFs, Frank Holmes, Gold, Gold Bullion, gold stocks, Great Depression, Gsci, Happy Holidays, Nasdaq Composite, Rapid Economic Growth, Skeptics, U S Stock Market, Xau Index
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Stocks vs. Bonds: What’s Next?

Friday, October 9th, 2009

A very interesting chart from Leuthold Group points out that this would be the third time since the 1920s that we have emerged from a period in which bonds have outperformed stocks.

In the periods following this re-emergence from bond superiority, stocks enjoyed massive outperformance. The first of the three periods outlined in the chart, was the 1930s bust, the second was 1949 thru 1955.

Jeremy Siegel, too, offers the following argument in favour of “stocks for the long run,” from his recent op-ed in FT.com (worth reading):

A look at history shows that the recent experience is not uncommon and excellent returns are available to those who survive rough patches. Since 1871, the three worst 10-year returns for stocks have ended in the years 1920, 1974 and 1978.

These were followed, respectively, by real, after-inflation stock returns of more than 8 per cent, 13 per cent, and 9 per cent over the next 10 years.

In fact for the 13 10-year periods of negative returns stocks have suffered since 1871, the next 10 years gave investors real returns that averaged more than 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all 10-year periods, and is twice the return offered by long-term government bonds.

Strong future returns also followed poor returns if one extends the analysis to the worst-performing of all 127 10-year stretches since 1871. Without exception, for each 10-year return that fell in the bottom quartile, the following 10-year period yielded positive real returns and the median return exceeded the long-run average.

Both Leuthold and Siegel make a notable case for the future of stocks, though Leuthold focuses on 5 year periods and Siegel on 10 year periods.

Earlier this year, we featured Robert Arnott’s thesis on Bonds for the Very Long Run (Bonds: Reversion Cuts Both Ways); Arnott focuses on the past 40 years:

For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.

Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.

Bill Gross, PIMCO’s Bond King, Chief Card Counter and Handicapper, has been exchanging high-grade corporate bonds for longer-dated government bonds, out of concern for deflation.

Is it possible they are all right? Bonds are forecasting deflation and stocks are forecasting reflation. The track record of the bond market, however, as a forecasting tool has proven to be more accurate historically. Pragmatic Capitalist says:

Bond investors (who tend to have a longer time horizon) are forecasting a long battle with deflation.  Equity investors (who tend not to think much farther than one quarter into the future), on the other hand, are putting their money on the line in the hopes that the reflation trade is alive and well.

Unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors.   There have been 4 famous cases of such bond and stock divergences in the last 20 years.  The most famous is the summer of 1987.  We all know what occurred then.  The other three cases were fall ‘94, summer ‘98 and winter 2000.   All three preceded declines in the market.  Of all 4 instances, three of them preceded 15% declines in the S&P 500.

The strongest case for equities today seems to rest on the sheer amount of cash sitting on the sidelines; $10-trillion in the US and $1-trillion in Canada. Its a weak argument – investors do not invest simply because they have the cash, and these days investors aren’t exactly inspired.

James Bianco, of Bianco Research, however, (via WSJ), is skeptical of this simplistic theme:

“If you look at the mutual-fund flows there is a record amount going into bond funds. Forty-two billion dollars went into bond funds in August, which is an all-time monthly record. In fact, the all-time monthly record, I believe, for stock funds was $55 billion back in February of 2000. So it’s pretty close to the stock-fund record. But when you break it down, what you’ll find is that short-term muni funds, and short-term corporate funds, those are the funds that are getting huge, huge inflows.

The short-term corporate funds are up 12% this year. And as we talk right now, the S&P 500 is up around 16% this year and the Dow is up about 11% this year. That’s including dividends. So my conclusion was, “Yes, there’s a lot of money that’s built up in the cash on the sidelines. Yes, it is going to come out of that zero interest rate funds. And its going into short-term bond funds, which by the way are performing pretty much in line with the stock market. So don’t hold your breath. You’re going to be waiting a long time before you see that money ever matriculate into the stock market.””

And,

“Now a couple things about that. The first one is I hate when they say, “There’s $3.5 trillion on the sidelines and that’s a whole lot of money.” It implies that all of that money should be put in investments like the stock market. That’s not true. The vast, vast majority is in transactional balances.

It’s money that is going to be needed in a very short period of time, like, within a year. It’s going to be spent on something. They’re almost like checking accounts, if you want to think of it that way. It’s like somebody saying, “You’ve got $10,000 dollars in your checking account, why don’t you $10,000 worth of stocks?” And the answer is, “Well because I’ve got to pay my credit card bill and my rent.”

The strongest case for the bond market is coming out of PIMCO’s thesis, which calls for a ‘New Normal,” a future of De-Leveraging, De-Globalization, and Re-Regulation. The three elements combine as a recipe that ultimately results in stable and stronger dollar outcome as debt repayment repatriates cash from abroad as well as domestically into the credit and bond markets. A strong dollar on this basis results in falling prices, thus the case for deflation.

Bottom line: This may be time to use the equity market’s strength to rebalance out of equities in favour of government bond and money market allocations.

Tags: 1920s, 1930s, Bill Gross, Bottom Quartile, Bust, Canadian Market, Emergence, Favour, Future Returns, Government Bonds, inflation, Jeremy Siegel, Periods, Robert Arnott, Rough Patches, Skeptics, Stock Returns, Stocks, Stocks Bonds, Stretches, Superiority, Thesis, Third Time
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Bonds: Reversion Cuts Both Ways

Friday, April 24th, 2009

Robert Arnott, Founder, Research Affiliates, and innovator of FTSE-RAFI Fundamental Indices, has published a detailed report testing the question of why investors should bother holding bonds (at all?) and displacing the long-standing notion that stocks for the long run hold a 5-percent risk premium over bonds. This is a must-read-over-the-weekend report as it is lengthy, but far from boring.

Here is a preview:

“Reversion cuts both ways,” according to Arnott.

For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.

Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.

The Death Of The Risk Premium?

It’s now well-known that stocks have produced negative returns for just over a decade. Real returns for capitalization-weighted U.S. indexes, like the S&P 500 Index, are now negative over any span starting 1997 or later. People fret about our “lost decade” for stocks, with good reason, but they underestimate the carnage. Even this simple real return analysis ignores our opportunity cost. Starting any time we choose from 1979 through 2008, the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor. In fact, from the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, our 20-year bond investors win by a nose. We’re now looking at a lost 40 years!

Stocks have done better, but not in the last 40 years…

It’s hard to imagine that bonds could ever have outpaced stocks for 40 years, but there is precedent. Figure 1 shows the wealth of a stock investor, relative to a bond investor. From 1802 to February 2009, the line rises nearly 150-fold. This doesn’t mean that the stock investor profited 150-fold over the past 200 years. Stocks actually did far better than that, giving us about 4 million times our money in 207 years. But bonds gave us 27,000 times our money over the same span. So, the investor holding a broad U.S. stock market portfolio was 150 times wealthier than an investor holding U.S. bonds over this 207-year span. So far, so good.

That 150-fold relative wealth works out to a 2.5-percentage-point-per-year advantage for the stock market investor, almost exactly matching the historical average ex ante expected risk premium that Peter Bernstein and I derived in 2002 in “What Risk Premium Is ‘Normal’?” Those who expect a 5 percent risk premium from their stock market investments, relative to bonds, either haven’t studied enough market history—a charitable interpretation—or have forgotten some basic arithmetic—a less charitable view.

A 2.5 percentage point advantage over two centuries compounds mightily over time. But it’s a thin enough differential that it gives us a heck of a ride.

• From 1803 to 1857, stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered. Oh, by the way, there was a bit of a war—or three—in between. Forget relative wealth if you owned Confederate States of America stocks or bonds. Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds.
• Stocks continued their bumpy ride, delivering impressive returns for investors, over and above the returns available in bonds, from 1857 until 1929. This 72-year span was long enough to lull new generations of investors into wondering “why bother with bonds?” Which brings us to 1929.
• The crash of 1929–32 reminded us, once again, that stocks can hurt us, especially if our starting point involves dividend yields of less than 3 percent and P/E ratios north of 20x. It took 20 years for the stock market investor to loft past the bond investor again, and to achieve new relative-wealth peaks.
• Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment. Indeed, stocks were seen as so very low risk that we tolerated a 1 percent yield on stocks, at a time when bond yields were 6 percent and even TIPS yields were north of 4 percent.
• From the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his or her wealth, relative to the investor in long Treasuries.

This is an in-depth analysis and worthy of a back to back read, from one of the industry’s pre-eminent philosophers, as well as the innovator of FTSE-RAFI Fundamental Indexes.

The full report can be read and printed here.

Tags: Bond Yields, Capitalization, Carnage, Contradictory Evidence, Excess Return, Excess Returns, Ftse Rafi, Good Reason, Innovator, Observers, Opportunity Cost, Percentage Points, Premium Bonds, Research Affiliates, Risk Premium, Robert Arnott, Skeptics, Stock Returns, Stocks Bonds, Term Investor, Treasuries, Treasury Bonds
Posted in Bonds, Credit Markets, Economy, Markets | 2 Comments »