Sound and Fury, Signifying Nothing
While all eyes have been focused on Europe lately, China has quietly been falling apart. In a normal environment, I believe that much more attention would be focused on the looming banking and local government debt crisis in China. Fortunately for them, the train wreck that is Europe is too engrossing for financial markets to tear their eyes away. (By the way, the train went off the rails in Germany last week too. The denouement is at hand. Read this brief article for the summary).
Change "Life" in the next sentence to "China" and Shakespeare's Macbeth soliloquy (Act 5, Scene 5 for those that slept through 11th grade English) looks mighty fitting:
Life's [China's] but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
How can I say that one of the world's largest economies, the one that is going to replace America as the global growth engine, the one to which we are losing jobs and profits, the one that owns large amounts of our debt, and on and on, signifies nothing? It's actually quite simple – because the "Chinese Miracle" is based on tremendous amounts of bad loans made by state-controlled banks to state-controlled entities, usually run by politically connected members of the Communist Party's families or the People's Liberation Army (PLA). Those loans will not be paid back. The money that hasn't been siphoned off by the ruling parties families (read this extremely interesting article in the Wall Street Journal about the children of Party members driving Ferraris to pick up their dates and buying $32 million homes in Australia) has been invested in companies that have no return hurdles or expectations for return on capital – in fact, return OF capital itself will be a miracle. Why? Again, it's simple: Character, or lack thereof.
Put bluntly, the Chinese as a whole, as a country, lack character. For those that don't "get" the Chinese moral code, read this article on a recent event in China in which a little 2 year old girl was hit by a truck and 18 people simply walked by and did nothing, leaving her bleeding in the street. If you can stomach it, watch the video, but it's heart-wrenching. The levels of fraud, lying, and stealing that occurs in China is mind-boggling to the western world, which presumes a certain level of trust and honesty in business dealings between strangers. Not so in China. Zinch China, a consulting company that advises American colleges and universities about China, last year published a report based on interviews with 250 Beijing high school students bound for the United States, their parents, and a dozen agents and admissions consultants. The company concluded that 90 percent of Chinese applicants submit false recommendations, 70 percent have other people write their personal essays, 50 percent have forged high school transcripts and 10 percent list academic awards and other achievements they did not receive. The "tide of application fraud," the report predicted, will likely only worsen as more students go to America.
We held off posting recently because the more things changed, the more they stayed the same. I could have simply reposted the November 11th musing and been done. Another European country lost its leader (welcome to the club Spain. Silvio, scoot over.), which for some reason the various parliaments seem to think is a good idea. (For our thoughts, see our November 9th post “The Devils We Know”.) We are of the opposite opinion – confidence votes, new technocrat Prime Ministers, new governments, etc. are not what Europe needs at the moment. What it needs are leaders who are able to act and “do the right thing” (more on that later) without worrying about a confidence vote every other week. How can you run a country on week-to-week polls? It makes the current US system look functional by comparison. And that’s hard to do. While European governments play musical chairs, European bond markets don’t like the changes. Spain had to pay a Euro-era record 5.11% today for 3-month money. See this Wall Street Journal article for a concise recap of the current stress in the Euro sovereign markets.
If you come to a fork in the road, take it. - Yogi Berra
On October 27th we said “This is a big move and the markets are working off of a big oversold condition last month. Our long call starting October 5th was about as good as it gets, but it’s nearing time to tip the man and go home.” That call wasn’t too bad. Since the close on 10/27/11, the S&P 500 has dropped 7.5%. That’s not a huge loss, but something to avoid if you can. Interestingly, the Financial Select Spider (XLF) has dropped nearly 14% in the same time frame, while Citigroup (C) and Bank of America (BAC) have gotten crushed, down 28.4% and 25.6% respectively. So the feel good rally on bank earnings and Greek crisis “resolution” that drove the nice min-rally in October is clearly over, and playing defense was the right move. What's next?
We are right in the middle of a trading range defined by the lows of early October and the resistance from 1265 to 1285. (In our post from 11/11/11 we said resistance was 1265 followed by 1285. The high since was 1264.25. Good enough for government work). For tomorrow, November 23, the levels look like: Support at 1175, 1160/1162, then a nice little drop to 1120/1122.
Resistance at 1222/1225, with 1260/1265 a very tough level to break through (it was support in June, resistance in October/November).
An interesting part of trading today was the strength in consumer stocks. While the S&P 500 dipped 0.41%, Apple (AAPL) was up 2.03%, Amazon (AMZN) was up 1.63%, Estee Lauder (EL) rose 1.87% and Mead Johnson (MJN) was up 2.61%. Other strong consumer stocks were Autonation (AN) and Whole Foods (WFM). Energy, financials and utilities were the worst performing sectors. While one day doesn’t a trend make, it was notable for the divergence in sector performance.
If You Don’t Know Where You are Going, You Might Wind up Someplace Else. - Yogi Berra
We continue to hold a nearly maximum allowed cash position in the accounts we manage. Since those playing the home game aren’t subject to limits on cash (a topic for a future rant about the mutual fund industry), more is better right now. Markets on are on edge over Europe. In my mind, they should more worried long-term about China, the topic of our upcoming note this weekend. When in doubt, play defense and live to fight another day. There are times to be aggressive in the markets – this is not one of those times. The markets for now are intently focused on Europe to the exclusion of almost anything else. The crisis can only end in 3 ways, 2 of which are bad, the other of which is bad for the Euro. First is default via Greek-style “haircuts” (translation: default), which are now being openly discussed for other countries. Second is the ECB prints Euro and monetizes the debt of all the weaker countries (aka, the good option) – Germany vehemently opposes this option (see this article from the WSJ). It prefers option 1, and then rescuing its own banks with its own money. Third is the European Monetary Union breaks up, the weak countries get their own currencies, and they repay their debts in the new, debased currencies. If you can short Euro, I don’t see much downside in that trade. If anyone has a fourth option, one that "fixes" the problem, please pass it along…
Disclosure: Accounts managed by Jeffrey Miller have positions in AAPL, AMZN, EL, MJN, and the financial and energy sectors. Positions may change at any time, and mention of the securities above is in no way a recommendation to purchase any securities nor is it investment advice. See our Disclaimer Page for more disclosures.
As I write this note at midday on Veterans Day, the US stock markets are experiencing a bit of a relief rally (bond markets are closed). We think this small bounce is a good opportunity to lighten-up on positions you may not love, particularly in companies that are overly exposed to European demand for their earnings. While Greece and Italy have both found temporary caretaker PMs ahead of elections early next year (a change that I don't think was a good idea – see our last note "The Devils We Know"), they still have some significant issues facing them. Greece is definitely insolvent. (Spain and Portugal likely are as well, but in a global game of kick the can down the road, those issues have been booted forward a few years.) Italy is the focus not because it's debt and deficits are worse than Greece's (they aren't) or that their economy isn't able to produce growth in the future (it is – Italy is still one of Europe's strongest industrial nations, and its products are known for their quality and workmanship). It is the focus precisely because of its size and importance in the global economy. Italy is different. It doesn't go in the same bucket as the others. This article in the FT by Nouriel Roubini reads a lot like our recent posts, and captures the issue concisely – Italy is a problem because the Euro structure prohibits Italy from printing money with which to pay its debts. The US doesn't have this issue because when debt comes due, we can simply "print" (although an electronic debit to the account of the bondholder is the reality) more money to pay it back. Hence, no default. Could the purchasing power of the dollars the bondholder receive be lower? Of course – but that's not a default, that's a devaluation of purchasing power. They have different results near term (longer term, they tend to have the same effect).
So while the markets today like the new caretakers and the possibility of more austerity budgets in Greece and Italy, what these deals are really doing is delaying the inevitable. The austerity programs will actually exacerbate the problem long term, as the economies will shrink from less government spending and higher taxes. There are only 2 solutions (and I apologize for repeating myself lately here, but this is the main issue for the markets): either the ECB becomes the buyer of last resort in unlimited amounts, or the Euro breaks up. Since Germany seems unlikely to support unlimited ECB buying, the Euro breakup becomes more likely, which will roil markets globally when it happens. If Germany changes its tune on ECB buying, then the stock markets will go screaming higher, as the real resolution will be at hand. So monitoring the German mood regarding the ECB will be the key to making the right call on the markets going forward. Until then, enjoy the bounce, raise some cash, and play defense. Have a great weekend.
SPX Levels for today:
Support at 1245/1247, then 1235 followed by 1218/1220.
Resistance at 1265, then 1285 has a lot of resistance overhead.
The Devils We know
"To know that you do not know is the best. To pretend to know when you do not know is a disease."
The credit cards are getting cut off. That is what is going on in the markets. Greece doesn't have the money to pay back its debts. Neither does Italy. (Hey psst, over here – let me tell you a secret. Neither does France…but that's a story for another day). Since neither can print its own money to make up the difference, they are cooked, unless the ECB (aka, the Federal Reserve of Europe) agrees to monetize the debt on their behalf. But the Germans want no part of this (see our post from 10/27/11 on Why the Germans Won't Bail out Europe"). So the only solution is for countries that can't pay their debt in essentially a fixed currency (the Euro) to leave the Euro and print their own currencies again.
There was some hope that China and Brazil would be willing to invest in a fund that would buy Greek and Italian debt, allowing them more time to get their GDP going and eventually "earn" their way out of the problem. China made it clear that it is not going to do that in a very interesting interview on Al Jazeera the other day. Jin Liqun, supervising chairman of China's sovereign wealth fund said:
If you look at the troubles which happened in European countries, this is purely because of the accumulated troubles of the worn out welfare society. I think the labor laws are outdated. The labor laws induce sloth, indolence, rather than hardworking. The incentive system is totally out of whack.
Why should, for instance, within [the] Eurozone some member's people have to work to 65, even longer, whereas in some other countries they are happily retiring at 55, languishing on the beach? This is unfair. The welfare system is good for any society to reduce the gap, to help those who happen to have disadvantages, to enjoy a good life, but a welfare society should not induce people not to work hard.
Furthermore, there is no "rescue deal", despite what was announced a few weeks ago. See our post from 10/27/11 titled "I got it, I got it! What is it?" For some reason, the markets seemed to think that the fact that a deal that still needed 17 very different countries to ratify, and the details of which weren't going to be decided until "the future", was going to solve things. At that time, we counseled investors to "tip the man" and go home. As markets are now coming to the realization that the speakeasy is getting raided by the cops, they are jumping out of windows and running out the back door. The question investors are asking is, "What is going to happen from here?". The truthful answer is, we don't know. There really aren't a whole lot of options. But here they are:
The ECB starts buying all the debt of Greece and Italy (and French banks, etc.) that needs to be rolled over. But again, Germany wants no part of this option.
The ECB doesn't buy the debt, so Greece and Italy (and Spain? Don't forget about Spain) all leave the Euro, convert their debt back into Lira and Drachmas, and start printing.
Well, why won't private buyers come in and buy Italian and Greek debt? We have a deal for austerity, right? Let's be clear about something – NO PRIVATE BUYERS CAN BUY SOVEREIGN DEBT IN EUROPE RIGHT NOW. The haircuts that were imposed on private market buyers of Greek debt combined with the voiding of the insurance contracts (CDS) on the same debt make it impossible for private buyers to do so. What isn't being talked about is that when Germany and Co imposed the haircuts but didn't call it a default, they killed the market for those bonds because they voided the insurance on those bonds. Hence why CDS is trading lower – it's not because the risk of default is lower. It's because the governments (via ISDA) changed the rules of the game and confiscated private investors funds, just the same as when Venezuela privatizes an oil refinery or Russia voids an oil deal.
There were 3 disincentives to owning/buying Italian bonds before the Greek and Italian PMs decided to step down. (The markets rallied on these resignations at first, but I have no idea why. I always prefer the "devil I know". The markets for some reason thought that having the 2 biggest problem countries in Europe leaderless was a good thing. The next time some professor tells you markets are rational, show him a chart of the S&P 500 from 2011 and sit back and giggle. There is a reason they are professors and not traders. Traders need to be right to keep their job. But I digress...) Now there are 4 reasons why investors can't buy these bonds:
1. Private Sector Involvement (PSI) undermined the safe haven status of sovereign bonds (which is important because it undermines governments' ability to backstop banks).
2. Changes in ISDA (which governs the CDS – aka, the insurance) which reduces the trustworthiness of the hedge (so if you don't trust the hedge for a position you already don't trust, you sell it).
3. Merkozy banter of booting Greece out of the Euro (threatening to boot Greece doesn't make you feel like they won't threaten Italy/Spain. If that were to happen, the currency devaluation would crush your investment in the bonds).
4. Uncertainty regarding political outlook due to changes in troubled government leadership (i.e. "the devil that you don't know versus the devil you do know.")
Some readers have asked for the stock market support and resistance levels. So here they are, using the SPX. (Note: we use a marker not a pen. Use +- 2 handles on these numbers.) Resistance for today is 1285 followed by big overhead at 1315. Support looks like 1250, then 1225/1228. After that its 1200 and 1175.
This is not a time to be a hero in the markets. The first rule is always protect capital and live to fight another day. This is one of those times. We have a near maximum allowable level of cash in the funds we manage (which could change at any time). As Sergeant Phil Esterhaus always said in Hill Street Blues: "Hey, let's be careful out there."
Family Feud, Financial Edition.
Where’s Richard Dawson when you need him? If we were playing Family Feud, and the host, the aforementioned Mr. Dawson, asked me to name the Top 5 things I lose, my list may have included keys, pens, and track of time. $600 million dollars would not have made my list. Just sayin. I’d like to able to lose track of $600 million, but right now I’m stuck losing a Bic. And yet, somehow, MF Global managed to misplace at least $600 million, give or take a few large, right when its back was against the wall and it was trying to sell itself. Last weekend it looked like it was going to be sold, avoiding bankruptcy, until the potential buyer noticed the small change that was missing from the company cookie jar and called the deal off. Within 24 hours they were gone, filing bankruptcy at 10 A.M. E.D.T. this past Monday.
Now, I don’t know about you, but I still get a thrill when I find five bucks in my jacket pocket. And yet, at about 1:30 E.D.T. today, this headline came across the ticker:
*MF GLOBAL'S MISSING CLIENT FUNDS SAID TO BE LOCATED AT JPMORGAN
*MF ACCOUNT WITH $658.8M IN CLIENT FUNDS SAID TO BE AT JPMORGAN
How cool must it be to find almost $659 million just sitting in an account at JP Morgan? Of course, the thrill of finding $659 million is tempered by the knowledge that if you had been able to, oh, I don’t know, not lose it in the first place, maybe you’d still have a functioning company. MF Global is saying that when it was busy liquidating $26 billion in assets to raise cash last week, that some brokers were slow to pay. As an investor for over 17 years, I can vouch for the fact that sometimes the brokers don’t pay right when they should, although it is fairly rare. But what I can’t vouch for is not knowing that you were owed the money in the first place. Simply losing track of over $600 million precisely when you need the money the most is just stupid. Maybe next time they’ll really follow the money.
Read the Wall Street Journal article on the found money and Corzine’s exit here.