"It's always darkest before it turns absolutely pitch black." - Paul Newman
I am loathe to write about Europe again, but since it is the topic du jour (and du mois and de l'année) I feel like a bit of history is in order. The sovereign debt crisis in Europe appears to be eerily reminiscent of what happened in the U.S. during the recent (circa 2007-2009) financial crisis. The U.S. followed a similar "it's all ok" pattern of government responses to a series of problems. While the headlines focused on issues in a large, liquid market that was theoretically immune from principal risk and therefore could be highly-leveraged in short-term or overnight markets (U.S. mortgage-backed securities then, European sovereign debt now) and the failure of a large investment bank with too much exposure to that market (Bear Stearns then, Dexia now), the real troubles were brewing in the so-called "shadow banking" markets of commercial paper and short-term interbank lending. What caused the ultimate demise of Lehman was that the markets ceased to trust its viability from a short-term liquidity standpoint – which caused the short-term liquidity event. Perception in banking becomes reality. This same fear quickly spread to Goldman Sachs, Merrill Lynch, Morgan Stanley, AIG and other companies without access to bank deposits or the Fed borrowing facilities. (For a great recap of this contagion, watch or read Too Big to Fail by Andrew Ross Sorkin – I thought the HBO movie version was excellent).
But wait, this time it's different, right? Europe's central bank, the ECB, is on top of this situation. It recently agreed to lend to banks for 3 years, trying to alleviate the short-term funding pressures that are building. But in a sign that European banks don't trust each other, overnight deposits at the ECB are at an all-time high, reaching $590 billion overnight on December 27th, 2011. For an interesting historical parallel, we can read Tim Geithner's speech titled Reducing Systemic Risk in a Dynamic Financial System on June 9, 2008 (after Bear Stearns' forced sale and other mortgage-market problems surfaced) while President of the Federal Reserve Bank of New York.
The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles. The system appeared to be more stable across a broader range of circumstances and better able to withstand the effects of moderate stress, but it had become more vulnerable to more extreme events. And the change in the structure of the system made the crisis more difficult to manage with the traditional mix of instruments available to central banks and governments.
First Repair, Then Reform
What should be done to reduce these vulnerabilities?
"Oooo... It's the Big One... You hear that Elizabeth... I'm comin' to you, I'm comin' home to Georgia." Fred Sanford, Sanford and Son
Is this it? Is this the big one? Are we a "comin' home" with this move? Trying to figure out if this latest market upswing is the start of the big rally people have been waiting for (or if it's a head-fake) is the all-consuming market issue. Figure that out, and you'll end up looking like a hero into year-end. But if you're a portfolio manager managing an underperforming fund and you get it wrong, you'll be spending New Year's working on your resume.
Lamont Sanford: They're predicting a massive earthquake on November 6.
Fred Sanford: November 6? That's only five days away!
Lamont Sanford: Don't worry about a thing, Pop, it's not possible.
Grady Wilson: Oh I beg to differ with you, Lamont. Today is November 1, and it's extremely possible that November 6 is only five days away. Sanford & Son
Unfortunately, like Fred Sanford, this uncertain market is likely to be around with us for awhile longer. There are too many structural and solvency related issues in Europe (we covered Why Europe Matters to US Stocks in last week's article) and it's "extremely possible" they will rear their ugly heads in the new year. So buy and hold here probably won't work. Buy and sell? That will. Be nimble, and while this move (which is real and is based on the ECB relieving some, but not nearly all, of the funding pressures that were strangling the European financial markets lately) is nice, we're fast running into resistance headwinds here. Taking profits is the smart move.
If you waited until the XLF hit that $12.10/$12.20 support on Monday and bought the basket from last week (Citigroup (C), JP Morgan (JPM), US Bancorp (USB), PNC Financial (PNC), Goldman Sachs (GS) and Lazard (LAZ)), you're up about 10-13% in those names. Take the gain and go, and wait for the chance to do it again. When the "big one" in Europe reveals itself, then you can buy and hold – but only after the massive selloff. Until then, an itchy trigger finger is a good trigger finger.
Some stocks that are still sitting near their lows that look interesting are Thermo Fisher Scientific (TMO), Covidien (COV), Cummins (CMI), and Freeport McMoran (FCX). They all have strong businesses and high returns on invested capital. Take a look.
The S&P 500 is rapidly approaching some significant resistance levels. The market seems fixated on the 200 day moving average around 1260. That also happens to be a level with a lot of resistance from November and early December. The odds favor a rollover there.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1205/1210, then 1193/1195 and 1180/1182.
Resistance: 1260, then 1265/1266 and 1285/1287.
Enjoy the holidays!
Positions: C, LAZ, CMI, TMO, FCX, COV. These could change at any moment.
"On a long enough timeline, the survival rate for everyone drops to zero." – Tyler Durden, Fight Club
So the much hyped EU summit came to pass last week and what exactly happened is still up for debate. What isn't up for debate is that whatever deal it is that they agreed to is not going to do anything to alleviate the funding and solvency issues facing the weaker EU countries anytime soon.
The U.K. caused a bit of a stir (ok, quite a bit of a stir) by vetoing the proposal that Merkel championed to lock all the E.U. member nations into a very tight deficit spending range. Apparently the leaders of the other E.U. countries were shocked (shocked I say!) that the U.K didn't quite feel like throwing itself into the death spiral that the other EU countries seem so eager to enter. But the question that apparently went unasked in the Merkozy pre-summit prep was "Why would they?" Given the high levels of EU sovereign debt, adhering to the tight deficit targets effectively means that all future deficit spending will go to pay interest on existing debts. No net fiscal stimulus will be forthcoming from member governments. But given the huge role that governments play in European economies, and the inefficiencies with which they operate, this effectively means that even strong growth in the private sector will create only tepid growth overall. Hence, net tax revenues won't grow. So in order to pay down the debt, the governments will eventually have to tax private capital and income even more than they already do. The result for Europe: a recession combined with higher taxes. The survival rate for equities in Europe isn't looking so good. Tyler Durden was on to something.
So why is the U.S stock market so fixated on European government bonds and the Euro these days? For two reasons – one, the U.S. is not decoupled (remember that phrase from a few years back? Ah, the good old days…) from Europe or the rest of the world – problems in financial markets there bleed into our markets and are driving a lot of our daily market moves. Second, many U.S. companies get a large portion of their earnings from Europe, and as the Euro weakens (which we have been predicting for the past month or so) those earnings translate into fewer U.S. dollars. For example, according to the Financial Times, McDonalds (MCD) gets 40% of its sales from Europe. Hence, lower earnings and lower stocks. So, for the time being, we have to watch the unfolding drama in Europe and try to mitigate the risks to our portfolios from the fallout as best we can.
It's only after we've lost everything that we're free to do anything. Tyler Durden, Fight Club
There is a silver lining to the crisis. The welfare states that created much of the current crisis are rapidly being downsized. Italy is moving the fastest and is the most likely of the troubled countries to emerge from this crisis in strong condition. Raising the retirement age and reducing retirement benefits were good steps towards getting its fiscal house in order. Greece unfortunately continues to battle strikes and other unrest over the similar reforms that it needs to make. But eventually the Greeks will have to either wipe the entitlement slate clean, or leave the Euro and default, wiping the debt slate clean. If they lose the entitlement mentality, they will be free to build a functioning society. But not before.
Our prior market calls to short Euro and sell the rally a few weeks ago continue to look good, but we are approaching some support levels fairly rapidly. The XLF looks to be about 3% or so away from decent support around $12.10/$12.20. Focus on the big U.S. banks if you want to take a shot, and continue to avoid the European financials. Citigroup (C), JP Morgan (JPM), US Bancorp (USB), PNC Financial (PNC), Goldman Sachs (GS) and Lazard (LAZ) would make a nice little bank basket. Away from financials the recent selloff in Amazon (AMZN) makes it very interesting in here, and if you want to play commodities (gold and copper), the recent drop in Barrick Gold (ABX) from $53 to the mid $40s is mighty tempting. Las Vegas Sands (LVS) is getting to good levels here – maybe buy half and see if you can get the rest in the $37/$38 range.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1200/1205, then 1193/1195 and 1180/1182.
Resistance (not that I think we're going to hit it this week): 1232/1235, then 1244/1246 and 1260/1262.
Positions: Lazard (LAZ), Amazon (AMZN), Barrick Gold (ABX), Las Vegas Sands (LVS), all long.
The EU meetings tomorrow should open with a reading from De Vita Caesarum by Suetonius in AD 121: "Ave, Imperator, morituri te salutant", or "Hail, Emperor, those who are about to die salute you." Then at least we'd know they understood their predicament. Because as it stands now, it's fairly clear that despite all the talk of closer fiscal union, ECB rate cutting, and EFSF leverage, the leaders of Europe just don't get that they are about to die. Not literally, but as a functioning, unified, growing economy, they are done. As we enter the holiday season, it's more likely that Santa Claus is going to come down my chimney with gifts for my girls than it is that somehow the EU is going to get all 27 EU members, or all 17 Eurozone countries, to agree to anything quickly. There are serious doubts that the EU can fast-track anything that cedes individual national control over budgets to a central authority – instead, each of the member states will have to get parliamentary approval for changes, and some will need a referendum as well. For more information on the 28 changes to the EU treaty that would need to be made, see this interesting article by a member of European Parliament and this article on the Euro issues by Paul Krugman.
The downward spiral has begun (and I don't mean the Nine Inch Nails album unfortunately). Europe's sovereign bonds are untouchable for private market buyers (aka, non-governmental buyers), except for those banks based within an issuing country that are getting a royal arm-twisting to buy their own countries' debt – which is just more deeply embedding the virus in the banking system and making it more likely that a banking crisis will hit various European countries in the next year or two. Mutual funds, money market funds, and non-European banks are avoiding these bonds like the plague. But why you ask? Aren't they going to "fix" things? Oh, they fixed things alright – this virus germinated when Merkel insisted on "private market participation" in the Greek crisis and then called it "voluntary", which had the fatal effect of voiding the credit default swaps on that same debt. Think of it this way: if someone puts a gun to your head and demands your wallet, were you robbed or did you make a "voluntary" charitable donation? Does the thief have to snatch it from your hand for it to be a robbery, or because I handed it over to him, even under gunpoint, was that then voluntary? What the #$%@^?
Why Yesterday's Stock Market Rally Is a Head Fake
In case you were out on a walkabout in the Outback and missed Wednesday's stock market action, the S&P 500 (SPX) had a massive 4.33% move upward. There were 3 causes of the move.
First, China cut its reserve ratio requirement by 50 basis points overnight, (which is the most effective means it has for trying to boost bank lending), which sent the markets up a bit over 1%. This is the first time since 2008 they have done so, indicating that the recent weakness in housing and construction markets in China is bad enough that officials acted aggressively today. But the part that should have investors worried is that the Chinese economy is hitting a wall despite massive amounts of bank lending (aka, deficit spending) equal to at least 37% of GDP in each of the last 3 years. Read this Wall Street Journal article for more details. The reserve cut is a sign of weakness. Buyer beware.
Second, there was coordinated global central bank action to lower swap rates for European banks borrowing dollars. Effectively, the Fed, ECB and other central banks are trying to make it attractive for banks in the Eurozone to borrow dollars directly from the ECB instead of in the private or interbank markets – this mainly has the effect of keeping LIBOR down a bit and possibly easing a liquidity crunch that was (appropriately) seeping into European markets. This was good for another 2% or so move in the markets. However, this does nothing to solve the underlying credit issues that are plaguing Europe, but merely postpones the day of reckoning a bit. For more information on how these Central Bank swap lines work, click here.
The third reason for the move was that the markets were oversold and trading on light volume (which makes the sustainability of the move suspect). Despite the big move on "news", the markets stopped dead in the middle of the resistance band of 1245/1250 on the SPX, which I noted in my recent post. From here, I expect a sideways consolidation in U.S. stocks for a day or two, probably followed by another leg down next week when the hype is replaced by reality. Why the long face? Read on.
More swap lines aren't going to change the reality of insolvent countries, which is the real issue that hasn't yet been addressed. In fact, I suspect Wednesday's Central Bank action was directly related to the pressure that European countries are putting on their own banks to buy their sovereign debt. That's right, the same governments that are telling them to raise large amounts of capital (via the European Banking Association new capital rules set to go into effect in June 2012) are also pressuring them to buy the debt of their own countries. And you thought U.S. lobbyists were bad? Read this Wall Street Journal article – it's eye-opening. So the banks that are being force-fed bonds are being given a little push by having their borrowing costs lowered a bit. However, when you are looking at 40%-50% "haircuts" (read: losses) on sovereign debt and the voiding of the credit insurance on that same debt, you could lend me 100% of the purchase amount at 0% interest and I still wouldn't touch that deal. 50 basis points on funding versus 40% losses on principal? No thanks, I can lose my money in Vegas and at least get a free drink and $3.99 buffet coupon.
So while the markets Wednesday liked the new swap lines and lower reserve requirements for Chinese banks, those actions are simply delaying the inevitable. The austerity programs that Germany wants strictly enforced will exacerbate the problem, as the affected economies shrink from less government spending and higher taxes. There are only 2 solutions: either the ECB becomes the buyer of last resort in unlimited amounts, or the Euro breaks up. Since Germany seems highly 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. And right now the mood isn't good. US banks like Citigroup (C), Bank of America (BAC), JP Morgan (JPM), Goldman Sachs (GS) and Morgan Stanley (MS) will be the ones to buy on the selloff when the Euro break-up occurs, but not before…patience young Skywalker. Until then, enjoy the bounce, raise some cash, and play defense. It's best to heed the advice of Public Enemy and "Don't Believe the Hype".
Support and Resistance levels for the S&P 500 (SPX) are:
Support: 1235/1238, then 1228/1230 followed by 1218/1222. Below that its 1198/1202.
Resistance: 1246/1250 has a lot of resistance, with a little at 1255 and a big level at 1264/1266.