"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. 12/8/2011 Don’t be the Rabbit: The EU and ECB meetings this week can’t fix Europe or US Stocks.Read Now 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. 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, Signifying nothing." 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. "To know that you do not know is the best. To pretend to know when you do not know is a disease." -- Lao-Tzu 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." |
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