"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 I think the labor laws are outdated.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."