Germany Says No!

In my last post I highlighted a recent interview by George Soros where he outlined a solution for the Eurozone’s problems – Eurobonds; however, Germany was against that plan.  Why?

Politically it is unpopular.  German citizens are essentially paying for problems in other members.  To me this seems a bit unfounded as Germany is a creditor nation, meaning they lent the money to the indebted nations in the first place.   

Since Germany lent the money to these countries, a default or financial crisis from a Euro unraveling would certainly have a major adverse impact on the German economy.  It logically follows that the rest of the Eurozone and global economy would also suffer.   As a result, at some point there needs to be a universal solution as the pain will be felt by debtor and creditor nation alike.

Currently indebted nations are cutting back on public spending, experiencing falling wages, and reducing social safety nets.   The markets still aren’t buying that this will solve the crisis – sovereign interest rates are rising and European bank shares are falling.  Further, those nations are experiencing more social unrest as a result of the measures taken to date.  As this builds, so does the geopolitical risk.

Basically the action taken to date appears to be grossly inadequate.

Is the solution Eurobonds?  I don’t know with any certainty; however, the risks associated with a Eurozone collapse are great.  As such, we have to see a discussion of real solutions sooner than later and Eurobonds should be one of the options on the table.  Like most problems there is no magic bullet, and it will require multiple tactics as things evolve.

Soros on Europe

George Soros is arguably the most well known, highly successful macro hedge fund manager around.  In a recent interview he sat down with Der Spiegel to discuss the issues facing the Eurozone, among other things.

I have commented on the main issues before, but Soros outlined why these problems need sorting out as well as some potential solutions.

Essentially he states:

1. A Eurozone breakup would lead to a banking crisis that would spiral out of control. 
2. A European fiscal authority is needed to re-finance indebted members on more reasonable terms. 
3. To do this the authority would issue Eurobonds.
4. These bonds would be backed by the union.
5. Germany, being the largest country with the best credit rating and largest surplus in the EU, is essential to making this work.

In short, the Eurozone acting as a whole would issue bonds to help member nations that are financially under pressure (Greece, Portugal, maybe Italy, etc.).  These bonds would in part be backed by Germany who is the key player in the whole process.

Seems good to me.  The problem?  Germany doesn’t want any part of that quite yet. 

My next post will comment on Germany’s objections, as well my take on what they should do.

Revisiting Quantitative Easing

Much of the sell-side research we get is hinting that more quantitative easing in on the way.  Here is a Bloomberg article that highlights this.  This would be QE3.

In the past I have highlighted that QE didn’t appear to accomplish much in the real economy (as opposed to the financial markets).  Further, the Pragmatic Capitalist has an extensive list with graphs on how QE2 turned out.  Here are the highlights:

• Private sector lending did not increase
• Unemployment was not reduced
• Consumption didn’t increase
• GDP didn’t pickup
• The dollar moved down and exports moved up.
• In the meantime, it appears the initial positive effect on equity markets has evaporated as the S&P 500 is close to the value it was when QE2 was announced.  
• Many commodity prices have also pulled back, although are still higher than they were last August. 
• Interestingly, Treasury yields rose as the Fed purchased longer-dated Treasuries and fell when the purchases stopped. 

Thus, I still don’t think more QE is the answer and my points are the same as they have been all along:

1. QE2 doesn’t appear to have a substantial impact on the real economy with the exception of commodity prices and exports.
2. The resulting increase in commodity prices actually hurts the consumer.
3. There was an increase in exports, which helps growth; however, given the lack of pickup in GDP this was negated by other factors.
4. It does seem to impact equity and commodity markets; however, that appears to be temporary. 
5. The Treasury market didn't seem to move at all.

How Rare are “Black Swans”?

“Black Swans” are rare events by definition.  However, I would contend many of the events that people classify as “Black Swans” happen with greater regularity than most think.  Doug Kass compiled a list (via Barry Ritholtz) of “Black Swan” events in the last ten years:

• Sept. 11, 2001, attacks on the World Trade Center and Pentagon;
• 78% decline in the Nasdaq;
• 2003 European heat wave (40,000 deaths);
• 2004 Tsunami in Sumatra, Indonesia (230,000 deaths);
• 2005 Kashmir, Pakistan, earthquake (80,000 deaths);
• 2008 Myanmar cyclone (140,000 deaths);
• 2008 Sichuan, China, earthquake (68,000 deaths);
• Derivatives roil the world’s banking system and financial markets;
• Failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
• 30% drop in U.S. home prices;
• 2010 Port-Au-Prince, Haiti, earthquake (315,000 deaths);.
• 2010 Russian heat wave (56,000 deaths);
• 2010 BP’s Gulf of Mexico oil spill;
• 2010 market flash crash (a 1,000-point drop in the DJIA);
• Surge of unrest in the Middle East;
• Thursday’s earthquake and tsunami in Japan

Now frankly I don’t recall all of these events; however, all of them had a drastic human toll and/or economic toll.  So when it comes to portfolio management, and as the linked articles allude to, a few important things stand out:

1. “Black Swan” events are more frequent than one probably anticipates
2. “Black Swan” events are drastic
3. “Black Swan” events are unpredictable
4. Given the first 3 bullets an investor should probably have a plan in place when a “Black Swan” event happens

To elaborate on the last bullet, I am not advocating building a portfolio around the extremes (except in a few possible cases).  What I am saying is that the time to plan for a “Black Swan” event is not after an event, but beforehand given that you don’t know when such an event will take place.  Put it this way, the time to buy insurance on a house is not when it’s on fire. 

Short-Selling Isn’t So Bad

First, short-selling is when I borrow shares and then sell them.  I buy those shares back at a later date and return them to the lender.  If the stock moves down I make money. 

For example, I borrow a stock at $45 and sell it.  I get $45 in cash.  A few weeks later the stock is at $35, I buy it, and return the shares.  I made a $10 profit. 

I tend to think short-selling gets demonized by many, especially corporate executives looking for an excuse, but it serves a very useful purpose:

• Price Discovery.  Increased selling pressure helps stocks find their true value.  Let’s say a stock is trading at $50 a share.  A short-seller believes the true value is $30.  In this instance the short-seller is correct and the stock is worth $30.  The market will eventually reflect this value; however, the inability to short-sell the stock will only make the stock’s fall to $30 more drawn out. 
• Short Covering Rally.   When markets crater, short-sellers often put a floor on the losses.  Why?  They lock in their gains by buying the stock back.
• Liquidity.  The more traders of a security the more liquid.  The more liquid a stock is the easier it is to enter and exit a position.  More short-sellers = more traders = more liquidity.      
• Hedging.  Being long a stock and going short in the same stock can help mitigate loses. 
• Finding the Truth.  It helps expose companies like Lehman.  If a short-seller can illustrate effectively why the company is worth less than the market perceives it, he or she can assist in finding the true value of a company. 

Further, executives and commentators are usually pumping up a stock.  Why isn’t that rumor spreading met with the same vitriol? 

There are probably more reasons why short-selling is a necessary evil.  I just wanted to provide a bit different perspective by illustrating why short-selling bans, like what is taking place in parts of Europe right now, are at best ineffective (price discovery) and at worst harmful (short covering rally, liquidity, hedging, finding the truth).

Don’t Have Nightmares

One of the things that gets lost in the “buy/hold/sell” debate is how investors will sleep at night.  I bring this up now given the recent volatility in the market place. 

 

Looking at the short-term, could this be a quick move down before we move higher by the end of the year?  Of course it could be.  Corporate earnings are still very good and the macro data, while troubling, still seems to indicate expansion.  

Could it also prove to be the start of a larger move down?  Of course it could be.  There is no shortage of headwinds and secular bear markets can be quite choppy.

When coupled with my last post, what I am getting at is that regardless of where we go in the near-term I am pretty certain increased volatility and uncertainty isn’t going away for awhile. 

Depending on your risk tolerance, outlook, and/or time horizon it could be beneficial to take some risk off the table, increase cash, add hedges, and/or adjust your allocation.   On the flip side, you could also see this as a buying opportunity and add risk accordingly.

Regardless of your decision, one of the most important factors is that you understand the risks you are taking and are comfortable with your overall portfolio allocation.  If you are up at night worrying about your money, it’s time to get a better handle on risk and possibly re-evaluate your allocation.  

My Thoughts on the Recent Market Volatility

No one can fully explain the market movements.   Thus, here is a broad list of fundamental data or happenings that may have helped sparked the last few wild weeks:

• Weakening macro data that could lower earnings estimates.
• European debt problems seem to be escalating with focus moving from the PIIGS to Italy and French and German banks.
• Lack of confidence in Washington.
• Possible overheating in emerging markets.  Emerging market equities have performed worse than domestic equities this year.

I am 100% sure this list doesn’t include everything, but I don’t think it’s a stretch to say these are some of the bigger headwinds.

What I am struggling with is why any of the above would lead to increased volatility now.  When I read that list, it contains nothing that in my opinion should sneak up on investors.  Thus, I have come up with a few possible reasons on why now:

• Psychology.  There was a catalyst that got people selling, once they started others got nervous and pulled the plug.
• Margin Calls.  As the market starts moving down hedge funds or institutions that buy stocks on margin (borrowing to buy stocks) get margin calls (they need to put up cash to meet the loan).  To get cash, investors sell stocks, which in turn puts more downward pressure on stocks and leads to more margin calls.  It’s a viscous cycle.
• Computer Trading.  This I am less sure about.  However, since a lot of trading happens in milliseconds at predetermined prices, I don’t think it’s a stretch to say that once markets were moving down algorithms started saying “sell” making markets move down even further.

While this may not help you make a decision on how to play this – everyone is different and thus strategy will change accordingly – I hope this can help you start to wrap your head around the situation.    

Don’t Get Emotional, It Can Cloud Judgment

If you have a large, unhedged position, yesterday was probably the time to put in some sort of risk control.   Further, if your position reflects one of the following characteristics, you may have developed “blind spots” and/or an emotional attachment:

• Owned a position for several decades
• Experienced a nice return along the way
• Have a good sense of security
• Been generously compensated in company stock
• Someone who recently inherited a large position

This attachment may cause you to lose sight of some risk factors including under-performance, a changing macro landscape, mismanagement, or fraud, among other issues that can destroy capital.  Recent instances of these risks are not hard to find: GE, AIG, and Enron, are fine examples of what happens when good stocks go bad.  Further, it’s conceivable that if you had blind faith in any one of those stocks, you could have ridden them to the bottom. 

Will most stocks end up like that? There is a high probability that they won't; however, not having adequate risk controls on a large position can destroy capital if you convince yourself the stock will turn around on the way down.

We use strategies as simple as selling at various targets or shaping the portfolio around that position to more complicated strategies like using derivatives.  Everyone is different, so if you use a risk management strategy make sure you pick the one that is right for you.

1937, or Why I Want More Short-Term Spending

I have mentioned on many occasions that I think the Federal Government should increase stimulus spending in the short-term.

And in my last post I outlined how the Feds tightened monetary policy and decreased spending in 1936 and 1937.  So here are a couple consequences. 

• GDP sank:

•  The unemployment rate went from 9.2 in 1937 to 12.5 in 1938. 

With a quick glance at my previous post, you can see when spending picked up both GDP and unemployment started to look better.  The money supply also increased again.  

Now is it possible the monetary and fiscal contraction were not the cause of the 1938 recession?  Or that maybe only monetary or fiscal policy matters?

Of course; however, given the past fallout from such contractionary policies I don’t believe it is prudent to do either at this moment.  This is especially true since inflation and interest rates are low.  As such, the risk/reward trade-off of cutting back seems heavily skewed toward risk. 

1937, a Primer

In the late 1920’s we had a massive credit bubble collapse, we then loosened the money supply and increased Federal spending to help improve the situation.   In the later part of this decade we had something similar. 

Here is what happened in 1937.

First, the Fed tightened monetary policy.  Starting in 1936 and through 1937 the Fed doubled reserve requirements (the amount of cash a bank must hold relative to its liabilities).  You can see how the money supply dropped here.

Less money = less lending = less borrowing = private sector contraction = recession. 

Now it is possible that if Federal government spends money it can counteract the drop in the private sector, along with an increase in exports (GDP = private consumption + private investment + government spending + net exports).

Did the Federal government spend in 1937?  Nope.  They also raised taxes.  

So to conclude, things were starting to look better later in the 1930’s; however, the Feds tightened monetary policy and decreased spending.  In my next post I will cover the fallout from that and why I think it’s dangerous to follow a similar path now.

The Debt Deal is Done – Yay

I am glad a deal got done, but I am not yet willing to throw a party with magicians and piñatas. 

I will start good news:

• We won’t default, which I viewed as political issue, not a solvency issue.
• The spending cuts won’t be drastic and immediate like Greece.   

And now the bad news:

• The USwas still get downgraded, although I am not sure how bad this actually is for interest rates.
• It showed how poorly we are governed.  I don’t think anyone in Washington came out looking good after this.  Politicians took something simple and necessary and turned it into a school yard name calling contest.
• The deal signifies any future stimulus is probably out of the questions.  As I have mentioned before I think short-term spending is still needed. 

I think how you evaluate the deal depends on your perspective.  If you evaluate it on a possible catastrophe being avoided then it’s a huge success.  However, if you take Armageddon out of the equation as I did (I never thought we would reach that point), the apparent removal of fiscal stimulus from the equation is not a good thing.

Note:  I didn’t mention anything about long-term fiscal health because I couldn't find an objective point of view.  So if you find one feel free to forward it along.

Commodity Bubble?

John Hussman recently showed the chart below:

As chart notes, commodity prices over time have not risen indefinitely without pulling back to flat or neutral returns.  This isn’t to say commodities can’t rise further, as bubbles can continue much longer than expected.  Ray Dalio, founder and chief investment officer of Bridgewater Associates, notes the commodity bubble can last “until China and those countries become too tight, and that's probably not until late 2012”.

It appears that commodities are a bubble and will pullback at some point.  The combination of easy monetary/fiscal policy, market psychology, emerging markets demand, supply shortages, etc. have certainly helped elevate prices over the last decade; however, it doesn’t seem likely that commodities can continue in this uptrend forever.  The big question is when the bubble will begin to deflate and that is anyone’s guess.  Regardless, commodities can still play the role of diversifier or inflation hedge in the portfolio. 

Active versus Active: Is That Really the Issue?

We get inundated by research, which compares active management - managers who try  beat a certain benchmark - against passive management - managers who try to mimic a certain benchmark.

Most of the research presents a compelling conclusion for the use of all passive or all active managers.  However, after a good hard look, the evidence that supports such claims is highly skewed.  In my opinion, "There are three kinds of lies: lies, damned lies, and statistics." It’s easy to make the case for passive or active when you cherry pick the data.  The reality is that there are sound reasons to use each.

I do find a compelling case to put one kind of management at the bottom of the list – the closet indexer.  The closet indexer is a manager who is classified as active, but in fact holds a lot of stocks, keeps sector weightings close to that of his or her benchmark, and/or rarely deviates from the benchmark.  There is no reason to pay active management fees, which are higher than passive management fees, for someone who by and large will perform relatively close to the index.

That isn’t to say I want my active managers taking an inordinate amount risk.  However, I do want them to earn their fees by doing diligent research, creating value, and beating the index over a full market cycle.  If an active manager simply owns the same securities in the same weighting as the index, he or she can’t beat it.  

The Debt Ceiling is Stupid II

Raising the debt ceiling should be simple.  We print our own money so in my view we technically can’t default.  Thus, this is NOT a solvency issue.  We pass the debt ceiling increase, create more money, and pay our bills.  

Instead, this is a political issue. The Republicans want cuts in spending in order to raise the debt ceiling.  Fair enough, increased spending and excessive money printing certainly have the potential to be inflationary and cause interest rates to rise. 

However, neither inflation nor interest rates are an issue now and much of the Federal Debt issue seems to by cyclically induced by the financial crisis and “Great Recession”.  This is why I think the spending compromise should focus more on cuts long-term while increasing stimulus spending in the short-term.

So when I take into consideration our current issues with spending (listed above) and the consequences of not passing the debt ceiling, I can’t think a deal won’t get done.  Right now we are witnessing a partisan standoff where next year’s election and appealing to ideologues take precedent over pragmatism at the expense of the American people.

Update: A deal is done and Rome lives another day as our heroes save us from disaster.