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).