Straight Talk on Markets: 2011

Friday, December 2, 2011

US to the rescue!

But can the US save the world?

Raul Elizalde - Friday, December 2 2011

Thanksgiving week was a tough one. According to newspaper articles, the stock market had the worst Thanksgiving week since 1932. Never mind that Thanksgiving only became a US federal holiday in 1941: by any measure, the market was unquestionably lousy.

That was then, and this is now. Merely a week later the US stock market is finishing the best week since March 2009, which itself was one of the best ever. This is by now a familiar tale: euphoria one week and despair the next, most of it due to the unpredictable turns of European policy. Most market participants have become hopelessly confused.

We will spare the reader from a detail account of all the ups and downs since early August. Suffice to say that the enormous volatility of the last few months is due not only to violent swings in confidence, but also to the desperation by market participants to be the first ones in –or out. The prevailing sentiment seems to be that if everything turns out to be fine, the market will explode to the upside; but if things turn out to be bad, the market will implode and there will be no time to get out. Is this true?

One thing seems undeniable: everyone is sprinting back and forth because nobody knows in what direction “fundamentals” are pointing. For all the rhetoric about staying the course, investing for the long term, looking for solid companies with a story of increasing dividends, etc. etc. the fact is that if the eurozone breaks up, China hard-lands, or the US falls into a new recessionary cycle, all that you-must-look-beyond-the-horizon advice won’t prevent huge portfolio losses that could take years to repair, just as it happened in 2008.

By the same token, we are not convinced that even if the “fundamentals” turn out to be good, the market will move up explosively and quickly plateau at a higher level, condemning those who didn’t dare to bet early to a future life of regret.

Notwithstanding the finger-on-the-trigger atmosphere of the moment, building up to a market that can sustain steady returns like the recent bull markets of 1982-2000 or 2003-2007 will take time. Large swaths of the economy – housing and the banking sectors, for example – have a long way to go. Setting sail in the middle of the squall could give you a head start, but it can also sink you. Waiting for fairer weather may be a more reasonable strategy, especially for those investors nearing retirement or who may no longer be in their asset-accumulation phase.

With this background, how should an investor interpret the latest US data? Corporate leverage is at its lowest in 25 years, corporate profits are at a record high, retail sales are strong, unemployment seems to be falling, and manufacturing data released this week shows a surprising pick-up in activity. US banks’ assets, if not stellar, at least seem sufficiently understood and provisioned against to preclude an unexpected banking crisis. Are these not the signs we were waiting for to know that things are finally stabilizing, that the time to plunge into risk assets has arrived?

A cooler analysis may make you wonder whether the US is in such great shape that it can help the entire world to emerge from the current woes. While the US is stepping on firmer ground, Europe is sinking deeper and deeper in what the Governor of the Bank of England just this week called “an exceptionally threatening environment” that threatens to “spiral” into a full-fledge crisis and unravel the eurozone. Never mind that the French President Nicolas Sarkozy just stated that a breakup of the eurozone would be the “demise of Europe”: some European businesses are starting to stress-test their processes to prepare for just that.

According to the Institute of Supply Management, “the downturn in demand at Eurozone manufacturers deepened to the most severe since May 2009, while China and Japan saw new business drop at the fastest rates for 32 and 7 months respectively.” This is in contrast to the US, which reached a 7-month peak. (Graph: Financial Times)

All this is happening while Europe is falling inexorably into a new recession. Manufacturing data shows that factory output there has been steadily declining for months and is now contracting (see graph). Unemployment in the periphery is astronomical (close to 50% among the youth in Spain), and European banks are in such dire need of financing that six central banks – the US Fed along with the central banks of Europe, Switzerland, England, Canada and Japan – had to step in to provide desperately needed liquidity to prevent the system from seizing up. That the market thought this was good news was met with most analysts’ stupefaction.

So it all boils down to an image that a cartoonist could easily conceive. Above the precipice is the US, pulling on a rope labeled “world economy” which European countries, dangling above the void, are grasping with all their might while squabbling among themselves. Somewhere in between is China, which having been on the side of pulling is now sliding toward the edge of the cliff, dragged down by a surprising downturn in exports, manufacturing activity, and falling real estate values. A crucial detail in this cartoon is that the “world economy” rope is tied around one of Uncle Sam’s ankles, which eliminates the option of letting go. As much as one may want to bet on the US’ newly found strength, nobody yet knows whether it will be enough to pull everyone up and prevent a nasty fall.

Raul Elizalde | raul@pathfinancial.net

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Friday, November 11, 2011

Rise of the Vulcans

The deployment of scientists is not enough to save Europe
Raul Elizalde - Friday, November 11 2011

History would often make you believe that humans are spectators instead of protagonists. People act sensibly and yet catastrophes materialize, seemingly out of nowhere. Only in hindsight one can see where people got it wrong.

How will history judge 21st century Europe? As the euro experiment got under way at the turn of the century, even naysayers started to believe that the experiment was a success. Interest rates in different countries converged, peripheral economies thrived, and Germany became the largest exporter in the world. What started as a political gamble was on the way to becoming a macroeconomic triumph.

Twelve years on, the same politics that gave birth to the euro now threaten to destroy it. Growing nationalistic pressures in Germany and the Netherlands, exacerbated by economic failures and political unrest in Greece, Spain and Italy pose a fatal risk to the eurozone future.

Where people went wrong has now become apparent. European banks have become huge and are bloated with government bonds. Germany has amassed an enormous bill against its neighbors. Large swaths of private debt have been or will be transferred to the public. Unemployment is soaring. As these problems grow out of control alarms go off and expert help is summoned to the rescue.

Enter Mario Monti, the future Italian prime minister (that is, if Berlusconi steps down) and Lucas Papademos, his counterpart in Greece.

Monti is credited with the “Klein-Monti Model” to describe monopolistic banks and has written papers for publications such as Mathematical Methods in Investment and Finance. Papademos is an MIT graduate with degrees in physics, electrical engineering and economics, and recently co-edited a book titled “Enhancing Monetary Analysis.” Monti taught economics (including fifteen years at the University of Turin) and worked at the European Commission. Papademos taught economics (including nine years at Columbia University) and worked at the European Central Bank. These impeccable credentials have pleased the bureaucrats in Berlin and Brussels.

But the fact that these luminaries are thought to be the right people to convince masses not to smash building facades for material to hurl back at riot police speaks volumes about the emotional fatigue of Europe’s ruling political class. Unable to steer the continent back to course, they have called the technocrats for help. This might well be the biggest blunder of all. Technocratic expertise alone will be insufficient to tackle the current challenges.

What is urgently needed is political skill precisely to permit the implementation of highly technical and unpopular solutions. As the Financial Times recently noted, successful politicians are those who master the art of the politically feasible, not those who start their speeches with words like “liquidity facility.”

Pushing austerity down the throat of populations where unemployment approaches 50% (such as among the youth in Spain) or forcing a brutal shrinkage of the state where one third of the workforce is employed by it (such as in Greece) may make sense to those who teach macroeconomic theory. The masses will remain unconvinced.

Politicians may well have concluded that they have little to gain playing the statesmanship card: an attempt to get public buy-in for the rescue plan in Greece caused such an outcry in the eurozone core that it cost the prime minister his job.

This may lead some to think that democracy should not get in the way of solving Europe. This would be wrong. Success will depend on the public accepting unpalatable choices today for what the technocrats insist will be a better future. Without skilful politicians to sell this message, the chances of success might be quite bleak.

Italy

Greece

Raul Elizalde | raul@pathfinancial.net

Tuesday, October 18, 2011

Welcome to Bear Country

Now read these safety tips
Raul Elizalde - Tuesday, October 18, 2011

Most rational people would not load up on aggressive growth stocks if they knew that they were in the middle of a bear market. But how would they know?
Telling apart a bear market from a bull market has to do with investment horizons. For example, a rally started on October 4th and propelled the S&P500 more than 13% in less than two weeks. Somewhere, a day trader probably exclaimed that markets were “on fire.” But investors who only open their statements once a quarter most likely didn’t feel that way, since the S&P 500 closed the third quarter lower than the second, and the second lower than the first. While the trader wanted to be all-in, the investor probably wished he wasn’t.
This is not a mere statement of the obvious. Since last August, stocks have swung wildly within a 12% range and dipped briefly into an “official” bear market upon registering a 20% decline from the previous top – just before the 13% rally. Sentiment fluctuated accordingly, leaving most investors confused as to whether days when the market plunged represented an opportunity to buy or a glimpse into the abyss, or whether strong climbs were a golden opportunity to exit at relatively good levels or signs that the bull market train was leaving town. Emotional rollercoasters like these can easily distort an investor’s time frame perspective.
While it is impossible to know where the market is heading next, it is possible to say where the market actually is. One can make a strong case that the stock market is now in bear territory by using a simple model. How long this bear market could last nobody knows, but the last 20 years suggest that stock markets can stay in bear or bull modes for quite a while.
Our model labels the market “bull” if stocks are above their one-year average and the average is climbing. When both conditions are reversed, the market is labeled as “bear.” A change in one condition gives notice that the market may change from “bull” to “bear” or vice versa when the remaining factor switches too. This simple model may not be useful as a predictor, but it describes well what kind of market investors are in. At least this is useful for those investors that can look at periods measured in quarters, not days.
Bull and Bear Markets

This model accurately labels the massive bull climb from early 1991 to early 2001, the following bear market after the dot-com crash, the credit-fueled bull market of the mid-2000s, the recent financial market bear market, and the most recent 2009-2011 bull recovery.
One period that stands out is after the 1994 Mexican devaluation, when markets lost direction for almost a full year and the model switched back and forth. And in 1998 the stock market tumbled because of the Asian financial crisis and the model generated a short-lived “bear” alarm. Apart from these two periods, however, conditions are identified sharply and correctly by the model. And according to it, the S&P 500 entered a new “bear” phase in early August.
That this might be the case is suggested by the fact that the market climbed so strongly in the last two weeks. Since 1973 the average daily return in up-days during bull markets is about 0.65%, but during bear markets, stocks go up more in up-days, by an average of 1.02%.
Up and Down Days in Bull and Bear Markets

Since 2003, the difference has grown larger. The S&P500 now goes up by an average of 0.59% in up-days during bull markets, and an eye-popping 1.51% in up-days during bear markets. This is consistent with the known fact that shaky markets are more volatile. It should make investors think twice before celebrating strong up-days like the ones we had in recent weeks.
It’s possible that the current “bear” mode could be short-lived. Europe could find a way to save its banks and reduce its debt, albeit at the cost of economic growth (see our newsletter The Elusive Grand Solution, 9/30/11). The US could find political consensus to improve its long-term fiscal problems, which are far from insurmountable, while allowing whatever economic “green shoots” to flourish by easing short-term fiscal concerns. And China could prevent its increasingly unproductive investments in infrastructure from causing a hard landing.
But these challenges are unlikely to be dealt with swiftly. European leaders can’t move quickly when solutions depend on huge structural changes such as changing treaties, building new supra-national entities, or agreeing on pan-European actions affecting national banking systems. Nor will the global public and private debt excesses of the past be purged overnight. And economies don’t spring to life or get restructured in a matter of weeks. It’s not that it can’t be done; it’s that it will take time.
If we are right on this, our model may remain in “bear” mode for some time. This means that keeping portfolios defensive and light on stocks may be the right strategy, while taking the plunge right now would be foremost and mainly a leap of faith.

Raul Elizalde | raul@pathfinancial.net

Thursday, October 13, 2011

The Elusive Grand Solution

Why markets can't get traction
Raul Elizalde - Friday, September 30 2011

The challenges facing the developed world are clear: slow growth, weak banks, and a mountain of debt. With determination, cooperation, and skill, policymakers could resolve any single one these challenges. Confronting them all at once, however, presents a different problem: efforts directed at solving any one of these issues risks making another one worse.

This is the key to understand the extraordinary difficulty that the West encounters today. Policies to stimulate growth require additional debt; efforts to reduce debt can make banks weaker; making banks stronger can stifle growth.

This also explains why monetary and fiscal policies today pull in opposite directions. While central bankers drive down interest rates to historically low levels and drop money from helicopters, economy ministers impose draconian spending cuts and – in the case of Mediterranean Europe – huge tax increases. The result is that all stimulative benefits of easing monetary policy designed to support the banks are canceled out by tight fiscal policy directed at reducing public debt.

Better banks and less debt = slow growth

Banks with weakening balance sheets are a threat to any economy, and any sensible policymaker knows this. One way banks can help themselves is by lowering the risk profile of their assets – in other words, by cutting lending. This is exactly what is happening in the US today (see graph). But the private sector finds it hard to grow without being able to borrow, and households spend less as banks pull back on mortgages and revolving credit.
Bank Assets as % of Total Banking System Assets

The government can help banks by absorbing their losses. This is what the Federal Reserve did in the early stages of the financial crisis in the US, when it purchased bad assets at 100 cents on the dollar from various financial institutions. The result was a transfer of debt from the private to the public sector (see graph).

Private and Public debt as % of GDP

The increase in public debt generated alarm among US and European politicians and so they pushed hard for spending cuts. As a result, both the private and the public sector went into heavy deleveraging at the same time. While this will probably succeed at improving bank balance sheets and the long-term fiscal outlook of government accounts, the inevitable outcome is that economic growth will slow.

Better banks and higher growth = more debt

The Keynesian argument is that when the private sector deleverages someone has to step in to keep the economy moving by picking up the slack of lending and spending. The inevitable conclusion is that maintaining economic growth requires the public sector to play that role. To keep the economy growing while helping the banks forces higher levels of debt. Strengthening the banks forces a choice between more debt and stronger growth.

Less debt and higher growth = weaker banks

Germany and core Europe have been exceedingly reluctant to let Greece default. This is because such an event would be a blow to European banks, which would have to book large losses not only on their large holdings of Greek debt, but also on holdings of other sovereign debt to which they heavily exposed and could be perceived as likelier to default if Greece does.

However, calls for European banks to book more substantial losses are increasing, as virtually everyone has come to the realization that creditors – the banks – will eventually have to take a hit on their exposure to Greece. The hope that the country will pay all its obligations in time and in full has vanished. But forcing a debt reduction by making banks eat up a large loss is tough medicine. How can the economy grow in such scenario?

Germany insists that the way of dealing with low leverage in the economy while maintaining growth is trough exports. At first glance this seems sensible: if internal demand is depressed, countries should look abroad to find sources of growth while cleaning up the banks and dealing with debt.

But, apart from the fact that it is mathematically impossible for all countries to be net exporters at the same time, such remedy ignores the fact that Germany itself extended huge amounts of credit to its European partners – one of the reasons why the weaker ones are now drowning in debt. For growth to exist, someone has to run up a tab.

A stark example of this dynamics can be found in the impressive growth of China’s exports, only possible through a massive amount of lending to its trading partners. One needs only to look at the mountain of foreign debt held by the People’s Bank of China to realize how true this is (see graph).

China's exports and foreign exchange reserves

Germany can hardly expect that its export locomotive will continue to run at full speed if its European partners stop borrowing. For its export-led economy to chug along, it has to keep lending, or else write off at least some of its partners’ debt.

In fact this is exactly what is happening today as Germany commits itself to fund supra-national bodies ready to lend massive amounts of money to eurozone members in trouble. This increases Germany’s contingent liabilities to the tune of hundreds of billions of euros – and the resulting public backlash has prompted Merkel to renew calls for banks to foot more of the bill. The difficulty of shrinking debt without hurting the banks or affecting growth is evident.

No single solution

So these are the contradictions of the day. Solutions that can improve the banks, reduce debt and keep economies going are at odds with each other.

The only possible way of attacking all fronts at once is with a soft hand. Attempts to implement big, radical solutions to any single aspect of this conundrum can make any other much worse. The best example is Greece itself: the all-out measures directed at dealing with the country’s debt are crushing economic growth and posing a serious risk to the country’s banks.

Small steps are the West’s best bet. This will entail finding ways for targeted growth in some areas; accepting that some debts will not be paid in full; slowly recapitalizing some banks while other are allowed to fail; providing focused public stimulus in some areas; generating additional tax revenues in others. The process will be tortuous and grinding.

Politically this will be difficult in an environment of high unemployment, hardening ideological stances, and calls for “bold action.” Despite all the bitter accusations, no big announcement from European authorities, draconian measures in the periphery, or radical change in US policy will be able to loosen the knot quickly. Resolution will take time and hasty action will only make matters worse.

In this environment, the outlook for equities remains cloudy. If economic activity is constrained, so are earnings and equity prices (see graph).

US Corporate earnings, GDP growth and S&P500

However, the possibility that some sectors can perform better than others as growth proceeds in fits and starts could have a silver lining. If different sectors move at different speeds diversification benefits can improve, which have been notably absent from portfolios as stocks have tended to move up and down together in recent times

Interest rates are likely to remain low, since higher rates would affect banks by lowering the value of the bonds they hold. Long-term rates are of particular concern, and that’s why the Federal Reserve engaged in “Operation Twist” – far more effective at supporting the value of long-dated debt held by banks than at creating economic growth by reducing the cost of mortgages to consumers by a few basis points. Therefore the bonds may stay strong until either growth or inflation start to show – neither of which appears imminent.

Exchange rates may become more volatile as the West looks for external sources of demand. Emerging countries, most notably Brazil, have complained loudly about these “currency wars”, underscoring that this is already happening. Those investors who can predict directional moves and stomach the twists and turns of exchange rates may turn to currencies to generate returns at a time when equities values are capped and interest rates are low.

The bottom line is that investors confront a new set of challenges as the resolution of global problems proceeds at a glacial pace. High levels of cash could prove very useful under these conditions. Dry powder, and patience, may ultimately be the best tool to have in hand as the world works to break free of the ropes that bind it.

Raul Elizalde | raul@pathfinancial.net