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Greek Spring


Ah, spring is in the air, and that must mean: firebombs.

Yes, last year we had the Arab Spring, with violent protests and governments overthrown in Libya and Egypt with others tottering. This year, it’s Athens that is in flame against autocratic leaders. The fact that the Greek parliament passed resolutions that the people are so fervently opposed to, in the country where democracy (literally, ‘people rule’), has been remarked upon by many observers as ironic. It is even more ironic than most people think, since the idea we have today about democracy is of representative democracy in which elected representatives sometimes pass laws that contravene what the people desire…for a recent example, see Obamacare, which has never been supported by a majority of Americans. But the democracy that developed in Athens was direct democracy in which the people (or, anyway, the adult male citizens who had completed military training) voted on each piece of legislation. So the midnight passage of austerity measures was even more offensive to the Athenian sense of democracy than to ‘newer’ democracies.

And it was even worse than that, since representatives that did not vote the party line were booted from representation by the party bosses. Some 43 representatives will no longer represent their constituencies (it’s unclear how or if they will be replaced), along with a half-dozen or so members of the government who resigned before the vote. But, in the end, the legislation was approved and after the government adds a few more austerity measures demanded by the EU, the EU will pass judgment. That is scheduled to be Wednesday, but don’t be shocked if this firm deadline shifts a bit.

Greece fatigue is clearly in the air. With that news, the stock market managed to print the lowest-volume day of the year. February’s volume is running at an even slower pace than January’s volume. And perhaps it is more than just Greece fatigue, and more than political fatigue. Maybe there’s some price fatigue as well. As strange as it seems, the stock market is currently sporting its best 3-year performance since early 2000. Think about that. With only a weak recovery so far realized, stocks are up about 75% from 156 weeks ago (see Chart, source Bloomberg).

Bulls will say that this validates their boundless faith in America and will cascade “I told you so’s” onto the heads of poor benighted bears. The bears will say that this represents a triumph of hope over mathematics and wonder whether how bulls can still see stocks as cheap. And, of course, real-value investors will note that relative to the growth in the money supply, the stock market bears far more resemblance to the Nikkei from 1990-2009 than we’d like to believe (see Chart, source Bloomberg, showing the S&P divided by M2, scaled by 100).

So perhaps that means that stocks are cheap, although to me it looks at best like they are back in real, raw price terms to where they were in 1996 or so and that’s not necessarily an endorsement unless 1996 was cheap. That’s a topic for a different letter, but consider what it means about the 2002-2007 market rally: the S&P in price terms made it back to the old highs, but only because of the Fed’s serious easing over that period. Relative to the amount of cash in the system, stocks recovered only 1/3 or so of the real value lost in the 2000-2002 bear market.

Of course, the picture looks similar but less dramatic if you use the Consumer Price Index. In terms of the number of “consumption baskets” a given equity investment will buy, the 2002-2007 rally restored 68% of the wealth destroyed in 2000-2002 (see Chart, source Bloomberg, of SPX divided by the NSA CPI price index, monthly).

However, I like the SPX/M2 version because it highlights just how much our wealth has been diluted by something directly caused by the Federal Reserve. Certain purists, like Jim Grant of Grant’s Interest Rate Observer, hold that the increase in money is the only measure of inflation that matters. I don’t fully agree, but looking at it in these terms does abstract from changes in money velocity. If velocity is mean-reverting over some long time frame, then the second chart is the one that matters most. M2 money velocity is currently at the lowest level on record (see Chart, source Bloomberg), which is the only reason that the extended period of M2 money growth greater than 10% per annum hasn’t caused more inflation than we’ve already seen. However, the same share of the stock market buys a much smaller share of the money in circulation – in a real sense, that is why we feel poorer with stocks near recent highs. I wonder whether the current declining trading volume is consistent with a 1995 attitude about stocks, and if so…if we have finally returned to the old normal.

Aside from such abstract musings: the ratings agencies have been busy over the last couple of days. S&P downgraded 34 Italian banks on Friday and 15 Spanish banks today. Santander dropped to A+ from AA-, but is actually above the sovereign A rating of Spain. I can understand why an industrial conglomerate might trade above its sovereign rating, but a large bank? That seems odd to me. Moody’s, the laggard agency who still has France at AAA, begrudgingly put that country on outlook negative today while downgrading Italy, Portugal, Spain, Malta, Slovakia, and Slovenia. Moody’s also put UK and Austria on watch for a downgrade from their current AAA ratings.

On Tuesday, the beginning of a heavy tide of economic data sweeps into town when January Retail Sales (Consensus: +0.8%/+0.5% ex-autos) is released at 8:30ET. Regional FRB Presidents Plosser and Lockhart are speaking on the economic outlook, but that’s not likely to garner much attention at the moment. Wednesday, Thursday, and Friday have much more data, so enjoy your Valentine’s Day but not too much.

I remain reluctantly long equities (although long less than my neutral policy weighting), aware that on a valuation basis I have much less than the margin of comfort I normally demand. But our models at Enduring Investments continue to be quite overweight in commodity indices, and show both nominal and inflation-linked bonds as expensive (but nominal much more so), so I hold USCI and DBB on the commodity side, TBF (short 20+ year Treasuries) on the bond side, and both INFL and RINF on the long-inflation side.

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  1. Jim H.
    February 14, 2012 at 11:25 am

    ‘I hold … TBF (short 20+ year Treasuries) on the bond side.’

    Until last week, I was holding TBF myself. I ended up closing the position at about the same price I bought it in December.

    The mathematics of shorting bonds are pretty discouraging. When the yield curve is upward-sloping as it is now, the positive carry of a long position in bonds represents a negative carry for an inverse fund’s short position … of around 3% at present.

    TBF’s prospectus (page 510) shows that if Treasury yields remain flat, volatility drag will subtract 1% in return if volatility is 10%, and 6.1% in return if volatility is 25%. Historical volatility of the long Treasury over the past 5 years was around 15%. If I’ve done the logarithmic interpolation correctly, volatility drag will cost TBF over 3% in annual return if volatility remains at 15%.

    Thus the expected return from TBF if the long Treasury yield remains unchanged is around minus 6%, from negative carry and volatility drag. Just to equal the positive 3% return of holding the long Treasury bond would require, it seems, a multiple standard-deviation move in TBF, way-y-y-y out on its right-hand tail of return distributions.

    For a one-day holding period, the probabiility of making money in TBF approaches 50-50. But the longer it’s held, the more extreme is the leap in Treasury yields needed to overcome the deeply negative expected return of TBF in an unchanged-yield scenario.

    Unlike shorting dividend-free stocks (did someone say ‘Apple’?), where the expected negative return in an unchanged-price scenario is just the broker loan rate, shorting Treasuries is more like bicycling uphill into a 80 mph headwind with an open parachute strapped to your back. Being more of a Clark Kent than a Superman type, I decided to get off my TBF bike, declare victory and walk home.

    • February 14, 2012 at 12:20 pm

      The loss on the inverse is the reason I go with the unlevered version, where the effect is quite small. I would short the long version, and there’s some advantage to that but you can’t do it in many IRAs.

      The carry argument is that you’re fundamentally betting against the forwards, which is always true. I’m very comfortable betting against the forwards here.

      I figure there’s some chance of a 5% loss, a smaller chance of a 10% loss, but a decent chance of a move 100bps higher in yield (roughly 15% gain) and some chance of a very large increase in yields over the next couple of years.

      That said, I will carefully cover this position at the end of August, to avoid the strongly bullish seasonals, and re-establish in late November or December. The expected return for the rest of the year, even during the great bull market of our time, would outweigh the 6% systematic loss.

      Good comment Jim! Thanks for putting a sharp pencil to this.

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