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Friendly Takeover


And now, for a couple of days, every wiggle in the market will have something to do with the European summit. Rumors and statements and denials are already flying thick and fast. None of it sounds like it is something that is likely to immediately precede a “Grand Plan” to save Europe.

S&P put the EU on Creditwatch negative. I thought we sorta already knew that was going on when 15 of the 17 Eurozone members were on the watch list, but the EU being broader than the EZ I suppose doesn’t make that outcome automatic.

The ECB, said officials who are not part of the ECB but have “knowledge of policy makers’ deliberations”, is considering new ways to stimulate lending by the effectively-bankrupt institutions they call “banks”.  Among the methods reportedly being considered is the possibility that the ECB might loosen collateral criteria so they can take junkier junk from the banks for cash. Other brilliant ideas (although probably none so brilliant as this one) are also being tossed about.

There was a report late in the day, shortly before the stock market closed, that the G-20 might get a new $600bln IMF lending problem. There was apparently little thought of where that money might come from, since the IMF was also saying that it “may need more cash resources to help finance a newly created lending facility.”  It’s hard to pony up $600bln when you’re looking for the last $120bln. In any event, the IMF promptly denied the rumor that they’re readying new money.

The rumors seem more promising than the concrete news relating to Europe. For example, it is the case that Merkel and Sarkozy have called for Eurozone countries to have common corporate tax rates. This sounds like a great idea if they converge on a low rate like Ireland’s, but one suspects – since France is known to be annoyed at Ireland’s naked ploy to attract business – that the intent is to have tax rates converge higher. That seems like a fertile ground for disagreement. But the bigger issue is that the Big One-and-a-Half (Germany and France) have proposed, essentially, that all Eurozone countries agree to have their fiscal budgets approved by Berlin and Paris. France, which is hardly in a position to make any demands right now, is on the podium mainly because Sarkozy is Merkel’s buddy and because if Germany makes this proposal alone it looks like the sovereign equivalent of a “friendly” takeover of one corporation by another.

There are only two pieces of good news there. (1) A continent basically managed by Berlin would have a chance of making things work and becoming another great power, instead of the mish-mash of conflicting interests that mark a decision-by-committee approach. (2) At least it wasn’t a proposal for a hostile takeover.

It is early yet but I give the France/Germany proposal about a 5% chance of being accepted by other European nations. I initially wrote “1%” and then I remembered to correct for overconfidence bias. But it’s a long shot however you want to call it.

That doesn’t mean there won’t be warm fuzzies coming out of the summit, although I am skeptical there as well. But I have to say I am absolutely terrified to be short stocks even though (a) they’re overvalued by quite a bit unless profit margins have permanently widened and (b) I have trouble thinking of a way out of the European crisis that doesn’t end with at least a couple of key defaults or restructurings and/or a long period of sub-par growth. Partly, that’s the “don’t do anything in December that you can’t live with until January” effect, but partly a concern that either the politicians will come up with something seemingly-positive to say along with big smiles, or the market will simply react positively to whatever they have to say.

The fact that I am terrified to be short probably means it is time to do so, but meanwhile I am merely less-long than my neutral position. But I am also still short a small amount of bonds via TBF. Our firm’s four-asset model is completely out of stocks and TIPS (with a real yield of -0.05% on the 10y) and therefore overweight cash and commodity indices.

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Categories: Europe
  1. December 8, 2011 at 8:25 am

    HI Mike, thank you for your thoughts. I would be interested to hear where you think oil is going? Is your overweight in commodities a weak dollar play or a global strengthening play? I don’t see either but I do hear a lot about Iran being taken off-line. That seems to be a harder reality then it sounds. If oil breaks $100 for a few days…watch out below.

    • December 8, 2011 at 8:44 am

      Neither! i think global growth is likely to remain weak, and the dollar not likely to weaken anytime soon relative to other major currencies (although it should eventually). It’s a recognition of the significant central bank money-printing activities. If that leads to growth, then that helps the inflation play because people will think faster growth should cause inflation, but if it doesn’t lead to growth that will still result in higher prices unless central banks rapidly withdraw the liquidity starting right away. I don’t see that happening.

  2. December 8, 2011 at 9:42 am

    Where can growth come from if all the CB printing is to recap the banks? Are we going to see cost push inflation? I can’t seem to get my arms around inflation via velocity when it has not worked here so well.

    • December 8, 2011 at 10:08 am

      I don’t believe in cost push or demand pull inflation. More money means higher prices – wiht the caveat that that’s only true if money velocity doesn’t fall continuously. We have had weak money growth in the US until the last 4-5 months, so it wasn’t until recently that the inflation indications got very positive. But the money printing globally should overwhelm any normal decline in velocity unless there is a complete collapse in Europe (and then all bets are off!).

  3. Jim H.
    December 8, 2011 at 9:52 am

    “Our firm’s four-asset model is completely out of stocks and TIPS (with a real yield of -0.05% on the 10y) and therefore overweight cash and commodity indices.”

    I gather that the four assets treated in your model are stocks, bonds, cash and commodities — correct?

    David Swensen, in his book about managing Yale’s endowment, rather vehemently (for him) asserts that nominal bonds and TIPS are completely different assets, since the former is hurt by unexpected inflation, while the latter benefits. Doubtless your model makes this distinction, but do you agree with Swensen’s notion that TIPS actually are a separate asset class?

    Another question — why do REITs not make your cut as a fifth asset class? Worldwide, stocks, bonds and property are the three largest asset classes … and every additional asset class potentially adds some uncorrelated diversification benefit to a portfolio.

    • December 8, 2011 at 10:15 am

      I don’t see TIPS as a distinct asset class – if they were, then you would need to also separate floating-rate notes, which don’t get hurt as much from inflation as fixed-rate bonds. They are a different flavor of interest rate instrument. Nominal bonds are just bonds where we have allowed the real rate paid to float over time based on where inflation actually comes in. So nominal and real bonds exist in the same space, but have different characteristics. He is right in that they are certainly not direct substitutes for one another but calling them a separate asset class implies that you should have an allocation to TIPS and an allocation to nominal bonds and they should have nothing to do with one another, and that’s silly.

      REITS have predominantly equity beta. If there was a clean way to trade property directly in a retail-sized accounts then we’d probably add that as an asset class but our simple model only has two tilts and we like its spare nature. Residential property is essentially a zero-coupon inflation-linked bond (it returns roughly 0%-0.5% real return over time). Commercial property may have a slightly higher real return. But both act more like low-coupon real bonds. REITs don’t capture that dynamic. If housing futures or swaps were liquid, it would be worth considering but the performance characteristics of property, as I’ve just noted, aren’t very good. A house doesn’t produce more houses, so it doesn’t have any a priori expectation of real return. (Commodities don’t either, but the construction of commodity indices – which is what our fourth asset class is, not direct commodities – provides returns from collateral and rebalancing that are actually quite ample over time).

  4. Jim H.
    December 8, 2011 at 10:57 am

    Thanks for the explanation! Depending on the cap rate of commercial RE, it sometimes provides a bond-like lease income higher than ‘low coupon,’ while its capital value is more equity-like. But agreed, the publicly-traded REITs have a lot of equity beta … as in October 2008, when they got a damned good whacking alongside their bad-boy cousins, common stocks.

    As for models, simple is definitely better, because it’s more robust to secular changes in markets. This is probably a dumb newbie follow-up question, but what are the ‘two tilts’ among your four asset classes? e.g., bonds vs. stocks; rising inflation vs. falling inflation assets?

    • December 8, 2011 at 11:26 am

      One is a real-interest rate tilt, one is a relative value tilt of sorts. It has performed amazingly well over all kinds of markets going back fifty years. We developed it for a midwestern money manager who we think will roll it out to their clients soon (and we also manage money to the model directly for some clients).

  5. Jim H.
    December 8, 2011 at 12:21 pm

    Thanks again! I scoff at Wall Street investment products that are rolled out with 10 or 20 years of backtested history, when secular cycles can easily last that long. For robustness, asset allocation strategies need to be tested on data extending as far back as possible, encompassing everything from high inflation to deflation.

    The CRB index, to mention one example, starts in 1956. Ibbotson’s SBBI data for stocks and bonds goes back three decades more, to 1926. [TIPS are the relative newcomer, introduced only in 1997.]

    Et voila — data trove in hand, now all one needs is a spreadsheet, nimble fingers, and a creative mind. Oh, the thrill of changing a parameter and hitting recalc — KACHING!

    • December 8, 2011 at 2:31 pm

      Ha ha! Well, not quite THAT easy…the CRB series doesn’t include collateral returns, so it’s not a ‘modern’ index series in that you would have earned different returns had you invested in it.

      We initially tested on 10 years of history, set parameters, then backtested on 40 more years (using some back-filled real yield data provided by an academic to recreate a TIPS series) and the performance was almost identical. Best out-of-sample test I’ve ever seen.

  6. Jim H.
    December 8, 2011 at 4:50 pm

    An historical synthetic TIPS time series … VERY interesting. It probably sucked in the Seventies, but made money hand-over-fist in the early to mid-eighties. Nice work!

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