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An Umbrella, Just In Case


Greece, Greece, Greece. I’ve had it up to here with Greece. I’m tired about writing about Greece. Apparently, I am not alone; after the conference call today, Jean-Claude Juncker said that he was confident that a “decision” on a bailout for Greece will be made at the next meeting…on February 20th. Gee, that would be great, Jean-Claude. If it’s not too much trouble, you know.

I grow more confident by the day that the Greek default is reasonably imminent. Today there was also talk about the possibility of a ‘bridge loan’ to get Greece past the March bond payments. Aside from the fact that the mere possibility of a bridge loan will keep holders of the March debt from agreeing to the PSI (gee, get paid at par or get paid 30% of par. Hmmm.) in the hopes that they get paid out, and the fact that (as TF Market Advisors points out) paying the March redemption would add about €8bln to the total cost of the bailout, my question is: what good does more time do? Have the last months and years not been enough, so that another month will allow you to reach a solution? If that’s the case, then by all means fritter away another €8bln, but that’s one heck of a leap of faith if the only thing they could resolve on the conference call today was to have another meeting on February 20th. Can I hear an ‘Amen?’

More likely, the foot-dragging now is to figure out how best to effect the default so that it has the most salutary (or least-hurtful) effect on the political careers of those currently on the stage. For example, a certain French President announced today that he is going to seek re-election, a prospect which is fairly dim at the moment since Sarkozy is trailing the Socialist candidate (Hollande) by a healthy 7-9 points in the polls and, more importantly, losing by a huge 59-41 margin in a hypothetical head-to-head runoff matchup with Hollande. It isn’t clear what Sarkozy can do to salvage his re-election, although with two months to go anything can happen, but I can’t imagine it would hurt to stop shipping French taxpayer money to Greece. What do I know, I’m not French, but my point is that the political pain of keeping Greece may finally be outweighing the political pain of sending her on her way.

There are more reasons to be wary of the equity market here. As readers know, I’ve been reluctantly long in this rallying (but expensive) market, but this is no time to be a hero.

One of the other reasons is the news this evening that Moody’s is considering cutting the ratings of Morgan Stanley, Credit Suisse, and UBS three notches, and Goldman, Barclays, BNP, Deutsche, JP Morgan, Credit Agricole, HSBC, Macquarie, RBC, and Citi two notches each. Oh, and for good measure, Bank of America, Nomura, RBS, and Soc Gen are potential single-notch downgrade targets. They also acted today to cut some European insurers’ ratings. While we all know that ratings should be taken with a shaker of salt (if not altogether ignored and replaced with actual analysis), in a world of CSA (collateral support annex) ratings triggers, downgrading the whole financial system would have the effect of pulling a Lehman/AIG on the whole mess. All of these counterparties would suddenly have to post large amounts of additional margin with each other. Financial companies’ leverage has declined markedly over the last few years (in contrast to households, for example, where leverage hasn’t changed much), but this could still conceivably require a strong, concerted central bank liquidity injection of massive proportions.

A 3-notch downgrade to Morgan Stanley would put them at Baa2, which it might share with Citi and Goldman only slightly better at Baa1. Now, in 2008 both MS and GS became commercial banks, so they have access now to the Fed window – a Bear/Lehman moment would thus be unlikely. However, either or both could conceivably be in a BOA/Merrill shotgun wedding situation.

I don’t want to sound alarmist, because no ratings actions have yet been taken on the banks. And I obviously don’t disagree with Moody’s reasoning, when I have said as much here myself. They said

Capital markets firms are confronting evolving challenges, such as more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions. These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms.

Yes, agreed, but the point here is that the ratings downgrade itself can cause a contagion, because of the existence of (well-intentioned) credit triggers. Those credit triggers are the papier mâché palm trees in the Coconut Grove.

I haven’t the faintest idea where those triggers are, and which ones may be triggered. And because no one else does either, it will not surprise me a bit if interbank lending grinds to a halt again. And this time, JP Morgan can’t step in as the big man on campus, because they’re in the same boat.

That’s not the only reason that the landscape suddenly looks less inviting for investors. Let’s talk about Apple. Now, I am a big fan of Apple products. I will note the Graham and Dodd admonition that a good stock differs from a good company in that a good stock is also cheap, but I’m not passing judgment on the valuation of Apple stock. Frankly, it’s not even a stock I watch very much, because it doesn’t pay a dividend and stocks of that type don’t generally interest me (firms that distribute dividends historically have tended to have a higher ROE). But today, when a highly-touted stock hits a new high and then reverses on huge volume – especially in an otherwise-somnolent market – it is a bad technical signal. When I say huge volume, I don’t just mean it was the highest share volume since January of last year. Keep in mind that the price is also some 45% higher now, and also keep in mind the aforementioned sleepy-market context. The chart below shows what I mean: Apple’s dollar volume today (with no news evident that I could see), on a day it set a new high and then reversed, was an absurd 5.2% of the total dollar volume traded on the Nasdaq. And frankly, that understates the point since I valued the dollar volume as the total shares traded times the closing price, and the closing price for Apple was the low of the day and more than 5% below the day’s highs.

So this is bad behavior from one of the generals.

Finally, back in geopolitics, Iran threatened to cut oil exports to six countries.  It didn’t cause much distress in the oil markets, since these are six countries that were already planning to embargo Iran in the summer. So Iran’s “you can’t fire me because I quit” routine should have scant effect. That said, Brent Crude was already at highs not seen since last summer, and NYMEX Crude was near the top of its recent range as well. I don’t expect any spike (although the ideal time for an Iranian provocation would be in the midst of a Greek default-related turmoil in global markets, wouldn’t it?), but it’s another risk that is turning acute at the moment.

None of this stuff is deterministic. They are all warning signs, and they might be completely ignored tomorrow, outweighed if there is a strong report from Initial Claims (Consensus: 365k), Housing Starts (Consensus: 675k), the Philly Fed Index (Consensus: 9.0), or all three. But the possibility of a very bad payoff, and a worsening edge/odds calculus, implies that investors should be scaling back long-stocks bets. (I wrote something similar back on March 1, 2011 in a piece called “The Market’s Pot Odds,”  which references in turn one of my all-time favorite article from back in 2010, “Tales of Tails,” talking about the implication of the Kelly criterion for investing. I submit these may be worth reading if you are interested in the edge/odds reference I just made.)

Implied volatilities, as represented by the VIX, have recently begun rising again, but protection is still relatively cheap considering the risks. If you feel this is a passing thundercloud, it still might make sense to buy an umbrella just in case.

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  1. usikpa
    February 16, 2012 at 6:42 am

    Excellent piece as usual, Michael

    On Apple I think there was some news Ipads can no longer be sold in China (or something along those lines).

    My question to you is this. Brent price in Euros is close to the highest ever. Not good for the European economies but definitely bullish for PPI and CPI (in fact, most recent PMI releases out of Europe stressed that fact). As ECB does not distinguish very much between core and non-core, what will it do when inflation strikes back in Europe next couple of months? Raise interest rates again?

    • February 16, 2012 at 7:22 am

      Not under Monti, I think. And even if they ignore energy and just focus on core, the trend in prices (as it is in the US) is disturbing and if inflation was their concern they already should be pulling back stimulus. BUT, these central bankers believe very strongly that inflation can’t go up when you have an output gap, and we have very large output gaps around the world. Despite the fact that that theory has completely failed over the last few years, when inflation accelerated with a very large output gap, they seem to rely on it.

      Either they say they believe that inflation will level off and decline from here, or they really believe it. Either way, they’re not going to be worrying about inflation in 2012.

  2. Andy
    February 16, 2012 at 3:06 pm

    first, Draghi is the proper Mario for this discussion, he’s the ECB president. Monti is the Italian PM.
    second, I don’t know if you read the Lacy Hunt interview on Mauldin, but it was very interesting, especially the discussion of velocity of money, and how there is no reason to necessarily believe that it is going to revert to its levels seen prior to the financial crisis in 08. I am wondering what your thoughts are on that topic. It seems to me if the velocity of money finds a home at a lower level, say 1.25, then the massive increase in liquidity may not be as inflationary as you believe. I’m not opining in either direction, just trying to understand the other side of the argument, which I believe you will have at hand.

    • February 16, 2012 at 3:54 pm

      DOH! Monti instead of Draghi! too many Marios! Mea culpa!

      If velocity just stays steady at any given level, then 10% money growth leads to 10% rise in PQ. It’s not the LEVEL of velocity that matters, it’s the change. MV=PQ; the first-differences equation is (change in M) + (change in V) = (change in P) + (change in Q). It is true that if V spontaneously snapped back, it would cause a change in inflation, but that’s not necessary for the inflationary case. All that is necessary is that it stops declining every quarter. I haven’t yet read the Lacy Hunt interview you mention, so I’m not sure what he’s saying, but he certainly should know that…he may be attacking a straw man, or he may be making a less-important point.

      Thanks for pointing out my super Mario mistake! Duh….

  3. Jim H.
    February 17, 2012 at 10:44 am

    In the interview cited by Andy, Lacy Hunt takes a very long-term perspective. He cites two 19th century surges in debt/GDP in addition to the 1920s-30s and the current one. His point is that beyond a certain threshold, excessive debt begins to dominate and neutralize nearly any possible policy measure aimed at stimulating growth. This leads him to a deflationary conclusion. He presents a very interesting table, showing that bond returns beat stocks for 20 years during and after each of these four ‘debt overhang’ events.

    What stunned me was his proud admission that a bond fund he runs was up 40% last year by virtue of being positioned in long-dated zeroes. Not surprisingly, he admitted that it’s been a stressful ride. No kidding — in 1982, 30-year zeros delivered a return of 156%. But in a bond bear market (just a figure of speech, I know bond bear markets don’t exist anymore), zeros get crucified.

    I wonder how many owners of his fund bought it for its sparkling return, but are unaware of its Fukushima-earthquake volatility? One of these days, they’ll learn that volatility is a two-sided sword!

    • February 17, 2012 at 11:05 am

      He’s been pretty public about being in long zeroes for a while. I did a bunch of work on the debt-disinflation hypothesis, and in fact it’s part of our inflation model. Lacy Hunt doesn’t distinguish between high levels of PRIVATE debt (which are inherently disinflationary, and I agree with him ) and high levels of PUBLIC debt (which are inherently inflationary). It turns out that the ratio of public to private debt is what matters, and that ratio has severely tipped the last few years and is continuing to do so.

      For his sake I hope he doesn’t ride his theory all the way down, if it turns out to be wrong (or, rather, not complete).

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