An Upside-Down World

Earlier this week the market flashed-crashed on a fake tweet from a hacked AP account.  When the word got out that the tweet was a fake, the market bounced back to its pre-tweet level.  During the round-trip the market moved a total of $400 billion.  A couple of things…

·          When did we start trading on tweets?  I must have missed that meeting.

·          Why do we continue to allow the high frequency traders to remove all liquidity from the market in a matter of seconds? (Check out Nanex.net for a great pictorial.)

·          How did it come to pass in such a short period of time that social media is actually being relied upon for ANYTHING?  Do the words “Manti Te’o” ring a bell?  Or how about that girl in NJ who faked her own kidnapping causing 34, 000 people to retweet her “tweet for help?”

Earlier today it was released that numerous central banks around the world are stepping up their purchases of equities using their reserves.  This was generally received as a good idea.   The Fed is prohibited from buying stocks, but Japan’s central bank isn’t.  So…  a wink and a nod to Abe about the JPY devaluation and voila’ – the JCB is down for doubling its ETF exposure to 3.5 trillion yen.  Israel has been in the game since last fall.

·         This is a good thing?  Banks diversifying their reserves into a stock market that is now up more than 100% since March 2009?  That seems as crazy as yelling “Movie!” in a crowded Firehouse.

It was reported this morning that Spain’s youth unemployment has risen to 57%.  The European Stoxx 600 closed the day up 0.76%

And now for the clincher.

I received an email today from a marketer who was trying to sell me on his firm’s option trading acumen.  Yesterday, I rejected the idea.  He is now requesting that I send him $500/hour for each of the four hours he spent trying to get our business. As one of my partners said, “we should charge them for wasting the last month of our lives with them and receiving no value.”

You just can’t make this stuff up.  – LL

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The Spanish Bail-in. Huh?

Sometime between attending the high school graduation party for the son of one of my high school classmates, and waiting for the temperature to drop a little so I might mow the lawn in comfort, I spent an hour reading more about this weekend’s Spanish bank bailout.

But before I comment on that…  I have to say that, in the event gray hair doesn’t make one conscious of his age, attending a graduation party for the offspring of a peer will remedy that in short order!   That, and finding out, at that same party, that Bruce Springsteen signed his initial recording contract 40 years ago this week.

I tried to rationalize my feelings by recalling a line from a song by Jethro Tull:  “You’re never too old to rock and roll.”  Then someone pointed out that the song was released 36 years ago.

Back to Spain.  In the hour I had allotted to reading, I read a piece by DeutcheBank detailing how the Spanish bailout would work within the framework of the existing Euro-zone treaties.  I also read an analysis of the weekend’s events written by Bruce Krasting.  Finally, I hopped over to Bloomberg to look at the equity market futures and the EUR/USD exchange rates.  What follows are my observations in no particular order:

  • As of this writing, the Euro has strengthened by 1.02% over the USD.  Forex seems to think the bailout has legs.
  • US stock futures (DJIA) were up 141 points.  The bulls are back.
  • The Nikkei Index is trading up 60 points while Singapore has thus far added 38 points to its index.
  • Other markets have yet to open.

All-in-all, the weekend’s developments have brought back evidence of the “animal spirits.”

I hope the rally truly has legs and the bailout is a meaningful step towards removing the Sword of Damocles that has hung over the market’s head for the past 5 years.  But here’s the problem.  It’s not a bailout.  Having read the documents (the DB doc in particular since it referenced this term twice), what is occurring is known as a bail-in.  A bail-in!  Sounds nice.

The thing about a bail-in, is that it really is (as is known in bankruptcy parlance) a cramdown.   I mean, if someone came up to me and asked if I’d rather be “bailed-in” or “crammed down, ” my gut would say “Bail me in!”

But they are one in the same.  And this is where the Krasting article makes its finest point.

In a bail-in (or cramdown), positions in the capital structure that had previously been senior get “crammed down” into subordinate positions.  Spanish bank loans that were subordinate only to the actual depositor’s money will likely be moved to the third position, as the bailout loans take the second spot – essentially cramming down the senior loan holders.  Sorry, I mean bailing them in.

On the surface, that sounds dandy.  The bondholders knew the risks when they bought the bonds, so knocking them down a notch in the capital structure is fair and just.

Kind of.

If you wanted to be fair and just, the entire capital structure all the way up to, but not including, depositor accounts should be wiped out until the bank has adequate capital.  That’s a different argument to be made another time.

But we live in a world of unintended consequences.  We presently have the luxury of witnessing these consequences much more frequently, since governments can’t seem to take their hands of the knobs for even a second.

My reticence about this bail-in, is that senior bank loan holders in other countries (like Italy, France, and maybe even Germany) might decide that it’s too risky to hold these loans.  Should things go poorly in those countries, might they be bailed-in too?  Could fear of this (unintended consequence) create mass liquidation of senior loans in Europe, akin to those we saw in the US in 1998 (you could buy $1 worth of senior floating bank debt for about $0.50 at the time)?

If I were long the senior loans of banks in the above-mentioned countries, it would certainly give me something to consider.

But…  I’m not long those loans, and it looks like it’s time to cut some grass.

This has been my 3rd blog in as many days, and I thank you for your indulgence.  I find living in this period of history to be fascinating.  And I enjoy sharing that enthusiasm via the blog.  What strikes me as funny, though, is through all the troubling big-picture discussions, there are still parties where we celebrate fine young men graduating from high school.  And weed-riddled grass that needs to be mowed.  It’s that small-picture stuff that makes life so enjoyable.

Whether or not some Spanish bank is getting bailed-in.

PIGS at the Trough

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It was announced today that the world now has porcine in the plural.

Portugal, Ireland, Greece, and now Spain.

After a contentious phone conference among the EU’s muckety-mucks, Spain will receive $125 billion in loans to shore up the capital in their banks.  Spain’s economy minister, Luis de Guindos, announced that the loans (coming from the EFSF, and not from the IMF) will be added to Spain’s bailout fund, then pushed into the failing banking system.  While initial estimates of the size of the Spanish bank-hole were around $60 billion, The EFSF wanted to over-promise in order to bring confidence back into the system.  “Going forward, it will be critical to communicate clearly the strategy for providing a credible backstop for capital shortfalls — a backstop that experience shows it is better to overestimate than underestimate, ” said Ceyla Pazarbasioglu, deputy director of the IMF’s monetary and capital markets department (as well as the winner in the “Impossible to Pronounce Name” contest).

But here’s the thing (or things).  From the beginning, Spain has never been clear (or truthful) on the capital needs of their banks.  Take the recently nationalized Bankia, for example.  On May 21, Bankia was nationalized by Spain to plug the 4.5 billion Euro hole in its capital.  By May 23 that figure had risen to 9 billion Euro.  The following day the number rose to 15 billion Euro.  By the 27th, when all was said and done, the total bailout was 19 billion Euro.  I’d hate to apply that same kind of exponential math to the $60 billion number being thrown around today!

Further, there is the issue of the cajas.  Basically these are Spanish savings and loans.  A bunch of them were failing and subsequently were bundled up to become the bank known as Bankia.  Even more of them, however, are still walking the Spanish landscape like so many George Romero extras at the mall.  Being highly unregulated, these cajas made many, many sub-prime (and worse) loans during the inflating of the Spanish real estate bubble.  This isn’t merely speculation.  To wit, I refer you back to the founding of Bankia.  No clear number that I can find totals the bad loans buried within the cajas.  And if someone knows, they ain’t talkin’.

The bright side to all of this is that Spain, who was effectively cut out of the bond market, can now borrow at sub-market rates from the EFSF.  Also, the lack of IMF participation leaves the American taxpayer out of the lending syndicate.  It’s also likely to be short-term bullish for stocks (and bearish for US bonds).

That is, until the markets decide that bad news is actually… well… bad.

I have to think we’re getting awfully close to that point.

Saving Spain’s banks may have been necessary, but the act of saving them screams to just how bad the European situation has become.

To conclude with a quote from Ben Bernanke at this week’s Congressional hearing, “a trillion here and a trillion there and pretty soon your talking about real money.”

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I Still Can’t Get No Satisfaction

As a follow-up to my previous blog post (and in keeping with the theme of questions asked by my clients), I was recently queried the following:

“Why do you seem consistently filled with doom and gloom?”

I would have felt a little better if the question ended with “doom and gloom in the financial markets.”  I’ll assume that was the context of the question; if for no other reason than to soothe my ego!    Notwithstanding that, the short answer is that, against the backdrop of facts, I try my best to use reason instead of hope.

Let me take a few minutes to share our macro view, and it may help explain why our investment process has led us to where we are today.

In the big picture, the banking crisis of 2008 was never resolved.  The crisis was, as Kyle Bass put it, “smothered by the full faith and credit of rich Western Governments.”  What was already dangerously high public debt became even higher as bank debt was transferred to the public.  Compound that with the fact that debt accumulation was accelerating in reaction to the financial crisis and you are left with what we’re now seeing in Europe and potentially here in the US.

Anyone watching the European crisis has to be getting the sense that pain can only be delayed; not avoided.  Austerity cuts reduce public deficits, but they also crimp economic growth.  As we watch the race between increasing stimulus and debt, and that stimulus ultimately translating into meaningful economic growth, we are doubtful that growth will arrive quickly and materially enough before most of Europe’s debt reaches a tipping point.

On Monday, Spain was forced into a state bailout of its third largest bank, Bankia.  This represents a 180 degree reversal of Spanish policy and will cost between 7 and 10 billion Euros.  For those keeping track of post-crisis acronyms (TARP, LTRO, etc.) it will provide you the opportunity to add another to your list:  “COCO” — meaning contingent convertible bonds – the vehicle that will be used to inject capital into Bankia.

But Europe may not be the initial catalyst for Crisis Part II.  Hugh Hendry lays out a pretty cogent argument about why China may be the epicenter of the next pullback.  Briefly (and I’m happy to forward the full article to anyone who would like a copy), the argument goes like this:

  •  China’s massive currency manipulation punished its bank savers, so the citizens went on a home-buying spree figuring that homes were an appreciating asset.
  • The scale of China’s housing bubble dwarfs that of the pre-crisis US bubble
  • There are trillions of dollars of loans from underground creditors, who do not have rigorous (or any) underwriting standards.
  • China is aware of this, and to curtail the activity has been handing out death sentences to some of the underground lenders.  If this sounds too unbelievable (as I am occasionally prone to hyperbole), Google “Wu Ying.”
  • China’s government has spent so much money boondoggling unnecessary infrastructure under the assumption that exports will cover the costs; a global economic slowdown will crush their balance sheet.

Then Japan…

Japan has its own set of problems from awful corporate balance sheets to unbelievably dilutive corporate actions, to lousy demographics, to linkage to China’s growth.  We see no reprieve for the beleaguered Japanese stock market.

As for the US, reasons for optimism include the economic growth likely to be brought on by new oil and gas development projects.  You only have to look at North Dakota to get a sense of how powerful this can be.  The US is also experiencing record corporate profitability.  Earnings, driven by productivity gains, have been nothing short of stunning.  Yet, you can only increase productivity and maintain record margins for so long.  As the belt-tightening reaches its peak, earnings growth will no longer have that tailwind.  Further, top line growth will likely be hampered by a contracting global economy.  We also have a Presidential election coming up that will have significant tax and healthcare implications.  At best, we rate US stocks as a neutral.  But, its stocks are being treated like a strong buy on a relative basis when compared to bonds, cash, Europe, etc.

Finally, across the globe we are witnessing social unrest of varying degrees.  From the Arab Spring, to Greece’s anti-austerity riots, to the UK’s tuition protests, to Occupy Wall Street, the populous is becoming increasingly agitated.    Socialist and far right political ideology is gaining strength in Europe – France and Greece in particular.  The French just elected only their second socialist president since Mitterrand, and Greece’s neo-Nazi (Golden Dawn) party won 20 seats in Parliament by garnering 7% of the popular vote in last Sunday’s election.  Wealth disparity in the US is at record levels.  Unemployment in Spain exceeds 24%.  The list could go on and on, but you get the gist.

In an environment characterized by global fiscal distress, dangerous global monetary expansion, social unrest, and political upheaval, I find it difficult to hit the street with bullish optimism.

I look forward to the day when these blog posts are about how bright the future looks.  And I’m sure that day will come.  But right now, every developed country in the world has their pedal to the monetary metal yet has only managed to slow the bleeding.  If that is the best result that all out, globally-coordinated government action can deliver, it begs the question as to just how bad the underlying problem is.

Friday’s Random Thoughts

Re-visiting the Robots

Yesterday I tweeted (or twittered, or whatever) an article from the Financial Times titled “Real Investors Eclipsed by Fast Trading.”  It was later pointed out to me (by both or our followers!) that the article could only be opened by those who were registered with the Financial Times.  So, in order to right that wrong, I thought I’d put a couple of bullet points from the article in the blog:

  • Trading by “real” investors (defined as buy and sell orders from mutual funds, hedge funds, pensions and brokerages) is taking up the smallest share of US stock market volumes in over a decade.  Source:  Morgan Stanley’s Quantitative and Derivative Strategies group.
  • “Real money” trades account for only 16% of buying volume and 13% of selling volume
  • The takeaway, by the authors of the study, is this:  “Matching of ‘real’ buyers and sellers is more challenging in a market where there are fewer of them.”

 Let’s just hope the bots don’t begin to gain a sense of self.  From what I’ve heard, that would be bad.

Apple

I really don’t have anything to say about Apple.  It’s just that there is a new law stating that if you’re going to publish, speak, or give hand signals regarding anything about investing, you have to mention Apple.  I think this puts me in compliance.

Japan

With the European crisis taking up the bulk of the international headlines, the Bank of Japan has quietly decided to add another 5 – 10 trillion Yen to their asset-purchasing program.  This is in addition to the 65 trillion Yen already in the program.  With this round of quantitative easing, the BOJ re-asserts itself as the central bank with the biggest balance sheet as a percentage of GDP in the world.  Congratulations guys!

With the horrible demographics in Japan, growing their way out of the crisis seems unlikely.  This is something worth watching.

 Europe

  • Spain’s unemployment rate is now at 24.4%.
  • S&P has cut Spain’s credit rating by two notches on Thursday, setting it at BBB+
  • Spain’s foreign minister Jose’ Garcia-Margallo says, “Spain is undergoing a crisis of enormous proportions.”
  • In France, it appears that socialist Presidential candidate Francois Hollande has a pretty good shot at winning the run-off elections next Sunday.    His platform includes dumping the austerity program, increasing government spending and not ratifying the new European fiscal treaty.  That should do wonders in reducing France’s debt strain.
  • For the second time in two months, Romania’s government has fallen.  This morning, in the wake of the continued collapse of their currency (leu), a vote of no confidence meant that Mihai Ungureanu was getting the boot.  Austerity takes another victim.  As a result, the IMF has decided to not send Romania it’s expected 5 billion Euro aid package until a new government is in place.
  • In the Netherlands, the government quit on April 23, only to pull a “Never Mind” later in the week.  The reason…  the opposition Freedom Party refused to support the proposed austerity and tax hike program.  Later, they agreed to it and are now back in business.  I guess for a few days, you could say they were “In Dutch.”

United States

  • So far in this earnings season, 200 of the S&P 500 companies have reported.  75% have beaten their estimates, 10% have matched, and 15% have missed.
  • Across the S&P 500, the average earnings surprise was +12.1% (just for yucks, that number is 7.5% if you take out Apple).
  •  Apple.
  • Year-to-date, the S&P 500 is up over 11%

While the global scene certainly looks glum, the US remains profitable and growing at an ever-so-slight rate (this morning’s GDP came in at 2.2% versus and expected 2.5%).  $7 trillion in newly created global money, the Bernanke Put, and Apple seem to be buoying the US stock market.

It makes me wonder if we may just be the prettiest horse in the glue factory.