April 20, 2012
On Monday, billionaire investor and philanthropist George Soros stated, “I’m afraid that the euro crisis is getting worse. It’s not over yet, and it is going in the wrong direction.”
European Central Bank (ECB) largesse has pushed off the day of reckoning; for how long, no one knows. But it has encouraged equity appreciation in the stock market this spring and it may continue through the election, depending on how much the Fed decides to accommodate the Obama re-election. However, we expect that the end of the year may be a lot tougher than the beginning, as central bank funding is slated to run out before too long.
According to Deutsche Bank, credit-default-swap (CDS) prices suggest that “four or more European nations may suffer so-called credit events such as having to restructure their debt.” The associated article can be found at http://www.bloomberg.com/news/2012-04-18/worst-yet-to-come-as-crisis-rescue-cash-ebbs-deutsche-bank-says.html.
The IMF warns that a drastic contraction of European bank balance sheets is coming, amounting to€2.6 trillion ($2 trillion) over the next 18 months. That is about 7% of total bank assets. It would be painful and may trigger fear induced investing, which usually results in bad decisions and bad timing. For more information from the IMF on the global financial mess than you could ever hope to see, go to http://www.imf.org/External/Pubs/FT/GFSR/2012/01/index.htm.
It is easy to get into a debt crisis, but very hard to get out of one. Italy and Greece borrowed capital to spend on overweight public sectors. Ireland and Spain attempted to get rich by selling homes to each other based on the greater fool theory of economics. Banks created their own alternative economics model, hoping to get rich by pumping out 100% mortgages.
Recently the LTRO (Long Term Refinancing Operation) effectively force fed Italian and Spanish banks more toxic sovereign debt. This kept sovereign yields low for some time, but it has also deepened banks’ solvency problems. The new bonds they bought will likely cause them to take large losses.
George Soros said, “You can grow out of excessive debt, you cannot shrink out of excessive debt. Greece, Italy, Portugal and Ireland are learning this lesson first hand. I hope the U.S. will learn it sooner rather than later.
The actions of our Fed and the ECB have made it impossible to determine what assets are really worth anymore. Our Fed actively suppresses Treasury yields, which forces up Treasury prices, thereby forcing investors into stocks with the hope of making some kind of return. The ECB has caused huge distortions in euro-zone credit and CDS markets. Investors have too much faith in the ECB and this has precluded encouraging European peripheral governments to “put their houses in order” in a timely manner.
Some of our clients wonder why we have not been invested fully in equities this year. It is for the reasons above, among others, that we have been cautious. Other macro issues include slowing growth in China and in Europe. One has to ask — What is the catalyst that will move us forward from here?
We expect disappointing second quarter earnings and a reversion to the mean, resetting the earnings of US corporations much closer to historical levels . This would imply a correction all by itself, without all of the macro problems. We do not think productivity gains of the past can be built upon from here, nor can they sustain the current earnings levels. Also, the efficiency efforts and belt tightening by the corporations that have added significantly to the bottom line, through elimination of jobs and creation of part time jobs from full time jobs, cannot be duplicated going forward.
This is not a market we want to bet big in. We will wait for value to appear.
“Panics do not destroy capital – they merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works.”
– John Mills, On Credit Cycles and the Origin of Commercial Panic
When good value reappears, we will buy back in. Of course we keep some money in equity markets because we also understand that, by printing more money, the government may keep the charade going for some time to come. But… the day of reckoning will come.
Choose wisely the risks you take in your portfolios.
Randy M. Long, J.D., CFP®
Long Investment Advisory, Inc.
North Carolina Office:
5101 Dunlea Court
Wilmington, NC 28405
1756 11th Street
Reedley, CA 93654