On April 6th, just after US stocks touched a high for the year and climbed to within 10% of the all-time high set back in October 2007, we wrote:
"The market will do one of three things over the rest of the year:
Trade flat for the next 9 months - not likely.
Surge into a "buying panic" as investors finally jump back into stocks, which would leave the market up 20% or more by year end.
Plummet as some exogenous event (like last year's Japanese tsunami or the Greek credit crisis) cause investors to retreat to cash once again."
We got three "exogenous events" in May:
- Greek credit crisis resumed, with Greece likely to exit the Eurozone this summer.
- JP Morgan Chase lost $3 billion on Credit Default Swap trading.
- The FaceBook "FacePlant".
And on June 1st, the Labor department reported a minimal gain in jobs, which has economists worried anew about the United States returning to recession.
So from the high on April 2, to the low on June 1st, US stocks sank 9.9%. Unfortunately, human nature focuses more on losses than on gains. Stocks remain 81% above the March 9, 2009 low, and 18% above the October 3rd low. But as we saw today (best one day return of the year,) universal bearishness tend to lead to outsize upside returns.
Many, many questions from our clients:
What is going on with Europe?
As we have said many times, the Europeans spent 30 years building to the current situation, and it will take at least a decade to straighten things out. The situation in Greece is the "canary in the coal mine." Greece is an artificial country cobbled together by the US and Great Britain at the end of World War II to prevent the Soviets from getting warm water naval ports on the Mediterranean. As of 2010, Greece had about the same GDP as Maryland, now probably 20% less. The country has three important industries: agriculture, tourism and shipping. These industries did not generate enough cash flow to purchase what Greeks wanted to buy, namely, German cars and dishwashers. Germans were anxious to keep exports booming, so helpful French and Italian banks stepped in to lend money so that Greeks could buy German exports (and build super-highways and other modern infrastructure.) The bankers felt confident in making loans despite the Greek national tendency to not pay taxes because a.) the loans were denoted in Euros, not some trashy third world currency like the Drachma and b.) scores of hedge funds were willing to write Credit Default Swaps on Greek debt (more on CDS below.) The bankers did not consider that their purchase of CDS did not eliminate their risk in buying Greek debt. It only transferred that risk from a junky country to junky hedge funds, which, as history has shown, tend to close shop when a payment is owed.
Over the last two years, bankers, governments, hedge funds and the Greek people have played "hot potato" as to who ultimately takes the loss on tens of billions in Greek debt. Thus, time and again a "deal" is declared, which is replaced by another deal a few months later, and another and another. The latest deal will most likely be rejected by a new Greek Parliament elected June 17th, 2012 and Greece will exit (or be forced out of the Euro.) 50% of young Greeks will emigrate over the next 3 years as unemployment remains in the +20% range.
The real threat is that Spain (the 12 largest economy in the world, ahead of Texas but behind California) goes next.
Is Greece the next Lehman Brothers?
No - two distinctions:
Lehman was central to the world banking system, Greece is peripheral to the Eurozone. When Lehman failed so did AIG. Merrill Lynch, Morgan Stanley, Goldman Sachs, Barclays Bank and Deutche Bank were right behind. Only a miraculous intervention by the US Treasury and Federal Reserve to payoff AIG's liabilities in CDS (there's that word again!) saved the day. As of now,
Greek debt has already been written down by 75%.
Lehman was there Friday afternoon and gone Sunday afternoon, leaving its counterparties no time to react. Is there any investment manager in the world who hasn't expected to Greece to fail for a year now?
What is a Credit Default Swap?
Once upon a time, managers of bond portfolios believed it was their job to adequately evaluate the credit quality of their bond investments and diversify accordingly. Then, in the mid 1990's, JP
Morgan bankers created a nifty bond put option. In the event that an issue failed, the writer of the put option would pay the buyer of the put option the difference between the issue price (par) of the bond and any residual value of the bond.
