Tuesday, August 30, 2011

Things aren't adding up for bulls

Despite the big rally in stocks on Monday, some things aren't quite adding up for me. Let's discuss the problem regions one by one: the United States and Europe.

A looming US recession
A market analyst would have to be in hibernation to know that strategists have raising their probability of a recession. John Hussman believes that either one is inevitable or we are already in a recession [emphasis added]:
It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn't mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that "this time is different."

On top of that, you have the effects of Hurricane Irene. I happen to have a personal interest as we still have an interest in a recreational property in Greene County in upstate New York, which was hit badly by Irene. Consider this picture from Greene Country of the devastation below.

Then I got to thinking - Greene County is one of the poorest counties in New York State. Chances are most of the losses are localized and manageable, but given this recent CNN poll indicating that only 36% of Americans can handle a $1,000 emergency expense, could Irene push an already fragile American consumer further into the abyss? No doubt there will be some insurance and federal aid, but the out-of-pocket loss for many households in upstate New York and Vermont, which are some of the hardest hit areas, will be more than $1,000. (See this link for further details on the damage in upstate New York).

A circular firing squad in Europe
The European markets were buoyed Monday by the announcement of a merger between two major Greek banks, with a capital injection from Qatari interests. While such a development is a positive first step, why are Greek 2-year yields still north of 45%? At these levels, the market continues to discount a Greek default. It's a question of when, not if.

Greek 2-year bond yields still soaring

Bulls were also comforted by reports that the EU and ECB were working a radical rescue plan:
Following weeks of heavy losses for banking stocks across Europe, the Sunday Times in the UK reported Sunday that European officials are working on a "radical plan" to prevent a fresh pan-European credit crunch.

Without citing sources, the paper said officials from the European Central Bank and European Commission are considering offering central guarantees over certain types of debt issued by banks.
How plausible a solution?
This sounds like a version of the Swedish solution that I suggested before. While this is certainly possible I just don't see it as being plausible given the lack of agreement among the European. Consider this account from Richard Smith, who posted on Naked Capitalism, of the disagreements among the major European players looking like a circular firing squad:
This is all displacement: no one wants to recognize the losses and write off the debt, yet; not in Europe, (and not in the US, either, as we know well). There’s still too much room to argue about whether it’s liquidity or solvency, and about who should end up holding the bag, et cetera. Round and round it goes.
Nick Rowe at Worthwhile Canadian Initiative hit the nail on the head by outlining the political issue in Europe:
The Tea Party is much more powerful in Europe than in the US. Read Ambrose Evans-Pritchard to see an example. It's just they don't call it the "Tea Party" in Europe. It doesn't seem to have a name over there, but that's what it is.

The basic philosophy underlying the Tea Party is, at its crudest: "We're not paying for them". Who's "we" and who's "them" differs across two centuries and across the Atlantic Ocean, but it's still recognisably the same philosophy. The Tea Party makes life difficult for the Lender of Last Resort, because the Tea Party wants some sort of guarantee it will get its money back. And that guarantee can never be made cast-iron. If it could, you probably wouldn't need a Lender of Last Resort in the first place.
He concluded:

It's hard deciding these things when there is one central bank governor, one finance minister, and one country. With 17, it's a lot harder. As I have said before. Mish says it's "17 veto points".
In my last post entitled "Not too late to buy the long bond", I wrote, "In the absence of policy intervention, the path of least resistance for equities is down." I don't see any developments here that indicate anything that changes my views.


keithpiccirillo said...

Pretty nasty storm hit us in Ct.
I just got power up after 3 down days, no damage other than that inconvenience.
Bloomberg radio was all I could muster last few days. Interesting Eric Cantor rhetoric on his objection/unwillingness to bolster hard hit areas with federal disaster funds without an offset by cuts in other programs.

Cam Hui, CFA said...

Your Eric Cantor comment reminds me of a joke:

Q: How does George W. Bush feel about Roe vs. Wade?

A: He doesn't care how you get out of New Orleans (post-Katrina).