As the investment community and world focuses on the Goldman Sachs hearings and the unscrupulous practices seen on Wall Street over the past 10 years, investors should understand that no matter what the outcome of the hearings, the global economy is still extremely weak and even more vulnerable to shocks than it was two years ago. The US markets have had a near record rally over the past 12 months, blowing away even the most aggressive estimates. The Federal Reserve is once again begging us to speculate with 0% interest rates which hurt conservative investors like pensioners who cannot make a dime on their cash. We would caution investors, those on a fixed income in particular, to not chase for higher returns even as equity markets continue to ramp up. Despite going through this dance of speculation twice over the past 10 years due to abnormally low interest rates and getting punished for it severely, investors are again faced with the question of whether or not to participate in what is starting to look like another bubble forming in equities.
While no one can really say where the market is headed in the short run, one can make a reasonable observation of what the Fed is going to do with respect to interest rates and how that will affect the markets and economy. Using the premise that stocks have disconnected from the economy, which in our view has occurred because stocks are far more sensitive to low rates and the Fed than the economy itself, we can make a reasonable assumption of what the Fed ‘s next move will be. While we may get lucky and the economy suddenly gains strength, we must understand that the problems that plague our economy after this bubble implosion, i.e. mortgage and credit card defaults, will linger for at least a couple of years.
The most likely outcome is that the economy will have an uneven recovery with interest rate affected areas of the economy doing better than the rest of the economy until the time that the Fed decides to raise rates. However if the recovery is stronger than expected, interest rates will most likely rise before we reach further bubble territory. As rates rise, equity markets will begin to settle down and will only be moderately overpriced until valuations catch up to the market or we get a long overdue correction in equities, which, believe it or not would probably not have much of a damaging effect on the economy. However, if the recovery is slow and unemployment remains elevated, Bernanke will keep rates very low, as promised, certainly continuing to fuel the bubble which would be a disaster for the economy in the long run.
Further, as we explained in our previous writings, we fully expected that the debt problems in Europe would sooner rather than later turn into a major headwind for the global economy as the sovereign crisis spreads to other European nations and eventually the United States. The past couple of months had seen a back and forth between Greece, the European Union and the debt markets, as Greece attempted to put its fiscal house in order. All the while, higher borrowing costs began to spread to other European nations including Spain and Portugal whose credit ratings were recently downgraded. With the recently announced $962 billion bailout package, the Europeans knew that this was no longer a story about an IMF package for Greece, but rather a crisis of the fundamental structure of the entire Euro zone and the ability and, more importantly, the willingness of the international community to restructure government debt in an orderly manner, i.e. who will support whom and on what basis. One of the comedies of the Greek bailout is that Spain and Portugal, who are deeply in debt themselves (and will eventually need their own rescue packages) were required to pony up billions of dollars for Greece as part of the package. Once again, our political leaders think they have solved a problem of too much debt by robbing Peter to pay Paul and in the process just saddling Paul (Greece in this case) with more debt.
In our view, Greece is the equivalent of Bear Stearns in context of the US financial crisis seen two years ago. While our politicians and regulators believed that they were able to stave off a contagion to the rest of the financial community by papering over Bear Stearns’ problems, it only took 6 short months for both Lehman Brothers and Merrill Lynch to collapse and the entire financial industry to find itself at the brink of bankruptcy. We have seen this story play out many times before. Politicians cannot stop a contagion, they can merely delay it until the entity or country can no longer go to the market to raise capital. Just for the record, Spain’s economy is five times the size of Greece, meaning that just the Spanish portion of the bailout requires approximately $500 billion. And after Spain, the European Union will have to figure out what to do with Italy, whose economy amounts to approximately 25% of total European GDP. It’s no wonder that George Soros and other major players in the currency market have taken out massive short bets against the Euro. In Greek mythology when Pandora’s Box was opened it was the start of many new and unexpected problems. Likewise, we view Greeks bailout package as just the beginning in what will be a long road for Europe with challenges that may break up the Union or at the very least see the ejection of some of its weaker member countries. There aren’t going to be any easy solutions or pleasant outcomes for Europe’s debt problems.
Finally, as we wrote about in previous posts, the technicals of the market show that the individual investor is back in the markets hoping to cash in on the rising tide in equities. Margin debt has surged since the crash of 2008 indicating that speculation is rampant and traders are speculating with leverage. Additionally, as Europe’s debt problems continue, the dollar has surged to its highest level versus the Euro in over a year. Our models indicate that global liquidity topped at the end of 2009, which also can explain why equity markets have lost momentum and gone virtually nowhere in 5 months. As we have been explaining for months now, the rally that we saw in equities last year was mostly due to the Fed’s Quantitative Easing program which provided a massive shot of liquidity for financial markets. All that extra liquidity found a home in stocks, bidding up prices. Now as the programs wind down, the Fed is hoping that the market can stand on its own and that the economy will begin to pick up.
History has shown that as the dollar rally begins to broaden, owners of risky assets such as stocks need to be extremely careful. The last time the dollar rallied on a multi-month basis was when liquidity came to a virtual halt during the financial crisis that took down Bear Stearns, Merrill Lynch, and Lehman Brothers. Before the financial crisis, major dollar rallies occurred during the Asian Contagion and LTCM blowups in 1998, and in 2000 during the Nasdaq/Dot-Com Bust. While the recent strength in the dollar could just be an anti-cyclical move from the major multi- year trend (falling dollar), investors need to be wary that the strength in the dollar doesn’t manifest itself into another major liquidity event as capital leaves Europe and moves to the relative safety of the US. While the European bailout package sounds promising, as we have been saying, the problem with the global economy is that there is simply too much debt and we need to start acknowledging it. The train that always kills you is the one that you pretended wasn’t there.
