Seasick: Hangin on the Rail
“At first you are so sick you are afraid you will die, and then you are so sick you are afraid you won’t die.” – Mark Twain
“Oh God, please just get me off this boat and back to the dock. Please God, just get me back to land.” – Cliff Draughn
There are certain moments in your life that you never forget: your first car, first date, first day of college, first paying job. These are life events that bring a smile to your face. And then there are those events that are gut wrenching: first heartbreak, first car wreck and, for those of us unlucky enough to suffer from motion sickness, that first deep-sea fishing trip where you spend the day feeding the fish. As I stare at the abyss of the third-quarter stock market statistics, I am reminded of how I hung onto the rail of the boat for hours, pleading to be returned to shore and enduring the laughter of the captain and my friends. As the markets roiled and flowed, with 20-foot waves hitting investment portfolios, stocks were tossed around as if they were toy boats in the perfect storm. For the record, Q3 2011 returns for the major equity indices were:
1. S&P 500 -13.87%
2. MSCI EAFE -20.55%
3. MSCI Emerging -26.27%
The stunning part regarding the third quarter was the amount of volatility we experienced, which is the reason investors are getting seasick. There were some compelling market statistics that causes one to pause – or puke:
• Of the 64 trading days during Q3 2011, we had 33 event days and 31 nonevent days. An event day is one where the market moves more than 1% in either direction.
• 16 days with returns greater than +1%
• 17 days with loss returns greater than -1%
• Largest single-day gain was +4.74% on 8/9/11, with volume of 1,861,723,648
• Largest single-day loss was –6.66% on 8/8/11, with volume of 1,938,670,720
• Average volume for event days and positive returns greater than 1% = 924,521,060
• Average volume for event days and negative returns larger than –1% = 1,077,991,360
• Average volume for non-event days = 841,337,350
The month of October provided the best monthly percentage increase in the S&P 500 since December of 1991, with a 10.77% recovery from Q3. And, we experienced the third largest monthly gain ever measured by the Dow Jones Industrial. However, October was no less volatile:
• No. trading days = 21
• Event says (returns greater than +/- 1%) = 15 (71% of the time)
• Non-event days = 6
• 10 days with returns greater than 1%
• 5 days with losses greater than 1%
• Average event day gain was 2.071%; highest return = 3.43% (10/27/11)
• Average event day loss was -2.104%; lowest return = -2.85% (10/3/11)
So, as we continue to hang on to the rail of volatility and suffer the rolling sea, one has to ask, “When can we please get back to land and dock this boat?” And, in the manner of the captain and my friends consoling me on the first and last deep-sea fishing expedition of my life, my answer to you is: When the forces that govern the EU and the USA understand the perils of government-promoted, debt-driven economic bubbles that lead to currency debasement followed by severe recessions, then the seas will calm. Until then, hang on to that rail and, no, don’t take off your life jacket.
Our focus factors for the remainder of 2011 and going into Q1 2012 are as follows:
• The Numbers: Valuations and Economic Activity
• Apocalypse Now?
• Greek Default or Voluntary Concessions: The Lunacy of Credit Default Swaps
The Numbers
From a consumer and earnings perspective it is difficult to substantiate all of the gloom and doom forecasts due to geo-political risks that have roiled the markets. Unemployment, while not being significantly reduced, has seemingly found a bottom, as evidenced by September’s increase in nonfarm payrolls. This is confirmed by ADP’s report of an 110,000 increase in nonfarm for the month of October. These moderate employment gains are consistent with a sluggish, muddle-through GDP growth, which is what we are predicting going into Q1 of 2012. The ISM Manufacturing Composite stands at 50.6,and this represented the 27th straight month of manufacturing growth.
Although the Consumer Confidence Index, at 39.8, is at a low not seen since Q1 of 2009, personal consumption for the month of October increased 0.6%, with increases in both motor vehicles and durable goods. The spending coincided with a reduction in the personal savings rate from 4.1% to 3.6%. Loss of confidence typically means a reduction in spending, but this was not the case for Q3 2011. My conclusion is to go against the ECRI and the consensus that a double dip is inevitable and predict we are going to continue to muddle through, barring some sort of Armageddon event from the EU.
Equity markets around the globe rebounded sharply in October, reflecting hope that the ECB and European nations are going to resolve the Greek debt crisis. Behind the stock moves, however, a number of positive forces are at work:
1. Dividend yield is consistently the most positive value factor for large-cap equities. For the first time since the Great Depression, dividend yield on the S&P 500 is greater than the 10-year Treasury yield.
2. Average earnings growth for Q3 2011 versus Q3 2010 is higher. With 392 out of the largest 500 S&P companies having already reported earnings for Q3, the average growth for the cap-weighted index is 25.1% and equal-weighted 18.4%. If we drop out financials, the numbers improve to 28.9% in the capweighted and 22.4% for equal-weighted.
3. As evidenced in the difference between the above-stated cap-weighted versus equal-weighted earnings growth, we can conclude that large-cap stocks are growing earnings at a faster rate than their mid-cap or small-cap brethren.
Third quarters are often cruel, as the -13.87% decline in the S&P 500 reminded us. Since WWII the S&P 500 has produced 10 quarters of -14% or more. Six of the ten were third quarters. The good news is that in 89% of the cases where we experienced a huge negative quarter, the following quarter was positive. The following chart documents investor sentiment, as recorded by the Ned Davis Research Crowd Sentiment Poll. We pay attention to the trend in this chart, as our discipline is to be contrarian to the crowd. At the first of October, we tilted our allocations to be more favorable to high-quality, dividend-paying stocks, and view bonds as having significantly more downside risk than the other asset classes.
The next two graphs after the NDR Crowd Sentiment indicate (a) the superiority of dividend-paying stocks as opposed to non-dividend stocks and (b) the cheapness of stocks when using a comparison of T-Bill yields to S&P 500 dividends. In the case of dividend-paying versus non-dividend, compare the black and red lines versus the green line. In the case of comparing T-Bill yields to dividends, we have entered a valuation territory not seen since the Great Depression.
We recognize that fear trumps valuations when geo-political risks become the focus point of the markets. Political paralysis on both sides of the pond (US debt debacle and Euro Sovereign debt defaults) have been the jet stream for investment returns. These geo-political risks will remain a feature of the investment landscape that we will not ignore. Major market disasters such as Lehman in 2008 rarely occur when everyone is expecting one. By definition, black swan events are unpredictable. Today, everyone and his brother recognizes the European disunion and the impending bankruptcy of Greece.
Apocalypse Now?
For the past 22 months the question has lingered: when will Greece default? The markets are beginning to learn from the prior three Euro-crises what to expect from European policymakers. In the end it will be what Germany wants, as they are seemingly content to amputate the leg of Greece six inches at a time. Even prior to this past weekend’s summit, German Chancellor Merkel complimented now former Prime Minister Papandreou for stepping down but implored the new Greek policymakers to carry out the Brussels decisions completely and immediately. This past weekend’s summit to end all summits of the G-20 at Cannes followed a nowfamiliar pattern:
1. Let’s play Liar’s Poker. Policy makers are amplifying the problems in attempts to get as many concessions as possible from European bank bond holders and capital assistance from the international banking community. The attempt is to bring in the IMF, US, Chinese, and any other international player who fears contagion risk and is willing to be a part of the solution (i.e., give away money).
2. As various lines in the sand get stepped over, Germany is more and more assuming the role of dictator, imposing its will on the other European nations. The ECB, while under new leadership, is clearly taking direction from Merkel and company. The announcement from Merkel that Greece is free to leave the euro is a protectionist action based on the notion that euro-zone countries should not become liable for each other’s debts. Really?
3. The European financial crisis is in reality a political crisis. Germany is intent on not engaging in any large-scale fiscal transfers to countries like Greece or Italy or any other struggling euro-zone country. This will play on until December, when the German constitutional court will decide whether the Bundestag can approve funding of the EFSF (European Financial Stability Fund). Although it is more than likely the court will rule in favor of funding the EFSF, there is always the political risk that Germany will play an even tougher hand.
The Euro-crisis is far from over. Any solving of the problems facing Europe will require a complicated coalition of European banks agreeing from both an economic and political perspective that it was not a handful of small countries making poor decisions that brought them to brinksmanship of the highest order; but rather it was the banking community’s willingness to continue buying the bonds of these countries when their economics were clearly deteriorating. One needs to remember that the European banks were the primary purchasers of sovereign debt, and no one held a gun to the heads of the banks to purchase what will eventually be defaulted obligations. Nevertheless, European policymakers are conscious of the mistakes the
US made during the Lehman bankruptcy and the counterparty risks that surfaced in the credit default swap arena. I expect that each partial Greek amputation will be commensurate with a rising pain level, and with the pain the remaining countries will become more and more politically aligned rather than also face disownment by Germany. Greece will eventually default and leave the euro, but the real struggle here is a political one as to who is going to solidify and control the euro, as though the euro zone were one state. In our opinion, the political risks of a European meltdown have been overpriced in the financial markets, though there does remain a chance of financial meltdown.
Greek Default? Or Voluntary Concessions?
In efforts to increase earnings, large US and European banks have sold huge amounts of insurance against both sovereign and corporate bond defaults, in the form of an instrument known as a “credit default swap” agreement. Credit default swaps (CDS) originally had the purpose of giving institutions the ability to insure against bond default for securities they owned. The seller of the insurance hopes to pocket the premium and never pay a claim; the buyer of the insurance is attempting to insure against a loss. During the US mortgage meltdown in 2008, firms such as AIG and Lehman were net big sellers of insurance against mortgage default, which put multi-billions of risk on their trade desks. As with all insurance, everything is fine
until something goes wrong, and then claims have to be paid. The term that then surfaces is counterparty risk, when firms such as Lehman and AIG declare bankruptcy and state they cannot honor their commitments, thereby imperiling the likes of CitiGroup, Goldman, and Morgan Stanley, who were buyers of insurance and ended up both (a) losing the premiums they had paid to AIG and Lehman and (b) staring at large losses from mortgage paper they owned and being forced take the losses from the positions they thought they had insured against.
In the CDS world, there is supposedly a winner and a loser, but the US government decided in 2008 to socialize the losses by bailing out AIG and paying off the CDS claims with taxpayer money. What did US banks learn from that experience? One, if you make really BIG mistakes and are too big to fail, then you get bailed out. And two, as a trader on a bank prop desk, you have no risk, so load up the wagon with big bets and collect your year-end bonus. If you are right, then the bank pays you for performing. If you’re wrong, then the bank or financial institution whose capital you exposed to risk may face the threat of going under and need bailout money; but you as the trader simply walk away, ala Joe Cassano. Who is Joe Cassano? He was the head trader for AIG’s CDS unit, who ended up with the moniker Mr. Credit Default Swap. His unit caused the bankruptcy of insurance giant AIG and resulted in a $280-billion-dollar bailout from the US government (us taxpayers) to settle AIG’s CDS liability claims. In 2008 (the year AIG declared bankruptcy) Mr. Cassano received a $34-million-dollar bonus, and his total bonus compensation from 2000-2008 for writing CDS agreements was $280 million. Mr. Cassano never faced any criminal or civil charges and walked away a very rich man at the expense of you and me.
The Lunacy
According to Bloomberg, US banks greatly increased their sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish, and Italian debt during the first half of 2011. According to the Bank for International Settlements, guarantees from US banks on debt of those countries rose from $80.7 billion to $518 billion. The banks counter that their “net” positions are far less than this number, as they have other trades where they too have purchased CDSs to reduce their exposure. Five banks – JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America, and Citigroup – underwrite 97% of all credit default swaps in the US – that statistic from none other than the Comptroller of the Currency. The banks refuse to
disclose/identify the counterparty risks should a default occur. Just this past week Bank of America, according to Bert Dohmen, reportedly shifted derivatives in its Merrill Lynch investment banking unit over to BofA’s depository arm, thereby gaining FDIC protection from the derivatives exposure. According to Bert, “This means that the investment bank’s European derivatives exposure is now back stopped by U.S. Taxpayers. Bank of America did not get regulatory approval to do this; they just did it at the request of frightened
counterparties. Now the Fed and the FDIC are fighting as to whether this was sound. The Fed wants to give relief to the bank holding company, which is under heavy pressure.”
Rest assured that if BofA is allowed to do this, JPMorgan, Morgan Stanley, Citigroup, and Goldman Sachs will not be far behind. This is insanity. This is the reason the European governments structured the Greek debt haircut of 50% as “voluntary,” thereby technically not triggering default and avoiding claims from owners of CDS insurance. But what good is buying CDS insurance when there is no default … technically?
The probability is that there is going to be another AIG moment, because DoddFrank did absolutely nothing to deal with the CDS markets. In my opinion, Congress should enact legislation to prohibit any financial institution that has governmentinsured deposits from engaging in any derivative transaction that is unregulated and not part of a listed exchange. The massive amounts of CDS being floated do absolutely nothing to promote the formation and allocation of capital and do everything to create a leveraged gambling casino within our financial system, where traders use house money (taxpayer guarantees) as their betting capital. The credit default swap market, in its present form, is a cancer within our system and will come back again and again if not eradicated.
Summary
The past four months have proven to be a challenging time to be a money manager. Stock prices are moving in step with news surrounding the euro-zone debt crisis and the US deficit rather than business fundamentals. Economic conditions are not great, but not bad either. Earnings season has proven that corporate America is healthy and has increased the amount of cash being held on the sidelines. If Europe falls prey to the cold reality of political paralysis, dogmatism, and deep philosophical divides, we could experience another meltdown. If Merkel and company can come up with a credible plan, then we will have a melt-up. The safety of depositor funds in European banks must be unconditionally guaranteed for any EFSF funding to work. My prediction is that eventually there will be some form of euro monetization, with the Germans in control. Greece eventually opts out of the euro, probably in March of next year. The risk of a euro implosion, while low in probability, cannot be discounted. US GDP, while declining, will remain sluggishly positive. Global GDP will suffer from a potential Euro recession but the emerging markets should continue to propel positive growth.
In closing, I attach a link of Phil Donahue interviewing Milton Friedman in 1979. Take 2:24 minutes and watch this; it sums up the case against Occupy Wall Street and class warfare of the rich versus the poor. Our issues in 1979 were very similar to our issues today. Copy and paste the following to your web browser:
http://www.youtube.com/watch?v=RWsx1X8PV_A
Keep a cool head and maintain your discipline in these types of volatile markets. It’s very easy to find yourself tossed overboard and searching for a lifeline. And if you don’t have a captain to steer the boat and kid you over your seasickness, get one, take some Dramamine, and maintain your sleeping point.
Cliff W. Draughn
President
