Investors should recognize that Euroland’s problems are global and secular in nature; it will be years before Euroland and developed nations in total can constructively escape from their straitjacket of debt.

A 12-year-old coffee mug has a permanent place on the right corner of my office desk. Given to me by an Allianz executive to commemorate PIMCO’s marriage in 1999, it reads: “You can always tell a German but you can’t tell him much.”

It was hilarious then, but less so today given the events of the past several months, which have exposed a rather dysfunctional Euroland family. Still, my mug might now legitimately be joined by others that jointly bear the burden of dysfunctionality.

“Beware of Greeks bearing gifts” could be one; “Luck of the Irish” another; and how about a giant Italian five-letter “Scusi” to sum up the current predicament?

The fact is that Euroland’s fingers are pointing in all directions, each member believing they have done more than their fair share to resolve a crisis that appears intractable and never-ending. The world is telling them to come together; they’re telling each other the same; but as of now, it appears that you can’t tell any of them very much.

The investment message to be taken from this policy foodfight is that sovereign credit is a legitimate risk spread from now until the “twelfth of never.”

Standard & Poor’s shocked the world in August with its downgrade of the U.S. – one of the world’s cleanest dirty shirts – to double A plus. But what was once an emerging market phenomenon has long since infected developed economies as post-Lehman deleveraging and disappointing growth exposed balance sheet excesses of prior decades.

Portugal, Ireland, Iceland and Greece hit the headlines first, but “new normal” growth that was structurally as opposed to cyclically dominated exposed gaping holes in previously sacrosanct sovereign credits.

What has become obvious in the last few years is that debt-driven growth is a flawed business model when financial markets and society no longer have an appetite for it. In addition to initial conditions of debt to gross domestic product and related metrics, the ability of a sovereign to snatch more than its fair share of growth from an anorexic global economy has become the defining condition of creditworthiness – and very few nations are equal to the challenge.

It was in this “growth snatching” that the dysfunctional Euroland family was especially vulnerable. Work ethic and hourly working weeks aside, the Euroland clan has long been confined to the same monetary house. One rate, one policy fits all, whereas serial debt offenders such as the U.S., U.K. and numerous G-20 others have had the ability to print and “grow” their way out of it.

Beggar thy neighbor if necessary was the weapon of choice in the Depression, and it has conveniently kept highly indebted non-Euroland sovereigns with independent central banks afloat during the past few years as well. Depressed growth with more inflation, perhaps, but better than the alternative straitjacket in Euroland. As currently structured, Euroland’s worst offenders now find themselves at the feet of a Germanic European Central Bank that cannot be told to go all-in and to print as much and as quickly as America and its lookalikes.

Proposals from the German/French axis in the last few days have heartened risk markets under the assumption that fiscal union anchored by a smaller number of less debt-laden core countries will finally allow the ECB to cap yields in Italy and Spain and encourage private investors to once again reengage Euroland bond markets. To do so, the ECB would have to affirm its intent via language or stepped up daily purchases of peripheral debt on the order of five billion Euros or more. The next few days or weeks will shed more light on the possibility, but bondholders have imposed a “no trust zone” on policymaker flyovers recently. Any plan that involves an “all-in” commitment from the ECB will require a strong hand indeed.

On the fiscal side the EU’s solution has been to “clean up your act,” throw out the scoundrels and scofflaws (eight governments have fallen) and balance your budgets. Such a process, however, almost necessarily involves several years of recessionary growth and deflationary wage pressures on labor markets in the offending countries. While the freshly proposed 20-30% insurance scheme of the European Financial Stability Facility (EFSF) offers hope for the refunding of maturing debt, it is the deflationary, growth-stifling, labor/wage destroying aspect of the EU’s original currency construction that threatens a positive outcome over the long term. Without an ability to devalue their currency vs. global competitors or even – “Gott im Himmel” – Germany itself, peripheral countries may have survival to look forward to, but little else. Perhaps the Italians and Spaniards will put up with it, but maybe they won’t. The ultimate vote of the working men and women in these countries will always hang over the markets like a Damocles sword or perhaps a French/German guillotine. If the axe falls, then bond defaults may follow no matter what current policies may promise in the short term.

Investors and investment markets will likely be supported or even heartened by recent days’ policy proposals. The problem of Euroland is twofold however. First of all, they will remain a dysfunctional family no matter what the outcome. You can’t tell a German much, and while they can issue what appear to be constructive orders and solutions to the southern peripherals, there is little doubt that none of them will “like it very much.” Slow/negative growth and historically wide bond yield spreads will therefore likely continue. Globalized markets themselves will remain relatively dysfunctional, pointing towards high cash balances in presumably safe haven countries such as the United Kingdom, Canada and the United States. The U.S. dollar should stay relatively strong, ultimately affecting its own anemic growth rate in a downward direction.

Secondly, and perhaps more importantly however, investors should recognize that Euroland’s problems are global and secular in nature, reflecting worldwide delevering and growth dynamics that began in 2008. It will be years before Euroland, the United States, Japan and developed nations in total can constructively escape from their straitjacket of high debt and low growth. If so, then global growth will remain stunted, interest rates artificially low and the investor class continually disenchanted with returns that fail to match expectations. If you can get long-term returns of 5% from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors.

To approach those numbers, risk assets in developing as opposed to developed economies should be emphasized. Consider Brazil with its agricultural breadbasket and its oil. Consider Asia with its underdeveloped consumer sector but be mindful of credit bubbles. In bond market space, the favorite strategy will be to locate the cleanest dirty shirts – the United States, Canada, United Kingdom and Australia at the moment – and focus on a consistent, “extended period of time” policy rate that allows two- to ten-year maturities to roll down a near perpetually steep yield curve to produce capital gains and total returns which exceed stingy, financially repressive coupons. A 1% five-year Treasury yield, for instance, produces a 2% return when held for 12 months under such conditions. Bond investors should also consider high as opposed to lower quality corporates as economic growth slows in 2012.

Because of Euroland’s family feud, because of too much global debt, because of deflationary policy solutions that are in some cases too little, in some cases ill conceived, and in many cases too late, financial markets will remain low returning and frequently frightening for months/years to come. I can imagine the coffee mugs for 2020 now: “Gesundheit!” from the Germans, “C’est la vie,” from the French and “Stiff Upper Lip,” from the British. In the United States I suppose it’ll still say, “Let’s go shopping,” although our wallets will be skinnier. You can always tell an American, you know, but you can’t tell ‘em to stop shopping. Likewise, investors should always be able to tell a delevering, growth constrictive global economy – but perhaps not. Dysfunction is not exclusive to politicians. Families, it seems, feud everywhere.

Note: Initial paragraphs were originally published in Financial Times Markets Insight on November 15, 2011
(http://www.ft.com/intl/cms/s/0/cc1ada48-0c4d-11e1-8ac6-00144feabdc0.html#axzz1f1q48ixJ)

An Interview with Seth Klarman and Charlie Rose from Facing History and Ourselves on Vimeo.

…we can expect to observe one of the following three outcomes:

1) A European Federal System emerges whereby each country surrenders its own fiscal sovereignty, losing the ability to set fiscal policy without broad approval from a central European authority. This is the only condition on which Germany would be likely to agree to a change in the ECB’s mandate to allow it to broadly purchase weaker European debt. It is difficult to see how a sufficiently binding enforcement mechanism could be created to prevent individual countries from acting in what they see as their own best interests. In my view, any hope for this solution has a shelf-life of about three months, because as a broadening recession becomes clearer, the willingness of individual European countries to give up their own fiscal reins may vaporize.

2) Heavily indebted European nations begin to adopt versions of a dual-currency system, issuing various forms of IOU’s or convertible debt, thereby creating the longer-term option of converting their debts into currencies that they can print and devalue individually. This is probably the best option for Europe, but is not one that distressed countries will choose on their own so long as bailouts can be extracted.

3) Germany adopts a version of a dual-currency system by itself. This is something of a “nuclear option” after failing all other approaches. The benefit of this is that it would effectively allow Germany to issue new debt at negative real interest rates in euro terms, as Germany’s own inflation and exchange rate credibility is greater than that of the euro itself. Indeed, Germany could likely convert its entire stock of euro-denominated debt to deutschemark-denominated debt within about a week, and could legislate DM as legal tender just as quickly. This would also free the ECB to print euros to its heart’s content, without extracting seigniorage from the German people. It would, however, accelerate the depreciation of the euro since a reinstated German mark would be viewed as a safe-haven, much like the Swiss franc. It would also create some difficulty for German companies with long-term contracts having revenues payable in euros, and would sharply narrow Germany’s trade surplus with the rest of Europe. The benefit is that technically, the peripheral European countries would be saved from default. Moreover, Germany could conceivably re-join the common currency on more favorable exchange terms, post-depreciation, so it would not necessarily be the end of the euro.

In short, if you can’t save the euro by restructuring the debt of the weak members, or by having the weak members leave, or by having the fiscal costs fall squarely on the German people, the remaining option is for Germany to leave, inflate the heck out of the euro to deal with the debt problem, and reinstate Germany on post-devaluation terms.”

You can read the full piece here.

Once again, there are no good options at this point. Let us look at three of the choices bandied about from Germany’s point of view:

1. The ECB prints money: Leaving aside the inflation issue, this reduces the cost of today’s debt load, but transfers resources from Germany to other countries. From a structural viewpoint this transfer  has no constraint on spending and leads to further profligacy in the countries that are having the problem and endless transfers from Germany to the PIIGS. If accompanied by austerity and no ability for the PIIGS to depreciate their currency to become more competitive with Germany, the peripheral economies will enter depression (or continue the present one for some of these countries) and lead to endless transfers from Germany as the ECB will need to buy more and more bonds. The crisis becomes an expensive one for Germany and the issues never really goes away under any variation of this option. The PIIGS need to become more competitive in order to stop accumulating more debt and leading to crisis further down the road.

2. Germany leaves the Euro: The ECB will print money and the Euro will depreciate against the new German currency, the Deutschmark. German exporters lose their competitive advantage and the German economy tanks. Not good either, and often given as a reason Germany will never leave the Euro, though as Hussman has pointed out, leaving the Euro need not be permanent.

3. Full Fiscal Integration: Since all other solutions put in place circumstances that are unstable and merely kick the can down the road, the fundamental flaw in the Euro needs to be addressed. That is the lack of a unified fiscal policy. The answer then is the end of sovereignty, the creation of a US of Europe. An obvious objection is that Germany wants to be a sovereign nation. We’ll skip this niggling little detail, but even if they didn’t want to remain sovereign do they want to harmonize laws and economic policy with Greece and some of the other PIIGS? West Germany just  integrated with East Germany and the experience was traumatic featuring massive transfers to East Germans. The PIIGS will still not be competitive with Germany. That means internal adjustments (internal devaluation or austerity) to allow them to become more competitive for the PIIGS’ or massive transfers. Thus unifying the Eurozone under a single fiscal policy means massive transfers from Germany to the PIIGS to harmonize the welfare states and unify the debt and avoid austerity throwing the entire Eurozone into depression. Germans will pay for the debt in one fashion or another.

Cullen Roche points out that in the US we don’t worry much about the need for internal transfers between states to keep the system sound.  Today that is true, though it has led to large conflicts in our past, playing a role in civil unrest, uprisings, the conquest of a continent and near destruction of its former inhabitants and the Civil War. Our unity was easier to envision and still born of blood and tragedy.

I am not saying unification of Europe would lead to such tragedies and conflicts. However, we need to ask if Germany (or really all the countries) want to make the internal transfers that make such a system work? Germans would pay a great deal, Greece and the other PIIGS would suffer internal austerity to the extent that they contribute to the economic re-balancing. Do Europeans, or most importantly the Germans, view themselves as a people who will be responsible for paying all the bills to integrate the Greeks and others?

Are Europeans ready to think about their home countries in the same way Texans think of Texas? Their state, but completely subordinate to the US? Will they be able to secede? We answered that question in the US with a war of incredible savagery and destruction. My guess is a unified Europe would be far less stable. They will not choose a civil war comparable to the US, but instead countries leaving over time as well as never entering the union. That leaves us with all the problems we have now still being there. Without a European populace overwhelmingly in favor of a true union this will not work. We would be faced with a PIIGS like crisis with every election and the possibility of secession in each of the former countries.

There are other variations, but we won’t go into all of them here.  The point is that there are no “good” options from Germany’s point of view. However, we should think rationally when analyzing this and admit that any final solution except breakup needs to result in the PIIGS becoming more competitive with Germany. A tanking economy may be a small price to pay compared to endless transfers to the PIIGS. It is often suggested and even out right claimed that the reluctance to print from the German’s is purely an irrational fear of inflation born of the 1920′s and 1930′s. However, the issues go so much deeper than that. The German’s are faced with a terrible set of options. The ramifications  for Germany as a people are near existential. Germany may make the choice to accept the ECB printing for now, but eventually they will want to cut the cord. The cord is the Euro.

1. Secular cycles are driven by the inflation rate (deflation, price stability, and higher inflation)

2. Secular bulls occur when P/E starts low and ends high over an extended period

3. Secular bears occur when P/E starts high and ends low over an extended period

4. Cyclical bulls and bears are interim periods of directional swings within secular periods

5. Cyclical cycles are driven by market psychology, illiquidity, or other generally temporary condition(s)

6. Time is irrelevant to the length of secular stock market cycles

7. Secular bulls require a doubling or tripling of P/E

8. Secular bears occur as P/E stalls and falls by one-third to two-thirds or more

9. When real economic growth is near 3%, there is a natural floor for P/E between 5 and 10, a natural ceiling around the mid-20s, and a typical average in the mid-teens

10. If economic growth shifts upward or downward for the foreseeable future, the natural range moves upward or downward, respectively

11. Inflation drives P/Es location within the range; economic growth drives the level of the range

12. The stock market is not consistently predictable over months, quarters, or periods of a few years; the stock market is, however, quite predictable over periods approaching a decade or longer based upon starting P/E

That pretty much nails it. I highly recommend that you read the analysis below from July of 2012 which shows exactly why so many have been so wrong about how cheap the market is over the last eight years or so. Click the image to read, or print the article.

Accompanying the news of the “grand and comprehensive” European solution on Thursday was the news that GDP rose at an annual rate of 2.5% in the third quarter. There was already coincident data that the U.S. was not yet in contraction in August or September, so this was no surprise. Still, investors continued the habit of confusing lagging and coincident indicators for leading ones, so the positive GDP figure was taken as evidence that an oncoming economic downturn was “off the table.”

I can’t emphasize enough that leading evidence is in fact leading evidence. Take, for example, the ECRI Weekly Leading Index. It’s certainly not a perfect indicator in itself, but its leading properties are instructive. If you look at the historical points where the WLI growth rate fell below zero, you’ll find that weekly unemployment claims (a coincident indicator) were generally still about 3% below their 5-year average. It generally took about 13-16 weeks for unemployment claims to climb above that 5-year average, and even longer for the unemployment rate (a lagging indicator) to rise sharply. That’s not much of a lag in the grand scheme of the full economic cycle, but allows a great deal of intervening and often contradictory action in the financial markets.

The tendency to demand predictable outcomes to also be immediate is a dangerous one, because it allows investors to be sucked in by temporary reprieves during what are, in fact, very negative conditions. As I noted in May (see Extreme Conditions and Typical Outcomes ), “It’s clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes.”

The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest very high recession risks, and even sparse combinations of indicators provide a major basis for concern.

For example, since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.

If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.

That simple set of conditions (WLI < -5, PMI < 52, SPX < 6 months earlier) has been seen in every postwar recession for which the data is available. Though we’ve seen recessions without a drop in the WLI much below -5, when a WLI below -7 has been coupled with a PMI below 52 and an S&P 500 below its level of 6 months earlier, the economy has been in recession within 13 weeks, 100% of the time. This is the combination, incidentally, that we observe today.

We certainly don’t base our economic expectations solely on these data points, as a broad ensemble of other data continues to present high risk of an oncoming recession. Still, we view the virtual abandonment of recession concerns to be remarkably naive, and lacking of any real basis in historical evidence. Wall Street eagerly points to 2010, when the ECRI’s WLI dropped below -10 without a subsequent recession, largely thanks to the brief can-kick produced by QE2. But even in that instance, a smaller set of negatives was in place (the ECRI itself did not observe enough deterioration in its indicators to project a recession). In the present instance, a much broader range of evidence has turned down, both in the U.S. and internationally.

Given that nothing in economics is entirely certain, it’s possible that this time will be different. But that possibility is not one that has support in the data. To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time that similar data has been in hand.

We share the concern. While we are not convinced a recession is a definite outcome here, we too wonder at the ability of investors to continue to weigh current data ahead of forward looking indicators. In addition we are told repeatedly by many we will not have a recession unless a shock from Europe, China or elsewhere were to occur. Which brings to mind two points.

1. If an overseas shock could lead to recession then our economy is in a very fragile state. Obviously the margin for error in such an analysis is quite small and thus could be quite incorrect.
2. Shocks from China and/or Europe over the next six to twelve months are not exactly a remote possibility.

To wit, Hussman addresses some of the issues with Europe’s latest “solution” as well.

The bond market remains in a full fledged secular bull market, though it is probably safe to say after this year’s downleg in yields to new lows out to the 10 year part of the curve at least we are in the very mature phase.  With that in mind, it may pay to reassess what the backdrop may look like when the Great Bull Market in Bonds, which began in 1981 with 30 year Treasury Bonds yielding 15.25%, finally comes to its glorious end.

For starters, I think it’s safe to say that the bull market in bonds will end reasonably close to the point in time that inflation (or deflation) bottoms.  This is because we have determined that the only economic factor that correlates workably with interest rates, at least for long term Treasury bonds, is core CPI inflation.

…what about the end of the Great Bull Market in Bonds?  It could come pretty soon.  You heard right.  Long term Treasury bond yields could reach a secular bottom in the next couple of years.  And what will it look like?  Well, rates will likely be much lower than anyone expects and, as occurs at most secular market peaks, the public will probably swear by them.  In order for the public to love 2% 30 year Treasury bonds, they will first have to believe in stable or modestly deflating core CPI as a long term forecast.  After all, what other safe investment has delivered inflation plus 2% or better, guaranteed, in the past 30 years?  They will also need to be fed up with risk and, judging by the extreme volatility of the stocks and weakness in real estate, who could blame them?  We can see that boomers are already voting with their feet, as the mutual fund flows clearly indicate.

Finally, the investing public will probably need to be afraid to be out of the bond market.  That will most likely be due to a “flight to quality” as we continue to suffer bear market in stocks and real estate and suffer the economic setbacks of renewed recession.

Pull this all together, as I said at the outset, bonds are not better or worse than equities.  They are different.  It goes without saying that the best time to allocate to equities is at the point of maximum pessimism.  We know that historically, that moment has coincided with valuations below 10X trailing 12 months reported earnings and dividend yields above 5% as measured by the S&P 500 index.  We also know that conventional wisdom is erroneously linear at inflection points, so not only is the market “cheap” at these secular lows, but the future is much brighter than generally perceived.  Pulling the trigger at that magic moment when bonds have peaked and stocks can’t hurt you anymore and dividend yields are more than secure at twice the Treasury rate would be nice.  But you never know for sure at the right time or you think you know for sure too early.  For now, we are not even close.

The refusal of many to see what history tells us about what the end of bear and bull markets look like is disappointing, but not surprising. That the past need not be a perfect guide to the future I understand. That the intellectual case of the process of getting here, much less where we are likely to get, has been fought and denied every step of the way is infuriating and has cost investors an extraordinary amount of money.

• We are on a spiral caused by mass credit creation, excessive borrowing, reckless spending, and a enormous credit crisis. The end result is inevitable, and most likely unavoidable.
• The Europeans have created their own credit crisis, and it is attributable, in part, to the creation of the EU. They EU is following a path similar to what the US went through n 2008-09.
• There will be yet another bailout in the US and QE3 (or more) — but not until the situation gets much worse; That refers to both the market and the economy.
• There was a window for an Austrian economics solution, but that opportunity has passed. Worse still, imposing Austrian economics on weak countries here and now will only make the situation worse, causing a recession or making any contraction worse.
• Equities remain in a long term secular bear market dating back to 2000, one that is unlikely to end before 2017.
• Multiples will compress over this time period. Look at more than P/E — consider Price to Sales as well.
• Of all the currencies in thew world, the US Dollar is the least ugly. That says less about the Greenback than it does about the Euro and Yen.
• The Eurozone was problematic since its inception. You cannot have a monetary union but not simultaneous fiscal union.
• Policy makers inevitably punish savers.
• Germany is the creditor to the rest of Europe. Given their history, their biggest concern is hyper inflation, while nations like Greece, Italy and Ireland are facing deflation
• Watch for rising populism in response to economic turmoil. It is already happening in Europe, and will eventually come to the US.
• The political situation in Europe is unlikely to improve until the crisis is much worse. The same is likely true in the US.
• There will be an eventual repricing of all currencies.
• Greece may very well will leave the Euro, but Italy is probably to big to do so.
• Countries that can print & devalue their own currencies get to invite tourists, stimulate economy, and climb out of their morass. Tied to the Euro, they simply cannot.
• There is no currency that will retain its value over the next decade except Gold. Every other currency is in a race to print and devalue, inflating away the debt.
• There is no price target on Gold, but he expects higher prices, and perhaps significantly higher prices over the next decade.

By Niels Jensen, Absolute Return Partners

I can’t remember having experienced this much pessimism before. 2008-09 was different. Back then it was fear more than pessimism, fostered by investors being hopelessly unprepared for what happened. The present crisis is well advertised, causing more pessimism than actual fear; however, whatever you call it, the current level of gloom and doom is quite simply overwhelming. Marc Faber must be having a field day!

I am writing these lines from Geneva. In a meeting earlier today I learned that a leading Swiss private bank currently allocates approximately 25% each to gold, cash and alternatives. In other words, three quarters of its client portfolios generate little or no income. Astonishing!

Meanwhile my brother-in-law, who is a die-hard value investor, told me of a trip he made to Germany last week in search of new investment ideas. He met with nine companies; all solid German businesses, most of them industrial. Not one talked about business being weak or weakening. Most of them asked the question: What’s wrong with you finance guys? Are you trying to destroy the world?

I shall be the first to admit that we are facing unprecedented challenges. Europe has rarely been up against stronger headwinds than now. It could fall into a prolonged recession, possibly even depression, and the eurozone could quite conceivably disintegrate altogether. However, as the French economist Charles Gave of GaveKal Research is fond of saying, and I paraphrase (without being able to do the French accent convincingly), “the French economy isn’t competitive but lots of French companies are”.

The best performing stock in our global equity fund in recent months has been Hermes, the French luxury goods maker (which, for the record, was sold a couple of weeks ago). Charles Gave’s point is that we live in a world where trade recognises few borders. Hermes may be a European brand, but the world is its market place. A European recession will only have limited effect on its fortunes. Likewise with dozens of other European companies.

Why are investors not capable of recognising this fact? Because most of us tend to extrapolate and because we are all subject to a phenomenon that behavioural analysts call recency; we assign more value to recent events than we do to more distant ones.

Let me provide you with one example. As you can see from chart 1 below, emerging markets have offered the best equity returns in six of the last eight years. The majority of investors expect emerging markets to offer the best returns going forward. They will argue that the superior earnings outlook justifies their bullish expectations. In reality, or so behavioural finance theory goes, their judgement is coloured by their knowledge of recent performance patterns.

Chart 1:  Annual Returns for Various Equity Indices

Source: http://www.callan.com/research/download/?file=periodic%2ffree%2f457.pdf

We have been structurally bearish on equities since Absolute Return Partners was established in 2002. ‘Structurally bearish’ does not imply that we, or our clients, have had no exposure to equities throughout this period. Neither does it mean that we have been expecting equities to post a loss every year for the past nine years. No, ‘structurally bearish’ is a term we (and others) use to express our view on multiple trends. In a structural bear market, price/earnings (P/E) ratios decline; i.e. corporate earnings need to outgrow the decline in valuations for equities to post positive returns. Equity investors are swimming against the tide, so to speak.

The opposite is the case in structural bull markets where P/E ratios expand, sometimes dramatically so. In the last structural bull market, lasting from 1982 to 2000, P/E expansion was the single largest contributor to stock market performance, dwarfing the contribution from dividends and corporate earnings.

Chart 2: The Link between Valuation and Returns

Source: Crestmont Research

That said, our decision to turn structurally bearish on equities back in 2002 was a function of P/E multiples at the time. Following an 18 year bull market, valuations had reached dizzying levels which we considered unsustainable. It is a well documented fact that long-term equity returns correlate negatively with valuation levels at the point of entry. As you can see from chart 2, 20-year returns have averaged 13.4% per annum, assuming you bought into the market when P/E levels were rock bottom (decile 10) as opposed to 3.2% per annum if you made your investment when P/E levels were at their highest (decile 1).

Our call has been broadly correct, although it has worked better in some markets than others. It is also fair to say that since we first made our call, market gyrations have been a great deal more spectacular than we would have expected, providing plenty of trading opportunities within a market that has offered only modest returns for buy-and-hold investors.

Now, nine years after having made that call, we begin to spot real value again with European equities trading at 9.4 times trailing 12-month earnings and 7.6 times next year’s earnings (see chart 3). A price-to-book value just below 1 and a dividend yield of 5.3% does not exactly make the value story any less compelling.

Chart 3:  European vs. US Valuation Metrics

Source: Bloomberg. Based on valuations as at 6^th October, 2011.

At first glance, European equities look a great deal more attractive than US equities; however, comparing P/E and other multiples across borders can be misleading due to the fact that the underlying economies can be at different stages in the economic cycle. Professor Shiller has addressed that problem by developing the so-called Shiller P/E (also known as the cyclically adjusted P/E or CAPE). Shiller evens out the impact from the economic cycle by calculating the P/E ratio as a 10-year average and inflation-adjusting it.

The results can be seen in charts 4 and 5. On a cyclically adjusted basis, the divergence in valuations is even more pronounced. While Germany and France are back to 1981-82 levels (chart 4), the Shiller P/E ratio for the S&P500 at almost 20 is still well above its long term average of 15-16 (chart 5).

Chart 4:  Shiller P/E Ratios for France and Germany

Source: SocGen

The ability to buy European equities at 1981-82 valuations ought to make everyone sit up and listen. I remember the dark days of the early 1980s when nobody wanted equities in their portfolios. 18 years later, when earnings multiples were 50-60, everyone did. Guess who had the last laugh.

Chart 5:  The Shiller P/E Ratio for the US

Having said that, there is no question that valuation levels are attractive for a reason.Europe’s outlook is murky to say the least. It could very well be that earnings estimates for 2012 are wildly optimistic and that earnings will actually fall from this year to next. It is also possible that we could be entering an extended period of subdued economic growth. However, we must remind ourselves that it is not a question of what happens next but to what extent such calamity has already been priced in.

Bloomberg publishes a quarterly survey of global investors. The most recent one was published on the 26^th September. The results reveal an astonishing amount of gloom directed at Europe:

• 88% say the eurozone economy is deteriorating while 75% expect it to fall into recession within the next 12 months.
• 40% predict the eurozone will lose at least one member in the next year and 72% expect at least one country to abandon the eurozone within 2-5 years.
• 51% say the euro zone will collapse eventually but only 8% expect it to happen within a year.
• 93% say Greece will eventually default while 56% expect Portugal to face the same fate.
• 67% believe US officials have handled their economic challenges the best; only 11% believe European officials have done the best job.
• Less than 20% expect the EU’s markets to offer the best investment opportunities over the next 12 months whereas 53% suggest that they actually offer the worst opportunities in the world.

Source: Bloomberg.

Frank Veneroso kindly pointed me towards this study, stating that “this is simply enormous pessimism.” The Bloomberg survey confirms to me what I already suspected. I believe a Greek default is now fully discounted. So is a eurozone recession within the next year. The one risk factor which is probably not fully discounted yet is the systemic risk associated with Greece defaulting on its debt. If the authorities cannot contain the domino effect, European equities could fall further.

The extreme level of pessimism is further documented in Citibank’s euphoria/panic model which shows that investors are currently extremely bearish (see chart 6). While Citi’s model is US centric, it goes to show that even if the draw-down in US equities has been less dramatic than losses on this side of the Atlantic, pessimism is widespread.

According to the model’s originator, Citigroup strategist Tobias Levkovitch, the current reading indicates a roughly 90% probability that equity prices will be higher in six months and a 97% chance of gains in 12 months.

Chart 6:  Citibank’s Euphoria/Panic Model

One further piece of ‘evidence’ for those who are still doubtful: Professor Richard Sylla of New York University’s Stern School of Business has researched US equity returns over the past 200 years and found some remarkably consistent patterns. Using 10-year average inflation-adjusted returns, Professor Sylla found that when returns drop below 5%, markets are likely to bottom out and begin a recovery. Years later, at the end of the secular bull market when average returns exceed 15%, the cycle peaks and a new downturn commences (see chart 7).

Drawing upon behavioural finance, such consistency in equity return patterns can be explained by investor over- and under-confidence (or greed and fear as some prefer to call it). Not surprisingly, 10-year average returns are now below 5%, both in the US and in Europe, suggesting that now may not be a bad time to begin accumulating equities again if you are a long term investor.

Chart 7:  Professor Sylla’s Return Forecasting Model

One final note on the valuation gap between Europe and the US: Less than two decades ago, European valuations were higher than they were in the US. The balance shifted with the dot.com bubble and has never reversed. It begs the questions – why? In my opinion, the Greenspan

(now Bernanke) put plays a big part. In the US, for years, it has been a widely held belief that the Fed will not allow a wholesale fall in asset prices – a perception which provides an invisible hand under US financial markets. Such views do not prevail in Europe, exposing European equity markets to the full force of the current bear market dynamics.

Secondly, financial markets have a curious inability to focus on more than one problem at the time. For this reason the undeniably large problems facing the US economy have received limited attention when compared to the massive coverage of the eurozone crisis. At some point the markets’ focus will change and the Bernanke put will be seriously tested.

For precisely this reason, a relative value trade – long Eurostoxx 50 and short S&P500 – may not be a bad idea (easy to do with ETFs these days) as opposed to an outright long position in European equities. I feel pretty strongly that whether markets fall further or rebound from here, the valuation discount currently on offer in Europe is likely to shrink once Europe gets itself sorted out (and it will).

One note of caution: Financials account for 24% of the Eurostoxx 50 and only 14% of the S&P500. If the eurozone crisis worsens and more banks require bailouts, the European index could be badly impacted.

Despite the storm clouds, we have recently begun to add to our European equity exposure again for the first time in years (we are avoiding financials). Please note that this is not a trading call. One cannot predict near term performance with a value approach. I could easily look foolish a year from now. However, I vividly remember the dark days of early 2009. The world was coming to an end, or so we all thought. By early March of that year the probability of bumping into a bull in the streets of London was on par with Gordon Brown winning Strictly Come Dancing. Yet we were reminded shortly afterwards that the darkest hour is often just before sunrise. Within weeks, global equity markets had shaken off the misery of the previous six months and we went on to register one of the greatest bull runs of all times.

I shall be the first to admit that the current situation is different on several accounts (it always is); however, investor behaviour rarely changes, and there is no reason to believe that they haven’t fallen victim to the same behavioural patterns they have been subjected to in the past.

Buy while the opportunity is there, but buy only if you can afford to see through the short term volatility that I fully expect to plague markets for some time to come. I am convinced you will be amply rewarded. Eventually.

PS. Hedge the euro. Not so sure about that one…

Niels C. Jensen

7 October 2011

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In the US he feels Robert Shiller is right, and the US stock market is still overvalued. The only major stock market he sees that is truly cheap is Japan.

We are headed toward a new recession because our policy makers never addressed the underlying problem in the first place, which was, and remains, the need for debt restructuring. This is an issue that I suspect will re-emerge to the forefront of public debate in the next year. Hopefully, the response of our policymakers will be at different.

{…}

You can do the same calculations for nearly every major financial institution in the world. The amount of bondholders and equity coverage varies somewhat, but in virtually every case, bondholder and shareholder capital of these institutions are more than sufficient to absorb any losses without the need for public funds, provided that the objective of government policy is to protect the people and the long-term viability of the economy, rather than defending the existing owners, bondholders, and managements of these institutions. Make no mistake – that choice is what the oncoming crisis is going to be about (See An Imminent Downturn – Whom Will Our Leaders Defend? ).

But who are those bondholders? They include corporate investors, pension funds, endowments, mutual funds and ordinary investors. And all of them willingly take a risk in order to reach for return. As do stock market investors. And if the risk doesn’t work out, none of them should look to the government to fire teachers, lay off social workers, underfund the National Institutes of Health, cut Medicaid, and print money (because until the Fed sells its Treasury and GSE holdings, it has indeed printed money), just because they take their risk in a different type of security.

My impression is that the scare-mongering of self-serving financial “experts” on Wall Street is shortly about to become deafening. It would be catastrophe, utter catastrophe, no, Armageddon, to let the global financial system collapse – collapse! – because the world as we know it will indeed collapse, as day follows night, if bondholders, who knowingly and voluntarily take risk and invest at a spread, are actually allowed to lose anything! We cannot, in a thinking society, allow losses to befall risk-takers who make reckless loans and bad investments. We must, must at all costs, divert money away from health, education, and welfare, in order to save these companies from failure, because neither health, nor education, nor welfare are even possible unless we save the financial system from unthinkable meltdown. We have no choice. No choice at all. They are too big to fail, and we cannot hesitate – they must be saved, for the sake of our children, for our children’s children, for our freedom, for the flag, and to honor the legacy of our forefathers, so that these Champions of Disfigured Capitalism can continue to do their vital work with impunity, unbound by any of the incentives or consequences that actually allow capitalism to work in practice.

To reiterate the observations of Sheila Bair, the outgoing head of the FDIC, in her discussion of the 2008-2009 crisis (see Sheila Bair’s Exit Interview ): “‘We were rarely consulted. They would bring me in after they’d made their decision on what needed to be done, and without giving me any information they would say, ‘You have to do this or the system will go down.’ If I heard that once, I heard it a thousand times. ‘Citi is systemic, you have to do this.’ No analysis, no meaningful discussion. It was very frustrating.’ … As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management’s risk-taking.”

I feel it is important to emphasize – as we move toward recession – that we shouldn’t blame what is happening here on capitalism or free markets. We really have only a caricature of those here. We have a system that is constantly eager to abandon the proper role of government in the markets – which is effective regulation of risk – and to substitute it with the worst role of government in the markets – which is absorbing losses for those whose losses should not be absorbed, and pursuing policies tilted toward the constant creation of speculative bubbles and the avoidance of required economic adjustments, rather than the productive allocation of capital.

Free markets work – provided that they operate within a framework of government policy that enforces property rights, provides reasonable regulation, coordinates objectives that cannot be achieved privately (e.g. certain infrastructure, insurance coverage for pre-existing conditions – which otherwise creates an adverse selection problem even for companies that would like to offer it), and maintains reasonable consumer protection (because there is a huge “information problem” in requiring each consumer to have all of the requisite facts to avoid abusive practices). To blame our economic problems on the free market is an insult to what has proved for centuries to be the most effective economic system for creating prosperity and raising living standards. We would be wise to stomp out the incessant policy of bailouts and monetary distortions if we hope for that to continue.

Of course, we suggest reading his letter in its entirety.

As a consequence, color me more concerned regarding the market’s short-term prospects — and I am back, as I wrote yesterday, into a market-neutral mode. If this week’s rally extends into quarter-end (Friday) and the fundamental input doesn’t change, tactically, I will consider getting back to a slightly net short position.

An important issue that I have been raising has been whether the sentiment plunge in August would hit the hard economic data in early winter. Unfortunately, I think it is significant that consumer confidence rebounded only modestly from the disastrous reading in August. Moreover, the labor differential worsened for the fifth consecutive month — not a good sign. Clearly, job growth and economic growth hold the potential of disappointing in the months ahead.

Meanwhile, another bad sign yesterday was the financial stocks, which, at the peak, were the best performers of the day, but, by day’s end, they were among the worst. Bank of America (BAC), American Express (AXP) and JPMorgan Chase (JPM) all closed in the red.

The markets and our economies are captive and beholden to policymakers (both here and abroad); it’s a slippery slope where investors and corporations don’t seem to be in control of their own destinies.

Add this together with the manufacturing malaise I observed yesterday (shown again below), and I am afraid that we appear to be headed in the wrong direction.

The National ISM (consensus is at 50.4), to be reported on Monday, will likely disappoint (and come in the high 40s) in the face of a compilation of all the now previously released regional ISMs.

Consensus domestic economic expectations (and corporate profits) are clearly exposed to downside risk.

Here is the chart Doug is referring to. All of the regional surveys are in negative territory:

I will admit, Doug’s relative bullishness made me wonder if I was weighing the probabilities in too pessimistic a manner. Doug is someone I listen closely to, but I explained why I couldn’t go there anyway. Listening to people who disagree with you who you respect and understanding precisely why you still disagree is a key to successful investing. You need to be able to change your mind. However, this week Doug closes with words quite similar to what we have been saying:

Given these concerns, if the markets continue to advance, it might be an ideal time to cull out poor-performing stocks or companies that face earnings challenges in a disappointing and decelerating domestic economy.

Err on the side of conservatism in these uncertain (and market volatile) times.

In an interview with CNBC yesterday Soros made some blunt comments:

• The USA is already in a double dip recession.
• The USA needs more fiscal stimulus.
• Europe could experience TWO or THREE periphery defaults. They would most likely remain in the EMU and default would be controlled. Uncontrolled default could result in defection.
• The Euro currency should remain fairly strong even in the case of defaults.
• The European leaders are way behind the curve here.
• A form of a central Treasury is required in Europe
• This is a “more dangerous” situation than Lehman Bros.
• The EMU will do what it takes to hold it all together.

There is no escape from this gloomy scenario as long as the authorities persist in their current course. They could, however, change course. They could recognize that they have reached the end of the road and take a radically different approach. Instead of acquiescing in the absence of a solution and trying to buy time, they could look for a solution first and then find a path leading to it. The path that leads to a solution has to be found in Germany, which, as the EU’s largest and highest-rated creditor country, has been thrust into the position of deciding the future of Europe. That is the approach I propose to explore.

To resolve a crisis in which the impossible becomes possible it is necessary to think about the unthinkable. To start with, it is imperative to prepare for the possibility of default and defection from the eurozone in the case of Greece, Portugal, and perhaps Ireland. To prevent a financial meltdown, four sets of measures would have to be taken. First, bank deposits have to be protected. If a euro deposited in a Greek bank would be lost to the depositor, a euro deposited in an Italian bank would then be worth less than one in a German or Dutch bank and there would be a run on the banks of other deficit countries. Second, some banks in the defaulting countries have to be kept functioning in order to keep the economy from breaking down. Third, the European banking system would have to be recapitalized and put under European, as distinct from national, supervision. Fourth, the government bonds of the other deficit countries would have to be protected from contagion. The last two requirements would apply even if no country defaults.

All this would cost money. Under existing arrangements no more money is to be found and no new arrangements are allowed by the German Constitutional Court decision without the authorization of the Bundestag. There is no alternative but to give birth to the missing ingredient: a European treasury with the power to tax and therefore to borrow. This would require a new treaty, transforming the EFSF into a full-fledged treasury.

That would presuppose a radical change of heart, particularly in Germany. The German public still thinks that it has a choice about whether to support the euro or to abandon it. That is a mistake. The euro exists and the assets and liabilities of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to contain. The longer it takes for the German public to realize this, the heavier the price they and the rest of the world will have to pay.

 …like we’ve talked about for three years, there’s only one way out in my opinion of this debt mess and it’s through restructuring and that means default. It’s not the end of the world. It just means a lot of people are going to lose a lot of money and then we’ll get up the next day and go back to work.

In short, neither economic theory nor established economic evidence provides any basis for the belief that further monetary intervention and distortion would ease any binding constraint on the real economy at present. This does not, of course, rule out the possibility of speculation grounded in superstition and a misguided impulse to reach for yield, but the Fed’s ability to weave yet another set of Emperor’s Clothes is justifiably deteriorating.

A point we have been making for several years has been the inappropriateness of treating a solvency problem as if it is a liquidity problem. We would add that institutions that repeatedly risk insolvency because of liquidity issues deserve their insolvency, but then we are considered obstinately frugal with public funds and public risk.  John Hussman makes the point well when pointing out that Fed policy does not keep banks solvent:

As a final note, since the likelihood of fresh credit strains is rapidly increasing, it’s important to recognize that reserves are different than capital. Reserves represent funds that the bank has taken in through deposits and which have not been used for new loans, securities or other investments. Capital is the difference between the assets of a bank (regardless of whether they take the form of loans, securities, or reserves) and the liabilities it owes to depositors and bondholders of the bank. Too little capital, and a bank has no cushion against insolvency – assets might fall short of the amount needed to satisfy liabilities. So keep in mind that if a bank loses money on loans or other investments, those losses can cut deeply into capital even though the bank is highly “liquid” on the basis of reserves. Fed actions to inject “liquidity” can help a bank satisfy demands for cash if depositors cut and run, but those actions do not add to bank capital, and do not improve the solvency of the bank.

As always, read the whole thing.

The Consequences of Austerity
Euro Break-Up – The Consequences
Welcome to the Hotel California
The Slow March to Recession in the US
Preparing for a Credit Crisis
What Can You Do About the Weather?
Europe, Houston, New York, and South Africa

I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.

-  Romano Prodi, EU Commission President, December 2001

Prodi and the other leaders who forged the euro knew what they were doing. They knew a crisis would develop, as Milton Friedman and many others had predicted. They accepted that as the price of European unity. But now the payment is coming due, and it is far larger than they probably thought.

This week we turn our eyes first to Europe and then the US, and ask about the possibility of a yet another credit crisis along the lines of late 2008. I then outline a few steps you might want to consider now rather than waiting until the middle of a crisis. It is possible we can avoid one but, as I admit, whether we do (and the extent of such a crisis) depends on the political leaders of the developed world (the US, Europe, and Japan) making the difficult choices and doing what is necessary. And in either case, there are some areas of investing you clearly want to avoid. Finally, I turn to that watering-hole favorite, the weather, and offer you a window into the coming seasons. Can we catch a break here? There is a lot to cover, so we will jump right in.

The Consequences of Austerity

The markets are pricing in an almost 100% certainty of a Greek default (OK, actually 91%), and the rumors in trading circles of a default this weekend by Greece are rampant. Bloomberg (and everyone else) reported that Germany is making contingency plans for the default. Of course, Greece has issued three denials today that I can count. I am reminded of that splendid quote from the British ’80s sitcom, Yes, Prime Minister: “Never believe anything until it’s been officially denied.”

Germany is assuming a 50% loss for their banks and insurance companies. Sean Egan (head of very reliable bond-analyst firm Egan-Jones) thinks the ultimate haircut will be closer to 90%. And that is just for Greece. More on the contagion factor below.

The existence of a ‘Plan B’underscores German concerns that Greece’s failure to stick to budget-cutting targets threatens European efforts to tame the debt crisis rattling the euro. German lawmakers stepped up their criticism of Greece this week, threatening to withhold aid unless it meets the terms of its austerity package, after an international mission to Athens suspended its report on the country’s progress.

‘Greece is “on a knife’s edge,”’German Finance Minister Wolfgang Schaeuble told lawmakers at a closed-door meeting in Berlin on Sept. 7, a report in parliament’s bulletin showed yesterday. If the government can’t meet the aid terms, ‘it’s up to Greece to figure out how to get financing without the euro zone’s help,’ he later said in a speech to parliament.

Schaeuble travelled to a meeting of central bankers and finance ministers from the Group of Seven nations in Marseille, France, today as they face calls to boost growth amid increasing threats from Europe’s debt crisis and a slowing global recovery. (Bloomberg: see http://www.bloomberg.com/news/2011-09-09/germany-said-to-prepare-plan-to-aid-country-s-banks-should-greece-default.html)

(There is an over/under betting pool in Europe on whether Schaeuble remains as Finance Minister much longer after this weekend’s G-7 meeting, given his clear disagreement with Merkel. I think I take the under. Merkel is tough. Or maybe he decides to play nice. His press doesn’t make him sound like that type, though. They are playing high-level hardball in Germany.)

Anyone reading my letter for the last three years cannot be surprised that Greece will default. It is elementary school arithmetic. The Greek debt-to-GDP is currently at 140%. It will be close to 180% by year’s end (assuming someone gives them the money). The deficit is north of 15%. They simply cannot afford to make the interest payments. True market (not Eurozone-subsidized) interest rates on Greek short-term debt are close to 100%, as I read the press. Their long-term debt simply cannot be refinanced without Eurozone bailouts.

Was anyone surprised that the Greeks announced a state fiscal deficit of €15.5 billion for the first six months of 2011, vs. €12.5 billion during the same period last year? What else would you expect from increased austerity? If you reduce GDP by as much as Greece attempted to do, OF COURSE you get less GDP and thus lower tax revenues. You can’t do it at 5% a year, as I have pointed out time and time again. These are the consequences of allowing debt to get too high. It is the Endgame.

[Quick sidebar: If (when) the US goes into recession, have you thought about what the result will be? A recession of course means lower GDP, which will mean higher unemployment. That will increase costs due to increased unemployment and other government aid, and of course lower revenues as tax receipts (revenues) go down. Given the projections and path we are currently on, that means even higher deficits than we have now. If Obama has his plan enacted, and if we go into a recession, we will see record-level deficits. Certainly over $1.5 trillion, and depending on the level of the recession, we could scare $2 trillion. Think the Tea Party will like that? Governments have less control than they think over these things. Ask Greece or any other country in a debt crisis how well they predicted their budgets.]

The Greeks were off by over 25%. And they are being asked to further cut their deficit by 4% or so every year for the next 3-4 years. That guarantees a full-blown depression. And it also means lower revenues and higher deficits, even at the reduced budget levels, which means they get further away from their goal, no matter how fast they run. They are now in a debt death spiral. There is no way out, short of Europe simply bailing them out for nothing, which is not likely.

Europe is going to deal with this Greek crisis. The problem is that this is the beginning of a string of crises and not the end. They do not appear, at least in public, to want to deal with the systemic problem of too much debt in all the peripheral countries.

Without ECB support, the interest rates that Italy and Spain would be paying would not be sustainable. I can see a path for Italy (not a pretty one, but a path nonetheless) but Spain is more difficult, given the weakness of its banks and massive private debt. These are economies that matter.

How do they get out of this without a debt crisis on the scale of 2008? By coming to grips with the problem. Germany is apparently doing that this weekend, by preparing to use the money it was going to pour into Greece to shore up its own banks. That is a much better plan. But as a well-researched report (by Stephane Deo, Paul Donovan, and Larry Hathaway in the London office – kudos, guys!) from UBS shows, solving the problem will be very costly. The next few paragraphs are from their introduction.

Euro Break-Up – The Consequences

The Euro should not exist (like this)

Under the current structure and with the current membership, the Euro does not work. Either the current structure will have to change, or the current membership will have to change.

Fiscal confederation, not break-up

Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries cannot be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such a move.

The economic cost (part 1)

The cost of a weak country leaving the Euro is significant. Consequences include sovereign default, corporate default, collapse of the banking system and collapse of international trade. There is little prospect of devaluation offering much assistance. We estimate that a weak Euro country leaving the Euro would incur a cost of around€9,500 to €11,500 per person in the exiting country during the first year. That cost would then probably amount to €3,000 to €4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.

The economic cost (part 2)

Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalization of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around €6,000 to €8,000 for every German adult and child in the first year, and a range of €3,500 to €4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over €1,000 per person, in a single hit.

The political cost

The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s ‘soft power’ influence internationally would cease (as the concept of ‘Europe’ as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.

Welcome to the Hotel California

Welcome to the Hotel California
Such a lovely place
Such a lovely face
They livin’ it up at the Hotel California
What a nice surprise, bring your alibis

Last thing I remember, I was running for the door
I had to find the passage back to the place I was before
“Relax,” said the night man, “We are programmed to receive.
You can check out any time you like, but you can never leave!”

-  The Eagles, 1977

You can disagree with the UBS analysis in various particulars, but what it shows is that there is no free lunch. It is not a matter of pain or no pain, but of how much pain and how is it shared. And to make it more difficult, breaking up may cost more than to stay and suffer, for both weak and strong countries. There are no easy choices, no simple answers. Like the Hotel California, you can check in but you can’t leave! There are simply no provisions for doing so, or even for expelling a member.

The costs of leaving for Greece would be horrendous. But then so are the costs of staying. Choose wisely. Quoting again from the UBS report:

…the only way for a country to leave the EMU in a legal manner is to negotiate an amendment of the treaty that creates an opt-out clause. Having negotiated the right to exit, the Member State could then, and only then, exercise its newly granted right. While this superficially seems a viable exit process, there are in fact some major obstacles.

Negotiating an exit is likely to take an extended period of time. Bear in mind the exiting country is not negotiating with the Euro area, but with the entire European Union. All of the legislation and treaties governing the Euro are European Union treaties (and, indeed, form the constitution of the European Union). Several of the 27 countries that make up the European Union require referenda to be held on treaty changes, and several others may choose to hold a referendum. While enduring the protracted process of negotiation, which may be vetoed by any single government or electorate, the potential secessionist will experience most or all of the problems we highlight in the next section (bank runs, sovereign default, corporate default, and what may be euphemistically termed‘civil unrest’).

Leaving abruptly would result in a lengthy bank holiday and massive lawsuits and require the willingness to simply thumb your nose in the face of any European court, as contracts of all sorts would have to be voided. The Greek government would have to“conveniently” pass a law that would require all Greek businesses to pay back euro contracts in the “new drachma,” giving cover to their businesses, who simply could not find the euros to repay. But then, what about business going forward?

Medical supplies? Food? –the basics? You have to find hard currencies for what you don’t produce in the country. Greece is not energy self-sufficient, importing more than 70% of its energy needs. They have a massive trade deficit, which would almost disappear, as who outside of Greece would want the “new drachma?” Banking? Parts for boats and business equipment? The list goes on and on. Commerce would slump dramatically, transportation would suffer, and unemployment would skyrocket.

If Germany were to leave, its export-driven economy would be hit very hard. It is likely that the “new mark”would appreciate in value, much like the Swiss Franc, making exports from Germany even more costly. Not to mention potential trade barriers and the serious (and probably lengthy) recession that many of their export and remaining Eurozone trade partners would be thrown into. And German banks, which have loaned money in euros, would have depreciating assets and would need massive government support. (Just as they do now!)

Can a crisis be avoided? Yes. But that does not mean there will be no pain. We can avoid a debt debacle in the US, but doing so will mean reducing debt every year for 5-6 years in the teeth of a slow-growth economy and high unemployment. It will require enormous political will and mean many people will be unemployed longer and companies will be lost.

Ray Dalio and his brilliant economics team at Bridgewater have done a series of reports on a plan for Europe. Basically, it involves deciding which institutions must be saved (and at what cost) and letting the rest simply go their own way. If they are bankrupt, then so be it. Use the capital of Europe to save the important institutions (not shareholders or bondholders). Will they do it? Maybe.

The extraordinarily insightful and brilliant John Hussman recently wrote on a similar theme. He is a must-read for me. Quoting:

The global economy is at a crossroad that demands a decision – whom will our leaders defend? One choice is to defend bondholders – existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties – but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.

In game theory, there is a concept known as ‘Nash equilibrium’ (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, ‘I drive on the right / you drive on the right’ is a Nash equilibrium, and so is ‘I drive on the left / you drive on the left.’ Other choices are fatal.

Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.

We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring. While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about ‘global financial meltdown.’ But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.”

See (http://hussmanfunds.com/wmc/wmc110905.htmfor the rest of the article.)

You think the world’s central banks and main institutions are not worried? They are pulling back from bank debt in Europe, as are US money-market funds. (Note: I would check and see what your money-market funds are holding – how much European bank debt and to whom? While they are reportedly reducing their exposure, there is some $1.2 trillion still in euro-area institutions that have PIIGS exposure.)

Look at the following graph from the St. Louis Fed. It is the amount of deposits at the US Fed from foreign official and international accounts, at rates that are next to nothing. It is higher now than in 2008. What do they know that you don’t?

The Slow March to Recession in the US

Until there is a real crisis in Europe, the US will continue on its path of slower growth. Economists who base their projections on past history will not see this coming. Analysts who base their earnings estimates on recent performance are going to miss it (again.) Note: analysts, as I have written numerous times in this letter, are so very, very bad as a group at predicting future earnings that I am amazed people pay attention to them; but they seemingly do. They consistently miss tops and bottoms. That is the one thing they are very good at.

John Hussman, in the same report, offers the chart below, which is a variant on themes I have highlighted in past issues, but with his own personal twist. It is a combination of four Fed indices and four ISM reports. And it has been reliable as a predictor of recessions – one of which it strongly suggests we are either in or heading into.

And recent revisions to economic data suggest that companies are going to have even more trouble making those powerhouse earnings that are being estimated. As Albert Edwards of Societe Generale reports this week:

… at the start of 2011, productivity trends took a remarkable turn for the worse –especially compared to what was initially reported. An initial estimate that Q1 productivity grew by 1.8% was transformed to show a decline of 0.6%. A slight 0.7% rise in Q1 ULC (unit labor costs) was transformed to show a staggering surge of 4.8%! In addition to that 4.8% rise, ULC rose a further 2.2% in Q2. But the news gets even worse Last week the BLS revised the ULC rise in Q2 up from 2.2% to 3.3% QoQ. US non-farm business unit labor costs are now rising by 2% yoy. That is very bad news for profits. Bad news for equities. And because the pace of ULC is a key driver of inflation (upwards in this instance), it is bad news for an increasingly criticized and divided Fed.

Preparing for a Credit Crisis

There is so much that could push us into another 2008 Lehman-type credit crisis. As I say, it is not a given, but the possibility should be on your radar screen. Lehman may have been the straw that broke the camel’s back, but there were a lot of other problems. Prior to 2008, we had seen several large companies in the financial world simply disappear. REFCO comes to mind. Not a whimper in the markets. But Lehman was one of a dozen problems all over the world resulting from the larger subprime crisis. Howard Marks of Oaktree writes about simultaneous problems in the markets and what happens:

Markets usually do a pretty good job of coping with problems one at a time. When one arises, analysts analyze and investors reach conclusions and calmly adjust their portfolios. But when there’s a confluence of negative events, the markets can become overwhelmed and lose their cool. Things that might be tolerable individually combine into an unfathomable mess whose extent and ramifications seem beyond analysis. Market crises are chaotic, not orderly, and the multiplicity and simultaneity of contributing causes play a big part in making them so.

I did an interview with good friends David Galland and Doug Casey of Casey Research yesterday. They are decidedly more bearish than I am, so wanted an “optimist” to sit on their panel. But they forced me to admit that some of my optimism depends on the probability of US political leaders doing the right thing. Depending on your opinion about that, you are more or less prone to think there is a crisis in our future. And while I like to think it is not me showing a home-town bias, I think Europe has worse problems and a tougher situation than the US. A crisis there is more likely, I think.

But whether you want to make it 50-50 to 70-30 or (pick a number), there is a reasonable prospect of another credit crisis. So what should you do?

First, think back to 2008. Were you liquid enough? Did you have enough cash? If not, then think about raising that cash now. When the crisis hits, you have to sell what you can for what you can get, not what you want for reasonable prices.

I am personally raising more cash in my business. I usually invest money as soon as I can. Now, I am still investing, and you too should still put money to work in places that you think have the potential to do well in a crisis. Go back and see what worked in 2008 and buy more of it! Long-only funds did not work. Those that were more nimble did.

In the next crisis, opportunities to buy assets on the cheap will grow, so having some cash will make it easier to buy things you want to own for the next 10-20 years, whether income-producing or just something you want for fun.

Think through your portfolio. In 2008 I watched investors liquidate solid funds, or sell off assets at fire-sale prices, because that was the only way they could raise cash, when that was the time to invest more, not redeem. Make sure you are the “strong hand.”

Understand, I am not saying sell your conviction stocks. I have some and am buying more. But no index funds, no long-only, unhedged funds. I make very specific choices when it comes to long-only investments that I am looking to hold over and beyond a ten-year horizon. And those are risks I want to take (at least today).

I do not want to own anything that looks like an index fund or long-only mutual fund. Think 2008. I want funds and managers that have an edge and have a hedge, preferably both.

I would not be long money-center bank stocks or bonds, not in the US and especially not in Europe. I have had private off-the-record conversations with Republican leaders. There is simply no willingness to do another TARP-like bailout of bondholders and shareholders. I believe them. As Hussman suggested, this time bondholders will lose. I just don’t know which ones will be ready, and there are lots of other places to deploy assets. If you feel you have some special insight, then be my guest; but I just see too much risk for the potential reward, especially in large bank bonds that pay so little. That is not to say they are all equally bad –certainly not the regionals with less exposure to Europe. But do your homework.

(Caveat: I do think even the GOP leaders will have to cave in and allow the government to be “debtor-in-possession”of the too-big-to-fail banks we allowed to exist under the really bad financial bill called Dodd-Frank, which needs to be repealed and replaced. We have to preserve the system, but not shareholders and bondholders, who will lose this time.)

Think through your business. Banking relationships are not what they used to be. Spend time now getting commitments. Remember the odd spike in 2008 in bank lending? It was from credit lines being drawn down. But no one got new lines at the time. What can you do if sales get tough? What can you do to increase market share when your competitors start to pull back? The winners in 2008-09 were the companies that increased innovation and did not pull back (according to a Boston Consulting Group survey).

If you plan correctly, the next crisis will be an opportunity for you and not a personal crisis. And you will be better able to help those who need it.

A special note. In a few weeks I will be sending out an email that will contain a link to a totally free treasure trove of business and marketing ideas you can use to keep your business at the cutting edge, whether you are established are just starting out. It is one of those things I can do that costs me very little, but that sometime may mean a lot to you. I am just glad to be in the position to help a little.

I know I sound rather stark at times, but I really don’t want you to dig a hole and get in and cover yourself up. I do not. While we are perhaps somewhat more cautious, we are also looking for ways to grow and be more aggressive here at my business. I will keep repeating: look for the opportunities. They are there. Just gauge your risk appropriately.

What Can You Do About the Weather?

The answer is, not very much, but you can prepare. I have arranged for my readers to get the latest copy of the Browning Newsletter,written by Evelyn Browning Gariss, who I think of as one of the world’s greatest climatologists. Her letter is a monthly must-read for me, and it is a steal at $250 a year. You need to read it for a few months to get the feel for it, as you may find it full of new terms, but you’ll soon get the hang of it. There are in fact patterns. And this winter we are sadly being set up for what may be a repeat of last year’s weather in the Southern Hemisphere, and rain at the wrong time in the US, during harvest. You can read the latest issue at my website, http://www.johnmauldin.com/frontlinethoughts/browning-newsletter-0911. (You will need to type in your email address to get it.)

Europe, Houston, New York, and South Africa

I leave in a few weeks for a whirlwind trip to Europe (London, Malta, Dublin, and Geneva) and then back. A quick trip to Houston for a conference (https://www.webinstinct.com/streettalkadvisors/) and then I fly to New York for the weekend, where I will be speaking at the Singularity Summit, which is October 15-16. This is an outstanding conference, and I am honored to be asked to speak. It is really a bunch of wild-eyed futurists (like your humble analyst) getting together to think about what the future holds for us. For two days I get to be an optimist, if only in the longer term! Ray Kurzweil is the guiding light, and he has assembled an all-star cast. You can learn more at www.singularitysummit.com/. For those who can make it, I think you will come back amazed and more positive about the future of our world. And you can see videos of previous conference presentations at their website – well worth an evening or two or three, and the price is right. But if you can make the conference, you will enjoy the experience and meet new friends. And then I’ll fly to South Africa for two nights, and head back home.

It is good to have Tiffani back in Dallas and home and in the office. She has been in Europe for most of the summer, staying with friends and working from there. Even with Skype, it’s just not the same. And she did bring the granddaughter back with her! And one of the twins and her husband have moved back to Dallas, so 6 of 7 are now local. The other is coming soon, I hope! Dad likes to have his kids near.

It has been a very hectic week. Can I get busier? And computer issues have been a plague. To deal with it, we purchased two new HP laptops, and one will now be a mirror, so I will not go down if my computer fails. It is just too cheap not to do it, and lost time is frustrating and costly. I am amazed at what you can get for $1250: 8 gigs of RAM, a terabyte of memory – more power than I can use – cool 17-inch screens, a fingerprint reader camera, and I think there is even a grill attachment somewhere.

And speaking of grills, we did get a new one for Labor Day. About 30 people were here, and I spent most of the day cooking. It was time for fun and family and friends. I need more times like that to remind me of the real values in life, and why we will get through all this hassle. The future was in my home, and what a future it will be! My plan is to hang around a long time to see them enjoy it.

This Sunday Rich Yamarone (of Bloomberg) will be here to brave a family brunch gathering. Then Barry Habib shows up on Wednesday for a day-long planning session on a new venture, ending with a great meal somewhere. (This food theme keeps recurring!) Have a great week. And find some great food of your own! Enjoy life’s pleasures!

Your actually losing weight in spite of the great food analyst,

John Mauldin

John@FrontlineThoughts.com

Source: JohnMauldin.com (http://s.tt/13dSm)

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“Helicopter Ben” Bernanke is a second-generation pilot. As he himself acknowledged in his now well-known 2002 speech, the term was an original of economist Milton Friedman.

Whether father or child, the concept of showering money over national economies to combat deflation has been an accepted principle of monetarism for decades. A helicopter, however, is not your average aeroplane, and the usual laws of aerodynamics do not necessarily apply in all cases. Similarly monetary policy at the zero interest rate bound introduces a new dynamic that may conflict or even reverse standard logic that lower interest rates across the sovereign yield curve are everywhere and always stimulative to economic growth.

Japanese experience over nearly two decades, but from an analysis of our modern-day financial system and its potential inadequacies. Fractional reserve banking, where only a portion of bank deposits are backed by hard cash, as well as unreserved collateral-based lending on overnight repo have allowed for an expansion of credit beyond the bounds of a central banker’s imagination.

Click here to read the article in its entirety.

For our purposes, it suffices that we have operated since the financial crisis under the assumption that the recovery would be sluggish, rather than V-shaped. We still feel that way.

And that feeling is inconsistent with moving out on the risk curve or down in credit quality, investing more in cyclicals or taking on leverage. Our enthusiasm regarding the macro economy has been muted for a number of reasons, including:

Howard Marks on What’s Behind the Downturn 09-07-11