It is said that bull markets climb a wall of worry but if that were true, then Wall and Broad should look like downtown Pamplona in July with market bears gored, trampled, spindled, mutilated and wrapped around the buttonwood tree. The list of worries for investors seems to grow by the day with slowing Chinese growth center stage one day and signs of slowdown in the US picking up the slack the next. Meanwhile, the Europeans have started a new installment of their economic novela, tentatively titled The Running of the PIIGS, with Greece and Spain playing the petulant Latin parts and Angela Merkel starring as the staid matriarch of an unbelievably dysfunctional European family. Throw in the Facebook/NASDAQ debacle, rapidly cooling emerging markets, bond yields scraping new lows and a nasty US election season ahead and we’ve got a wall of worry high enough for David Gilmour to take on tour.
Given all that’s going on in the world, one can’t help but wonder at the resilience of the US stock market, still down less than 10% in this correction. For that matter, if the pundits are right and Europe is about to implode, why haven’t European stocks at least had the decency to fall below their December lows? Even more curious perhaps is the Euro itself which, based on the size of the short position in the futures market, has no Facebook friends whatsoever. If what is going on in Europe is so awful why is the Euro still trading at 1.25 to the dollar? Are things so bad in the US that scared Europeans would rather buy a German Bund with a 0% coupon than hold dollars? Apparently so, since the German government floated a bond with that exact rate last week, forever changing the meaning of “zero coupon bond”.
Further confusing the bearish conventional wisdom is the refusal of gold to rally amidst all this global economic angst. With China’s bubble popping, Australia deflating, Brazil proving once again that its promise remains firmly rooted in the future, Europe ripping apart at the seams, the US heading for a fiscal cliff and everyone expecting the central banks to soon fire up the printing presses again, why aren’t investors flocking to the yellow metal as they have in the past? With the end of the world coming soon to a market near you, why is everyone so damned calm?
Maybe all these bearish items just aren’t fully incorporated into current market prices and things are about to get a lot worse. That is certainly possible but it wouldn’t exactly qualify as a black swan which don’t tend to come in flocks or on an expected schedule. Conventional wisdom is rarely wise and good investors should always question their assumptions. Markets don’t generally make big moves based on expected events and while we don’t know the exact outcome of our litany of economic woes detailed above, they are all expected to be negative for the global economy and markets. But what if that assumption is wrong? What if the events unfolding today are actually positives? What if there really is a silver lining in our global economic cloud?
The European situation is widely expected to produce a negative result for the global economy and therefore global markets. If Greece, for example, leaves the Euro, the conventional wisdom sees this as negative. How widespread is this belief? I met a young man on the golf course last week who is studying economics at one of our finer institutions of higher learning. He had just completed a paper on the European crisis and when I asked him how the Euro would react to Greece going back to the Drachma, he immediately said it would go down. No hesitation whatsoever. I don’t know if or when Greece will leave the Euro but if it does, I wouldn’t want to be short Euros when it happens.
There is no way to know the outcome of the European debt crisis except to say that debts that can’t be paid, won’t. Greece cannot pay back what it has borrowed. The losses have already occurred; all we’re waiting on now is to see how they will be apportioned. Either Greece will write down the value of their debts in Euros or they will leave the Euro and pay them off in devalued new Drachmas. In either case, the Greek economy will be better off in the immediate future, having finally rid themselves of the onerous debt, than they are now. The Greek people have already been impoverished by their government. They will discover the degree either through lower wages or higher inflation. After the event, the rest of Europe will also be in better shape, knowing what the losses are and able to finally move on. The ECB will perform its role as lender of last resort – to the banking system, not sovereigns – and there may be some other adjustments (European deposit insurance?) but the Europeans who have worked generations for a United States Of Europe will not allow Greece’s failure to end their determined efforts to prevent the last war. Europe will survive.
Of course, the fear from Europe isn’t just about Greece but the potential for a contagion that spreads through the Mediterranean region. Spain or Portugal would fall next, Ireland might decide to renegotiate and the Italians could also bid ciao to the Euro. What would the effect of all that be that we haven’t seen already? Some banks would fail but Spain just basically nationalized one of their largest domestic lenders last week and there was no meltdown. What would happen if all these countries left the Euro? Obviously their new national currencies would trade at a discount to the Euro but how much? 10%? 20%? I don’t know but those kinds of swings in other non-Euro EU countries haven’t presented a problem. Why would these? Maybe the resolution of the issue along with a swift devaluation would allow these countries to enact the types of reforms Germany is demanding. Maybe the reason the Euro hasn’t fallen more is because it would be a better currency without them. It is something to consider when the bearish side of the trade is occupied by the modern day equivalent of Joe Kennedy’s shoe shine boy.
I can construct a similarly positive narrative about China’s economic slowdown. It certainly isn’t unexpected. Anyone with a calculator knows that no country, not even the darling of central planners everywhere, can grow at double digit rates forever. A slowdown in growth was inevitable no matter what the latest 5 year plan says. So how might a Chinese slowdown be positive? Well, it probably won’t be for China but for a lot of the world, a slowdown might provide some welcome relief from higher commodity prices. US companies who have expanded their exports to resource rich emerging markets might see some slowdown but a drop in oil and other commodity prices might be enough to keep profit margins high and earnings growing. And China will likely still be growing even if at a slower rate. Remember all those economists who wanted a global rebalancing? Well, it’s here and it might be just what the doctor ordered.
What about our own problems here in the good old US of A? We’ve got a government deficit problem worse than some of the PIIGS, a QE monkey on our back and a dysfunctional political system but our problems aren’t insolvable. We’ve already got a cyclical recovery underway in autos and housing and even a minor improvement in fiscal policy would pay large dividends. We can look to Europe for guidance on what not to do. They tried raising taxes to close their budget deficits and got a recession for their efforts. Higher taxes, more government spending and more regulations have not produced economic growth in Europe and they won’t here either. We should do the opposite; cut spending, cut taxes and simplify our regulatory structure. Notice I didn’t say de-regulate. We need strong regulations but they don’t have to take up thousands of pages and involve intricate rules. Barry Ritholtz wrote a few hundred word blog post last week that would do more to end Too Big To Fail than anything found in the depths of Dodd-Frank.
So, back to that wall of worry. At Alhambra we raised our cash levels a few months ago due to our fears about many of the same things I’ve detailed here. Our all stock accounts are now over 25% cash and because of that we’ve outperformed during the correction (and over the last 1,2 and 3 years for that matter). But we are distinctly uncomfortable in the warmth of the crowd and have started the process of deciding where to put that cash to work. It isn’t easy to do when it seems there are good reasons to worry but that is the nature of investing. The hard trade is usually the right one and I can’t think of anything harder right now than being optimistic. So, get on your climbing gear and start tackling that wall of worry.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: email@example.com or 786-249-3773.
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