Pessimism Exhaustion

I am going to keep this month’s note short given that I am sure you are exhausted of hearing me go on about the European Crisis which has produced more back and forth moaning and groaning than a Williams/Sharapova match. 

Unfortunately despite recent headlines claiming the 2nd Greek bailout is done, the tragedy is not over. Digging a little deeper into the new requirements imposed on Greece:

“European creditor countries are demanding 38 specific changes in Greek tax, spending and wage policies by the end of this month and have laid out extra reforms that amount to micromanaging the country’s government for two years” – "Athens told to change spending and taxes”, Financial Times

It is difficult to envision how a country that couldn’t meet its original significantly less painful targets (over a span of two years!), will successfully meet these draconian, completely eviscerating, new demands in a few short weeks. However, according to Angela Merkel, these demands (and high private sector participation in the Greek bond swap which as we pointed out last month is far from certain) must be met in order to receive the new aid.

And yet, despite these long odds, markets have rallied like its 1999, ignoring the difficult road ahead for Greece and Europe. This leaves me, along with many other managers that have not fully bought into the recent rally, in the unenviable position of having to decide to: (1) chase the market higher, ignoring inherent risks and warning signals coming out of Europe, or (2) wait for the market to come back in as it is repriced to the real risks associated with the Greek bailout.

While not an easy decision given the swiftness of the rally, we are not chasing this market higher for several reasons:

1. We do not feel the Greek solution is a done deal. 
2. Crude and gas prices are surging due to worries in Iran; if sustained these higher prices could negatively affect global growth. 
3. Finally, the rally has been on extremely light volume—a sign that big investors do not have conviction in the current move (see chart below)

As evidence for point 3:

“Last January (2011) the average number of stocks traded on the NYSE per day was 891mm shares vs 661mm for this January (a 26% drop YoY!) and this is down an incredible 59% from January 2008.” 

Source: ZeroHedge.com, Chart: Bloomberg  

With that said, there are reasons to be bullish including the unprecedented amount of liquidity from central banks and relatively strong US economic data.  As a result we have added some lower risk US equities positions over the last month or so in attempt to capture some of the rally; however, until Greece either (1) makes their March 20 payment or (2) defaults, we will maintain a neutral to slightly negative stance across all portfolios based on our hypothesis that the Greek solution will be more messy than the market is currently pricing in (i.e. CDS triggered, policy errors, and renewed loss in confidence in the EZ). We feel this positioning will protect our portfolios regardless of the outcome in Greece.

Bottom Line: Like a 4am drunk, happy and full of confidence one minute, angry and sloppy the next, global markets are not on firm footing. Should there be successful resolution in Europe, we will shift away from our defensive stance by increasing equities exposure in developed and developing markets. Until then we remain defensive, which means we have:

• nearly full allocations to fixed income skewed towards bonds that should perform better in a down market (treasuries and muni bonds) versus bonds that should rally along with risk (corporate, high yield and emerging market bonds) 
• hedged positions in equities (lower beta (lower risk) US equities versus higher beta emerging market equities and volatility) 
• partial allocations to commodities skewed slightly long 
• short EUR/USD