17 Captains and No Admiral

Or is it 17 European leaders and no central banker? Either way there appears to be a lack of true leadership and power to do what is necessary to solve EUR crisis.

One would think that after one of the biggest monthly rallies for equities since the ‘70s everything would be roses and smiles, but October’s rally was more symptomatic of a market that is under extreme stress than of long-term optimism. In large part, October's spectacular rally appears to be the result of traders (particularly hedge funds) reversing their negative bets on the euro and equity markets as rumors of an European deal slowly surfaced and US economic data came in stronger than expected. 

However, there are still major questions that need to be answered before the “new” European plan has any bite.  As a result, we continue to be positioned defensively across all of our portfolios and maintain that this was/is the right positioning given the current risks for two core reasons (among many): 

(1) European debt markets still suggest a negative outcome. Debt markets, which are generally dominated by sophisticated, professional investors and traders (as opposed to individual investors), are often better or “smarter” at predicting the outcome of economic events than equity markets. As illustrated in the chart below, European debt markets are flashing warning signals and actually suggest that Europe’s problems are getting worse rather than better.

This chart shows credit spreads relative to German bunds— the wider the spread, the more credit risk associated with that country’s bonds. A spread above 450 generally suggests trouble ahead. As can be seen, Italy, the 3rd largest EMU economy, is coming dangerously close to the 450 mark (at the time of this writing Italian spreads have passed 450). 

(2) The “new” bailout plan, while a step in the right direction, is still more bark than bite (see last month’s commentary "All Bark and No Bite") and is deficient in many ways:

• Where is the $1 trillion going to come from? European leaders seem to be assuming that China or the IMF will come to the rescue and serve as the monetary anchor for the plan. However, neither China (which has issues of its own) nor the IMF (which was not designed to rescue large, “developed” countries) is in a position to take on such a big responsibility. Instead, there needs to be greater fiscal unification across the 17 euro countries and the ECB needs to be authorized to serve as the central anchor and to issue “Eurobonds”. 
• How are the banks going to be recapitalized? It appears the new plan requires banks to seek private sources of funds for recapitalization first, then go to their home country, and then as a last resort go to the ECB or EFSF. In my opinion, this is flawed in that it exposes which banks and countries are too weak to raise money on their own at each step of the way. Exposing the weak will potentially have hugely negative destabilizing effects. 
• Finally, by forcing a “voluntary” 50% haircut on Greek debt, European leaders have prevented Greece from technically defaulting. However, in the process, they have made European sovereign debt CDS (insurance on European debt) virtually obsolete. Large investors use CDS to reduce exposure and risk in the event of a catastrophic failure (bankruptcy or default). Now that these investors are no longer able to rely on the insurance-like protection of European CDS, their appetite to buy European bonds, particularly of weaker countries, will be substantially reduced. This is the exact opposite of what is desired from a successful bailout plan.

Bottom line: While it was painful to sit on the sidelines for last month’s rally, we feel that it was the right decision given the risks currently inherent in the markets. If the bond markets are correct and Italy is the next country to require help, then the European equity markets, the euro and all risky assets will face significant downward pressure. Therefore, until there are more convincing signs that European leaders are containing the problem and the issues raised above are addressed, we will continue to maintain our defensive stance. 

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On a somewhat lighter, albeit slightly disturbing, note: This article sums up the Greek issue well: Fast cars and loose fiscal morals: there are more Porsches in Greece than taxpayers declaring 50,000 euro incomes

All Bark and No Bite

When it comes to euro crisis, European leaders, so far, are all bark and no bite. They seem to understand their dire situation, but have yet to really take decisive action (a “bailout” on the order of trillion(s) of EUR) to prevent and contain their predicament. The following quote from the June 25th issue of The Economist summarizes their options well: 

…the euro zone’s leaders will sooner or later face a choice between three options: massive transfers to Greece that would infuriate other Europeans; a disorderly default that destabilises markets and threatens the European project; or an orderly debt restructuring. This last option would entail a long period of external support for Greece, greater political union and a debate about the institutions Europe would then need. But it is the best way out for Greece and the euro. That option will not be available for much longer. Europe’s leaders must grab it while they can. Source: "The euro crisis: If Greece goes" | The Economist

The last two sentences are key and yet three months after the article was written, there is still no clarity on how European leaders are addressing and containing Greece’s insolvency. Worse still, their indecision has now led to other much larger more systemically important periphery European countries and more ominously banks and insurance companies to become intertwined in the mess (see last month’s post: “Griechenland Bezahl' Deine eigenen Rechnungen”).  This lack of clarity has led markets around the world to price in not only the possibility of the worst of the three options (a disorderly default) but the potential for a global recession as well (see chart below). 

12-Month Comparison: shows the 12-month performance of major global equities markets, as well as US Treasuries and Gold.  September 2010 = base year.

What may be surprising to some about this performance comparison is that despite all of the negative headlines, US equities have been relative out-performers when compared to their foreign counterparts. Even more surprising is that US Treasuries—the securities at the center of the S&P ratings downgrade—have been one of the year’s best performers.  The weakness in Emerging and Commodity Country markets and strength of US Treasuries suggests that many investors are expecting a global economic slowdown in the coming months/quarters.

Bottom line: With the 2007/08 mortgage crisis and extremely disorderly Lehman bankruptcy still fresh on investors’ minds, many investors have been quick on the sell trigger so as to not get burned again (ourselves included).  However, a Greek default should not have the same hugely negative market impact if it is properly contained.  We hope that European leaders will realize that their experiment—the EUR—has the potential to fail catastrophically and therefore will resist political gamesmanship and address the situation.  If they do (soon) then one of the major impediments to market and economic growth will be removed and we expect a significant buying opportunity as most markets have been sold to exceptionally cheap levels. 

Until then, we are positioned extremely defensively across all of our portfolios.  This means our portfolios are skewed more towards the possibility of a Greek default (orderly or disorderly) and a global slowdown, than to a satisfactory resolution to the crisis.  See table below for a quick and very basic scenario analysis:

Does the euro have a future? | The Great Debate

good read...

By George SorosThe opinions expressed are his own.

The euro crisis is a direct consequence of the crash of 2008. When Lehman Brothers failed, the entire financial system started to collapse and had to be put on artificial life support. This took the form of substituting the sovereign credit of governments for the bank and other credit that had collapsed. At a memorable meeting of European finance ministers in November 2008, they guaranteed that no other financial institutions that are important to the workings of the financial system would be allowed to fail, and their example was followed by the United States.

Angela Merkel then declared that the guarantee should be exercised by each European state individually, not by the European Union or the eurozone acting as a whole. This sowed the seeds of the euro crisis because it revealed and activated a hidden weakness in the construction of the euro: the lack of a common treasury. The crisis itself erupted more than a year later, in 2010.

There is some similarity between the euro crisis and the subprime crisis that caused the crash of 2008. In each case a supposedly riskless asset—collateralized debt obligations (CDOs), based largely on mortgages, in 2008, and European government bonds now—lost some or all of their value.

To read more please see: Does the euro have a future? | The Great Debate

Griechenland Bezahl' Deine eigenen Rechnungen

This commentary is going out later than usual to coincide with the 3-year anniversary of one of the reasons I am living and working in the BVI — the Lehman Brothers bankruptcy … my beloved, albeit now infamous, former employer.  After the bankruptcy, I was fortunate enough to go on to Barclays Capital as part of their acquisition of Lehman; however, during the several weeks I had off while the two banks’ trading systems were being integrated, my friend, Steve, and I began to hatch a plan to sail the Caribbean. While we had no sailing experience, at the time, we thought getting out of the toxic atmosphere that was Manhattan was probably the healthier option (see Streak Freak below) Fast forward 3 years, and I am still in the Caribbean, Steve is married to a woman he met on Virgin Gorda and living back home in San Francisco, and the markets are once again in a similarly precarious position as to when I left.

Solvency issues that should have been contained to Greece and other periphery European countries are spreading and possibly metastasizing in some of Europe’s largest banks and insurance companies (see table below). As such we have shifted our base case scenario from the European crisis being successfully contained and minimal disruption to the European financial system to a base case where Greece defaults and possible one or multiple large European institutions need to be bailed out. 

Source: Financial Times

As a result, we have decided to ride out the current market uncertainty with a relatively conservative stance across all of our portfolios. This means we have been slightly more active over the past several months in terms of re-positioning our portfolios than we would generally like to be and have reduced high beta equities and commodities exposure, while maintaining or increasing our fixed income positions.  


Additionally we rolled our put hedges to the SPY Oct 2011 115/105 put spread and/or maintained our VXX position. (After initial success these put spreads have not produced much in terms of current returns however they have significantly reduced portfolio volatility and allowed us to sleep better knowing we are protected should the market make another big downside move.)  We expect to maintain this defensive stance until there is more clarity on how European banks will be supported in the event of a Greek default. 

We will be looking to buy again near this year’s lows (around 1100 in the S&P 500), as long as any combination of the following catalysts (with the last one being most important) are met: further stimulus from the US Fed (expected next week), the passing of Obama’s jobs bill (unlikely given the mess in Washington, but if a majority of the plan is passed then the market should rally), and Europe finally resolving their issues and insulating European banks from Greece and the other PIIGS (no longer our expected outcome).  If we get any combination of these, then we should see a huge buying opportunity possibly similar to March 2009.  Until then, we are willing to sit on the sidelines holding relatively conservative bonds and safe-haven commodities with little to no exposure to equities.  The obvious risk with this strategy is that if things are less worse than expected then the market could quickly rally higher and we will miss out on the upside.  For now, we are willing to accept this risk.

For the rest of this commentary I am going to defer to an excellent blog post from another investment manager that articulates the European dilemma much better than I can:

This week, the German Constitutional Court ruled that Germany’s role in supporting the EU’s periphery was not unlawful. The market’s knee-jerk reaction was to blast higher on the news, as the alternative would have been a total disaster. Upon closer inspection, it appears that smooth sailing into the future is far from certain. The court stressed that the decision was not a “blanket” approval for future bail-outs and demanded that the German Government “ask permission” of the Budget Committee before handing out any more cash to their southern neighbors. At the end of the day, this means that future bail-outs will be even more difficult to execute as the process is slowed further by administrative tape around afternoon siestas.

This is important. Time is quickly running out for the EU. The lack of a comprehensive solution after two years of “can kicking” means that the periphery’s disease has infected the core and the odds of a disorderly default have increased substantially. Rather than proactively addressing the challenges in the region – restructuring debt, recapitalizing banks, promoting growth, etc. – policymakers have waited for market’s to force their hand and only then, did they plug another hole in the periphery with their finger. With one year Greek debt within spitting distance of 100% yields, they are now running out of fingers. With Italian and Spanish yields back on the rise, the holes are getting too large to plug. Something’s gotta give.

To read more please go to http://www.viewfromtheblueridge.com/2011/09/09/you-lick-mine-first/

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On a final note: to read more about Lehman Brothers (and maybe a little more on why I considered the high seas as possibly safer than an investment bank trading desk) read Streak Freak, written by the former head of my ETF Trading desk, Jared Dillian.  

Just the Facts: S&P's $2 Trillion Mistake

Just the Facts: S&P's $2 Trillion Mistake: "In a document provided to Treasury on Friday afternoon, Standard and Poor’s (S&P) presented a judgment about the credit rating of the U.S. that was based on a $2 trillion mistake. After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.

S&P has said their decision to downgrade the U.S. was based in part on the fact that the Budget Control Act, which will reduce projected deficits by more than $2 trillion over the next 10 years, fell short of their $4 trillion expectation for deficit reduction. Clearly, in that context, S&P considers a $2 trillion change to projected deficits to be very significant. Yet, although S&P's math error understated the deficit reduction in the Budget Control Act by $2 trillion, they found this same sum insignificant in this instance."

“Just when I thought I was out … they pull me back in.”

For some reason that quote by Michael Corleone from The Godfather: Part III keeps popping into my head. For the past several months, each time we get a glimpse of a reprieve from volatile markets, new (or old) issues surface. Just when I think we have blue sky ahead, new clouds appear …

Yesterday’s market action was extremely ugly. FX intervention by the Japanese Central Bank and the Swiss National Bank enacted to weaken the Yen and Franc forced investors out of their safe-haven holdings (Yen and Francs) and simultaneously to reduce their riskier holdings—equities, commodities, etc. Furthermore, this intervention combined with weak global economic data, particularly in the US, and signs that the European Debt Crisis is spreading to larger, systemically more important countries such-as Italy to produce near panic selling.

Fortunately, last week (Thursday, July 28), we hedged some of the equities exposure for our clients invested in our 5 Model Portfolios because of the politics that were taking place in Washington. These hedges act like an insurance contract, going up in value when the markets go down—therefore protecting our clients’ portfolios if/when the markets decline. For the hedges we used one of the following strategies:

• VXX: We used the VXX ETN, which was created by my trading desk while at Barclays Capital. (In fact, I was one of the first traders to ever trade the product in 2009.) VXX tends to go up when market volatility goes up and the markets go down. 
• Vertical Put Spread: For other portfolios, we used an option strategy known as a Vertical Put Spread. For this hedge we bought the SPY Aug 20, 2011 132 / 124 Put Spread (SPY was trading around 131 at the time), which provides downside protection below 132 in the SPY, an ETF that tracks the S&P 500. 

These hedges were our response to a unique short-term opportunity where we thought we could avoid unnecessary market turbulence associated with the debt ceiling debate—effectively canceling out some of the downside market movements. Initially, we intended to only hold these hedges through the resolution of the US debt deal, however given weak global economic data and the resurgence of Europe’s debt issues we decided to maintain the hedge, which has proved a wise decision.

Please do not hesitate to contact us to learn if your portfolio is properly diversified for the current economic environment or to learn more about the hedges described above.

Bottom Line: The likelihood of some sort of QE3-like action by the US Fed has significantly increased over the last several days. Furthermore, Jean-Claude Trichet, of the European Central Bank, will likely announce additional stimulus soon as well. If/when this occurs it should provide a lift to the markets and continue downward pressure on the US dollar. In the meantime, all markets (including commodity currencies which have performed extremely well despite the world’s economic woes) will continue to be volatile; meanwhile safe-haven assets such-as Treasures, gold and possibly even the US Dollar could outperform.

Finally, at the risk of sounding like a broken record, in times of market stress like we are experiencing now it is always important to remember that these market moves are relatively minor in the context of a long-term investment strategy. As always we will diligently take the steps that we feel are appropriate to protect your portfolio—currently this is via an equity hedge and through safe-haven assets such-as US Treasuries and Gold.

PRESS RELEASE: Offshore Investment Advisor and Josh Ungerman write a White Paper on ‘Accidental Americans’ and the Offshore Voluntary Disclosure Initiative

TORTOLA, BVI – July 19, 2010 – Offshore Investment Advisor, a Registered Investment Advisor in the Caribbean, in association with LGS & Associates, announced today that it has teamed with Josh Ungerman of Meadows, Collier, Reed, Cousins, Crouch & Ungerman, L.L.P., to raise awareness within the Caribbean community on some of the tax implications associated with being a dual citizen with a US passport or US birth certificate.

“We are pleased to have teamed with Josh Ungerman, as part of our new financial education campaign called ‘Raise Your Financial IQ’, to write this White Paper and educate individuals on the IRS’ new Offshore Voluntary Disclosure Initiative,” said James Bridgewater, principal of Offshore Investment Advisor. “At Offshore Investment Advisor we believe that wealth management is more than simply helping clients create and manage portfolios tailored to their unique financial needs.  It is as much about minimizing unnecessary losses due to penalties associated with improper tax reporting or relying on very conservative securities, such-as short-term CDs, that currently offer a negative real rate of return.” 

“It is not uncommon for residents of the Caribbean to travel to the United States, USVI or Puerto Rico and have a baby.  As a result, a relatively high percentage of Caribbean residents were born in a US territory and therefore are dual citizens of their home country and the US,” said Josh Ungerman, a former US IRS Chief Counsel Senior Attorney & US Department of Justice Tax Division Special Assistant US Attorney is one of the foremost experts assisting clients with US tax obligations.  “While there are many benefits of US citizenship, once an individual is subject to the US tax regime, the individual is taxed on his/her worldwide income.” 

Though this is shocking to some at first, it is not as onerous as it sounds because there are certain provisions in the new OVDI that allows for significantly reduced penalties provided that individuals take action before August 31, 2011.

This new White Paper educates individuals who have a US passport or birth certificate on the steps they need to take in order to meet their obligations to the US IRS.  In particular, it highlights the key requirements for an individual to be considered an ‘Accidental American’ and therefore qualify for significantly reduced penalties from 25% to 5% (or even 0%). 

“Ongoing financial education across the Caribbean is important to our ability to remain a vibrant, growing community and to evolve with the rapidly changing and increasingly complex offshore financial landscape,” said Lorna Smith, founder of LGS & Associates, a BVI-based consultant on international business and finance related matters.  “This White Paper will help individuals understand the new realities of this changing environment.”

Please visit http://www.offshoreinvestmentadvisor.com/Investor-Resources/white-papers to download the White Paper.

Media Contact:

James Bridgewater

Offshore Investment Advisor

james@offshoreinvestmentadvisor.com

284-495-4179

About Offshore Investment Advisor

Founded in 2005, Offshore Investment Advisor has established itself as a leading investment manager in the Caribbean by leveraging the strengths of TD Ameritrade Institutional, a globally recognized leader in brokerage and custodial services, as well as by working closely with our clients to understand their entire financial picture and then delivering on their specific financial needs and goals.  Headquartered on Tortola, BVI, we are a boutique provider of wealth and asset management to individuals, families, trusts and BVI employers.  Our services center on your unique requirements and include the following comprehensive solutions: Private Wealth Management & Retirement Plan Services. 

For more information please visit: http://www.offshoreinvestmentadvisor.com/

About Josh O. Ungerman, Partner

Mr. Ungerman specializes in the resolution of tax matters.  He specializes in IRS voluntary disclosure and has extensive experience in the IRS 2009 VDI Program as well as the current IRS 2011 OVDI Program.  The tax matters in which Mr. Ungerman is involved are typically very complex from both a factual and legal perspective. These matters often require legal and accounting skills.  Mr. Ungerman is also a Certified Public Accountant.

Prior to joining private practice in 1994, he was a civil prosecutor for the Internal Revenue Service, Dallas District Counsel office. He was also a Special Assistant United States Attorney for the Department of Justice Tax Division in Dallas during his time as a civil prosecutor.  Prior to becoming an IRS attorney of a special assistant US attorney, he served as a law clerk to the Honorable Carolyn M. Parr at the United States Tax Court in Washington, D.C.

Mr. Ungerman is a past President of the Dallas Bar Association and a past Chair of the State Bar of Texas Tax Section Controversy Committee.  He is currently a Fellow of the American College of Tax Counsel and is currently a Vice Chair of the American Bar Association Tax Section Civil & Criminal Penalties Sub Committee.

Mr. Ungerman was admitted to practice in Texas in 1990.

For more information please visit: http://meadowscollier.com/attorneys/ungerman-josh-o/