“Angela, we’re going to need a bigger hose…”

“Policy makers don’t understand that they are not in control. It’s not that speculators are in control, either, but rather that fundamentals actually matter.” – interview with Colm O’Shea, “Hedge Fund Market Wizards”, Jack D. Schwager, 2012

With recent elections across Europe going to anti-austerity/anti-bailout parties and Greek bank runs, individuals—who largely have been silent throughout the crisis (aside from the occasional protest or riot in Greece)—are reacting to the deteriorating fundamentals of the Euro Zone and are forcing change one vote and one (large) ATM withdrawal at a time.

The entrance of individuals as active players in the European crisis is a sign that the crisis has entered a new and critical stage. To date central bankers and politicians have been able to prevent flare ups from turning into full blown wildfire through policies and rhetoric that bought time, but did nothing to address the true structural issues associated with the Euro. However, over the last several weeks, European citizens’ actions at polling stations and ATMs have reignited the crisis and reversed nearly all of the stabilization policies put in place over the last 6-12 months.

As a result, the Euro is trading near its 2010 low (see Figure 1) and the odds that a country (Greece) will leave the Euro before the end of 2013 have increased significantly (see Figure 1): 

Figure 1 – The Euro is down over 7% from its recent local maximum at the end of February. Source: http://www.barchart.com 

Figure 2 – According to intrade.com there is a 57.6% chance that a country currently using the Euro will announce intention to drop it before midnight ET 31 Dec 2013. Source: http://www.intrade.com/ 

But, a Greek exit from the Euro in and of itself does not need to be a catastrophe for the entire Euro Zone and signal an end to the Euro. In theory investors have had more than enough time to prepare for Greece’s exit — most private investors (including European banks) have already realized significant losses on their Greek debt holdings due to the private sector debt swap earlier in the year.  This means that the direct financial impact of a Greek exit on European banks should be relatively contained because they have already taken the hit.

Policy makers now need to shift their focus to policies that actually address the true structural flaws in the EZ — i.e. that a one size fits all monetary policy for the whole EZ does not work without greater fiscal unity and economic burden sharing across strong and weak countries — and that mitigates the growing threat of contagion and bank runs, which have already started in Greece and to a lesser extent in Spain:

According to the Financial Times, “Shares in Bankia, the Spanish bank which was part-nationalised last week, plunged by over a quarter on Thursday morning, after a report that customers had withdrawn €1bn from the bank over the past week.”

Specifically, the threat of bank runs could be significantly reduced by providing some sort of assurance that bank deposits are not only insured against bank failure but also guaranteed against adverse currency conversion should the banks' home country abandon the Euro for a weaker currency.

On the surface individuals moving their money to ‘safer places’ like Britain, Switzerland, and Germany does not seem as bad as an entire country defaulting; however, bank runs can be incredibly insidious 

Figure 3 – 'Gross' anatomy of a EZ bank run. 

because once they start they are difficult to stop. This problem is further magnified in Europe where most banks hold a significant portion of their assets in their home country’s debt. When the bank is forced to sell assets in order to raise cash to meet withdrawals, they have to sell their country's bonds, which further destabilizes the country’s credit and in turn the bank’s (see Figure 3).

Without currency conversion protection, bank runs will become the most significant challenge that the EZ has faced since the crisis began.

Bottom Line: Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit and to devaluation threats from currency conversion.  To date European policy makers have been putting out flare-ups with buckets and a garden hose on a country by country basis, but have done little address the threat of a widespread wildfire.

Consequently, despite the temptation to buy into the rally in the first half of the year, we largely maintained our conservative stance. This conservative, slightly bearish stance means that our portfolios underperformed as the markets moved higher earlier in the year; however is now providing the protection that we desire as the crisis once again is front and center in investors’ minds and as contagion risks rise. This means we are:

• Avoiding everything European (equities, bonds, EUR, bank accounts, insurance, etc.) 
• Fully invested in safe-haven Fixed Income assets like US treasuries and other relatively safe bonds 
• Underweight Equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight Commodities that will be negatively impacted by slowing global growth (energy and materials) and that are inversely correlated to the strengthening US Dollar (gold) 
• Short EUR versus long USD 

Policy makers' actions and elections results (Greece is holding more in June) over the next several weeks will guide our positioning.  If we see signs that policy makers are addressing bank run concerns, or a renewed coordinated program by central banks around the world then we will selectively increase exposure. Until then, despite possible market moves higher, uncertainty remains too high for us to move significantly away from our conservative positioning.

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

If You Can't Find The Fish At The Table

There is a saying in poker “if you can't find the fish at the table, then you're it.” And right now, when it comes to the Euro Crisis, no one thinks they are the fish. 

The amount of brinksmanship taking place in global financial markets has reached a fevered pitch more akin to the Word Series of Poker than the implementation of global economic policy. Depending on whom you listen to (or want to believe): 

1. the Euro crisis has been contained and financial markets are on the verge of a renewed bull market because of improving economic data and the amount of cash sitting on the sidelines, or 
2. Europe is staring into the abyss and heading for the next great depression because of the increasingly complicated financial trickery in Europe and the impending hard default of Greece

The reality, of course, is that both cannot be correct and odds are expectations will continue to oscillate wildly between the two outcomes over the next several months and quarters as the stresses in Europe eventually work themselves out. 

The most obvious place where this game is being played is in Greece where negotiations between the Greek government, the Troika (European Central Bank, European Union and International Monetary Fund), and European banks have been ongoing for months. Simply:

• Greece needs money for interest payments due in March so they have agreed to draconian austerity measures
• The Troika needs the EU to remain stable, so they have agreed to give Greece money even though Greece is a bottomless pit
• Banks do not want the EU crisis to deteriorate further, so they have agreed (in principal) to forgive a significant portion of Greece’s debt 

On the surface, this is THE main event—the stakes are high and all sides appear to be playing to win. 

However, in the last several months, a fourth player has shown up that no one has paid attention to who has the ability to significantly affect the outcome of the game. This player, small yet cutthroat, may be the real shark at the table. 

It appears that a handful of hedge funds have been buying Greek sovereign debt at distressed prices in amounts sufficient to influence the outcome of the restructuring negotiations. While their exact motive is unclear, it is likely they are attempting to engineer one of the following outcomes: 

1. These funds may simply want to force the hand of the Troika by blocking a Greek restructuring until new, more favorable terms are put in place for a quick profit (while the math is significantly more tricky, at the most basic level these funds probably paid around 20 to 30 cents for Greek bonds while they push for a restructured "new" price closer to 50 cents). 
2. The other, more insidious (albeit less likely), motive may be to exert enough pressure that Greece is forced into technical default. By buying CDS (insurance on bonds) that pay out when a country defaults, these funds may be gearing for a much larger win that pays off when Greece defaults (and contagion spreads to other periphery countries). 

Bottom line:  At the risk of remaining overly pessimistic for too long on Europe’s ability to contain the crisis we continue to maintain our negative positioning on the market.  We are prepared to adjust this stance once the details of Greece’s imminent restructuring are clear.

However, in our opinion, as it currently stands, the entrance of hedge funds into the Greek debt negotiations process significantly increases the likelihood that Greece and the Troika will make a policy mistake that will trigger a technical default and more importantly reduce investor appetite for other, more systemically important, European country bonds. 

Case in point, this morning there are rumors that “Greece Nears Deal With Creditors on Haircuts” that would pay only 32 cents on the euro for Greek bonds.  Forcing such a steep loss on all private investors, while good for Greece, may trigger credit default swap payments and at the same time inadvertently scare investors away from other high risk European countries like Portugal, Spain and Italy given the severity of the forced loss.

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.