Finding the Best Information about Europe

Every day US equity investors awaken and check futures trading and the latest news from Europe.  What might seem like small tidbits of information have major effects on the total market cap for US stocks.  It may not make sense, but it is the reality.

In this environment, it is important to ask:  Whom do you trust?

The answer is more elusive than we might think.

The chief candidates are the following:

• The market
• Political leaders
• Bank executives
• Leading analysts, pundits, and bloggers
• Rumors

Maybe I missed something, but that should get us started.

This morning's market action showed the problem.  Mark Gongloff's prolific blogging at the WSJ kept you on top of the twists and turns.  The market rallied on early comments from Treasury Secretary Geithner offering a guarantee against a Lehman-like event in Europe.  There was then selling because of a report that Austria had rejected expansion of the EFSF.  Then we had a rebound when it was only a delay.

Get ready for months of this, as the 17 different legislatures consider the EFSF, the ECB deliberates, the IMF ponders, the G7 and G20 consider..... well, you get the idea.

If you are a long-term investor, the volatility represents Mr. Market offering you a chance for good prices -- assuming that you are not in the end of the world camp.

If you have a shorter time horizon, or have genuine worries about the financial system, you need to know whom to trust.

My Handicapping

Here are a few thoughts on each of the sources you might consider.

• Markets.  Should we accept the verdict of the market on Europe --- the high credit default swap rates, etc?  Is Greece definitely going to default?  Here is the dilemma.  Everyone pointing to the market as the ultimate source on this is a liar!  If you asked them if they believed markets were efficient, they would say "no."  Otherwise they would have no job.  All of us get edge by finding market mistakes.  So pointing to the markets on this one occasion is hypocritical, self-serving and inaccurate.  It is confirmation bias in action.  Furthermore, I believe (but cannot prove) that the CDS market on European sovereigns and banks is relatively thin in relationship to what some can make by shorting the banks.  This is not like 2008.  We do not have an AIG selling CDS instruments with no collateral, so the price can be driven up more readily.  Then you email David Faber to make sure that he reports the bad news.
• Political Leaders.  Should we accept the statements of political leaders? We all know that they are trying to maintain confidence.  We also know that there are no guarantees.  When the Geithner news came out this morning, CNBC reported from both Rick Santelli and Bob Pisani -- veteran floor observers.  No one on either floor believed Geithner!  Here is the dilemma.  We all know that it pays to be contrarian.  Maybe everyone is too skeptical.  The collective memory of the Street is sketchy and simple.  For proof, do you really know what Bernanke said when he talked about subprime being "contained?"  If you do, you are one in a thousand.  Most people just accept the Wall Street Truthiness.  When it comes to this subject, no one is a contrarian. It is "smart" to dis the politicians.
• Bank Executives.  In 2008 we saw a number of statements from executives that proved to be inaccurate.  They could have been lying, mistaken, or inaccurate in their expectations about upcoming behavior.  Most of them did not see the collapse of short-term lending and the aggressive impact of FASB 157.  Is there a lesson?  What I do is to listen carefully -- very carefully -- for specifics.  I consider the overall exposure to dubious lending, the acknowledged level of markdowns, and the reliance on short-term fund sources.  Most traders reject corporate executives because they have "learned the lesson of 2008."  This is a gross oversimplification.  There is a legitimate concern that this is a crisis of confidence, so we need to evaluate each statement on the merits.
• Pundits.  Hooray!  Here is our chance to shine.  Anyone who can parse the information and avoid a knee-jerk reaction adds value.
• Rumors.  Forget them!  Enough said.

Conclusion

Most traders and pundits are wrong about Europe because they are over-weighting markets and under-weighting information from political leaders.  This is not black and white, but it is a dark shade of gray.

I expect that there will be some European solution that will drag out, displease many, and consist of a patchwork of plans.  My trader friends think in simple heuristics and binary solutions, so they will not see this coming.  It is a classic wall of worry, playing out over months.

Since I mostly focus on US equities, I have a second line of defense.  There is really no evidence of a US risk, other than the fact that stocks have declined.

Investment Implications

The most aggressive play would be European banks, but this does not fit my risk/reward criteria.  You can get plenty of leverage on this situation with US stocks, especially financials and those perceived to have European exposure.

I hold JPM and MSFT, as two good examples.

Comments

[Angel Martin]

Setbang, i'm late back to this but thanks for reminding me about possible euro appreciation scenarios. I don't want to be like Peter Schiff and others who predicted the subprime crisis, but lost money because they thought the dollar would collapse ...

I think in this case, since I assume Spain and Italy exit/default as well, and that there will be significant ECB debt monetization, i think euro appreciation is a pretty remote possibility.

[SetBang]

Angel/Others - there are euro scenarios that include default but will boost Euro/FXE.

Let's say the 3 worst off, greece, ireland, and portugal default. With the euro leaders messy way of lurching from one plan to another, there will be mass capital flight with an impending default looming as the local banks in these countries will be casualties of any default. With the banking system already in disarray, a euro exit becomes more tempting.

How do these economies credibly promise growth? One option is to freeze captial, default, exit the euro, and devalue by 50% or so. What are the implications to FXE in this scenario? Probably positive, you have removed the weakest links so the remaining countries have lower, more sustainable debts on average.

[oldprof]

I remember that episode!

[Angel Martin]

Jeff, thankyou.

I don't currently have time to do a blog, maybe in the future...

On the choice of Angel, I am pretty much the opposite of Angel in terms of appearance, dress, behavior and motivations... but that's part of the fun of being anonymous on the internet and getting to choose an avatar. It may say something about my sense of humour, but I'm amused by the concept of Angel Martin commenting on financial markets.

One thing I do agree with Angel on, I could definitely go for a 65 deville convertible.
http://www.cadillacplanet.com/2011/06/25/lucille-angel-martin-w-jim-rockford/

[oldprof]

Many of us would enjoy reading an "Angel" blog. Always thoughtful with good supporting evidence and links.

Hard to reconcile with your chosen pseudonym, however, even if he is one of my favorite characters.

Jeff

[Angel Martin]

Mike, sorry I don't have a blog or website.

On the future of the euro vs subprime. One difference is that subprime was incorrectly seen as being too small to be macro economically significant. On the euro, ironically, it is the opposite: a collapse is assumed to be so catastrophic that it won't be allowed to happen...

The future of the euro depends on the power of governments being able to overcome the power of markets. My take is, when governments are doing something that is unsustainable, markets are more powerful than governments and markets will eventually win.

On shorting the euro, your strategy of OTM LEAP puts is what the pro's would recommend, but it is an expensive strategy.

What i'm doing is holding OTM FXE puts only in the Spring and the Fall because, historically, that is when the big financial panics/crises happen.

That cuts the cost of the strategy by more than half. (but I will miss out if the euro crashes in february next year...)

[Mike C]

In either case, default or monetization, I think the euro will plummet. So any investment strategy which assumes the euro crisis will be "worked out" in some way is taking a big risk on currency losses due to the euro crashing.

Angel,

I've been enjoying reading your well thought out comments. Just curious, do you write a blog?

Regarding the Euro, I with you 110%, and have been seriously contemplating starting to build a speculative position in OTM LEAP puts on FXE. That said, for 4 months now I've except very recently I've watched the Euro trade between 1.40 and 1.45 and scratch my head and think how but then again maybe the market is just whistling past the graveyard. The endgame seems clear enough although who knows how the story exactly unfolds but I think you are right about the arithmetic. I wonder if shorting the Euro right now is basically the same opportunity as in 2007 when "subprime was contained" and all the junk housing related paper was still holding up.

[oldprof]

Angel -- Thanks for the name and the link. This is an interesting "inside" look. It was clear to me that it was not a product of their regular research team (I've read a lot of that).

BTW, the reports and the European bankers call these countries the GIIPS:) I'm not sure that is much better, actually...

Jeff

[Angel Martin]

Jeff, the GS deck was originally linked to by FT Alphaville. FT lists the author as Alan Brazil of GS.
http://ftalphaville.ft.com/blog/2011/09/02/668101/goldmans-doom-mongering-eye-bleeding-slide-deck/

I don't know enough about banking to comment on the cost of achieving Basel III standards.

When I look at the europe situation I look at what would be a sustainable sovereign debt situation for the PIIGS and what it would cost Germany.

For the PIIGS to get to current deficits of 6% of GDP and 90% debt to GDP ratio, it would cost approx 1.4 trillion euros, which Germany would have to borrow. That order of debt and deficit improvement would get the PIIGS (barely) to the financial condition of Belgium, which is currently borderline for joining the PIIGS.

If Germany had the political will to do that, it would increase their debt to gdp to 125% and likely drive their deficit to gdp up to 6% (depending on how much their borrowing costs increase).

I don't think it is financially plausible that Germany could carry that additional debt and, while i don't claim any detailed knowledge of german politics, I seriously doubt that such a strategy would be politically viable.

In summary, I don't think political will really matters when it comes to the future of the euro. The arithmetic says to me that this is not going to work. If the whole 3+ trillion in PIIGS debt ends up on the ECB balance sheet, Germany doesn't have to pay directly, but the euro will plummet.

In either case, default or monetization, I think the euro will plummet. So any investment strategy which assumes the euro crisis will be "worked out" in some way is taking a big risk on currency losses due to the euro crashing.

[oldprof]

jd and Angel - What Geithner was trying to convey was his sense of the commitment of European leaders. Angel's link is interesting, but the rationale is pretty thin. I wonder who wrote this.

There has been significant progress on determining the amount needed in additional bank capital. Whatever method is chosen will include a variety of sources and asset sales. Some significant portion will come from private investment.

I invite Angel to take the other side of his argument for a moment. Suppose you were a bank executive and wanted to raise capital to meet Basel III standards. What would you do?

The political will is important to maintain stability while the multi-part solutions are developed. Clearly there are many who are betting against Europe and will profit greatly from a disaster. On the other side, a Greek default would probably be more expensive for Germany than taking leadership in stabilizing things.

To summarize, what jd is hearing, and what I think is correct, is that there are many resources available, not just government bailouts.

Jeff

[Angel Martin]

jd, I think you need to look carefully at this assumption:

"There is money within the system to deal with losses that are necessary (even from default)and recaps of banks and they will figure out some structure to get it done."

Forget the arguments about the political will to bail out the PIIGs and the banks. I don't think it will matter because I don't think the German economy is big enough to do it. Neither does this analyst at Goldman Sachs (see slide 11).

http://www.scribd.com/fullscreen/63818804

[jd]

Thanks Jeff,

"Get ready for months of this, as the 17 different legislatures consider the EFSF, the ECB deliberates, the IMF ponders, the G7 and G20 consider..... well, you get the idea."

This is good. It sets the mind for what is ahead. This European thing is confusing and scary regarding the comments coming from media about systemic risk and a repeat of 2008. But, there's so many moving parts and relationsips between whole countries and banks, that there's article after article about interrelating structures and how the contagion will spread and take the whole system down.

But, here's a statement that I have read which I think may be the truth and would like your read on it. It's this:

There is money within the system to deal with losses that are necessary (even from default)and recaps of banks and they will figure out some structure to get it done.

If that is true, then we can just set back and watch it all unfold, and buy on dips or crashes.