Weighing the Week Ahead: The European Crisis Resumes

What constitutes progress in Europe?  I certainly had it wrong last week!

With a general framework in place, my hope and expectation was that we could finally refocus on matters directly related to corporate earnings, the economy, and the implications for the markets.  This hope lasted for less than 24 hours!

I have had a pretty good record of predicting the agenda for the week ahead, but I should have looked more carefully at that package we got from the Greeks!

News Background on Europe

The skeptics -- and that includes nearly all of the punditry -- want a pure and comprehensive solution.  I's dotted and t's crossed.  They want to analyze the deal the same way they would the Groupon IPO.  Provide specific commitments.  Who is on board?  What will they do?

They expect progress at the same speed they would accomplish in their own business -- problem, analysis, solution.

In democratic governments it does not work that way.

Progress on policy problems is messy, sloppy, imperfect, slow, and laden with compromises.

My expectation for Europe is a multi-faceted solution.  The outline is in place and there are solid indications of commitment.  The pieces of the puzzle will drop into place, but it is a gradual process.

I will suggest what we might look for in Europe at the end of the article.  First, let us do our regular review of last week's events.

 Background on "Weighing the Week Ahead"

There are many good sources for a comprehensive weekly review.  My mission is different. I single out what will be most important in the coming week.  My theme for the week is what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme.  I am sharing conclusions.  Sometimes these are topics that I have already written about, and others are on my agenda.  I am trying to put the news in context.

Readers often disagree with my conclusions.  (A commenter recently suggested that was proof that I was wrong -- an amazing interpretation!)  Do not be bashful.  Join in and comment about what we should expect.  This weekly piece emphasizes my opinions about what is really important and how to put the news in context.  I have had great success with my approach, but feel free to disagree.  That is what makes a market!

Last Week's Data

The economic and earnings news was pretty good, but the main story was about Europe.

The Good

The economic story was pretty good when compared to our current modest expectations.  Look more closely and you will see what I mean.

• The ISM manufacturing index was slightly below expectations, but this was mostly due to "prices paid."  Other subcategories were good and the overall reading is consistent with a 2.9% increase in GDP.  This information is freely available in the ISM release, the result of their research.  I have never seen this reported anywhere else.  Why is that?
• The Employment Situation Report was basically positive.  The payroll jobs gain, including revisions, was about 180K.  The revisions reflected late-reporting businesses, not any adjustment by the BLS.  I really like the balanced commentary from Steven Hansen, and I share his concern about the BLS seasonal adjustments.  Meanwhile, no one is doing a good job on this story.  The problem is that every media source focuses on net jobs change instead of labor market dynamics.  This has been a multi-year crusade for me.  Those who understand will profit, but the challenge is how I can explain this more effectively.  Meanwhile, the positive report is still not enough.  My favorite look at the overall labor market is from Calculated Risk.  By lining up the various recessions you can see the depth of the decline and also the slow nature of the recovery.

 

• Initial jobless claims dipped below the 400K mark.  Most observers are looking at this as a static target with 400K a mediocre reading, 500K a recession warning, and an expansion target in the low 300K range. We really should adjust our thinking to compensate for the changing size of the labor force.  Scott Grannis does this very nicely:

• Auto sales were strong.  Check out the charts from the Calafia Beach Pundit.
• Some economic forecasts from big-time sources are moving higher (via Calculated Risk).
• Earnings season is still strong, beating expectations by almost 65%, continuing a two-year pattern.

 

 The Bad

As always, there was some negative news.

• The most important story was the surprise call for a referendum in Greece.  I remind readers that "good" means market-friendly and "bad" means the opposite.  I am making no social commentary on what is right for Greece or for Europe.  The referendum threat is a clear negative for financial markets.
• The G20 did nothing.  This is related to the Greek story, since the referendum threat seemed to alter the timetable.  The outline of the plan remains in place, but the speechmaking impressed few observers.
• Revenue "beats" are weaker, as shown by The Bespoke Investment Group:

• This is leading to falling earnings expectations. Ed Yardeni and Brian Gilmartin both have fine coverage of this story.  Estimates are still pretty solid, but continue to weaken.  Recession worries, Europe, and possible decline in profit margins are combining to create this effect.

The Ugly

Despite the backdrop of slightly better economic news, the forward-looking ECRI indicators remain negative.  I have not found confirmation from other forecasters with similar excellent records, but the ECRI is standing firm about an inevitable recession.  So far we do not have a time frame.  Doug Short has a typically fine chart of the ECRI data, as well as insightful commentary on the strident nature of the ECRI position.

 

The Indicator Snapshot

It is important to keep the weekly news in perspective.  My weekly indicator snapshot includes important summary indicators:

• An Economic/Recession Indicator.  I am evaluating several candidates.
• The St. Louis Fed Stress Index
• The key measures from our "Felix" ETF model.

The SLFSI reports with a one-week lag.  This means that the reported values do not include last week's market action.  The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm.  This is an excellent tool for managing risk objectively, and it has suggested the need for more caution.

There will soon be at least one new indicator, and the current choices are still under review.

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.

We voted "Neutral" this week, adjusting the forecast on Friday.

[For more on the penalty box see this article.  For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

 

The Week Ahead

This will be a relatively light week for economic data.  I am especially interested in Thursday's report on initial jobless claims and Friday's preliminary report on the Michigan consumer confidence index.

There are a number of Eurozone meetings (Monday and Tuesday) and speeches by Fed members.  I am not expecting much from the Fed folks, but who knows about Eurozone executives and finance ministers -- not too mention any news from Greece.

Mark Gongloff has an excellent agenda of all events -- economic, earnings, and political.

Trading Time Frame

Our trading accounts were fully invested last week, but the nature shifted dramatically away from US equities.  Gold, oil, and emerging markets are moving higher.  Inverse ETFs on the US market have moved higher in the ratings.  It is a very fluid situation, with mixed implications for stocks.  This program has a three-week time horizon.

Investor Time Frame

Long-term investors should continue to watch the SLFSI.  Even for those of us who see many attractive stocks, it is important to pay attention to risk.  A month ago we reduced position sizes because of the elevated SLFSI.  The index has now pulled back out of our "trigger range," but it is still high.  We have some cash in these accounts, and will use volatility to establish new positions.

The Final Word

As part of my final word this week I want to join others in congratulating Josh Brown on the third anniversary of his blog, The Reformed Broker.  He has had a rapid rise to prominence on many fronts, including print media and some well-deserved TV spots.  In our office we back up the TIVO and turn up the sound when Josh is on.  Abnormal Returns had a very nice piece highlighting some of Josh's past articles.  While I had read most of them in real time, it was a nice review, including his advice for bloggers.

Part of this advice is a recognition about what each blogger can and cannot do.  Any of us who are trading and managing accounts, for example, will not be able to provide breaking news coverage on Greece.  Any specific news I write tonight may be obsolete by the time you read it.

Instead, I try to add value by providing perspective and tools to help you interpret breaking news.  With this in mind, here are some observations about the European situation:

• There is a commitment and a will among European leaders to maintain the Eurozone.
• Any plan will, at first, seem short on capital.  As the pieces become clear, more participants will join in.  We should not expect China or Middle East sovereigns to be the lead investors, but they may be ultimate particiants.  Imagine you were putting together an underwriting, starting with some lead investors.
• European banks capital needs will also be met through a combination of requirements, guarantees, and direct investments.
• Exposure of US financial institutions is a source of worry according to stock prices, but not so much by other market indicators.  This is the best risk/reward area if you think disaster in Europe will be avoided.
• The European fears partly reflect concern about counter-party failure and partly world economic growth effects.  This is holding down earnings forecasts and stock prices.

Most importantly, there is little market edge for the average investor in following the daily twists and turns in Europe.  Staying on top of this is a full-time job with little to gain.  The volatility makes little sense.  Many of the "events" are news stories and comments that add little fresh information, but stimulate trading.

The market swings can provide good opportunities if you follow my advice and think about both a buy and sell point for your positions.

 

Comments

[Angel Martin]

Mike C, thanks for the links, it took a while for me to get back to them...

In your links, one has euro depreciation spiking gold, and the other has forced financial asset seizures funding insolvent eurozone governments.

I expect to see both outcomes. On wed, gold fell along with the euro, so the correlation change from that post was short lived. But i think the end game for the euro is major devaluation along with significant eurozone inflation. The more inflation there is, the more it spooks the inflation fear demand for gold.

Residents of latin america would be familiar with financial repression such as exchange controls, forced conversion of bank accounts into gov't debt etc. But, residents of latin america also know that such measures never seem to change the outcome which is usually default, devaluation and hyperinflation.

[oldprof]

Angel - First off, I have no special expertise about Europe, so my inferences come from the more generalized field of public policymaking in a democratic environment.

What I see happening is something I have observed many times, the negotiating among disparate interests and the process of compromise. It is accompanied by strident lectures from outsiders and everyone hates the process.

Meanwhile, I have been fairly accurate so far. It was not that long ago that the skeptics were saying that the various parliaments would not approve the changes in the EFSF and we were fixated on Malta and Slovakia.

The Chinese and other SWF entities will not be the "first in." They will play hardball. But I am just repeating what I have written several times...

You cannot just add up the liabilities, since there will definitely be participants other than Germany and there will be leverage.

Good discussion here. I am trying to keep up my end, but I'll be on the road for a couple of days. Feel free to carry on, and maybe someone will take up my (lonely) side!

Jeff

[Mike C]

Angel,

One more note I just came across with Russell Napier thoughts on one more way this plays out:

http://www.moneyweek.com/blog/the-answer-to-the-eurozone-crisis-theft-55812

"However, Russell thinks that the electoral bias against endless printing might on this occasional actually prevent it happening in the kinds of volumes required. There'll be a bit of European Central Bank-led QE he reckons, but not as much as I think. Instead, governments will end up going for national theft solutions."

[Mike C]

Angel, I appreciate the detailed response. You might find this an interesting read

http://www.robertsinn.com/2011/11/07/what-are-gold-and-the-euro-telling-us-about-the-ecb/

I guess my overall thoughts are that I am in total agreement with your first few bullet points. Ultimately, the aggregate debt is unsustainable. Really, it just takes elementary school arithmetic to come to that conclusion. The harder question is what happens with the debt.

Does the ECB ultimately cave and monetize it? What I wonder (the cynic in me) is if all the various machinations we are going through now are just to move the debt from parties A, B, C to the bagholders who eventually get defaulted on down the road?

[Angel Martin]

Mike, here's what I assume about the future of the euro:
-the PIIGS are all insolvent including Spain and Italy
-Germany and the other non_PIIGS countries don't have enough borrowing capacity to fund a debt reduction for the PIIGs that would make them solvent
-neither the IMF or the BRICs are ultimately going to ride to the rescue
-the euro-elite is extraordinarily committed to the euro to the point that they are willing to risk severe economic damage to keep it going

If you put that all together, I get see the end game is either all the PIIGS crash out of the euro in a forced exit and devaluation, OR the ECB monetizes the PIIGS debt and gets severe inflation.

Along the way, because of the commitment of the euro-elite to the maintenance of the euro, I think you will see proposals (if not actual implementation) of eurobonds, fiscal transfers, a common finance ministry and even political union.

What is not clear is how far Germany will go with debt monetization. I claim no expertise on german politics but my assumption is that as long as the ruling coalition is CDU/CSU/FDP then really big debt monetization is off the table. If the more pro euro SDP/Greens somehow take over before this is done, we could see massive debt monetization and even an Argentina style hyperinflation.

I think the trajectory of the euro is down no matter what happens. The eurozone appears to be slipping into recession. Even if the US goes into recession as well, the chaos of uncontrolled defaults etc is going to weaken the economies of the remaining eurozone members and drive the euro down against the US dollar.

If they start on a course of aggressive monetization, the euro could drop to levels that would truly represent a "black swan".

Some caveats on trading strategy: the eurozone elite still has many cards to play, every time they announce something like fiscal transfers or eurobonds the euro is going to spike up.

My trading strategy is to have a small short position using out of the money options, which I will add to as the euro-elite graudually exhaust all their optoins like eurobonds and fiscal transfers.

If the SPD and Greens somehow become part of the ruling coalition in Germany, I am really going to pile in.

Another caveat, Jeff has 25+ years experience doing this for a living, plus experience as an academic specializing in public policy decision making, as well as quantitative methods, and he thinks that the eurozone will somehow get thru this without the catastrophic collapse that I am forecasting. Jeff was completely correct about the outcome of the debt ceiling, while I thought that the tea party Republicans i the House would use their leverage to force massive, immediate spending cuts...

So, you need to do your own thinking here...

[Mike C]

Good stuff Angel. Your analysis reminds me of Soros versus the Bank of England. I think it was Carville who said he wanted to be reincarnated as the bond market. Ultimately, the markets are bigger then government policymakers.

All that said, what is the long-term trade here? I'm just not sure that short euro for the long-term is the trade. The stronger countries could just give the PIGS the boot.

[Angel Martin]

my take, totally bogus. This paper has a cross country comparison of the determinants of consumer debt. Declining incomes by the "working class" is not one of them. byhttp://www.tinbergen.nl/discussionpapers/07087.pdf

The lack of wage growth is not related to "corporate power" or the "class interests of the wealthy" but is a function of the global labour supply shock of China and India abandoning autarchic socialism and entering the global economy. Global labour supply has quadrupled in the last two decades, it's actually amazing that wages have not gone down more.
http://www.bis.org/publ/bppdf/bispap50o.pdf

[oldprof]

jd -- analyzing the strong financial interests of various parties is a good method.

You are on the right track with your conclusions, and you might also add China and various sovereign funds to the analysis.

All will discover, bargain, and eventually act in their own interest.

Good concept, and thanks,

Jeff

[Angel Martin]

Jeff, my point about the bond offering pull was that Germany and France had no problems selling bonds last week, and the EFSF is also supposed to be AAA rated... it may be that there is very little demand for EFSF bonds at sustainable interest rates; as you noted we will see.

On the power of markets vs governments: I think the that is at the core of what is going on here. A few weeks ago, Merkel said that part of what they were doing was to re-establish the power of political decisions over markets. I think that is delusional thinking and if that is their strategy for saving the eurozone, they are going to fail for sure.

I'm not pushing my political views here (although i am generally a less government, more markets guy) i'm just talking historical fact. In my view, the power of markets is going to totally crush the eurozone leadership because they cannot force independent economic agents such as BRIC sovereign wealth funds, US money market funds, or even their own citizens to lend money at low interest rates to weak creditors like the PIIGs.

Governments are sovereign and they have a lot of power. But they do not have sufficient power to force economic agents to accept losses when they can be avoided. Even totalitarian states have limits on the control of economic behavior by their subjects, if they did not, the USSR would probably still be in business.

Joseph Stalin murdered millions, but even he could not eliminate the difference between the black market price of wheat and the official Gosplan price.

The EU wants to, in effect, use various incentives and partial guarantees to manipulate markets into lending to the PIIGs at below market rates. I don't think they are going to be successful.

[jd]

When I think of Europe, I ask the question, "Who has a vested interest in Europe succeeding?" I think the answer is, "the rest of the world." The rest of the world in various buckets has a great deal of money available.

So, in the final analysis, at the right time, when the political process has finally run it's course, the money will be there.

I used to be concerned about Europe. Now, not so much.
Although, many years of discipline will be needed. But, that discipline will have to unfold slowly, year after year, according to what the system can handle.

Strangely, it's the magnititude of the danger, that gives me comfort. It's about countries, banks and interconnections (contagion). The world simply can't fail in this one. So, it won't.

[John]

I just saw an animation about how class works made by Richard Wolff. Now I know that this isn't really related to investing but I just wanted to ask your opinion on this, Jeff. First off, here's the animation (12 mins):

http://www.rootsofhealthinequity.org/how-class-works.php

First question: Do you know anything about this Richard Wolff? What is his "track record"?

Second question: What is your take on the animation and the point Richard is making?

I personally have a bit mixed feelings. On the other hand I think he's on to something but on the other hand I think that it cannot be that simple.

[oldprof]

Angel -- So if you were in charge of the bond offering, you would have recommended going ahead despite the Greek referendum turmoil? I thought that the delay was a rather routine decision. We'll see how it prices when they try again.

You are raising a great point about markets and political decisions. Democratic leaders do not like to be told that they MUST do something. They believe they are deciding. Sometimes the market "opinion" is not the best solution -- at least in a social or public policy sense. The participants and values are quite different.

It is a good question, and there is no easy answer. The political process in 2008 would have avoided some of the damage if it had been faster. Same for the Obama transition. Same thing now in Europe.

Thanks for your continuing valuable observations and links.

Jeff

[Angel Martin]

Jeff, I know we disagree on the likely endgame in europe. For me, this week, the most important story out of europe was when the EFSF pulled the auction of 3 bil for Ireland, citing "market conditions".

http://www.bloomberg.com/news/2011-11-02/efsf-said-to-plan-delay-in-3-billion-euro-bond-sale.html?cmpid=bit

The way things are going in Italy, the EFSF is soon going to have to do much larger fundings than 3 bil, in much worse market conditions than last week. If they can't, then the EFSF is going to go way of the last half dozen "solutions" to the eurozone crisis.

I would also question the idea that the political process in europe is slow, and that's just how it is but they will get there eventually...

Sometimes markets have their own time table, that politicians have to meet whether they want to or not. Markets open every monday and if you are not ready, you get eliminated (like Lehman did).

We can see from the EFSF Ireland auction pull that the balance of power over schedule is shifting from governments to markets.

[John]

Thanks for the post Jeff.

It is my understanding that the Prime Minister of Greece called off the referendum. Now he is trying to form a unity government to take Greece through the austerity program.

Here's some news on this subject:

http://www.reuters.com/article/2011/11/06/us-greece-referendum-idUSTRE79U5PQ20111106