Europe: Get Ready for a Surprise Endgame!

How do you find an edge?

I was inspired by a news story yesterday:

Europe promises speedy response to crisis

What a joke!  This really highlights divergent viewpoints.

The market  wants to know why they have not already fixed these obvious problems.  Every new move is described as smoke and mirrors, kicking the can, or something similar.

Many stories begin by telling you how stupid or ineffective the European politicians are.

A Flashback

Back in my teaching days we had simulations as class exercises.  These were wonderful teaching tools -- much better than textbooks.

I only wish that I could collect a group of hedgies, traders, and market pundits for such an exercise.  Each player would be given a role.  The success in the game would be determined by how well the national objectives were met.  For Germany, it would be preserving the Euro, which has led to great financial success, while exacting concessions from others on changes in labor rules, agreement with debt limits, etc.

For the ECB the rules would stipulate not going too far until various governments had made commitments.

For the Chinese, it would mean not committing funds until the Europeans had done their part.  Ditto for the US.  If you acted too soon, you could not get an "A" for the simulation.

For Greece, it would mean exacting debt concessions, stimulus, and whatever else you could get.  Ditto for Italy.

For Spain and France, it would be a little more nuanced.

Please note that no single party gives flying Stanley Cup hockey puck (TM OldProf euphemism) about the short-term verdict of the US stock market.

The rules of the game do not optimize the global result.  If you and I were dictators, we would have "solved" this long ago, although our ideas of the best solution might differ.

The result from students who engaged in simulations like this was amazing.  They got it right away!

Meanwhile, the investment world consists of people who never took this class and who all mistakenly think they are smarter than the top leaders in the world.  The bloggers and the commenters seem to think that being sassy and sarcastic makes them look smart.  Even some good journalists fall into this trap.

The Alternative Viewpoint

Let us start with what does not work -- being a Wall Street Parrot (a species I identified here) and repeating what you read in the newspaper.

Anything that is in the paper is "old news" so you need to look beyond the headlines.  Sure, you can get your gig on CNBC and look smart by catering to what people think they already know.  It is too bad that this is not like baseball, where they put up the career stats along with the featured pundit.  Instead, they show the assets under management.  This shows how well management does in bringing fans in to watch a bad team!

I have a long-term forecasting record on this which has been pretty accurate on general European developments.  It is dragging out longer than even I expected, but I still see the following conclusions:

• Some sort of deposit insurance for Europe, ending the bank run worries that have dominated the stories for the last several weeks.  Do you really think that European leaders have no plan for this?  This will be the first news.
• More powers for the ESM -- either direct lending to banks, or giving bank powers and leverage to the ESM.
• Expanding the war chest -- this will happen gradually.
• Concerted action by G8 powers -- quite possible, and already rumored.
• Political and fiscal integration -- probably happening since most countries will benefit.  I do not know about Greece, but I will note that an exit now is much less painful than it would have been a  year ago.  This illustrates why it is useful for leaders to buy time.

Evaluating the Downside

I have noted some pundits and commenters who make an argument like the following:

Company X has 20% of its sales in Europe.  Europe is in a recession.  This is really bad for Company X so it is obvious to sell those shares. 

 This is one of the biggest investor blunders -- something that I call "light switch thinking."  It is employed by non-economists who do not try to identify and model quantitative relationships.  I invite readers to think about this.

Suppose that the European recession is a GDP decrease of 2%.  What should be the cut in the sales and/or earnings of Company X?  Would it matter if the company sold toilet paper?  Autos?  Business software?  What is the worst case?

With all of this in mind, how much should we adjust the fair value of Company X?  Is down 20% a good number?

The Right Approach

I like the approach of Steven Einhorn (perhaps because his list is what I have been highlighting for months).  Thanks to Doug Kass and Barry Ritholtz for highlighting this useful checklist of what you should be watching in Europe.

Most people are watching for some big, comprehensive plan.  They will not see a solution until they have missed the whole move.  If you follow the items on this list, you can track progress in real time.

There are many stocks that have been excessively punished through this thinking, but you might see the best leverage from some software names like Oracle (ORCL) and cyclical stocks like Caterpillar (CAT).  Stocks like Apple Computer (AAPL) have also been dragged down because of the excessively simplistic Karate Kid view of the markets -- risk on, risk off.

If you want to do better than advice from a kid movie, my suggestions are a good start!

Comments

[Hugh Manatee]

Europe has been dead since roughly August, 1914. Ignoring the tens of millions slaughtered in two world wars, we have the subsequent attempt to unify disparate religions, languages, cultures and histories into one unified political/fiscal entity.

One at least has to ask just when in world history has this type of integration ever been tried when the system did not immediately begin to disintegrate? Catholic and socialist France will be in effect merged with Protestant and capitalist Germany? Add in a language barrier and toss in a history of conflict going back to roughly Napoleon and what would you assign as a probability of success?

There's a reason the Puritans left Europe and settled in America. It's in the news almost every day. Try to imagine the unrestrained ignorance of American leaders who believe we should emulate this disaster area.

Do we actually need a checklist?

[Curt]

"The bloggers and the commenters seem to think that being sassy and sarcastic makes them look smart. Even some good journalists fall into this trap."

I try not to be sassy and sarcastic to look smart, b ut it just is amazing to see the deceptions in finance.

The stock market makes no sense for the masses. It is for the masses just a transfer system from the less wealthy to the more wealthy. The efficient way to make this transfer system is a graduated income tax. Just change the slant of the curve and you can transfer money from the rich to the not so rich or from the not so rich to the more rich.

For instance Warren Buffet is said to be worth 50 billion or so. If his wealth grows by say 5% a year than he makes well 2.5 billion in a year. He paid what 17 million in income tax so his rate of taxation in a somewhat sensible world(snarky?) would be less than one percent. And if we wanted to help Warren then we could reduce that to say a tenth of percent.

That is a straight forward no nonsense way to make the rich richer.

But the stock market is mainly a place where people trade based on limited information. The wealthy or about to be wealthy have a lot more information and so get wealthier still. Your average person should never be in the stock market because they have no time to invest in getting the information. The only reason some small investors make money is they take from other poorly informed small investors. So it is a transfer system from the foolish to the less foolish.

So then you suggest that the foolish find a trusted advisor. How does a foolish person find a trusted advisor. Do you pay someone to find the best advisor and if so would not someone with more money outbid you?

So if you could find the right mutual fund you would be much better off, but won't the wealthy always outcompete you in getting the best mutual fund.

So on average the stock market is rigged against the small and not so small investor.

But you may say even though this is the case it is the best game in town. This is true if you follow history and if history repeats itself.

There is however a better game if people were more honest. That is social security in a slightly different form. I think it is foolish to think of social security as an investment in its current form.
It is a means of transfering wealth and I am not against that. So people should receive a minimum amount of social security regardless of what they put in so they can survive.

And further we must index the fund. Then let politicians decide how much the country can afford to subsidize the less afluent.

But then for those who want to save and invest, let them invest in America ( or other countries I suppose) with GDP bonds. You cuy can buy all the GDP bonds you want for your retirement and the government will pay you back based on how well the GDP is doing. If America does well you do well and if not you do not so well. This limits the inside information to guessing how well America will do in the future.

Then how do companies get funded. Basicly they take out loans from the big banks. If facebook needs money to get started and it is such a great idea let Citibank loan them the money. Or let a partnership of wealthy informed individuals loan them the money.

Now how does City Bank get the money? They borrow it from the Fed and then if Citybank was smart they pay the fed back.

What if the original owners of facebook want to cash out. Then find a group of wealthy people to buy the business.

But please lets not go thru all these games to milk the little guy. Just use the tax system in straightforward efficient milking system

[Jack]

Possible. But similar things were said just up to the subprime crisis, Lehman, etc. With all those smart, rational people at the helm, they wouldn't let the system crash then would they?. I think I agree with Casso.

[Bill Casso]

The banks in Spain need lots of cash, the Germans will not sign a blank check to help Spain and the others. Unless you think that Merkel will violate German Law and pledge more money without a vote by the German Parliament the European house of cards will collapse. There is simply not enough time for these politicians to act. You may have a good track record but I think you are the one that's going to be surprised by the endgame.

[Greg]

Excellent article. I agree that "Eurozone Leaders" are rational people who will not let the world fall apart as they sit on their hands. Sure, there may be a lot of brinksmanship and posturing, but at the end of the day there won't be a total systemic collapse because that outcome is simply in nobody's interest. Unfortunately, that notion doesn't sell newspapers.