Eur Out!

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Posted By: Matthias Paul Kuhlmey

 

En route to Berlin for a meeting with German Chancellor Angela Merkel, newly sworn-in French president Francois Hollande had to change his travel plans, as his Presidential Aircraft was struck by lightning (strike 1). This could have been a somewhat “elegant” way to delay a meeting, but not to be stuck with a false image of laissez-faire right from the “get-go,” a second Presidential Plane (Austerity a la France!) took Mr. President safely to Germany. 

 

The new Franco-German Duo, Hollande/Merkel (nickname pending, but perhaps someone could suggest “HolMerk” and get into the political greeting card business?), most likely had a grim first official meeting – and not so much for reasons of Angela Merkel “picking-on” Brother Francois, prior to his election; rather, the two were pressured with breaking news that Greek politicians were unable to form an orderly Government after a 9-day meeting “marathon” (pretty Greek to begin with), leaving the country with the prospect of new elections to be held (strike 2). The timing is absolutely off, as the nation needs to secure a future financial lifeline (with or without the Euro).

 

To our frequent readers, the recent events in Europe should not come as a surprise; we advised months ago of Greece’s “going bust” and of Spain’s socio-economic malaise (strike 3). Events in the next 24 hours will show if the Europeans are committed to really “throw money” at the issue and solve the matter “Anglo-Saxon-style.” Bond market participants certainly have made-up their minds, already, with Spanish 10-year yields above +6.2%, Italian equivalents at +5.9%, and EMU bank stocks trading at the lowest level since 1987!

 

We do hope that our critics finally open their minds and “clear” us of false accusations of negativity. It is essential to continuously monitor all facts. Whereas markets may stay volatile over a short period of time, investors should not “throw-in the towel.” For background on our views, please see our recent Economic Update, ‘Seen the Future.

 

‘Seen the Future

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© Matthias Paul Kuhlmey, 2012

 

I. Status-Quo

 

It was quite the fascinating spectacle, not only for little boys, when about two weeks ago, the final journey of the Space Shuttle Enterprise took course over New York skies. The “retired” shuttle will be installed at the Intrepid Sea, Air and Space Museum on the Hudson River and will go on display July 19, 2012.

 

“Nice,” one may think, as something “quite distant,” at least under previously normal circumstances, will become closer to the eye of an observer. On the other hand, this is a somewhat “tragic retirement,” as nothing comparable, at least so far, has replaced the Shuttle or the entire related Space Mission. The same is true for the once fastest passenger plane, the Concorde, which was taken out of service in 2003 and not yet replaced with an equivalent. No longer being able to fly between London and New York in about 3.5 hours, or to lift-off to space in a manned spacecraft, makes us wonder whether we are truly creating a technological evolution, or if we may be moving backwards (hopefully to prepare for the next “wave forward”).

 

When observing today’s state of global financial markets, especially when ignoring the “noise” of intraday trading of financial instruments and their price movements/valuations, one may wonder if we are moving backwards in this area, as well. If the situation is evaluated on a purely nominal basis (for most onlookers, a relevant indicator is the level of stock markets), the anticipated economic recovery since the onset of the Credit Crisis of 2008/2009 may well be underway. If, however, this aspect is judged from a broader perspective, the global economy and related financial markets may have become a place with increased levels of imbedded systemic risk – with expansive credit creation being only one of the contributors to this issue.

 

‘Seen the Future is most certainly a daring title for this Quarterly Outlook, but as a mounting number of our respected clients and friends continue asking about “how the entire dilemma could play out,” we will attempt to bring some answers, or at least raise questions that should be asked when prudently allocating money.

 

One of the most important things to explore is whether we have indeed been moving backwards and if this may continue for some time to come or, alternatively, if the “move forward” has already started.

 

We realize that we must accept a certain degree of personal and/or professional risk, since our messaging may appear overly concerned, or even negative, at times. In applying an elevated standard of care, as a fiduciary to our clients, we have no choice but to “tell it like it is.” Thus, a broad investment framework on how investors should be positioned will be part of this update.

 

Please follow this hyperlink  for the full report.

 

 

Waiting for Godot

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Samuel Beckett was a great-grandmaster of absurdist fiction – “a genre of literature … that focuses on the experiences of characters in a situation where they cannot find any inherent purpose in life, most often represented by ultimately meaningless actions and events.” One of Beckett’s most recognized works (a play, to be specific) is entitled, Waiting for Godot. 

 

The play portrays two men, Vladimir and Estragon, “who divert themselves while waiting expectantly, vainly for someone named Godot to arrive. They claim he’s an acquaintance but in fact hardly know him, admitting that they would not recognize him were they to see him. To occupy the time they eat, sleep, converse, argue, sing, play games, exercise, swap hats, and contemplate suicide – anything to hold the terrible silence at bay.”

 

In early conclusion, this is how we feel about, or better yet, how we think of others and their way of perceiving the(ir) so-defined economic recovery and the related investment environment. It is still puzzling to us how things change by the hour:  Markets are up, as revised earnings are beat; markets are down, as Mr. (ECB) Draghi does not want to “play the liquidity game”; then markets are up, again, on the basis of questionable “shortcuts of the collective mind,” with poor economic data (and we had some) being the catalyst for more FED-provided stimulus, consequently driving up markets – a somewhat schizophrenic notion, or absurdist fiction, to stay with the plot.

 

All in mind, and similar to Vladimir and Estragon, most of us have never experienced a true economic recovery, and yet we believe it is right around the corner. The highly acclaimed David Rosenberg, of GluskinSheff, wrote earlier this week that “during this statistical recovery from the 2009 bottom, real U.S. GDP growth averaged 2.4% at an annual rate, and of that, 0.7 percentage points came from inventories. Excluding inventories, otherwise known as ‘real final sales,’ average annual real GDP growth was 1.7%, on average — is the weakest post-recession recovery on record. This despite a 10% deficit-to-GDP ratio, a government debt-to-GDP ratio rapidly heading to 100%, a near zero Fed funds rate, record low mortgage rates, and an unprecedented tripling in the size of the Fed balance sheet.” Not to brag, but those could be our words, except for the fact that Rosenberg is considered a brilliant mind, in contrast to us absurdist fictionists.

 

It is not surprising that “over the years, Beckett clearly realized that the greater part of Godot’s success came down to the fact that it was open to a variety of readings and that this was not necessarily a bad thing.” This is precisely the reason why markets may continue to trade higher; among the reasons cited are “the advantage of election years,” “the FED’s willingness to provide liquidity,” “attractively valued stocks,” etc. To capture the benefits, investors may want to keep an open mind and consider applying a tactical approach to their asset allocation, while maintaining a primary focus on risk mitigation …

 

P.S. Does anyone find it ironic that for the celebration of Samuel Beckett’s 100th Birthday (1906-1989), his portrait was depicted on an Irish commemorative coin that very much looks like a Euro?

 

Germany \’jər-mə-nē\

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A lot of interest is being generated around “my people” (more specifically, the Germans) these days. Among other news, the recent edition of The Economist is featuring a cover story entitled, “Is the German model worth copying”?

 

Why even bother? It appears that in the midst of a failing Europe (tbd), the German economy has shown extraordinary resilience, still posting somewhat attractive economic returns because of its stellar employment situation. If one considers that the average cost for an hour of labour in Germany is over 30% above the average cost of labour in the European Union, the picture is even more impressive. The explanation, from my humble view, is complex, but a couple of points are indeed noteworthy:

 

First, the savvy German Mittelstand (mainly family-owned, mid-size businesses that account for 50% of German GDP and 70% of all employment) has been conditioned to compete at unfavorable terms for decades; a strong Deutschmark prior to the implementation of the Euro was every exporter’s nightmare. What was done? Quality was increased to the point of making price a secondary consideration. Secondly, we (taking the German side), had our fair share of dealing with significant unemployment over 10+ years, specifically after the German reunification in 1989. One may conclude that we have learned how to deal with a challenging environment; for years, austerity was the norm, not the exception.

 

The above progression, as we know, was not the case for most Anglo-Saxon nations or other select economies in Europe. Lack of austerity, credit expansion, and related speculation often created a false impression of economic success. Think of Spain, for example, where housing/real estate was a one-sixth contributor to national GDP, not long ago. Funny enough, it did not seem odd at all. On the other hand, Germany’s heyday did not include such a housing bubble (although they have experienced an increase more recently), and, yet, 85% of Germans are satisfied with their standard of living. Further, on the merits of the old Teutonics (Germanic people), countries that run positive account balances are by definition (oversimplified) savers on a national level – most certainly the case for Germany (and China, for completeness of the story).

 

Now the really amusing request, generally posed by The Economist and others is that the “cheap Germans” need to get off their behinds and maximize consumption. In other words, the Germans are a pain to the rest of the world, as surpluses (or savings on a national level) must be distributed – save less and give to the needy! Brilliant!

 

The Germans, however, may already know that the “sweet ride” is about to change. Their biggest export markets are neighboring Europe and the emerging world, specifically China. Things are not looking so good, and the exporting business may be quite painful going forward. Better hold onto your money!

 

In conclusion, a bit of history: The article in The Economist is actually titled, “Modell Deutschland Über Alles” (Germany above everything), which is somewhat distasteful, considering that this was the message of the first verse of Germany’s national anthem, Deutschlandlied, during times of being the world’s most unreasonable aggressor. This opening verse was eventually removed (along with the second verse), and only the original third verse functions as Germany’s official national anthem, since 1952.

 

Doctor, Doctor

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Living in most of Europe may be an attractive proposition (forget about the credit crisis for a moment) – after all, isn’t health care and education (for the most part) free? Ever since grasping the nature of this concept, it has simply driven me crazy: “Oh, I have seen three doctors this week … my insurance covers it …” The sad thing about this notion is that the cost will remain in the system – in other words, even though we may not experience the cost “out of pocket,” there surely is a cost to be covered by someone, at some point in time; I think we can agree on this. 

 

Last week, we reported that major Central Banks around the world have expanded their balance sheets quite massively, when compared to respective GDPs, over the past years. Status Quo: 25% for the Japanese and Europeans and about 20% for the good ol’ US and the Brits. If we slap other liabilities on top of those claims  (in the U.S., this would refer to funded Public Debt and rather large unfunded allocations related to Medicare, Social Security, etc.), developed societies have been on a “spending binge,” and are unsustainably indebted; we call it, more tactfully, the Debt Supercycle.

 

Even though this unfavorable debt trend was already debated decades ago, we really “cranked-up the credit machinery” since 2000. So let’s not fool ourselves:  The cost is in the system, and it has to be absorbed at some point; this is the hard realization for member countries of the EMU and European bank these days. According to a recent report, “good will money” provided by Central Banks is “running on empty.” The price of Credit Default Swaps, instruments to compensate their buyers in the event of a loan default, are indicating that at least four more European nations may face a debt-restructuring, sooner than later.

 

We know how much our regular readers love our 80s music analogies, and this blog just gives us the perfect segue to yet another. Remember the Thompson Twins? … “Oh, doctor, doctor, can’t you see I’m burning, burning? Oh, doctor, doctor, is this love I’m feeling?” We have an answer – it’s not love – it’s that funny, sinking feeling you get in your stomach when you realize that there’s not enough cash in the bank to pay this month’s credit card bill …

 

Missing Words … and Numbers

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The German magazine, Der Spiegel, is running a very interesting cover story this week, entitled “Heimat.” When I tried to explain to my wife what the article is all about, I l realized that there is no English word to translate Heimat. After doing some research, we acknowledge that Heimat “is a German word that has no simple English translation, denoting the relationship of a human being towards a certain spatial social unit. The term forms a contrast to social alienation and usually carries positive connotations. It is often expressed with terms such as home or homeland, but these English counterparts fail to encapsulate the true meaning of the word.”

 

With further lack of words, let us attempt to explain the current market or market participants’ behavior — as good as we can (promise). Setting the scene: We have terrible job numbers in the U.S. — meaning terrible(!) — about 50% under expectations, as reported last Friday (known as a “miss” in financial jargon); there is a continuously deteriorating situation in Europe, with our beloved European Central Bank (ECB)  preparing to buy European Sovereign Debt to ease markets; and, last but not least, we have seen a modest increase in Unemployment Claims, here at home. The Conclusion:  It does not matter! The “Solution”:  As soon as bad news “hit the tape,” the Talking Heads of the FED, ECB et al (Central Banks Unite) are not shy of words, even though they should choose them carefully. The “quick fix” is generously promised, and a bit of “hinting here and there” gives investors the confidence needed.

 

Wait a minute, what is an investor, anyway? You would think a thoughtful person, studying balance sheets, and being in for the long run — but not so fast. Doing some research on this word, even speculators may as well be considered investors. And here is the dilemma: Central Banks, ever since the Credit Crisis of 2008/2009, have been facilitating the most significant liquidity injection ever experienced by modern society. The Bank of Japan (BoJ) and ECB have expanded their balance sheets to about 25% of respective GDPs, while the FED and Bank of England come in at around 20%. On this basis, we are not talking investing, but rather of a massive inflation trade in the making.

 

Without a more formal approach to investing (and now we are referring to the “real thing”), there will be disappointment over the outcome, sooner than later. However, if you think all is “dandy,” consider another great data point, as observed by Bloomberg:  Apple stock’s price performance has accounted for 8% (!) of the Standard and Poor’s increase from March 2009 to this week. Fortunately, we do have an English word to describe our reaction to this — “Speechless!”

 

… A Matter of Luck

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There are a few principles my father lives by, and one has become a crucial guide in my personal and professional life:  As his saying goes, “Thinking, (more often), is a matter of luck.”

 

If a random group is being asked to judge the level of energy consumption in New York City, the more common thought, or even conclusion, would be that it is “a lot,” “excessive,” or even “wasteful.” Assumptions would logically be based on prevailing facts: Massive office buildings are kept at comfortable temperatures all year around, a stream of cars “sit” in bumper-to-bumper traffic, plus millions and millions of people are simply constantly using energy. Case closed: Big cities are a nightmare for the green and conscious mind. But now, consider this:

 

“New York’s population density has environmental benefits … it facilitates the highest mass transit use in the United States … gasoline consumption in the city is at the rate the national average was in the 1920s, and greenhouse gas emissions are a fraction of the national average, at 7.1 metric tons per person per year, below San Francisco, at 11.2 metric tons, and the national average, at 24.5 metric tons. New York City accounts for only 1% of United States greenhouse gas emissions while housing 2.7% of its population.”

 

Yesterday’s FOMC Minutes (of Benny B’s group March meeting) concluded that the FED is not über-actively exploring monetary measures to further stimulate growth of the U.S. economy. Among other reasons cited, the concern of rising inflation played a role in policymakers’ decision not to extend bond purchases in an attempt to lower rates. One would think that this is all good news, as the economy is on-track, there’s a little inflation (hence, velocity of money finally “getting somewhere”), and cheap stocks to buy on this positive backdrop! However, sure enough, the opposite took place, with market participants “fleeing” from their commitments – from bond markets yesterday and equity markets today.

 

Total confusion. Wasn’t it the common understanding, and leading opinion, that stock markets have hardly ever been more attractively priced from a valuation standpoint? So what is the commotion all about? If things are much brighter (economically speaking), we would have expected more commitment from our investment community and, subsequently, markets to trade in positive territory. Investors, however, may have been led by a logical fallacy, accepting that a specific belief is true simply on the basis that we don’t know that it isn’t true.

 

Our suggestion is to, once again, examine the economic landscape more carefully; the recovery is not what we are led to believe it is. The U.S. may look good on the surface, but we are not dealing with a normal recovery. Several studies have shown that financial crises leave behind deep recessions of long duration and considerable volatility (we are most likely in the middle of the process). Europe is another topic, and a disappointing Spanish Bond auction is more than indicative that market participants are slowly changing their excitement about Euroland’s recent rescue mission.

 

It is about time to put behind us all that has occurred since the big turnaround in financial markets. In this respect, we will conclude with words by another great man:  “The world we have created is a product of our thinking; it cannot be changed without changing our thinking.” Thank you, Mr. Einstein.

 

How to Fix Stuff

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How do you fix a computer? Turn it off … and then back on. J How do you fix an economy? You cannot turn it off, that’s for sure – it only may have worked once, during the Great Depression, and the system did reset itself. Since Mr. Bernanke was recently declared a “hero,” we thought the “fixing-up” was complete. To be clear, we have no axe to grind and are most certain that our FED Chairman is attempting to do a very fine and thoughtful job; nevertheless, FED communication has been entirely confusing and, to a degree, misleading (at least for market participants that need stimulus money to make investment decisions).

 

This past Monday, Mr. Bernanke, during a clever publicity stunt, expressed his worries that the economic recovery could stall if the FED would end monetary stimulus too soon. So, things are not fixed? Here’s a shocker:  According to “Hero B.,” the recent improvement of the unemployment situation may (only) have been reflective of “a reversal of the unusually large layoffs that occurred in 2008 and 2009,” with this process now in conclusion. Further, Bernanke told ABC news that “It’s far too early to declare victory” (on the economy, that is). Huh?

 

On the other side of the argument stands Charles Plosser, President of the Philadelphia FED, suggesting in an interview that he does not “think there will be any need for further accommodation, or further QEs.” Federal Reserve Bank of Dallas President, Richard Fisher, seems to agree, having stated in a recent speech that the “Federal Reserve has done its job” (in providing liquidity). But, wait, here comes San Francisco FED President, John Williams, carefully remarking  that, “If the economy does need more stimulus, restarting our (the FED’s) program of purchasing mortgage-backed securities would probably be the best course of action.” His buddy, Federal Reserve Bank of Chicago President, Charles Evans, sums it up:  “The central bank should step up record monetary stimulus even as the economy shows signs of gaining traction” (for a selection of other differing FED opinions, click here).

 

So, how do you really fix things? One idea is to agree on what has to be fixed – the economy and related unemployment, or the stock market (easy money has certainly taken care of that). Go on guys!

 

360: The “E” Is Wrong! (Part II)

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Today, we have a brand-new edition of our 360 Observations, this time covering a topic that should be of great interest to the prudent equity investor: Earnings – and, ergo, the attractiveness of stocks versus other investments. Yada Yada Yada, we get it – stocks are cheap! Just to quickly refresh our memories: The attractiveness (or “cheapness”) of a stock is a function of the price a given investor is willing to pay for a future string of earnings, also expressed in the so-defined Price-to-Earnings (P/E) Ratio. In other words, with a P/E of 14.4 for the S&P 500 (using current forward-looking 12-month earnings estimates), an investor is willing to pay $14.40 to acquire $1 of earnings. Stated differently, it will take 14.4 years (on this basis alone) to reach a break-even point for this particular investment, assuming everything else stays the same. On a trailing P/E basis (using the past 12-month earnings), equity markets in the U.S. are also somewhat attractively priced with a reading of 16.2. Case dismissed?

 

What is important to consider is the quality or composition of “E,” as this very aspect can change the outcome for an investor quite substantially. Messrs. Graham and Dodd, in their highly acclaimed and classic text book, Security Analysis, “urged investors to focus on hard facts  - like a company’s past earnings and the value of its assets – rather than trying to guess what the future would bring.” Their suggestion is that stock prices should be divided by average annual corporate earnings, based on at least five years of history, but ideally ten years; this so-derived 10-year ratio has a reliable track record: “In 2007, when many Wall Street traders and economists were claiming that stocks were still a great buy, the 10-year ratio knew better. Likewise, it helped predict the market’s rebound in early 2009, when optimists were not easy to find.” Today, the 10-y P/E, noted at 23.5, is rather expensive, when compared to the commonly used forward-looking or trailing P/E estimates discussed above.

 

Investors also need to be concerned about the “inputs into E,” such as profit margins that are currently at or near historic highs for U.S. companies.  We have covered this aspect before, but a must-read update, What Goes Up Must Come Down, is available from James Montier, of GMO. Montier, in our words, is troubled by the fact that profits are where they are, despite the weakest economic recovery in post-war history. His paper concludes that Government expenditures significantly improved corporate profit margins, or “filled the gap,” since private investments went to insignificant levels as a result of the economic crisis. In consequence, profits are inflated and future austerity measures may be the trigger that will force necessary equilibrium. Time to panic? Not quite yet, as we “live and breathe” in an election year with everyone Buying time and GDP.

 

Of Maestros and Heroes

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It was 2006, when the “Maestro” left office:  The almighty Alan Greenspan! In fact, I made an effort to keep the front page of the FT that day – not exactly celebrating the act, but rather telling my wife that I was certain that the glory wouldn’t last. Only a few years later, through the events of the Credit Crisis of 2008/2009, the financial world as we knew it came to an end. Alan Greenspan, who became known as the man with the “Greenspan Put,” had gloriously fought the economic fallout from the dotcom-bubble, allowing interest rates to stay historically low (for longer than necessary). As a result, U.S. consumers never “missed a step,” venturing from one investment bubble (TNT Stocks) to yet another one – Real Estate. 

 

CNN, in 2010, reported, “People and institutions normally at each other’s throat all seem to agree: Editorial pages from the Boston Globe on the left to the Wall Street Journal on the right, think tanks from the liberal Institute for Policy Studies to the beyond-conservative Cato Institute, Nobel Prize-winning economists including Keynesian Paul Krugman and rationalist Gary Becker – they all know who’s to blame for the mess we’re in. Four years after leaving the Fed as the Greatest Central Banker Ever, the longest-serving chairman, the Maestro, Alan Greenspan is the designated goat.”

 

Staying on the topic of editorial cover pages, the current edition of The Atlantic profiles the other “Maestro (or ‘Hero,’ this time around),” FED Chairman, Mr. Ben Bernanke. We will not comment on this aspect today, as only time can tell, but one thing is somewhat odd:  Mr. Bernanke has studied and criticized the way Japanese monetary authorities dealt with their very own crisis, the Japanese asset price bubble, yet he has guided the FED directionally more “Japanese-style” over the past months, doing exactly what was considered to be irrelevant.

 

A concluding thought, coming back to Real Estate … No one was ever disappointed – and, consequently, it was a good thing (as Martha Stewart would say):  Builders built and made money; the banks provided lending and made money; brokers bought and sold and made money; the end-consumer had increasingly bigger (at times multiple) houses that “made money,” and this home “equity” was used as an ATM to finance other needs. No problem, right? … Until there was a problem.  

 

We do not exactly know how you feel about the current rally in stocks, now with the S&P having crossed another magical milestone at 1400, but one thing is for certain:  Economic data and indicators are not as clear as one might think. The so-called recovery needs to be tested and re-evaluated very cautiously, just like Benny B.’s “heroic” work. Make sure to keep the cover of The Atlantic!