I noticed the following tweet earlier today:
Investors Are Sitting on the Biggest Pile of Cash Ever – Grappling with the most economic uncertainty in decades and a head-spinning stretch of volatility in the U.S. stock market, many investors have rushed into money-market funds. Assets in the funds recently swelled to about $4.6 trillion, the highest level on record, according to data from Refinitiv Lipper going back to 1992. WSJ
While the cash is sitting in MMFs earning 0% interest, the SPX has rallied 30% off the March 23 low and the NASDAQ 100 has breached its all time high several times. NDX100 currently is at 10,015.23. SPX is at 3,126.84. (12:29p)
This is a good reminder that nobody can time the market. Some of the smartest financial minds have missed this market rally, including Warren Buffett. The rally was initially led by the WFM stocks, such as ZM, NFLX, ZS, CRWD, AMZN, but rotated swiftly into the 'recovery' plays such as airlines, hotels, and cruise lines.
With little corporate guidance, it is entirely possible that this move into cyclical recovery stocks is too soon too fast. Personally, I don't try to pick tops or bottoms, but simply look to allocate assets to good companies at good prices. I DO try to notice if the tide is moving in or out. While the recovery stocks might be priced on a too-rosy scenario, it is likely that there will be a recovery over the next 18 months and all of these stocks and the underlying operating businesses will approach 2019 levels.
On the other hand, the Pandemic-enforced WFM movement probably has changed or accelerated changes in our lifestyles on a permanent basis. Video conferencing will grow; delivery/take out dining will grow, and of course, streaming will grow. I am not opining on the current price levels, just pointing out that major secular shifts are evident to any careful observer and these shifts will be reflected in stock prices over a long period of time.
Finally, being fully invested does not mean solely in equities. If you are saving for retirement, a 50/50 split between high quality long term bonds and stocks is still a sensible path. As a side note, at the market low, at the time that the SPX was down 40% from its high, a 50/50 portfolio would have been down only about 5% (measured as of March 23).
Wednesday, June 17, 2020
Monday, May 18, 2020
Why the Stock Market is not overpriced
As of 10:30 am today, May 18, all of the major indices are in rally mode, with the SPX 2941.36 (+2.71%), NDX 100 9318.90 (+1.82%) and the DJIA 24,403 (+3.04%).
Early this morning, the three major indices were moving nicely higher, on the basis of improving virus news and Chairman Powell's interview on 60 Minutes on Sunday night, until news was released later in the pre-market period that Moderna (Ticker: MRNA) had positive early stage test results for its coronavirus vaccine. Since that point in the time, the three major indexes have roughly doubled their gains for the day.
Recent Economic news can only be described as terrible:
1. Industrial production -- lowest since 1919
2. Retail Sales: April -16%, far worse than the reduced expectations
3. Continuing jobless claims: over 22 million
4. First-Time unemployment claims: over 36 million in just eight weeks.
Within the last week, various stock market "experts", including Warren Buffett, David Tepper, Stanley Druckenmiller, and Ray Dalio, have said that the "market is overvalued". You have to respect these opinions since all of the aforementioned are real investors. In addition, many of the TV "experts" (not investing their own money) including the widely respected Mohamed El-Erian, have chimed in. As a lowly finance professor, also investing my own money, I must say that I disagree with this conventional theme that the markets are overvalued. I am not saying that the "market is cheap" but that generally stocks are fairly valued given the environment and expectations.
Many are asking how can the stock market be going up (although it is still below the pre-virus levels) given the terrible economic news?
I assert that all of these things make sense.
It is a market of stocks, not a stock market. Lets take a deeper look at market price dynamics.
Lets go back to fundamental principles as taught by every major business school in the world.
First, the market is a discounting mechanism that looks to the future--specifically future estimated cash flows. These cash flows can be in the form of dividends + stock repurchases, or implied dividends (using a variety of financial models, but the residual income model is the basic version). Second, the indexes are constructed by either market cap weighted (SPX, NDX) or price-weighted (DJIA). Index construction has an important impact on the movement of the index.
Looking at the performance YTD of the indices, we see 3 very different pictures of the "market". The NDX is up 1.02%, the SPX is -9.3%, and the DJIA lags down -15.1% (all YTD, without dividends). These levels are well above the lows of mid March. For instance, the SPX dropped about 33% in the Mid-March decline and has recovered about two-thirds of that decline. Our first conclusion is that nobody should be talking about the "market" without specifying an index. How do we explain this rather shocking divergence among the indices?
It comes back to the impact of the virus on future cash flows. The market is differentiating among three categories of firms: (1) those firms not affected by the Pandemic induced Lockdowns, or even positively affected by the "shelter in place" orders (examples: ZM & NFLX), (2) those that are currently impacted but perceived as recovering early after the Lockdown is ended (eg. DIS, SBUX); and (3) those that will not recover for some time (airlines, hotels, cruise ships, movie theaters etc). Take this matrix and apply it to the indices. The NDX is a market cap weighted index and the largest five firms account for over 40% of the index: MSFT (+15%), AAPL (+4.6%), AMZN (+31%), FB (4.4%) & GOOG (3.6%). What do these firms have in common? They are all less affected by the virus (MSFT & AMZN) or perceived as recovering sooner (AAPL). Lets take MSFT as an example: its sources of revenue are its legacy businesses of windows, and Office, and its newer business of data centers. None of these are very affected by the virus, and its cash flows are growing. When we look at the SPX, the same firms account for about 20% of the index. In other words, 495 other stocks account for 80% of the index but this group includes airlines, cruise lines and hotels, all of which are 30-50% below their pre-virus highs. The DJIA is down more because it is price weighted and affected by the sharp declines in BA (63%), RTX (40%) JPM (38%) Dow (34%), AXP (34%) XOM (32%), WAG (34%) CVX (25%), GS (25%) and 3M (21%).
As an investor, it is time to place your bets: Which firms are going to recover faster post Lockdown? Which firms will lag? Is the market too optimistic about the laggards? The thesis of the "experts" is that the "market" is too optimistic. But the laggards are well below their pre-virus levels. Examples: DAL (-63%), LUV (-50%) , MAR (-39.5%), HLT (-33.1%), are all far below their pre-virus levels.
If we look at the leaders for the year, including SHOP, ZM, NFLX, NVDA, PDD, SRNE, BTAI, NVAX, MRNA, and DOCU, it is easy to complain that their prices are too high and that too much credit is already incorporated into the prices for future growth. This is the group that is probably legitimately susceptible of the "1997" critique: good ideas, and even good firms, but much too expensive. A good portion of these firms are engaged in the development of revolutionary pharmaceutical products. These tend to be binary bets with a lot of downside risk. Fair enough to say that the stock of these firms are overvalued.
My point is that there is a tier of stocks that are growing fast, and have very attractive prospects, but are priced at levels that seem much too high. But many other stocks seem appropriately priced for the current environment, and the inherent risk to their future cash flows, and these are the largest stocks that drive the indices. Can we have a correction? Of course, and at any time for any reason, or for no reason. Nevertheless, my conclusion is that the "market" is fairly priced--not cheap, but not expensive.
Early this morning, the three major indices were moving nicely higher, on the basis of improving virus news and Chairman Powell's interview on 60 Minutes on Sunday night, until news was released later in the pre-market period that Moderna (Ticker: MRNA) had positive early stage test results for its coronavirus vaccine. Since that point in the time, the three major indexes have roughly doubled their gains for the day.
Recent Economic news can only be described as terrible:
1. Industrial production -- lowest since 1919
2. Retail Sales: April -16%, far worse than the reduced expectations
3. Continuing jobless claims: over 22 million
4. First-Time unemployment claims: over 36 million in just eight weeks.
Within the last week, various stock market "experts", including Warren Buffett, David Tepper, Stanley Druckenmiller, and Ray Dalio, have said that the "market is overvalued". You have to respect these opinions since all of the aforementioned are real investors. In addition, many of the TV "experts" (not investing their own money) including the widely respected Mohamed El-Erian, have chimed in. As a lowly finance professor, also investing my own money, I must say that I disagree with this conventional theme that the markets are overvalued. I am not saying that the "market is cheap" but that generally stocks are fairly valued given the environment and expectations.
Many are asking how can the stock market be going up (although it is still below the pre-virus levels) given the terrible economic news?
I assert that all of these things make sense.
It is a market of stocks, not a stock market. Lets take a deeper look at market price dynamics.
Lets go back to fundamental principles as taught by every major business school in the world.
First, the market is a discounting mechanism that looks to the future--specifically future estimated cash flows. These cash flows can be in the form of dividends + stock repurchases, or implied dividends (using a variety of financial models, but the residual income model is the basic version). Second, the indexes are constructed by either market cap weighted (SPX, NDX) or price-weighted (DJIA). Index construction has an important impact on the movement of the index.
Looking at the performance YTD of the indices, we see 3 very different pictures of the "market". The NDX is up 1.02%, the SPX is -9.3%, and the DJIA lags down -15.1% (all YTD, without dividends). These levels are well above the lows of mid March. For instance, the SPX dropped about 33% in the Mid-March decline and has recovered about two-thirds of that decline. Our first conclusion is that nobody should be talking about the "market" without specifying an index. How do we explain this rather shocking divergence among the indices?
It comes back to the impact of the virus on future cash flows. The market is differentiating among three categories of firms: (1) those firms not affected by the Pandemic induced Lockdowns, or even positively affected by the "shelter in place" orders (examples: ZM & NFLX), (2) those that are currently impacted but perceived as recovering early after the Lockdown is ended (eg. DIS, SBUX); and (3) those that will not recover for some time (airlines, hotels, cruise ships, movie theaters etc). Take this matrix and apply it to the indices. The NDX is a market cap weighted index and the largest five firms account for over 40% of the index: MSFT (+15%), AAPL (+4.6%), AMZN (+31%), FB (4.4%) & GOOG (3.6%). What do these firms have in common? They are all less affected by the virus (MSFT & AMZN) or perceived as recovering sooner (AAPL). Lets take MSFT as an example: its sources of revenue are its legacy businesses of windows, and Office, and its newer business of data centers. None of these are very affected by the virus, and its cash flows are growing. When we look at the SPX, the same firms account for about 20% of the index. In other words, 495 other stocks account for 80% of the index but this group includes airlines, cruise lines and hotels, all of which are 30-50% below their pre-virus highs. The DJIA is down more because it is price weighted and affected by the sharp declines in BA (63%), RTX (40%) JPM (38%) Dow (34%), AXP (34%) XOM (32%), WAG (34%) CVX (25%), GS (25%) and 3M (21%).
As an investor, it is time to place your bets: Which firms are going to recover faster post Lockdown? Which firms will lag? Is the market too optimistic about the laggards? The thesis of the "experts" is that the "market" is too optimistic. But the laggards are well below their pre-virus levels. Examples: DAL (-63%), LUV (-50%) , MAR (-39.5%), HLT (-33.1%), are all far below their pre-virus levels.
If we look at the leaders for the year, including SHOP, ZM, NFLX, NVDA, PDD, SRNE, BTAI, NVAX, MRNA, and DOCU, it is easy to complain that their prices are too high and that too much credit is already incorporated into the prices for future growth. This is the group that is probably legitimately susceptible of the "1997" critique: good ideas, and even good firms, but much too expensive. A good portion of these firms are engaged in the development of revolutionary pharmaceutical products. These tend to be binary bets with a lot of downside risk. Fair enough to say that the stock of these firms are overvalued.
My point is that there is a tier of stocks that are growing fast, and have very attractive prospects, but are priced at levels that seem much too high. But many other stocks seem appropriately priced for the current environment, and the inherent risk to their future cash flows, and these are the largest stocks that drive the indices. Can we have a correction? Of course, and at any time for any reason, or for no reason. Nevertheless, my conclusion is that the "market" is fairly priced--not cheap, but not expensive.
Friday, April 6, 2012
March Jobs Report
The equity markets are placing great reliance on the improvement, i.e., the decline, in the unemployment rate as confirmation that the US economy is slowly recovering from the impact of the Great Recession. Nevertheless, the Federal Reserve, particularly its chairman, is warning explicitly that the trend in the unemployment rate is unsustainable. For this reason, various Fed governors have asserted that QE 3 is still under consideration, and the Chairman has announced that interest rates will remain on hold until at least 2014.
What is causing the Fed to be so cautious about employment trends? Table 1 below shows the trend in month-to-month change since the onset of the Great Recession.
As shown in the table above, job growth has shown a degree of acceleration only at the end of 2011. Nevertheless, this rate of growth is below that which occurred after the 1990s recession which was not as severe.
As Table 2 shows, the monthly increase in employment post-1991 was over 300,000 jobs per month. (all data is seasonally adjusted).
The first conclusion is that the rate of job growth has been slow compared to the post recession periods of prior recessions. Notwithstanding the low rate of job growth, the unemployment rate has declined 1.5% since Dec 2010. The Fed's conclusion is that that decline has not been fueled by job growth, but, in significant part, by the decline in the participation rate, which is down 2.5% since 2007. In short, workers are getting discouraged and dropping out of the labor force and therefore do not fall into the unemployment rate. This is particularly striking among workers with a high school education or less. While the overall labor force is roughly equally divided between men and women, this category has a larger component of men. As manufacturing and construction employment was severely affected by the Great Recession, this is not surprising. The March employment report continues these trends. The number of new jobs added was only 120,000, a level that would not normally cause any change in the unemployment rate. But the unemployment rate declined slightly to 8.2% as the participation rate also declined by 0.1%.
Another reason for caution about the trend in unemployment is the large number of part-time workers. The number of people working part-time for economic reasons is nearly 8m. As the economy recovers, workers will shift from undesired part-time jobs to full time. These workers are likely to be the "first hired" since they are the most motivated, and have current skills. Again, the March report is a good example, The number of workers in part-time jobs for economic reasons declined by over 400,000 significantly greater than the decline in the number of unemployed, 133,000. In addition, discouraged workers are likely to be drawn back into the job market as the economy begins to generate, no matter how slowly, more low skilled jobs.
This data is what underlies the Fed's cautiousness about further improvement in the unemployment rate. Job growth would have to accelerate from its current level. There is no evidence of that this is occurring. Even at this low rate, it is likely that workers will be drawn back into the work force which will reverse the impact of the decline in the participation rate and cause the unemployment rate to stagnate if not rise.
What is causing the Fed to be so cautious about employment trends? Table 1 below shows the trend in month-to-month change since the onset of the Great Recession.
| Year | Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sep | Oct | Nov | Dec |
| 2007 | 236 | 93 | 190 | 72 | 139 | 75 | -40 | -18 | 73 | 79 | 112 | 89 |
| 2008 | 41 | -84 | -95 | -208 | -190 | -198 | -210 | -274 | -432 | -489 | -803 | -661 |
| 2009 | -818 | -724 | -799 | -692 | -361 | -482 | -339 | -231 | -199 | -202 | -42 | -171 |
| 2010 | -40 | -35 | 189 | 239 | 516 | -167 | -58 | -51 | -27 | 220 | 121 | 120 |
| 2011 | 110 | 220 | 246 | 251 | 54 | 84 | 96 | 85 | 202 | 112 | 157 | 223 |
| 2012 | 284 | 227 | 120 |
As shown in the table above, job growth has shown a degree of acceleration only at the end of 2011. Nevertheless, this rate of growth is below that which occurred after the 1990s recession which was not as severe.
| Year | Jan | Feb | Mar | Apr | May | Jun | July | Aug | Sep | Oct | Nov | Dec | |
| 1991 | -122 | -302 | -161 | -212 | -127 | 88 | -48 | 17 | 32 | 12 | -58 | 23 | |
| 1992 | 50 | -66 | 52 | 157 | 126 | 60 | 70 | 141 | 35 | 178 | 139 | 212 | |
| 1993 | 310 | 242 | -51 | 308 | 265 | 174 | 295 | 160 | 239 | 278 | 261 | 307 | |
| 1994 | 270 | 201 | 462 | 353 | 333 | 313 | 364 | 298 | 355 | 208 | 422 | 272 |
As Table 2 shows, the monthly increase in employment post-1991 was over 300,000 jobs per month. (all data is seasonally adjusted).
The first conclusion is that the rate of job growth has been slow compared to the post recession periods of prior recessions. Notwithstanding the low rate of job growth, the unemployment rate has declined 1.5% since Dec 2010. The Fed's conclusion is that that decline has not been fueled by job growth, but, in significant part, by the decline in the participation rate, which is down 2.5% since 2007. In short, workers are getting discouraged and dropping out of the labor force and therefore do not fall into the unemployment rate. This is particularly striking among workers with a high school education or less. While the overall labor force is roughly equally divided between men and women, this category has a larger component of men. As manufacturing and construction employment was severely affected by the Great Recession, this is not surprising. The March employment report continues these trends. The number of new jobs added was only 120,000, a level that would not normally cause any change in the unemployment rate. But the unemployment rate declined slightly to 8.2% as the participation rate also declined by 0.1%.
Another reason for caution about the trend in unemployment is the large number of part-time workers. The number of people working part-time for economic reasons is nearly 8m. As the economy recovers, workers will shift from undesired part-time jobs to full time. These workers are likely to be the "first hired" since they are the most motivated, and have current skills. Again, the March report is a good example, The number of workers in part-time jobs for economic reasons declined by over 400,000 significantly greater than the decline in the number of unemployed, 133,000. In addition, discouraged workers are likely to be drawn back into the job market as the economy begins to generate, no matter how slowly, more low skilled jobs.
This data is what underlies the Fed's cautiousness about further improvement in the unemployment rate. Job growth would have to accelerate from its current level. There is no evidence of that this is occurring. Even at this low rate, it is likely that workers will be drawn back into the work force which will reverse the impact of the decline in the participation rate and cause the unemployment rate to stagnate if not rise.
Wednesday, December 21, 2011
The can gets kicked in Europe
Today, the ECB announced that 523 Euro banks borrowed €489 Billion (source: Bloomberg) of 3-year loans under its emergency lending program.
There have been a number of media comments that have misunderstood the purposes and effect of this program. In sum, this is a liquidity facility which removes one risk but leaves solvency and capital issues unaffected.
All large banks finance a substantial portion of their assets through open market borrowings, as short as overnight. In ordinary times, this is a very liquid market and funds are readily available at low rates. The lenders are other banks, including US, Chinese, other Asian banks as well as US mutual funds, and other institutions that have short term funds to invest. In the last quarter, the liquidity in this market had been "drying up" as US banks (among others) began to worry obsessively about "counterparty" risk. One consequence of this can be seen in the negative yield on 1-month US Treasury bills. There is simply a strong risk aversion in the global debt markets. The cost of the overnight funds and other short term funds, the equivalent of auction CDs, for Euro banks has been increasing as availability has tightened. Last month the Fed Reserve and other central banks announced facilities to provide virtually unlimited funds to European banks. This IS important. Without this reassurance, there could have been a modern day version of a "run on the bank". As we all saw with MF Global, confidence is essential to funding large financial organizations. On this issues, let me congratulate the ECB and the Fed for making an astute move. This reassures all investors that no Euro bank is going to collapse because it could not roll-over short term debt.
The balance sheets of the European banks are somewhat opaque, so we don't know if most of these funds are simply replacing other short term, but higher cost, debt; but this is my suspicion. Because it was a requirement that all of these loans had to be collateralized, it does not seem like there will be excess funds to purchase additional sovereign debt or other assets. Nevertheless, this program should create a substantial positive carry for participating banks, which will increase profitability. This similar to the Fed's actions in 2009-10 in the US which allowed the major banks to earn their way out of the crisis. But this program eliminates counterparty risk for the major money-center banks such as JPM, C, GS and MS. The business model of the US money center banks (JPM, C, BAC) could be questionned in light of Dodd Frank and other regulatory initiatives, but the risk of European contagion from counterparties has been removed. In fact, lending money to European banks will again be a very profitable niche business.
BUT.....
The Euro banks still need additional capital for 3 primary reasons: (1) a special one time "buffer" against sovereign debt which is designed to reassure the financial markets. (2) additional capital to meet the Basel 3 requirements; and (3) additional capital to reach the 9% capital bench mark for risk weighted assets. This is going to have to be resolved in the first half of 2012. Historically, the Euro banks did not need to allocate capital to support sovereign debt because default was thought to be impossible. For purposes of calculating capital, sovereign bonds have not been marked to market. (in some cases, they are marked-to-market for accounting purposes). Today, part of the need for additional capital is to allow sovereign debt to be marked to market, ahead of the Basel 3 requirement. The remainder of the additional capital is for the purposes outlined in number 2 and 3 above.
European banks are required to present plans in January 2012. The European Banking Authority estimated the capital shortfall to be €114B. The largest shortfalls are in Greece (€30 Billion), Spain (€26Billion), Italy (€15B), and Germany (€13B). But the total amounts only tell half of the story. The other part is the size of the shortfall in relation to the size of any specific institution. In this regard, a few small-ish banks are facing large capital shortfalls when expressed as a percentage of their market capitalization. For instance, Commerzbank (PINK: CRZBY) is thought to need a capital injection of €5.8B according to the EBA, but this compares to a market capitalization of €6.8B. This is a stock to avoid due to the risk of an "AIG-like" solution or massive equity dilution. This will be doubly challenging due to that institution's history of erratic operations and profitability. On the other hand, Deutsche Bank (NYSE: DB) is thought to need capital of €3.2B according to the EBA, but this compares to a market cap of €27B. Given the size of the entity, this is likely to be raised without major dilution to shareholders.
The EBA has explicitly stated that these capital requirements are to be met by:
1. Retained earnings, including reduced bonus payments;
2. New common equity or other approved forms of capital; and
3. Sales of selected assets that do not impair lending capacity.
The EBA discouraged shrinkage of balance sheets, which would lead to contractionary pressures. Although unstated, the national governments are the investors of last resort.
A Definitive Solution is not in the cards
Most economists recognize that the "Geithner" solution would be the best way to proceed. This would require a combination of the liquidity program (which is now in place) and a massive equity capital injection similar to TARP. The mere availability of this equity capital would end the speculation about the solvency of the European banks and would free the banks to purchase government debt at something close to normal yields. However, this would require a massive sum of money; at least €2T and perhaps double that amount. Ultimately, it would be repaid, as TARP was largely repaid. Banks would raise replacement capital over a period of time, and calm, with a good share coming from retained earnings. But there is simply no political will for this program in the EU. It is seen as the strong subsidizing the profligate and accordingly is simply DOA (dead on arrival). So what is left????
Kick the can down the road, continue in small incremental steps, and hope that an economic recovery within the next decade will eventually bail out the sovereigns. In the long term, this is workable; but the path is likely to be rocky and painful at times.
There have been a number of media comments that have misunderstood the purposes and effect of this program. In sum, this is a liquidity facility which removes one risk but leaves solvency and capital issues unaffected.
All large banks finance a substantial portion of their assets through open market borrowings, as short as overnight. In ordinary times, this is a very liquid market and funds are readily available at low rates. The lenders are other banks, including US, Chinese, other Asian banks as well as US mutual funds, and other institutions that have short term funds to invest. In the last quarter, the liquidity in this market had been "drying up" as US banks (among others) began to worry obsessively about "counterparty" risk. One consequence of this can be seen in the negative yield on 1-month US Treasury bills. There is simply a strong risk aversion in the global debt markets. The cost of the overnight funds and other short term funds, the equivalent of auction CDs, for Euro banks has been increasing as availability has tightened. Last month the Fed Reserve and other central banks announced facilities to provide virtually unlimited funds to European banks. This IS important. Without this reassurance, there could have been a modern day version of a "run on the bank". As we all saw with MF Global, confidence is essential to funding large financial organizations. On this issues, let me congratulate the ECB and the Fed for making an astute move. This reassures all investors that no Euro bank is going to collapse because it could not roll-over short term debt.
The balance sheets of the European banks are somewhat opaque, so we don't know if most of these funds are simply replacing other short term, but higher cost, debt; but this is my suspicion. Because it was a requirement that all of these loans had to be collateralized, it does not seem like there will be excess funds to purchase additional sovereign debt or other assets. Nevertheless, this program should create a substantial positive carry for participating banks, which will increase profitability. This similar to the Fed's actions in 2009-10 in the US which allowed the major banks to earn their way out of the crisis. But this program eliminates counterparty risk for the major money-center banks such as JPM, C, GS and MS. The business model of the US money center banks (JPM, C, BAC) could be questionned in light of Dodd Frank and other regulatory initiatives, but the risk of European contagion from counterparties has been removed. In fact, lending money to European banks will again be a very profitable niche business.
BUT.....
The Euro banks still need additional capital for 3 primary reasons: (1) a special one time "buffer" against sovereign debt which is designed to reassure the financial markets. (2) additional capital to meet the Basel 3 requirements; and (3) additional capital to reach the 9% capital bench mark for risk weighted assets. This is going to have to be resolved in the first half of 2012. Historically, the Euro banks did not need to allocate capital to support sovereign debt because default was thought to be impossible. For purposes of calculating capital, sovereign bonds have not been marked to market. (in some cases, they are marked-to-market for accounting purposes). Today, part of the need for additional capital is to allow sovereign debt to be marked to market, ahead of the Basel 3 requirement. The remainder of the additional capital is for the purposes outlined in number 2 and 3 above.
European banks are required to present plans in January 2012. The European Banking Authority estimated the capital shortfall to be €114B. The largest shortfalls are in Greece (€30 Billion), Spain (€26Billion), Italy (€15B), and Germany (€13B). But the total amounts only tell half of the story. The other part is the size of the shortfall in relation to the size of any specific institution. In this regard, a few small-ish banks are facing large capital shortfalls when expressed as a percentage of their market capitalization. For instance, Commerzbank (PINK: CRZBY) is thought to need a capital injection of €5.8B according to the EBA, but this compares to a market capitalization of €6.8B. This is a stock to avoid due to the risk of an "AIG-like" solution or massive equity dilution. This will be doubly challenging due to that institution's history of erratic operations and profitability. On the other hand, Deutsche Bank (NYSE: DB) is thought to need capital of €3.2B according to the EBA, but this compares to a market cap of €27B. Given the size of the entity, this is likely to be raised without major dilution to shareholders.
The EBA has explicitly stated that these capital requirements are to be met by:
1. Retained earnings, including reduced bonus payments;
2. New common equity or other approved forms of capital; and
3. Sales of selected assets that do not impair lending capacity.
The EBA discouraged shrinkage of balance sheets, which would lead to contractionary pressures. Although unstated, the national governments are the investors of last resort.
A Definitive Solution is not in the cards
Most economists recognize that the "Geithner" solution would be the best way to proceed. This would require a combination of the liquidity program (which is now in place) and a massive equity capital injection similar to TARP. The mere availability of this equity capital would end the speculation about the solvency of the European banks and would free the banks to purchase government debt at something close to normal yields. However, this would require a massive sum of money; at least €2T and perhaps double that amount. Ultimately, it would be repaid, as TARP was largely repaid. Banks would raise replacement capital over a period of time, and calm, with a good share coming from retained earnings. But there is simply no political will for this program in the EU. It is seen as the strong subsidizing the profligate and accordingly is simply DOA (dead on arrival). So what is left????
Kick the can down the road, continue in small incremental steps, and hope that an economic recovery within the next decade will eventually bail out the sovereigns. In the long term, this is workable; but the path is likely to be rocky and painful at times.
Wednesday, December 14, 2011
Reality sucks
Happy talk of Euro summit tested at today's Italian bond auction. Reality takes hold as yields rise for 3 year notes to 6.47% from 6.29% of Nov auction. Indicates lack of market confidence since the new money is going to 3-year notes not 10-year bonds and even these shorter maturities are at the magic 6.5% limit.
Friday, December 9, 2011
The European Crisis Continues
The European Crisis Continues
American Equity markets are anxious for a definitive resolution to the European Debt/Fiscal crisis. Despite the rhetoric surrounding the latest “solution”, they will be disappointed.
First, lets cover some basics.
1. The EU is not going to break up because it is in the individual interests of the all of the main players for it to continue. It IS a political union (or Confederation) and for all of its shortcomings it has created the foundation for over a half-century of peace.
2. The Eurozone will survive in its present form. I wouldn’t say it is impossible for Greece to leave but highly unlikely. I am also NOT saying that there won't be a default.
3. The European leaders will not accept a “real” solution, but will resort to smoke and mirrors accompanied by high-minded rhetoric. The pseudo-solution will not solve anything but WILL kick the can down the road. Eventually, over the next decade, higher economic growth will solve the current problem.
It is commonly understood how to definitively solve the current fiscal crisis. As Secretary Geithner points out repeatedly the EU must create a “shock and awe” wall of money that will assuage the worries of the global credit markets. The problem is that this will require at least €2 Trillion, and the principal funding source, Germany, is simply politically unable to make the required commitment. The latest “solution” suffers from the same problems as the previous attempts. It is simply too little and too undefined.
The Structural Agreements
The European Summit agreed on basic budgetary principles that would limit “structural deficits” to 0.5% of GDP with “automatic correction measures” when national deficits violate the target.. This is in addition to a tightening of the disciplinary procedures for countries that violate the limit of deficits over 3% of GDP. These principles would apply to the 17 Eurozone countries. On its face, this solution is implausible and unworkable.
This first prong of the framework is a Treaty amendment to attempt to establish greater fiscal discipline. The new plank is a requirement for the member states to adopt a sort of balanced budget amendment that will be deemed satisfied if “structural deficits” are limited to 0.5% of GDP. Each nation is expected to adopt constitutional “automatic correction mechanisms” pursuant to principles to be established by the European Commission. In addition, the existing limit on deficits to 3% of GDP will be strengthened by additional (undefined) “automatic consequences” for failure to adhere to this limit. Why the reference to structural deficits? This relieves countries that might suffer temporary deficits due to recessions—such as occurred in France and Germany (!!!) in 2008-09, and continues in France today. The “automatic corrections” or the increased “disciplinary” actions have yet to be defined or implemented. Even if they were legitimate, they would be highly contractionary.
Little of this debate is new.
The issue of acceptable budget deficits was anticipated and debated in the early 1990s in connection with the adoption of the convergence standards in the Maastricht Treaty in 1992. The German position has not changed. Germany worried about the profligate Italians at that time and they accepted two “solutions”. One was an independent central bank, the ECB, that would adopt the strong German-oriented anti-inflationary fiscal policy. The powers of the ECB were carefully negotiated. The powers reflect a compromise of the divergent views of monetary policy within the EU and are unlikely to be radically changed.
In addition, fiscal deficits of the participants in the Eurozone were restricted to 3% of prior year GDP, except for temporary exigencies, in the Maastricht Treaty in 1992. The problem is that ALL of the Eurozone countries, including Germany, violated the limit during 2008-10. France is still in violation of the limit and is hoping to get back to it in 2012. (However, the question is whether the French public will support the changes necessary to bring expenses back into line. )
During the last decade the European Commission abandoned its cherished dream of fiscal harmonization, which is a necessary predicate to fiscal or political union, due to an inability to harmonize the BIG issues. This is nearly a decade-old process and it is not going to be reversed. The BIG issues are the places in which there is BIG money: pensions, medical care, labor regulation, and other social benefits. Americans see all of continental Europe as a bunch of aging socialist countries. There is a large dose of truth in this, but it masks very significant differences, both in terms of social benefit structure, savings rate and demographic makeup. Harmonization, and, therefore fiscal union, has not occurred because it is simply intractable.
American investors find Chancellor Merkel to be a difficult myopic personality. Actually, she merely reflects German culture and her life experience. There is no “equity market” culture in Germany. Investment in publicly traded equities is confined to a tiny portion of the populace. Ms. Merkel grew up in East Germany, and is educated as a physicist. She has no intuitive feel for the relevance of the capital markets. In Germany, capital is the responsibility of banks, supplemented by a small coterie of wealthy private family businesses. Germany is simply not a dynamic market based economy, and frankly, rejects every suggestion that it become one. American hand wringing about dithering misses the point. Providing certainty to the equity markets to encourage investment and innovation is simply not a goal of policy makers because their equity markets don’t provide that function in their societies. There is greater concern for the Bond market, but primarily insofar as it relates to local Banks.
The German goal is for each nation in the Eurozone to fix its own problems with only limited support from the other member states, i.e., the Italians must fix Italian problems. The Germans really don’t care how they do it: higher taxes, higher poverty etc. They are willing to provide a limited amount of backstop support but as little as possible. In this regard, Ms. Merkel is reflecting German public sentiment. Frankly we are watching a multi-dimensional game of “chicken”. Ms. Merkel wants to provide the smallest commitment possible that will achieve economic stability (Germans love stability). This is a TRIAL AND ERROR process. It will continue inching along until they find equilibrium. No German leader is going to be hurried.
There is one certainty. The solution will not be “real”. It will not really address the fundamental drivers of government spending: the large welfare state that is financed by a decreasing number of workers. Sarkozy is proposing to extend the retirement age for some workers, but this is still tinkering around the edges. And he is encountering fierce resistance. But over the next 30 years, as the baby boom ages, the problem will simply fester for another generation of leaders to deal with. Second, the solution will be highly contractionary. Europe is headed for a recession in 2012 in any event and the actions taken will exacerbate.
The Money game
While much attention has been focused on the purported benefits of the greater coordination of fiscal discipline, this will not solve the current short term funding issues in Europe.
The Summit took two actions, but the math is fuzzy. When math is fuzzy there is a reason. First, there was agreement to make €200 Billion of additional funding available from the European central banks to the IMF with a plea for more money from non-EU nations. Apparently, the understanding is that this would be lent back to the European nations in some form. This commitment apparently involves “real” money.
Secondly, the new European Stability Mechanism was accelerated by a year to mid 2012 and would operate side by side with the existing EFSF until its expiration in mid-2013. However, the total amount allowed to the combined EFSF/ESM was limited to €500 Billion. However, this limit would be reconsidered in March. In this case, the actual cash contributions were limited to 15% of the Funds with the rest to be obtained through “leverage”.
It seems that in the current best case, there is €700 Billion possibly available to solve short term funding issues in Europe. Apparently, the IMF is being used to avoid some of the constitutional restrictions on actions of the ECB.
Nevertheless, €700 Billion is not close to adequate to refinance the sovereign debt due in 2012 which Bloomberg estimates to be over €1 Trillion with an additional €500 Billion of European bank debt also needing to be refinanced and at least €100 Billion of bank capital to be raised in the first half of 2012. In effect, the EU is leaving Italy, Spain, and the other heavily indebted countries to live with the market reality of their position. The onus is on them, as the Germans desire, to create budgets that restore the confidence of the bond markets and reduce borrowing rates to a sustainable level. The ESM/EFSF and IMF will stand as a kind of last resort to plug any small gaps but will not to be the supra-financing vehicle that the Fed Reserve is in the US. The simple fact is that Germany is not willing to increase its assistance to the other nations of the Eurozone
The summit was long on rhetoric and short on funding. It is a continuation of the Euro leadership’s response to the crisis: an elaborate fudge. Initially the global equity markets seem content while global bond and currency markets are more wary. But the reality of the situation will set in during the first quarter of 2012 when European bond auctions occur.
The net result of the latest machinations is that the “can is simply being kicked down to road” to the next summit in March 2012.
Sunday, December 4, 2011
Don't be misled by the drop in the Unemployment Rate
November Labor report
The November labor report indicated that employers added 120,000 jobs in the month of November. The unemployment rate, measured by the household survey, dropped to 8.6% from 9%. Superficially, this seems like evidence of an economic expansion, or at the least the beginning of one. However, the leading indicators within the labor report indicate continued stability in the US labor force with no indications of either a meaningful improvement or a recession.
The “break even” number for maintaining the unemployment rate is generally accepted to be 150,000 new jobs. How could a mere 120,000 new jobs cause a four-tenths of one percent decline in the unemployment rate? The easy answer is “technical factors” which are discussed below. The key leading indicators within the report do not show signs of an improving labor market.
For reasons discussed below the best that can be said about this report is that it indicates stability in the labor force. It is NOT indicative of a “double dip” recession, but it is also NOT indicative of an incipient expansion. Within the report the “leading indicators” were all flat, not up. All of these indicators show a labor market that has improved since the end of the recession but is now largely stable with perhaps a tiny bias toward improvement. A focus on the improvement in the unemployment rate, to 8.6%, would be misleading.
Some key elements of the report.
1. Hours worked for production workers declined slightly to 33.6 from 33.7. This is a leading indicator of an improving economy and labor market. In an expanding economy, employers respond to increased demand by lengthening the hours worked in the initial phase since uncertainty is high and the cost in overtime is justified by flexibility. Normally, production work is the most variable part of the work force and is very sensitive to changes in demand. I wouldn’t attribute any significance to the small decline but merely point out that this is NOT indicating further expansion.
2. The average hours worked for all employees remained flat at 34.3 hours, the same as in September and October. Generally this is a leading indicator of a labor market improvement. Similarly Overtime hours remained flat compared to October at 4.1. Overtime is also an immediate source of flexibility for employers in responding to increases in demand.
3. The number of Temporary workers (seasonally adjusted) increased 1% in November compared to October and 7.8% compared to prior year. In October, the increase over prior year was 8.1%. Year over year gains have moderated throughout 2011.
4. The penetration rate of Temporary workers increased slightly to 1.77% of the workforce from 1.76% in October. The penetration rate is highly influenced by production workers. The rate has been improving since the bottom of the recession. This small improvement is consistent with the trend of a stable labor market.
5. Unemployment among college graduates remained flat at 4.4% compared to October, although a significant improvement from the 5.1% of prior year. This is a key statistic. It is partly a leading indicator since these are the most employable people in the labor force and partly because purchasing power is highest in this group.
These are important signals in the November Labor report that there is little risk of a double dip recession, which was greatly feared as recently as October. In previous recessions, these indicators turned down for many months before a recession was evident. On the other hand there is little evidence, in this data, of the economy entering into an expansionary phase strong enough to reduce the record unemployment rate.
The most encouraging data, the decline in the unemployment rate, is misleading as an indication of future activity. In fact, the unemployment rate is likely to increase in coming months. The decline in the unemployment rate was a function of two factors in the household survey that is used to measure it. First, the reduction in the total labor force in the household survey accounted for about half of the change in the unemployment rate or 0.2%. This reduction is due to discouraged workers dropping out of the workforce. Hardly a good sign; and perhaps influenced by seasonal factors. Second, the household survey contained a larger increase in the number of people employed compared to the establishment survey; this accounted for about half of the improvement or 0.2%. For many reasons the Household survey and the Establishment survey frequently differ; in this environment, the Household survey is probably a better view of new job formation, so let assume the 0.2% is real. Nevertheless, the nominal 0.4% improvement in the unemployment rate is unlikely to be sustainable. As the labor market recovers, more individuals will be drawn back into the work force, which will, paradoxically, cause the unemployment rate to increase.
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