Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. From PIIGS to Links: Trying to Save the Bacon. We continue to witness knee-jerk reactions within the currency and bond markets to each and every new announcement. It’s amusing to watch investors creatively bob and weave with their investments and ignore virtually all of the primary trends in place. Primary problems areas to avoid: Fiat currencies from any central bank, the sovereign debts issued by those same countries, and any other investment category that fits a true bubble dynamic (we’ll discuss this below). You might also wish to avoid investments that require you to wait 200 to 1,000 years to pay off (we’ll discuss that below, too).
Let’s begin with Europe. Fitch downgraded Greece from double B plus to B plus. No surprise; the interest rate on 10-year Greek paper is at 16.75%. Spain is fast on the heels of Portugal, Ireland, and Greece. German bonds of the same vintage (10-year) were bought as a safe haven play. Gold received more than passing interest as the investing public was reminded again that Greece is circling the drain.
We’ve been discussing the need to avoid an unwind in sovereign (European, and eventually American) debt for some time. Today’s primary problem, which can destabilize the world financial system, lies in the French, German, and Italian banks. Hundreds of billions in sovereign paper (country-specific, but euro-denominated, bonds) sit on these bank balance sheets for the same reason mortgage-backed securities were so widely held just a few years ago. Bankers are always looking to maximize float, and generally stable, implicitly guaranteed paper fits the bill perfectly. The returns were marginally higher, the ECB was the implicit guarantor of the paper – just like Fannie and Freddie having a special designation and internationally recognized government backstop. Dollar holders face the same issues as European banks, with a day of reckoning further into the future.
Anyone who’s been around the block a time or two knows that, when things seem too good to be true, they typically are. A higher rate of return with no more risk sounded attractive, so banks bought European debt with both fists and improved their immediate returns for bank shareholders. Now, another “no-brainer” has turned into a mind-bending mess.
Standard and Poor’s has begun to wonder about these banking institutions. Credit Agricole, France’s largest retail bank, was also downgraded this week (from Double A – to Single A+) on its exposure to Greece. How many more institutions will go through the same experience? How many banks had exposure to farm and ranch loans in the 1930s here in the U.S.? Bankers move in herds, just like any other subset of investors. These corporate downgrades are significant cracks in the financial system. Watch them carefully.
On this side of the pond, we all get to sit as spectators (some of you may own shares and be speculators) witnessing the social media carnival: Facebook, LinkedIn, Twitter, et al. Society seems to marvel at the most trivial of revelations and value them as gold. Did you eat eggs this morning? Have I worn my brown shoes today? Have you seen the recent picture I took of myself and posted on the Internet? With that revelation, or that picture, we must be best friends. (Ironic … as more and more people create these surface connections and reinforce a deeper sense of loneliness.) Relationships are increasingly mimicking the age of information. Quantity of universally disclosed data is replacing quality of grounded experience and depth of understanding. Dr. James Houston has described our culture as ¼ inch deep and a mile wide.
Back to the point – LinkedIn was forecasting a loss for the year, but decided to go public this week anyway. Shares traded from 45 to 122 and back to 93 in three days, and this is the least favorite social media company. But if you missed Facebook, this could be the next big thing. (This is like a retro ’90s party.) These are the marks of speculation. Speculation is what occurs when people amble up to a craps table or roulette wheel feeling lucky. For a split second, LinkedIn was worth 11.7 billion dollars. So, how much money does it make? Net income of two million dollars with seven cents earned in 2010 (pro forma). Is the market a little excitable? With a price-earning multiple of 1,329 you’d have to say so. Just a reminder: a P/E of 1,329 means that an investor today is of the mind that they should reasonably pay for 1,329 years worth of current earnings ahead of time, compressed into today’s price.
I never met a speculator that didn’t make money, at some point. I have also never met a speculator that didn’t hand it all back.
These are hallmarks of speculative frenzy, which is in point of fact quite different than a bubble. This small time frenzy is however attributable to the liquidity excesses in the market today. A bubble builds over a long period of time. A bubble includes broad sections of the investing public. A bubble ultimately is so popular that everyone with the wherewithal to invest has already invested, and when the last investor is “in,” there is no more money to push prices higher. Prices then fall of their own weight, with liquidations accelerating a decline. We have a bubble today in government finance. We have a bubble today in fiat currencies. We have the whole world already piled into these asset categories, and the asset categories need a new stock of investors for prices to be maintained – ergo QE and Fed money printing to push forward the day of the pin prick, and the decline in values for the bubble assets in question. Certainly there are signs of speculation today. But we continue to watch Europe, Asia, and the United States where the true bubbles remain, the risks are greater, and impairment is far more consequential.
2. The Yellow Dog Barks. This was a pivotal week, and could mark the inflection point for this Fed-staged economic recovery. Economic data, marginal at best in quarters past, turned decisively worse in this week’s series of releases. Also contributing to the erosion of confidence was the not-so-well-“contained” threat of bankruptcy among the PIIGS. Greece is again in the hot seat, with the need for another $150B in financing from reluctant EU lenders. However, nothing seems to put a dent in the stock market, which may be embracing the notion that bad things are allowed to happen en route to weaning the markets of Fed QE starting in June.
April home data fell far short of expectations. Housing starts fell to 523K from 585K, or 10.5%. Building permits also fell to 551K from 574K, or 4.0%. The decline was entirely unexpected, as the data fell far short of estimates. Overall new home construction, compared with the same month (April) a year earlier was down a whopping 23.9%. Existing home sales fell 0.8% instead of an expected gain of 2.0%.
April US Industrial production came in flat at 0.0% vs. expectations of 0.4%. Previous month’s gains were revised down to 0.7% from 0.8%. Vehicle Assembly rates declined 12% and Motor vehicle production (finished product) dropped off 8.9%. The inventory builds or “channel stuffing” that made prior production figures shine seems to have reached a zenith and is now in full reverse mode.
US Manufacturing continued to disappoint in May. The Empire State (NY) manufacturing index fell to 11.88 from 21.70 (and a high of 30.98 in October of 2009) along with the Philadelphia Fed index which fell to 3.9 from 18.5 (and a high of 43.40 in March). Escalating raw materials costs were said to be pressuring confidence.
US Leading Indicators fell 0.3% instead of the expected gain of 0.1. This was odd given the metric is over-weighted by monetary influences, while the Fed is still engaged in QE!
On the softer note, TIC flows turned more conservative in February. Total net TIC flows were a respectable $116B while net long-term TIC flows were less so at $24.0B (falling far short of expectations of $33.0B). This would suggest a bias toward more defensive shorter-term investments (money markets) on the part of foreign investors. Obviously, this helps keep the dollar firm, but not necessarily the economy, since long-term debt structures form the basis of US growth and its “recovery.” Also, the jobs data, week ending May 15th, was not as bad as expected, but still remains in recession territory. Initial jobless claims fell to 409K vs. 438K, and continuing claims fell to 3711K from 3792K.
Earnings reports for the week were mixed to some degree. Hewlett Packard surprised the street, beating estimates marginally, but cut $1B from sales forecasts. HP cited lower margins on PCs and computer services as consumers migrate to alternative products (Apple). Dell on the other hand reported some interesting progress. It beat estimates handily, surprising the street by 26.73%. Dell is moving away from PCs and into services, both at the corporate and local government level. However, its growth isn’t coming cheap, as Dell’s long-term borrowings are increasing faster than sales. Since last year, Dell’s long-term debt has nearly doubled to $6.7B, while overall sales have remained about the same since 2008 and 2009 peak levels. Growth in today’s market has a price – leverage.
Overseas, the eurozone experienced an uptick in inflation, which still has economists calling for further rate hikes. Eurozone inflation was higher than expected in March, 0.6% vs. 0.5%. Core inflation (ex food and energy) was 0.5% vs. an expected rate of 0.4%. Fuel for transport, heating oil, electricity, and gas costs contributed most to the gain. China cut its holdings of US Treasuries for the 5th month in a row, and, despite its crisis, Japan stepped up its purchases. Greece was downgraded again, with no solution in sight to its problems – but Dave M is covering the PIIGS today.
For whatever reason – call it wishful thinking – the consensus view was ready to embrace a stimulus reduction plan by the Fed in coming months, brought on by desires for cheaper gas, no doubt. Yet, it’s becoming increasingly clear that Fed rate hikes in light of our economic problems are becoming less likely every day. Combined with eurozone solvency issues, the pressure building on the Fed to continue QE is intensifying – thereby increasing the likelihood of a hyperinflationary environment.
We were encouraged to see that the euro-weakness/dollar-strength/sell-your-gold trade dissipated this week. Gold rose $18.95 on Friday, despite a fairly strong move to the upside in the dollar. One day does not make a trend, but we have been awaiting a moment in time when gold detaches from these two faulty currencies and trades on its own. With no definitive end to QE, here or abroad, we may indeed be witnessing this long awaited breakout.
Have a great weekend.
David McAlvany
President and CEO
MWM LLLP
David Burgess
VP Investment Management
MWM LLLP
