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Market Commentary

Greece - Europe - Credit Spreads Worldwide - Stocks
February 11, 2012   David Kotok, Chairman & Chief Investment Officer

So far, the Cassandras’ predictions of global collapse and failure have been proven false.  Some of the most notorious bears are now turning bullish and revising their forecasts to the positive.  Other “gloom and doom” holdouts are feeling the heat.  We think that heat will intensify.

The key to watch is in the credit markets.  Credit spreads tell a story of overwhelming liquidity being applied to the financial-system open wounds like a steroidal salve.  Such treatment can alleviate interim pain.  It is treatment for the symptom; it works for a while.  It does not provide a permanent cure. 

One can easily track the credit spreads of sovereigns around the world.  We have listed both the “good guys” and the “bad guys” on our website, http://www.cumber.com/.  We are following a concept first presented to us by Erwan Mahé, who is doing seminal work from his Paris location.  We have expanded on his work to include sovereign spreads in Asia and South America as well as those in Europe, both in and out of the eurozone.  We update these charts on a weekly basis, due to the continuous demand from clients and readers to view the data: http://www.cumber.com/content/misc/EU_Contagion.pdf.

Why have all the Cassandras been wrong?  Because they ignored the power of central banks to cause credit spreads to narrow.  The outcome is reflected in market movements and in certain sectors.

Banks are a good example.  If you made bets on banks, you won.  If you were a detractor of banks, you lost.  This holds true in Europe, in the United States, and in many other places in the world.  The European Central Bank’s ingenious concept of a three-year, 1% loan via LTRO (long-term refinancing operation) worked.  It was successful because it allowed the banks to buy their own debt at a higher yield than 1%, book the difference in yield as income, and mark up the value of their own bonds to par.  That process functioned as a mechanical way for there to be an addition to the bank’s capital.  The ECB used a creative way to solve a portion of its eurozone and the Europe-wide banking crisis.

We believe that the Fed must take notice of the LTRO.  It can give them another arrow in their quiver.  It takes the Fed beyond 28 or 84 days into contemplative periods of transitional policy, from the present massive stimulus that is all focused on the short run.  The ECB has given the Fed a monetary laboratory in which to watch a longer-term, transitional-workout framework. 

We expect the ECB to do another LTRO within the next month.  The size is unknown; the impact will be positive.  The markets now expect it and are already pricing it in. 

Credit spreads are reflecting transition from worldwide recession and double-dip forecasts to gradual and improving economic outlooks around the globe.  Data supports this shift in the United States, as well as in other places in the world.  It will happen in portions of Europe, but not in Greece.  In other European countries we expect to see some gradual improvement. 

The world has had enough gloom and doom.  Investors have been terrified since the beginning of the crisis in mid-2007, when Bear Stearns said “We have a small problem with a couple billion dollars in a hedge fund; don’t worry, it means nothing.” 

We have replaced meltdown of the type we saw after Lehman/AIG with “melt-up” of the type we have been seeing since March 2009.  We have shifted from collapsing leverage and failure at the institutional level to central bank intervention of unprecedented size. 

The G4 central banks (http://www.cumber.com/content/misc/G4_Charts.pdf)  have taken the size of their collective balance sheet from $3.5 trillion to $9 trillion.  That number is likely to rise.  The G4 have extended duration so that the focus of their policy is not just in the overnight lending rate or in the very short term.  Massive liquidity has blunted liquidity squeezes everywhere in the world. 

However, the issue of solvency remains.  Greece remains insolvent.  It must work out its payment schemes or it will default.  It will require austerity and hardship.  Despite the protests of unionized workers in public squares, there is not enough money to pay on the promises that were made. 

Workouts are not easy, whether they are in Greece or Harrisburg, PA.  Workouts involve recognition of loss and economic pain.  Deferring the workout only makes it worse.  Greece and Harrisburg will learn this lesson the hard way.  Default is even worse.  Ask Argentines who are still recovering from their government’s policies.  Ask the citizens of Vallejo, CA, who squandered $10 million in legal fees on a municipal bankruptcy and have lots of unfixed potholes to show for it.

Workouts, however, do not cause total collapse; in fact, they bring out strength.  Ask the Scandinavian countries that avoided this financial crisis, having learned from their previous one.  Ask Singapore, which has imposed governance standards.  If we had Singapore law applied in the US, many in Congress and on Wall Street would be in jail for many years to come.

The biggest threat to financial-market pricing comes from periods of uncertainty, the sequence of ambiguous and conflicting views that alter investor perceptions.  Uncertainty is the enemy of market pricing.  Once you achieve clarity, markets adjust quickly to the new reality and move on.  This will hold true in every city, county, and country.  And it will apply to every banking system in the world.

At the present time, our US stock market ETF portfolios remain fully invested.  We are concerned about a market correction, which appears underway.  It is necessary, since we have moved dramatically higher from the October selling-climax low.  The upward move has been at a sustained pace.  We expect this to be a correction, not a market peak.  We believe the financial sector is still attractive.  As it repairs, it will become even more attractive. 

We are going through huge transitional times.  Never before have we seen coordinated, global central bank activity of this order or magnitude.  By the end of this year, the G4 central banks will have expanded their balance sheets approximately threefold during the financial crisis.  The negative and inflationary results of this activity may appear in the future.  That remains to be seen.  For the present, this is a very bullish construction for asset prices and equities in particular.

David Kotok, Chairman & Chief Investment Officer
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