This morning’s risk off note was short and to the point. And more right than I would have guessed. When I started typing the report stock futures were higher on the day. As short as the report was, I couldn’t type fast enough, to get it out before futures had turned red. But I am now stuck with having a target of 1,400 to 1,375 which we breached already. Yesterday’s report happened to call for a Romney bounce followed by a fade. Turned out about right, but now back to the real issues and what is next for the market?
Is Europe really going to let Greece go and risk a series of exits? That was my concern last week when I invoked quotes from Planet of the Apes. Nothing much has happened since then to change that view.
Greece has a vote that may or may not pass. If it doesn’t pass, the process of a nasty Greek exit and full default is likely accelerated. If they pass it, which I expect they will, then that process is likely just delayed. Until the “official sector” takes losses on all of its dumb purchases of Greek bonds and restructures the loans that were made that never had a chance of getting paid back, there will be no other course for Greece. The fact the European officials either don’t see it, or are just ignoring it is a major concern. Greece and the risk of a painful and chaotic exit for Greece that affects the other weak countries is a real risk. I expect a small pop when the vote is done and it “passes”. If it doesn’t pass I will quickly get very nervous about the markets, but history tells us it will pass and everyone will pretend this time it will work. At least for a couple of days we can live that fairytale.
Then there is Germany. The comments coming out of Germany are growing more hostile. Germany today mentioned direct influence on other country’s budgets. Draghi specifically tried to point out to Germany that the European debt crisis is hurting Germany already and will hurt it more. He is clearly trying to make it easier for Germans to get on board with some aggressive ECB action. If you are truly an optimistic, you can think Draghi said this as a warning shot before he acts “independently”. While not completely at the beck and call of Germany, the ECB is far less independent than our Fed. Draghi has already made it clear that the IMF would be a model for any new programs, so he has given away some independence. He won’t just act unilaterally and aggressively. That leaves us with the conclusion that he is pushing Germany, and that Germany needs to be pushed. Back in September, Merkel sounded downright dovish. She pointed out even to her own finance people that the ECB had to remain independent. That is not the message that came out last week when she appeared to backtrack on letting banks get direct bailout money, and that message was further diminished by today’s comments. Germany will be hurt by not supporting more aggressive action, but people know smoking is bad, and yet many still do.
Then there is Spain. Spain is the other side of the coin. They need money but have decided to pretend like they don’t. Image seems more important than actually getting the economy kick started. They have fallen into the trap of believing their own feces doesn’t stink. That somehow rates are lower because of steps Spain has taken and not because speculators are scared to death that the ECB will launch OMT. The banks are stuck with what they have, but that doesn’t mean they will buy new issues if OMT gets taken off the table. I can understand Spain wanting clarity on what the programs would do and what the conditionality is, but time is running out. When Draghi resorts to threatening Germany, you know that the lenders are getting cold feet, so Spain should strike a deal quickly. Maybe it won’t be the best, but there is a real risk that at some point there won’t be a deal. The fact that ESM has some funding is good, but for all we know, countries funded it based on promises it would never get used. Spain is like the neighbor who comes to borrow some tools then asks why you don’t own better quality tools. It doesn’t endear the lender to them.
Then there is France. The best part about the situation is soon we can talk about FIGS, or better yet we can talk about how Europe is FRIGged up. Adding an F or FR to the initials we can use to describe the block of countries that have too much debt and no hope of repaying it is great. The reality is that France can no longer be mentioned in the same sentence as Germany and the Netherlands when talking about strong countries in Europe that can bail out the weak ones. It is not yet in the category of the PIIGS, but it is heading that direction and we have seen over and over again what a slippery slope that it. It is very hard to keep from slipping into the morass, especially if global growth continues to slow. Growth will continue to slow as long as Europe only puts in half hearted efforts to fix the problems.
Don’t worry about it. Seriously, I don’t think this will be an issue. Nothing will get truly fixed, but in the aftermath of the elections, I find it hard to believe that the parties will dig their heels in and let this become a problem. There won’t be a real solution. Anything that gets done will require fudging numbers, some promise of something in the future that won’t happen, and push it far enough off so it can be an election issue in 2014. I think it is stupid, but I see no chance of a real solution, and no chance they let sequestration occur, so they will do the only thing they know how – something that is small, doesn’t work, but bumps the problem into the future. Better yet, creates an election issue, and a good reason to get some lobbyists to take them out for dinner.
All the Other Reasons to Sell Stocks Because of Obama
There are lots of reasons to sell stocks based on an Obama win. They have been out there all year, and yet stocks are up over 10% (the S&P and Nasdaq). Is there is some tax selling that is triggering stop losses? That might be occurring, and certainly would seem to be a decent explanation for Apple, but that just creates value. I’m not overly worried about the markets because of an Obama election. Maybe I should be more concerned, but I think Obama driven selling is overdone.
Don’t Forget About QE
QE doesn’t guarantee stock returns, but the longer it is in operation, the more money that accumulates, and that can rush into risk assets at the same time. I don’t quite see it as a big positive yet, but it certainly isn’t a big negative at these levels.
Where Does that Leave Me?
I am neutral to mildly bullish in the U.S. I am now neutral in Europe. I think the next moves create a pop. We need some real bad news to break 1,375 and I don’t see it. I think above 1,425 is difficult without the ECB launching OMT, so I don’t want to be aggressive here. I am more likely to turn bearish, and anything above 1,410 on the S&P is time to start selling.
So yes, I’ve shifted away from aggressive bearish stance.
Fixed Income Asset Allocation Strategy
We have started publishing the TFMkts “core” “traded” and “aggressively traded” fixed income strategies. We took off risk last Thursday. I am adding 5% to the high yield allocation for the traded and aggressively traded strategy. I should have been short in the aggressive strategy and regret that, but having reduced the risk, I am comfortable adding some back.
This raises, or at least I think raises an interesting question. Why would you sell HYG for example at 92.60 to buy it back at 91.90? It seems like a small move. Not even 1%. True, but I’m not suggesting to put the entire amount we took off back on. We had weighting of 15% and 20% two weeks ago which were reduced to zero. So we have room to add more. But there is another way of looking at this.
People love to talk about “yield” and the chase for yield. HYG pays about 50 cents a month in interest. That gets you to the 6.6% yield people find so fascinating. So missing 70 cents in down movement in HYG would get you about 6 weeks of interest. The move since last Thursday has knocked off about 6 weeks of carry. You can ignore that if you want, and say you buy the fixed income market for income, not total return, but then you are just fooling yourself. Total return matters, especially if you are buying funds that don’t hold bonds to maturity, because you are subject to the price moves whether you like it or not.
So that is the update on those strategies. Leveraged loans, which had been a disappointment last week, especially given our reasonably high weighting, are holding their own this week which is encouraging. Our recommendation in Munis has done well, and we are very close to cutting the weighting there. They are outperforming corporate credit by too much. We are debating cutting the allocation or adding a treasury hedge on that portion of the portfolio. For now, we will leave it as is, but getting nervous about the outperformance.