“Each politician pursues self-interest while the common cause imperceptibly decays.” Thucydides.

“Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” Peter Lynch

“In short, the depression IS the “recovery” process, and the end of the depression heralds the return to normal and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom requires a bust.” Murray Rothbard


Yogi Berra might say that the month was like “déjà vu all over again” as the market plunged after a strong start the year, just as it did in 2010 and 2011. This was the “Third False Dawn” of recovery. Furthermore, the worries remain the same: no self sustaining recovery, continued private sector deleveraging, financial sector balance sheets and of course the intractable European currency crisis. The driver of market returns in the short term will likely be driven by “Volitics” the uncertain interaction of Policy Uncertainty and Volatility.

acropolis greece spain

More to Go?

Paraphrased from John Hussman….“Michael Wilson of Morgan Stanley noted “Make no mistake, institutional investors are all in.” Wilson reported that the monthly rolling beta of mutual funds (their sensitivity to market fluctuations) now exceeds 1.10 and is the highest since the previous record, just before the wicked market plunge in 2011.

Institutions hold their largest “overweight” in high-beta sectors than at any time since the start of data, and long-short funds are also near their most leveraged long positions in history. Of course, mutual fund cash levels also remain at record low levels.”

I have found the contrast between Positioning and Sentiment very interesting over the last few years and here we have another big divergence. Investors are panicked but fully invested. The rock bottom level of sentiment is definitely a short term bullish indicator.

Divergences in Index Performance

The valuation differential between the US indexes and European indexes is becoming quite extreme. The chart below shows roughly a 12% outperformance of the S&P 500 over the MSCI World since Q3 2011.

The currently Cyclically Adjusted Price to Earnings for the S&P 500 is 21.1x in contrast with the UK at 13x and the MSCI Europe at 12x.

Now the question is does the US deserve a 40% premium to the other major developed markets? Some European markets are trading at their 1982 valuation lows, levels from which spectacular future returns were earned. In contrast the US is trading at levels only exceeded at 2 or 3 times in the 130 years of historic data; furthermore each of those times would have been a disastrous time to invest. I am quite confident that on a reasonable time horizon these valuations will meet somewhere in the middle.

I recently attended a course with Andrew Smithers where he summed up this problem of valuation metrics defying gravity for extended periods.

“In the long run stock prices demonstrate negative serial correlation; however in the short run stock prices demonstrate positive serial correlation. The problem is determining at which point the short run becomes the long run.”

My short exposure remains focused on the S&P 500 and the Russell 2000
(INDEXRUSSELL:RUT) because I believe these indexes are much more overvalued than their European counterparts and that the emergence of a recession in the US is still perceived as a very unlikely event by the majority of market participants.

The “green shoots” (no mention of them since 2009!) in the US turning to weeds could really be the catalyst for the currently resilient S&P 500 turning lower. Elsewhere, HSBC’s China PMI, the earliest indicator of China’s industrial sector, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh straight month that the index has been below 50. The Euro Zone composite PMI, a combination of the services and manufacturing sectors and seen as a guide to growth, fell to 45.9 this month from April’s 46.7, its lowest reading since June 2009 and its ninth month below the 50-mark that divides growth from contraction. Official data also showed the UK economy shrank more than first thought between January and March, after the deepest fall in construction output in three years, while government spending made the biggest contribution to growth.

“Macro Friday” as some were calling it today was a washout. UK data was absolutely terrible with the UK Purchasing Managers Index posting it’s second sharpest decline in it’s 20 year history. The “new orders” segment was at a near catastrophic 42 down from 49 the month before.

US Non Farm Payrolls came in below the estimates of all 87 Wall Street economists at just 69,000 jobs when we need at least 120,000 to keep the unemployment rate stable.

Will QE 3 or LTRO 2 or a EuroBond Save the Day?

The most important question to answer is; can unprecedented, concerted global monetary policy action repeal the business cycle? Can central banks and politicians conspire to prevent a downturn in the economy? My answer to that would be no, because they have not managed it before. It’s not like the current set of leaders are the first to be extremely averse to a downturn on their watch, these things just happen, growth flows and then it ebbs – it is the natural order of things.

It seems quaint that only a few years ago the concern in Europe was that there would be “contagion” risk resulting from a Greek default. So worried were they that we had almost-daily pronouncements that Greece would not be allowed to default, that there was no need for a Greek default, the developed countries no longer defaulted, etc. Now that Greece has defaulted, the line in the sand is “That was just Greece; no other country will need to default.”

But just in case, European leaders created all sorts of funds, guaranteed joint and severally, to help bail out nations in trouble. First Greece, then Ireland and Portugal. Even with all the money that was raised, it was not enough to prevent a Greek default. And the “new” debt is trading at around 10% of its issue price.

Spain is too big to save and too big to fail. The only way for Spanish debt to remain at 6% is for the ECB to basically buy it (or lend to Spanish banks so they can buy it, or whatever creative new program Draghi and team can think up). When Spain goes the bond market will look to Italy and then to France. The line must be drawn with Spain. The only outfit with a balance sheet big enough that can also do it in a politically acceptable manner is the ECB, and the only way they can do it is with a printing press. I had actually written the first part of this

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