“There are three things we should all do every day: Number one is laugh (you should laugh every day),
number two is think (you should spend some time in thought) and
number three is you should have your emotions moved to tears (tears could be for happiness).
Think about it… that’s a heck of a day.”
– Jimmy Valvano
Up Next — The Italian Referendum.
While on the surface the Italian Referendum appears to be only about the structure of government power and Prime Minister Matteo Renzi’s desire to pass economic reforms, beneath the surface is a serious financial issue that has the potential to impact not just Italy, but Europe and beyond. This may sound small and meaningless to you and me but it is not.
A “No” vote or a “Yes” vote?
- A “No” vote means the government remains fat and stuck. A No vote would prolong Italy’s political and economic stagnation. Structural reforms would be put off while Italy’s lawmakers haggle over voting systems. Such government inertia is nothing new in Italy. But the country may no longer be able to afford it.
- A “Yes” vote gives Renzi the authority to shrink the government. His goal is to get it moving.
Here is what is at stake:
That risk centers on trouble at Italy’s third-biggest bank, Monte dei Paschi di Siena. The government is hoping investors will recapitalize it, but they are reluctant to commit their money unless the vote is “Yes.”
Investors are watching the vote closely. The structural reforms that would result from a more streamlined (albeit more concentrated power structure within Parliament) would in theory stimulate the Italian economy, thereby increasing a favorable resolution for the bank and pulling investors in off the sidelines. Should the bank collapse, it could ignite a full-blown (and potentially global) banking crisis.
Polls conducted before a ban on publication (yes – you read that right… a ban) took effect, two weeks before the end of the campaign, showed the “No” camp ahead by approximately four percentage points. But 40% to 60% of voters were still undecided or planning to abstain.
Bottom line, a “No” vote could unleash a devastating financial chain reaction.
You can read more on this in The Economist.
The irony of the vote is that, like the UK Brexit, voters may vote in a referendum that they do not fully understand. Here is the irony:
- Italian households own about €170 bn worth of bank bonds, or 49% of the total. Under new EU rules, bond holders and depositors (bank clients) would be responsible for absorbing some of the losses of the bank.
- The consequences of a “No” vote on their daily lives has a direct impact on their own personal financial interests. I’m not sure voters fully understand this.
- In short, those same “No” vote Italian voters are likely to be the ones bailing out Monti dei Paschi di Siena. Or should I say “bail-in?” Remember Cyprus?
- The EU, especially Germany, is sitting strongly in the “bail-in” camp. With Deutsche Bank on a cliff’s edge, how can Germany demand Italian citizens “bail-in” their bank and not do the same in Germany for DB?
The domino effect of a “No” vote could lead to a crisis of government. No mandate for Renzi… will he resign like David Cameron did after the Brexit vote?
At immediate risk is a run on the Italian banks, a spike in Italian bond yields and new crisis within the European Central Bank (ECB).
There is no shortage of palace intrigue as the head of the ECB, Mario Draghi (an Italian), would once again be tasked with riding to the rescue with ECB resources. In Germany, Angela Merkel would have to walk a fine line as an election looms next year.
If push comes to shove, don’t be surprised if a compromise between Germany and Italy saves not only Monti dei Paschi di Siena, but also helps provide DB the oxygen it needs. Keep this issue “On Your Radar.”
Debt’s a bitch man… and it is getting more and more interesting by the day. The Italian vote is December 4. Keep your eyes on Sunday’s evening news!
Maybe we should heed Jimmy V’s sage advice: “Laugh, think and cry.” I’m going to keep working on that.
Grab a coffee and find your favorite chair. As we do early each month, this week you’ll find updates on valuations (they remain high), forward returns (low), debt and the Fed. I hope you find the information helpful.
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Included in this week’s On My Radar:
- Valuation Charts and Comments
- Forward Returns
- Foreign Policy
- Trade Signals – U.S. Equity Bull, Global Equity Bull, Fixed Income Bear; Sentiment Suggests Caution
Valuation Charts and Comments
Market Cap-to-GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune interview that “it is probably the best single measure of where valuations stand at any given moment.” How can’t I agree?
Let’s first look at the current data (next chart) then think about what it means with regard to probable 7-year and 10-year forward returns.
1. Corporate Equities to GDP:
Think of the next chart as the market value of all publicly traded securities as a percentage of the country’s business.
Key points to focus in on:
- Note the levels (33.0% and 32.2% highlighted in yellow) at the beginning of the last two long-term secular bull markets (1954-1966 and the greatest bull market of all time: 1982-2000).
- Next, note the valuation level in January 2000. Crazy… right? Then investors poured record amounts of money into technology funds (the largest single record month of new money inflows occurred in March of 2000).
- As a quick aside: 75% of the money at Fidelity Funds was in their technology-oriented funds. Tech finally made a new all-time high in 2016. Sixteen years of no gain and technology stocks was where most of the money sat. If you lose 75%, your $100,000 drops to $25,000. An investor would need a return of 300% just to get back to even (and in tech’s case… SIXTEEN YEARS!)
- Today, the market sits at a point more expensive than it was before the great dislocation in 2008. It sits at just off of the second highest level in history.
Finally, what to do? Buffett opined, “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you.”
Hard to argue with the Oracle.
2. Median P/E = 22.8 (The Market Remains Overvalued)
The next chart looks at median P/E and compares the current reading with each month-end median P/E dating back to 1964. The dotted lines in the middle section show various valuation zones that range from “Very Overvalued” to “Bargains.”
The current reading of 22.8 puts the S&P 500 index in the “Overvalued” zone.
What does this mean in plain English? Well, we can look at the median P/E history and see what the returns were in subsequent 10-year periods of time.
You’ll find that in the