Spanish Conundrum: Too Big to Save but Too Big to Fail

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“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.

Spanish Conundrum: Too Big to Save but Too Big to Fail

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 paragraph earlier in the month – on the 31st May the market turned around on rumours of an IMF rescue package for Spain. This is truly absurd, this is exactly the US led (as largest partner in the IMF) bailout of Europe that was categorically ruled out in the past. Another example why ignoring the politicians is the only logical strategy.

From my perspective the market is not yet fully weighing the situation of Spain or Italy becoming more fully embroiled in the currency crisis and/or capital flight via deposits. The Spanish Bond/Bund spread continues to widen.


In Germany, Merkel’s CDU party won 26% of the vote in the North Rhein (Germany’s most populous state) down from 35% in the previous election. Her rivals the Social Democrats got 39% and the Greens got 12%. The Dutch Prime Minister was unable to reach agreement with his government on budget cuts and therefore resigned.

The growing support for extreme parties at either end of the spectrum has been quite predictable. Nothing has been done to address the structural issues in Europe. Painful solutions are postponed and fudged whilst voters refuse to face reality and politicians refuse to speak frankly about the extent of the problems. The time that has been bought by LTRO’s and Quantitative Easing has essentially been wasted.

Videos to View

ECRI re-affirm Recession Call

Charles Dumas on Euro Crisis –

Russell Napier on Europe –

Gold & Gold Miners

Gold has really been dull so far in 2012 basically flat to the end of May. Yet despite this the case for gold is stronger than it was at the turn of the year. The Emperor has no clothes.  See this quote from Eric Sprott

“The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%. On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.

Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history.”

In this context then, with the crisis proving chronic why has the gold price been so frustrating? I think it lies in the difference between the demand for paper gold and the demand for physical gold. Traders are liquidating paper gold in a “Risk OFF” play whilst long term investors are accumulating physical to protect their wealth. The net is a redistribution of the metal but no change in the price. Eric Sprott highlighted that China posted another record Hong Kong gold import number in March of 62.9 tonnes. Gold imports into China have now totaled 135.5 metric tonnes between January and March 2012, representing a 600% increase over the same period last year. These numbers are incredible!

Global central banks have also continued to accumulate physical gold, with the latest reports revealing another 70 tonnes of gold purchases completed in March and April by the central banks of Philippines, Turkey, Mexico, Kazakhstan, Ukraine and Sri Lanka.

Despite all of this gold only represents about 0.15% of global pension fund assets. The large institutional pools just do not have an allocation to this asset class. The total market cap of all precious metal miners is about 2/3rds of Apples.

Gold, gold mining and mining investment or royalty vehicles are a substantial holding in my portfolio at around 14%. These stocks are cheap on almost any measure, but the same could have been said a few months ago at 30% higher prices. One way to look at mining stocks is to compare them to the price of gold itself. See below from Sitka Pacific Capital…


While instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:


This final chart is something to get excited about – sentiment towards gold miner is now at 2009 lows. The combination of low valuations and terrible sentiment gets me excited.


Will Defensives Always be Defensive?

Murray Stahl made some very insightful points in his latest quarterly commentary regarding the perceived defensive nature of the Healthcare and Defence industries because of their lack of earnings variability.

They highlight that spending on national defence and spending on healthcare have grown year on year regardless of the state of the broader economy or market. This discretionary spending by global governments, particularly in the developed west has been the tide that has lifted all boats in these industries but there is no guarantee that this will always be the case, especially should governments catch austerity.

US government forecasts show that by 2017 they will be spending $104bn less on defence than they did in 2010. After eight decades of constant increases these are profound changes that long term investors must consider.


By kelpie-capital

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