“Because increased collateral values inspire more credit, reflexive dynamics can often be identified by the concomitant growth of credit and collateral values. If credit is rising rapidly along with asset prices, there is a high probability that reflexive dynamics are under way.”

With this in mind, I revisited the chart below from Steve Keen, illustrating Australian home prices and the change in credit growth in the economy.

Looks like the growth rate in Australian Housing credit is plumbing the lowest levels ever.  I’m not a quant guy, but I’m pretty sure that “ever” is a long time.

Given that Australia’s Private Sector Debt has rapidly exceeded that of even  the most prolific American spenders, I wonder what happens when the private sector begins deleveraging from the extremes shown below.

I also think it is interesting that most folks have the impression that Australia has very little debt.  If we learned anything from the recent crisis, it’s that private sector liabilities can quickly become the public sector’s responsibility.  So it’s important to look at the total debt in the system.  In this light, Aussies are actually in line with the US due to heaps of household and financial sector debt obligations.

 A good friend of mine, and one of the most successful investors I know, has been lecturing me on the importance of catalysts when sizing positions.  I am beginning to come around to the idea, particularly as we have been writing about the Australian Property Bubble for over a year now, and I am looking forward to moving on to something new.  Some may say we’ve been early, but I’d remind them that we’ve been warning of European defaults for over two years!  Call it what you want but our thesis continues to develop and we continue to see increasing evidence of falling prices and deteriorating economic conditions down under.  What follows is a collage of evidence I’ve accumulated over the past several weeks (maybe longer), that when put together, paints a very clear story in our opinion.  So Kyle, GET FIRED UP!!  Here is your evidence:

Properties are languishing on the market in a number of suburbs.  This article in Perth Now explains that, “Almost 311,286 properties are for sale across Australia, the highest in more than five years and almost 30 per cent more than the same time last year. In Melbourne, there are 50 per cent more properties for sale, 30 per cent in Sydney, 14 per cent in Brisbane and almost 40 per cent in Adelaide. Meanwhile, auction clearance rates have remained below 50 per cent for 20 consecutive weeks in Australia’s largest housing markets.”

CourierMail explains, that “Sellers who manage to snare a buyer in Brisbane’s soft property market are seeing their deals fall over as a new trend emerges of valuations coming in below contract prices, making it difficult to obtain finance. Owner’s estimates of their property’s actual value are often wildly optimistic.”

Prosper Australia has ignited a small but growing push calling for a “buyers’ strike” to protest against the high cost of housing.  “There are 1.3 million Australians with negatively geared rental properties. They are diverting all rents and some personal income to meeting interest payment in the hope of capital gains. When only capital losses are expected, investors will flood the market and overwhelm demand. Buyers will step back, making it virtually impossible to sell at any price.”

It seems that the Australian Bankers Association is waking up to reality, taking the unprecedented step of launching a website – www.doingittough.info – for financially stressed homeowners to negotiate hardship packages, according to the Daily Telegraph.  “The Big Four banks are on high alert for a rocky 2012 with a sharp rise in defaults.”  This is the first time the banks had set up a site to deal with customer hardship on mortgages and other financial products like credit cards and personal loans.  Recent reports have pointed to a higher ratio of “non-performing loans” and people falling behind on mortgage repayments in recent months.

One in ten Australian households are in housing stress, according to Australian’s for Affordable Housing.  A startling 460,000 households spend more than half of their income on housing costs.  It’s no wonder Australian’s are shouting out for help.  The cost of housing is the single biggest cost of living issue in Australia today.  Spend a few minutes perusing this site to get a feel for their frustrations.  We have seen how this story ends.

In a recent report, Moody’s warned that there are “meaningful uncertainties” for Australian housing and mortgage delinquency rates are likely to increase over the next decade. We doubt it will take that long.  “Capital city house prices have more than quadrupled and household debt has tripled since 1990. Simple metrics indicate that the current price levels are not sustainable.”

According to Australian Real Estate and Property, “If a second global financial crisis (GFC) occurs credit markets will tighten up.  Australian banks already have up to 40% exposure to European debt and the big four Australian banks ratings were downgraded by Moody’s Investor service due to this wholesale funding exposure. Unfortunately in 2011 Australian borrower home loan arrears hit a 15 years high with Australian banks and borrowers in a binge-buying hangover.  The time period 2008 and 2009 combined make up 40 per cent of the mortgage loan books of the major Australian lenders. The Australian borrowers who purchased property during the height of the Australian Government economic stimulus in 2009 and hence the peak property prices, are now most at risk to falling property prices.” 

It’s no wonder that, “The Australian Prudential Regulation Authority has told banks to model what would happen if the European meltdown spread to Australia through a series of stress tests designed to ensure the strength of the local banking system,” according to The Australian Financial Review.  “The stress test has been prompted by an escalation of the European sovereign debt crisis that could lead to a global recession and a hard landing in China. It comes in the same week that the Reserve Bank of Australia’s deputy governor, Ric Battellino, warned that Australia’s indirect exposure to Europe through the effect on some of our important trading partners, could be significant.  The short notice and time frame allowed by APRA, particularly in light of negative comments from the RBA, indicates the regulator is preparing for a difficult 2012.”

The banks problems are likely to be compounded as most of the Australian economy is already in recession.  So it shouldn’t come as a surprise that, “The number of companies entering some form of insolvency administration in calendar year 2011 continues to set new records, per Dissolve.  A recent report stated that, “The months of March, April, June and now July 2011 have been the highest ever for each of those months. The calendar year to July 2011 is also the highest ever.”

“Thirty-six companies in the residential construction sector have entered voluntary administration in the past two weeks,” often the precursor to liquidation, according to The Age.  ”There has been a marked increase in the insolvency of builders and building-related businesses over the last few weeks and this is likely to increase after Christmas when contractors have to fund the long slow-down or shut-down period, with little cash flow coming in. With banks being reluctant to increase facilities for building companies, this will only exacerbate the situation.”  The author concludes with a very important point:

“A big part of the problem is the delay of payments to these businesses, which puts their cash flows under undue pressure. According to the country’s biggest receivables management and credit report company, Dun & Bradstreet, the trade payment terms for the construction sector are at the highest level since the fourth quarter of 2009, which was at the height of the global financial crisis. Over the past 12 months, payment terms in the construction sector deteriorated by nearly two days from 52.8 to 54.4 days, which is almost double the conventional standard of 30 days. In 2003 the average was 45 days.

“Payment trends are known to be an accurate leading indicator of an economic correction. Indeed, the last economic decline was preceded by a blowout in trade payments. The concern is that as the global credit market crunches, and credit availability starts to tighten again, the impact of late payments on cash flow will be devastating in a sector that is already hurting.

“Residential housing and construction are a key component of the economy and when things go south they have a huge knock-on effect. Things are likely to get worse before they get better.”

A year ago, some of my Australian friends claimed that housing prices would not fall because the economy was so strong and without a rise in unemployment, prices would maintain their elevated levels.  I disagreed with the comment then but it is still worth noting that Australia’s job market is weakening today as businesses look to cut costs to cope with a deteriorating economy.  Per News.com.au, “The economy outside mining has been quite weak so companies have had to start laying people off to get their costs under control . . . That suggest for 2012 there will be weaker consumer spending, greater downside risk for businesses and this is of course even before the full impact of the European debt crisis.”  Perhaps this explains why consumer sentiment collapsed in Australia by the most since the start of the financial crisis three years ago.  At least for most consumers.  Apparently, some of them, like this 25-year-old high school dropout from Western Australia making $200,000 a year running drills in underground mines, is the exception, according the WSJ.  We’d suggest it is more likely just another indication of the unsustainable credit boom and forthcoming bust in China, as our friend Vikram eloquently outlined in his book.  Don’t worry, we’ll have more on this shortly as well.

“Brinkmanship (or brinksmanship) is the practice of pushing dangerous events to the verge of disaster in order to achieve the most advantageous outcome. It occurs in international politics, foreign policy, labour relations, and (in contemporary settings) military strategy involving the threatened use of nuclear weapons. This manoeuvre of pushing a situation with the opponent to the brink succeeds by forcing the opponent to back down and make concessions. This might be achieved through diplomatic maneuvers by creating the impression that one is willing to use extreme methods rather than concede. During the Cold War, the threat of nuclear force was often used as such an escalating measure. Adolf Hitler also used brinkmanship conspicuously during his rise to power.

The dangers of brinkmanship as a political or diplomatic tool can be understood as a slippery slope: In order for brinkmanship to be effective, the threats used are continuously escalated. However, a  threat is not worth anything unless it is credible; at some point, the aggressive party may have to back up its claim to prove its commitment to action. The chance of things sliding out of control is often used in itself as a tool of brinkmanship, because it can provide credibility to an otherwise incredible threat.

The Cuban Missile Crisis presents an example in which opposing leaders, namely John F. Kennedy and Nikita Khrushchev, continually issued warnings, with increasing force, about impending nuclear exchanges, without necessarily validating their statements. Pioneering game theorist Thomas Schelling called this “the threat that leaves something to chance.” The British intellectual Bertrand Russell compared nuclear brinkmanship to the game of chicken. The principle between the two is the same, to create immense pressure in a situation until one person or party backs down, or both are annihilated.”

So what does this mean for investors?  In a nutshell, it is a step in the right direction.  But is it enough?

First, we would note that Chinese policy needs to be relaxed.  But odds are the initial move out of the gate will be tentative given the extent of the credit excesses lingering in the system, and as such, are unlikely to reverse slowing economic growth. Historically, policymakers response will be proportionate to the deterioration in the economy which means risk assets will likely be down substantially before policymakers respond in force. If and when, the party undertakes substantial fiscal and credit stimulus, we would turn more bullish on China-related assets.  We are not there yet.

It is important to remember that massive reflation and market intervention does not occur in healthy bull markets. Such policies can mark a bottom in price, but these “bottoms” are usually preceded by major crisis.  For example, the Fed began easing policy in January 2001 after the tech bubble burst but equities sold off through March 2003.  More recently, the Fed began liquidity injections and easing in August 2007 but market only hit bottom in March 2009.  The point is that an initial shift in policy is more likely confirmation of a bear market in risk assets and in this case, may indicate an economic acceleration to the downside before policymakers get ahead of the curve. 

Regarding the “coordinated action” announced today, investors might be reminded of similar central bank policies that saved us from Financial Armageddon a few years ago, and sparked a massive rally in risk assets which launched in March 2009.  Unfortunately, the first coordinated policy response was announced as early as 2007 so investors had a long ride ahead of them before the bottom!  For perspective, we compiled a timeline of central bank policy below using excerpts from a St Louis Fed report titled Lessons Learned?  Caution – this is somewhat exhausting!

• The crisis first appeared in interbank lending markets in early August 2007, when the London Interbank Offered Rate (LIBOR) and other funding rates spiked after the French bank BNP Paribas announced that it was halting redemptions for three of its investment funds.
• The Federal Reserve sought to calm markets by announcing on August 10 that “the Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets” and noting that, “as always, the discount window is available as a source of funding.”
• Subsequently, on August 17, the Board of Governors voted to reduce the primary credit rate by 50 basis points and to extend the maximum term of discount window loans to 30 days.
• Then, in September, the Federal Open Market Committee (FOMC) lowered its target for the federal funds rate in the first of many cuts that took the rate essentially to zero by December 2008.
• Financial strains eased somewhat in September and October 2007 but reappeared in November. On December 12 2007, the Federal Reserve announced the establishment of reciprocal currency agreements (“swap lines”) with the European Central Bank and Swiss National Bank to provide a source of dollar funding in European financial markets. Over the next 10 months, the Fed established swap lines with a total of 14 central banks.
• On December 12, the Fed also announced the creation of the Term Auction Facility (TAF) to lend funds directly to banks for a fixed term.
• Financial markets remained unusually strained in early 2008. In March, the Federal Reserve established the Term Securities Lending Facility (TSLF) to provide secured loans of Treasury securities to primary dealers for 28-day terms.
• Later in March, the Fed established the Primary Dealer Credit Facility (PDCF) to provide fully secured overnight loans to primary dealers.
• Shortly after the creation of the PDCF, the Federal Reserve Board authorized the Federal Reserve Bank of New York to lend $29 billion to a newly created limited liability corporation (Maiden Lane, LLC) to facilitate the acquisition of the distressed investment bank Bear Stearns by JPMorgan Chase. The PDCF—and especially the Maiden Lane loan—marked significant departures from the Fed’s usual practice of lending only to financially sound depository institutions against good collateral.
• In July 2008, the Federal Reserve Board once again authorized loans to non-bank financial firms when it granted the Federal Reserve Bank of New York authority to lend to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) if necessary to supplement attempts by the U.S. Department of the Treasury to stabilize those firms. The Fed was not called on to lend to either firm, however, and the Treasury Department placed both Fannie Mae and Freddie Mac under conservatorship in September 2008.
• The financial crisis intensified during the final four months of 2008. Lehman Brothers, a major investment bank, filed for bankruptcy on September 15 after the failure of efforts coordinated by the Fed and Treasury Department to find a buyer for the firm. 
• Within hours of the Lehman bankruptcy, the Fed was forced to confront the possible failure of American International Group (AIG). Hence, on September 16 the Fed again invoked Section 13(3) of the Federal Reserve Act and made an $85 billion loan to AIG, secured by the assets of AIG and its subsidiaries. 
• The Lehman bankruptcy produced immediate fallout. On September 16, the Reserve Primary Money Fund announced that the net asset value of its shares had fallen below $1 because of losses incurred on the fund’s holdings of Lehman commercial paper and medium-term notes. The Federal Reserve responded to the runs on money funds by establishing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to extend non-recourse loans to U.S. depository institutions and bank holding companies to finance purchases of asset-backed commercial paper from money market mutual funds.
• To help stabilize the financial system, on September 21, the Fed approved the applications of Goldman Sachs and Morgan Stanley to become bank holding companies and authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of both firms, as well as to Merrill Lynch. A few days later, the Fed increased its existing swap lines with the European Central Bank and several other central banks to supply additional dollar liquidity in international money markets.
• Financial markets remained in turmoil over the ensuing weeks. To help alleviate financial strains in the commercial paper market, the Fed established the Commercial Paper Funding Facility (CPFF) on October 7.
• The Fed’s next rescue operation came in November, when it participated with the Treasury Department and Federal Deposit Insurance Corporation in a financial assistance package for Citigroup. The Federal Reserve agreed, if necessary, to provide a non-recourse loan to support a federal government guarantee of some $300 billion of real estate loans and securities held by Citigroup.
• Two days later, on November 25, the Federal Reserve announced the creation of the Term Asset-Backed Securities Lending Facility (TALF). Under this facility, the Federal Reserve Bank of New York provides loans on a nonrecourse basis to holders of AAA-rated asset-backed securities and recently originated consumer and small business loans. The TALF was launched on March 3, 2009, and the types of eligible collateral for TALF loans were subsequently expanded on March 19 and May 19, 2009.

“Throughout the fall of 2008, the Federal Reserve Board approved the applications of several large financial firms to become bank holding companies; these firms included Goldman Sachs, Morgan Stanley, American Express, CIT, and GMAC. The Board cited “unusual and exigent circumstances affecting the financial markets” for expeditious action on several of these applications. 

“In addition to the Fed’s rescue operations and programs to stabilize specific financial markets, the FOMC reduced its target for the federal funds rate in a series of moves that lowered the target rate from 5.25 percent in August 2007 to a range of 0 to 0.25 percent in December 2008. On November 25, 2008, the FOMC announced its intention to purchase large amounts of U.S. Treasury securities and mortgage-backed securities issued by Fannie Mae, Freddie Mac, and the Government National Mortgage Association (Ginnie Mae). The FOMC increased the amount of its purchases in 2009. The stated purpose of the purchases of mortgage-backed securities was to reduce the cost and increase the availability of credit for the purchase of houses. The move to support a particular market through open market purchases is highly unusual for the Federal Reserve and unprecedented on this scale since before World War II.”

A friend sent me this updated look at the S&P yesterday, which provides some perspective on where we are in this cycle using “the last time around” as a guideline.  The chart aligns the bail out of Bear Stearns in March 2008 with the bail out of Dexia this year.  The conclusion appears obvious if you are able to step away from the day-to-day noise, rumors, plans, and announcements.  This will take some time to fully play out.  Until it does, we’d recommend reducing exposure to risk assets on policy-induced rallies.  We have not yet learned the most obvious lesson of this ongoing financial crisis.  You cannot solve a solvency problem with liquidity.

]]> http://www.viewfromtheblueridge.com/2011/11/30/is-it-enough/feed/ 0 http://www.viewfromtheblueridge.com/2011/11/29/mountains-of-cash/ http://www.viewfromtheblueridge.com/2011/11/29/mountains-of-cash/#comments Tue, 29 Nov 2011 16:11:08 +0000 Christopher Pavese http://www.viewfromtheblueridge.com/?p=1615 In a recent post, The Buyback Paradox, we suggested that cash on corporate balance sheets was one of many Bullish Mirages.  We stated, “Companies do hold piles of cash that could potentially be used to buy back shares.  But why do they have this cash?  I would submit that there are a few reasons, none of which have bullish implications. One, low interest rates encourage managements to issue debt – in some cases a lot of debt. Note that these new claims on the business are higher in the capital structure than equity, so stockholders should not be particularly excited about high cash balances which result from selling debt. Two, the regulatory and political environment is not exactly pro-business in case you haven’t noticed today. Companies are holding cash because it is very difficult to make long term investments when the rules of the game and their tax consequences are impossible to predict even one week forward.  Cash on the sidelines is a sign of uncertainty, and frankly, I don’t see anything on the horizon that will change this.”

It is nice to know that every investment manager out there is wearing their “bubble-vision goggles” today.  In his latest weekly, John Hussman provides some hard facts to illustrate our point.  The full commentary is worth a read, but at a minimum, read the section titled, Are Corporate Balance Sheets Really the Strongest in History?  A few excerpts are below, for those not tempted by links within blogs:

 “As the following chart shows (based on Federal Reserve Flow of Funds data), the debt burden of U.S. corporations is near all-time highs, having retreated only modestly since 2009. Debt burdens are elevated regardless of whether they are measured against total assets or net worth. Certainly, corporations are presently benefiting from very low interest rates on corporate debt, which substantially reduces the servicing burden of these obligations. But the combination of high debt levels and low servicing burdens does create a potential risk to corporate health in the event that yields rise in future years. Overall, the picture is fairly stable at present thanks to low yields and high levels of cash-equivalents, but it is important for investors to keep in mind that cash can burn fairly quickly during economic downturns, and debt is not spread evenly across corporations.

 “The bottom line is that at an aggregate level, corporate balance sheets look reasonable, but are certainly not “stronger than they have ever been in history.” Cash levels are elevated, but this is at best a second-order factor (with excess cash representing only a few percent of total assets), while debt remains near record levels relative to total assets and net worth. In any event, balance sheet risks should be evaluated on a business-by-business level, rather than accepting the blanket notion that cash levels are so high that nobody needs to worry about corporate credit risk.”

“In going through the Flow of Funds data this week, I thought a few other features of the data were interesting. First, was the profound decline in tangible assets as a percentage of total corporate assets since 1980. This decline goes hand-in-hand with an increase in financial assets held by non-financial companies. At present, more than half of the total assets held by non-financial companies in the U.S. represent financial assets such as debt securities and equities. This is striking, in that we presently have a menu of prospective returns on financial assets that is among the most dismal in history. While the move toward zero interest rates has certainly been excellent for bonds when we look in the rear-view mirror, the fact that prospective rates of return are now so low suggests that a large portion of corporate assets are unlikely to achieve very much in the way of future returns, barring a decline in those asset prices. Something to think about.”

http://www.telegraph.co.uk/news/worldnews/europe/eu/8897662/EU-bans-claim-that-water-can-prevent-dehydration.html

They may not have figured out the debt crisis just yet, but at least they have scrapped the bans on bent bananas and curved cucumbers.

• As soon as any depositor realizes that bank deposits are likely to be redenominated into drachma, he will pull his deposits out of the banks so as to protect the value of his savings (this has been ongoing in Greece already).? But obviously only a few depositors will be able to do this before forcing the bank into closing. In order to prevent the resulting collapse in the banking system, the only thing Athens can do is to freeze bank deposits long before most depositors have had a chance to cash out.

• But depositors know this. As the probability of Greece’s leaving the euro rises – and clearly it rose dramatically this past week – anxious depositors eager to prevent their deposits from being frozen and redenominated in a weaker currency know that they will have to speed up their withdrawal of deposits from banks.  And of course as anxious depositors withdraw their deposits, the likelihood of a banking crisis rises, and with it the likelihood of Greece’s being forced to freeze deposits and leave the euro.?

• We are caught, it seems, in one of those self-reinforcing loops that almost always presage a collapse. Rational behavior by individual agents leads towards a catastrophic event the threat of which reinforces the behavior.

• Without a credible intervention this process almost always ends the same way. There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro. Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations. Will Greece follow suit??

It is remarkable how closely Greece is following the Argentina experience.  The charts below are from JPM’s Sovereign Default Time Capsule.  Note that in each case, IMF and other bail-outs did not end the crisis.  Without a devaluation, short-term fixes and bridge loans do little do solve underlying structural issues.  Pettis asks the difficult question, “As households from Italy, Spain, Ireland, Portuguese, and other vulnerable countries read every day about hardships faced by Greek families, what will they do?”  And answers, “Once Greece goes, even the least sophisticated households in other countries will know what the consequences for depositors will be . . . This is simply part of the logic of sovereign financial distress – declining credibility causes stakeholders to act in ways that reduce credibility further.”

For those looking for a quick summary of the European Crisis, this short clip should do the job.  In short, bankrupt governments are doing everything in their power to keep bankrupt banks on life support, while bankrupt banks try to prop up bankrupt governments.

We provided investors with our interpretation of recent events in Europe last week.  While the news-flow out of the EU is coming at a rapid-fire pace, and rumor mill is spinning even faster, we thought it was worth sharing, so an excerpt from our letter is available below:

Last month, risk assets globally celebrated the “solution” to Europe’s debt crisis with one of the strongest one-month rallies in equity prices.  It is important to understand that rallies of this magnitude are hallmarks of “bear markets” and are prone to fantastic failure. Two particular developments sparked October’s short-covering rally. The first component was better US economic data that exceeded overly pessimistic expectations. “Hit your head with a hammer long enough and it just stopping feels great,” is the best analogy we’ve heard for the recent “improvement” in economic indicators. The second factor was the latest “Band-Aid” to patch Europe’s credit crisis. In this letter, we’ll provide additional color on both developments, in addition to our understanding of the implications.  In short, we think the coming hangover from last week’s risk party will be painful. 

The few investors that saw even a remote probability of recession a month ago have now vanished, along with any aversion for risk, after learning that GDP grew 2.5% last quarter. Put simply, the consensus is assuming that because the economy grew last quarter, it will not contract in future quarters.  We prefer to look ahead while managing the portfolio, rather than staring in the rear view mirror. The forward looking evidence still suggests that the US, as well as the EU, is in recession or at least staring over the edge. This is clearly a non-consensus view after October’s market rally, but it is important to recognize that the recovery of initial losses after early signs of economic weakness is not unusual, and is often followed by more abrupt and more severe losses. My friend Marcus Griffin, Chief Investment Officer of Glenmore Advisors in Atlanta, shared the chart below with us this week, which clearly illustrates this point.

Last week, European policymakers announced a new plan during the final hours of a self-imposed deadline.  While the plan may have reduced the short term risk of a disorderly default, upon closer inspection of the “new” plan, investors should recognize that there is really nothing “new” here at all – it is simply a leveraged version of the “old” plan. We discuss the three components of the announcement below:

• European Financial Stability Fund (EFSF) - Leaders of the Eurozone countries agreed to more than double the size of their rescue fund to 1 trillion euros, but still failed to elaborate on who will foot the bill. It’s worth noting that the EFSF is not actually a “rescue fund” in its current structure.  It is simply a plan with no actual capital, but roughly 250 billion euros promised (net of the funds already committed to bail out Greece) from the same EU countries in need of assistance, seeking additional funding from private investors, not yet identified. Got that? Essentially European leaders have promised to borrow money that they do not have, in order to leverage these funds four or five times, to be able to buy enough debt that they will issue to pay back existing debt. No wonder markets are so excited. Unfortunately, stocks aren’t the only thing making new highs on this announcement. European debt spreads, a measure of the cost of borrowing, are rising across Europe as shown below. The basic idea of leveraging the EFSF is flawed. The “protection” offered does nothing but potentially delay default IF it entices outside investors to cover the 1.5 trillion euros of Italian and Spanish sovereign funding needs for the next few years (which completely ignores several trillions more in bank rollovers). IF investors are unwilling to buy bonds from these governments today, we wonder who will buy EFSF bonds backed by these same governments when the markets have decided that these countries are no longer credit worthy. Apparently, very few, as the EU just postponed a 3 billion euro bond issue due to “market conditions.”

• Capitalisation of Banks: The European Council concluded that, “There is a broad agreement on requiring a significantly higher capital ratio of 9% of the highest quality capital . . . to be attained by 30 June 2012 . . . Banks should first use private sources of capital . . . If necessary, national governments should provide support, and if this support is not available, recapitalization should be funded via a loan from the EFSF in the case of Eurozone countries.” While well intended, European estimates of just 106 billion euros to recapitalize the banks, are simply inadequate. The IMF recently increased their estimate of bank capital needs to 300 billion euros a few weeks ago. At the same time, these capital estimates do not take into consideration the impact of the current economic contraction underway, resulting in an increased pace deleveraging, additional asset sales, and ultimately, capital requirements which could be multiples of current guestimates.

Furthermore, Tier 1 capital, or “the highest quality capital” required by Europe’s Heads of State, is an utterly useless measure of solvency during times of stress.  Dexia was supposedly at 12% right up to its ultimate bankruptcy. It is ridiculous to treat the same government bonds at risk of default as “riskless” assets when determining capital adequacy. Rather, investors should only consider the simplest form of capital that can absorb losses – tangible common equity. On this basis, we can easily identify the banks and banking sectors most at risk. In addition to Dexia, which had a tangible common equity to total assets ratio of 1%, French and German banks stand out as the ones most in need of capital injections. Seen in this light, the reluctance to accept additional “haircuts” from their southern neighbors is quite obvious.  Both the German and French governments have significantly less fiscal flexibility to bail out their reckless peers once you consider the cost of recapitalizing their banks at home. And per former Bundesbank President Axel Weber, as the sole guarantor to the EFSF, “Germany could end up with a debt of 314 percent of GDP in an extreme case.”

Source: BCA Research

•  Beware Greeks Bearing Debt: Under the deal, private sector banks “voluntarily” agreed to a 50% haircut on Greece’s debt burden, which would potentially cut its debt to 120% of GDP by 2020 (in line with Italy’s massive debt burden today) from 160% currently. Once again, this is not enough as the ECB, one of the largest holders of Greek debt, does not appear to be subject to the haircut. This is not a sustainable debt level considering the lack of growth in the country and in the Eurozone. 

The flurry of news out of Athens over the past week has been nothing short of spectacular.  Rather than recap the Papandreou Circus Show, which might require an additional letter in itself, we thought this illustration below provided a good sense of the antics we have been watching and the market’s reaction to every word emanating from Europe. The bottom line is that the Greek Prime Minister’s ridiculous maneuverings forced policymakers to openly admit that a country could actually leave the Eurozone.  Europe is crumbling and the likelihood of a messy default is increasing by the day.

The current condition has all the elements of the classic “prisoner’s dilemma” where there is temptation for each party to deviate from agreement at every step of the way, even if it ends up being extremely counterproductive to everyone. The evidence speaks for itself – approaching two dozen “Summits” over the past two years and we are no closer to resolving the problem of too much debt, with more debt. Instead, we are a lot closer to the end of the European Union as we know it. European policymakers may still prevent a disorderly sovereign default with a “grand and comprehensive” solution, but they cannot prevent the recession which is already in progress. Consequently, we are sticking with our credit default swaps, which cost us during the recent rally, but should see much higher prices ahead.

We recently read a piece from a manager we respect who is now “fully invested” largely based on the following premise – “IF we are not in a recession, and IF we are not going to have one, and IF the European “can kick” means no repeat of the Lehman systemic meltdown – IF all these “IF’s” are likely to be realized – then the bear is going into hibernation for the winter and the surprise will be to the upside.” While we would love nothing to be so optimistic, we can’t help but notice that those are A LOT of IF’s!!  As prudent managers of your capital, we believe that having some insurance in case all those “IF’s” don’t line up perfectly, is a necessity in the world we live in today. 

Our goal is to try to generate attractive returns in any market environment, so we use a variety of strategies to protect capital during difficult periods.  Risk protection must be in place at all times since the timing and magnitude of market dislocations are unpredictable. As such, insurance creates a drag on our profits because timing inherently unpredictable events is impossible, but well worth the cost during periods like last quarter. The Wall of Worry is high enough that positive surprises could lead to higher stock prices near term.  In fact, the cycle work we follow points to another “high” in December. Our best guess for how far a rally could run is shown in the chart above, which does not leave a lot of upside potential from here. Given deteriorating fundamentals, slowing growth and increasing financial market stresses, we view the risk-reward profile today as less than compelling – a fact that becomes abundantly clear when viewing the risk levels shown above.  Of the 11 “waterfall declines” since 1929 identified by Ned Davis Research, we have not seen a single case historically where the market has exceeded pre-crash highs within eight months.  In the eight cases where the crash lows had been broken, the market went on to break to lower lows 75% of the time.

Bulls claim that current weakness in the property market has been largely driven by government tightening.  We would agree, but they also contend that as policy reverses and addresses weakening fundamentals, markets will respond accordingly.  Fed tightening ultimately busted the US housing bubble, but subsequent easing hasn’t had much of an impact.  The oversight in this argument is sentiment.  Once Chinese buyers awaken to the reality that house prices can move in two directions, we believe the genie is out of the bottle.  This article from Caijing suggests the genie might be a little upset about falling prices, as investors storm the offices of property developers after 25% price cuts.  Optimists also point to varying regional dynamics to support the notion that national market is holding up well.  Entirely possible, but California, Florida and the rest of the sunshine states were more than enough to wreak havoc on our banking system.  We doubt the Chinese capital cities (or Australian “regionals” for that matter) will avoid similar repercussions.

While many agree that a property-led hard landing is likely “in the next few years,” few are willing to acknowledge that it could happen sooner rather than later.  We wonder how long a country can go on building ghost towns and empty housing projects, before the bill comes due.  I suppose they need to create demand for all their Expressways of Excess.  Signs of misallocation are everywhere, but the most unsettling is the affect unregulated mining is having on one of the world’s great wonders.  Apparently, part of the Great Wall is now collapsing according to China Daily. Investors are also aware of the issues that the Chinese banks are facing, but point to declining NPLs as “proof” that the banks are well capitalized or that the deterioration will remain manageable.  History is not on their side. Didn’t American banks boast miniscule NPLs prior to the collapse of US housing?  It would seem the street is confusing cause and effect.

Finally, even those willing to admit that the banking system may be insolvent (trust us . . . it is), argue that an insolvent banking system is not an issue for China’s command economy as the problem is ultimately a fiscal issue and will inspire a fiscal solution.  This is perhaps the most misunderstood and ridiculous claim by consensus today. China’s reserves do not make its economy bullet proof by any means.  They simply represent assets on the PBOCs balance sheet for which there are offsetting liabilities.  The dangerous assumption underlying a bullish China thesis today is that these capital inflows will continue.  In an economic slowdown, particularly one driven by a credit freeze, capital flight is a significant risk.  Importantly, we have begun to see this already in the third quarter as outflows were more intense than even those experienced in 2008.  Increasing this risk, is shifting sentiment within China as 60% of the rich are already looking to take their money elsewhere, according to the FT.  Victor Shih has highlighted The Fragile State of China’s FX Reserves repeatedly.  But perhaps the most disturbing development we’ve recently heard, is this quote from a Chinese banker with close ties to powerful political parties: “There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers . . Almost all the elements are in place for an uprising like we saw in 1989. Corruption is worse today than it was then, people feel they can’t get ahead without political connections, the wealth gap is much bigger and growing , and  there has been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

We have written extensively about the link between China and Australia over the past year.  We think now is a good time to revisit these Predictable Surprises we outlined in June 2011, and the potential for an abrupt reversal in Australia’s terms of trade.  On November 2^nd, Governor Stevens explained the following after cutting Australian interest rates: “The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.”  What he means by “very high” is illustrated below.  The rise in Australia’s terms of trade over the past decade is the biggest in a very long time.  In the five major mining booms in Australia’s history since 1850, the exchange rate has played an important role in each of them.  In the current episode, the only period with a floating rate, it has risen by a large amount.  If the terms of trade has now peaked, as the RBA (and Chinese growth) suggests, the implications for AUD are massive

But don’t take it from us.  This recent interview with Jim Chanos touches on all the main points of our thesis.  Here’s a quick summary of his points along with a link to the video well worth a few moments of your weekend:

• The Chinese were supposed to get involved a year ago, that didn’t happen.  They were supposed to save Greece months ago, but that didn’t happen.  China will do what’s in China’s interest.
• Big misconception regarding Chinese reserves.  FX reserves have liabilities against them. They arise when exporters earn income in other currencies and turn them in for RMB. Like any central bank liability, there are RMB liabilities against their dollar reserves.
• China is on a bigger and faster treadmill to hell than ever.
• Chinese are beginning to realize that property prices can go down.  Numerous reports of investors thrashing property development offices.
• Take Chinese bank profits with a grain of salt.  American banks recorded record profits prior to 2007. It’s all about credit.
• In the last two banking crisis in 1999 and 2004, Chinese banks had 40% non performing loans without recession.
• Real estate transactions are down 60% year over year.  The property slow down has started.
• Chanos is short Ag Bank of China.  They are holding onto restructuring receivables from previous bailouts at 100 cents on the dollar.  Those receivables account for more than 100% of their tangible book value.  They are probably worth 10 or 20 cents on the dollar.
• Most China observers weren’t talking about any “landing” three months ago.  The fact that they are not admitting that the plane is not staying aloft says something in itself.
• Chinese consumers are shrinking as a percent of the economy. Fixed asset investment is driving everything – up 24% versus 9% economic growth in the year.
• The inherent problem China has it two governments. Central government is hitting the breaks, but local governments who are in bed with developers have every incentive to keep building.
• There were 30-40% rallies in credit-sensitive sectors for three years in the west.  Chanos didn’t cover his shorts until things stopped deteriorating in 2008. We are not anywhere close to that in China as things have just begun to unravel.  The property slow down started in the third quarter of this year. The fundamentals have just started to deteriorate.
• No numbers of visas in your passport will substitute for lack of judgement.  Plenty of people who lived in Miami all of their lives lost everything.

Easy Money (Nov-11)

• Mortgage House will offer a home loan equivalent to 105 per cent of the property’s value.
• The company also offers a 99 per cent loan-to-value ratio loan
• Westpac raised its LVR for new customers from 87 per cent to 92 per cent.
• ANZ also last week raised the maximum LVRs from 95 per cent to 97 per cent for existing customers, and from 90 per cent to 92 per cent for new borrowers.
• Commonwealth Bank has left its LVRs unchanged, at 97 per cent.

It’s worth noting that these LVR’s are substantially different than the “average” LVRs the bank’s claim on their current books.  As we learned in the states, “average” doesn’t mean a whole lot, if say, half of your loans are “money good” . . . while the other half are something less than “good.”  Time will tell.

Disclosure: At the time of publication, the author was short various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.

Despite the harassment, I decided to take the risk and share another except from Hussman Funds Weekly Market Comment.  We’ll explore this one in detail as there is a lot of meat here.  Be forewarned – this turned out to be quite a lengthy post.  So here is a quick summary of the material to follow:

1. Denial
2. Deja Vu All Over Again
3. Europe’s Banks
4. The Fallacy of Forward Earnings
5. Bad Estimates
6. Setting the Record Straight
7. Bottom Line – Too Much Leverage

Denial

 “Last week, the financial markets mounted a striking shift back to the “risk-on” trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected eager short-covering, and investor interest shifted strongly away from defensive sectors to speculative ones. For defensive investors, it was admittedly a difficult week, as the markets suddenly became convinced that no defense was needed, and treated defensive investments accordingly.

“From my perspective, Wall Street’s “relief” about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, “We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted.” Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.”

Here is a picture of the most recent picture from ECRI.  The interview with Lakshman Achuthan Hussman refers to is available here. We think an important point lost on the consensus is the frequency of recessions.  John Mauldin has discussed this at length as well.  The bottom line is that during an extended deleveraging process, economic volatility is higher than “normal” which means recessions are more frequent than “normal” when you are dragging along at “stall speed.” More frequent recessions, more volatile economic growth . . . higher risk premiums, lower equity prices.  We’d also recommend taking a moment to read this interview, available at GuruFocus, with Fairfax CEO, Prem Watsa to get a feel for the possibilities here.  “That second leg can be vicious, and we might well be entering that second stage.”

Deja Vu All Over Again

“The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a “denial” phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high”

In addition to the economic similarities, here’s a look at the current set-up is from a technical standpoint, compliments of The Chart Store:

Source: thechartstore.com

 Europe’s Banks

“At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.”

Here’s a great illustration of the extent of Europe’s problems in one concise chart.  Per the folks at Credit Writedowns, “The size of the largest four banking institutions in France, for example, represents over 300 percent of the country’s GDP.”

The Fallacy of Forward Earnings

 “While many Wall Street analysts continue to view stocks as cheap on the basis of forward operating earnings (which reflect expectations of a continued economic expansion and the maintenance of record profit margins indefinitely), the use of forward P/E multiples is a valid shorthand for discounted cash flow valuation only when profit margins reflect a level that is actually likely to be sustained over several decades. Even then, the benchmarks typically applied to forward operating earnings are actually based on historical norms for price-to-trailing net earnings.”

Here’s one of the problems with “forward earnings” in a nutshell.  We will discuss the second momentarily.  For now, suffice it to say that profits are extremely high and have always reverted to trend historically.  Perhaps this time is different, but it never has been, so we’d caution those betting it is.  In fact, if indeed this time is different, we’d suggest that the major trend change ahead is best signaled by the Occupy Wall Street movement.  The largest driver of profit margins today is clearly employment – meaning there is very little of it.  The share of profits making its way to corporate balance sheets rather than their employees has been increasing for a generation.  The result is record income inequality at home and abroad.  This is precisely why we have America’s next generation unemployed and sitting outside the Financial District as if it were Tahrir Square.  Again, my bet is that if indeed “this time is different,” the difference will not be in favor of profit margins, as the pendulum is likely to swing back towards labor over time. I suspect that income inequality across the globe does not end well for any of us. This is definitely something worth monitoring.

Bad Estimates

 “Investors should recognize that P/E multiples are simply a crude shorthand for legitimate valuation calculations (specifically, the careful discounting of a whole stream of future cash expected to be delivered into investor’s hands over time). P/E multiples subsume a whole set of assumptions regarding the entire future path of growth rates, profit margins, return on invested capital, and other factors. The common practice of valuing the stock market based on “forward operating earnings times arbitrary P/E multiple” is not only misguided – it’s an utterly disappointing display of Wall Street’s willingness to dumb-down the investment process. As investors have discovered through more than a decade of zero returns, the constant abandonment of intellectual effort comes at a cost over the long-term.”

The second issue with forward earnings multiples is simply that they are WRONG.  The chart below, initially posted at The Big Picture shows S&P operating earnings (red line) and their 12-month forward forecasts shifted ahead one year. Bottom line according to James Bianco, “If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong.”

Source: Bianco Research

The second chart shows the difference between the forecasts and actual releases. The shaded areas highlight official recessions. Bianco notes, “Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession. During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%. Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. During the 2000/2001 recession, top-down forecasters were too optimistic by 25%. Bottom-up forecasters were too optimistic by 23%. During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%. Bottom-up forecasters were too optimistic by 40%. Also notice the difference between the top-down and bottom-up forecasts. Current strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.”

Source: Bianco Research

Consensus expectations, particularly bottom-up, are still wildly optimistic.  Bulls continue to point to “excellent” company fundamentals to support their thesis, completely missing the fact that they are staring in the rear view mirror.  Top down forecasts are less rosy but are yet to bake in recession which I think is a given at this point.  Equity analysts rarely lower estimates, recommendations, etc. based on in-house forecasts. They wait until they are told by management, which by definition, is too late.  Company fundamentals still appeared “excellent” in H1-08 as well.  Until they didn’t. By the time management admits the economy has turned, we are typically closer to the recovery.  According to research performed by Ned Davis, the S&P has actually declined historically when earnings expectations have been this lofty.  The time to get bullish is only once consensus has baked in the drop in forward earnings.  Not before.

Setting the Record Straight

One last point on valuation that drives me mad.  This one is almost as popular as forward earnings. Take a look at the illustration below. If you can determine any relationship between the “earnings yield” on stocks and interest rates, please give me a call.  Because outside of the brief period in history that an illusion of a relationship appeared – which happens to coincide with the time period that most investment managers in the business today have operated – there is no relationship between expected returns on stocks and expected returns on bonds. The consensus would also have you believe that as interest rates and inflation come down, PE’s should go up.  Ask the folks in Japan how this has worked out for them.  The fact is, today’s models worked great in an environment of increasing leverage.  No one has thought to look at how they would perform as that leverage is unwound.  The impact on economic growth, financial asset prices, inflation, etc. is profound and few have yet to grasp this change.

Source: GMO

Consider a few simple examples to help illustrate why this is utter nonsense. First, suppose I am willing to sell you a quart of milk for $10 but offer you a gallon for $30.  Does that mean the gallon is cheap or that it is a good buy at today’s price?  If you answered yes, and you are a long-only investor, good luck. Alternatively, suppose you can buy a dollar today for 50 cents. Tomorrow, you pay two dollars for that same dollar. Is the level of the ten year treasury, or any interest rate for that matter, a significant determinant of how those investments work out for you? If you answered no, you are on your way to separating fact from fiction. Now please press mute on your remote control the next time you hear anyone comparing the yields on stocks to interest rates on bonds. Chances are anything else they have to say is not worth listening to.

Bottom Line – Too Much Leverage

 “This is a good opportunity for investors to review their tolerance for significant losses. My impression is that this may be the best opportunity to reduce risk that investors are likely to see for a while.

“As of last week, the Market Climate in stocks remains negative, but has deteriorated significantly from the more benign negative levels that we’ve seen in recent weeks. Generally speaking, the worst market plunges tend to feature three things – overvaluation, negative market action, and a short-term overbought condition.”

A quick look at just how overbought this market is in the short term.  As a general rule, overbought conditions should be sold in bear markets. In case you were wondering, this is a bear market.

Source: thechartstore.com

“You rarely see the three together, because establishing that sort of condition requires a strong rally against both overvaluation and negative internals. That’s about where we are, though we can’t rule out a modest extension for a bit – mostly because advisory bearishness is reasonably elevated as of last week. That said, the drop in the CBOE volatility index late last week suggests an abandonment of bearish views, and more generally, just as early shifts toward advisory bullishness at the beginning of bull markets are often accurate and followed by further gains, early shifts toward advisory bearishness at the beginning of bear markets are also often accurate and followed by further losses. Overall, market conditions remain negative . . . “

Contrary to popular belief, the market is NOT cheap here. There are pockets of value if you look hard enough.  But broadly speaking most major stock averages are not cheap. The chart below shows the S&P 500 trading at over 20x normalized earnings, relative to a long-term average closer to 16x. The current multiple is not that far off from where the market traded in the mid-60s prior to a bear market that lasted for almost two decades. You can feel comfortable hitting the mute button on your remote control whenever you hear someone claim that the next ten years look good for stocks, based solely on the fact that the last ten years were poor.  Will they ever learn?

While many of our indicators are pointing to excessive pessimism, which may well be supportive of further rally, it is worth noting that AAII’s measure of Bullish Sentiment has rebounded sharply back to levels last seen in July, when all was still well in the world.

Putting it all together, the immediate future is not so bright for the buy-and-hold type today.  While there are certainly values to be found in the large, multinational franchises that historically traded at premiums to the market, I am also growing concerned that this is more of a consensus belief today. Groupthink is dangerous. When everyone crowds into the same trade, the crowd is rarely right. One of the factors which made the 2008 crash so devastating was the forced liquidation driven by excessive leverage in the system. Once the crowd started selling, they all sold. We run from one side of the boat to the other, and back again. As they say, financial memory is notoriously short.  But even we are surprised by speculators’ willingness to jump back on the leverage train after being so badly burned three short years ago.  The amount of leverage in the system today is back at dangerous levels – it is declining, but prior market bottoms did not occur until these debts were entirely wiped out. I just hope this doesn’t mean that owners of risk assets and retirement plans get wiped out for the third time in ten years.  Be careful out there.