The Grand Illusion


“And thus the native hue of resolution is sicklied o’er with the pale cast of thought.” – William Shakespeare, Hamlet

What a day that Thursday was, wasn’t it? It’s about time the Europeans finally got their act together so the globe can get back on track. Except that the Europeans haven’t really fixed anything. They intend to recapitalize the banks, details to follow. They intend to leverage the rescue fund, details to follow. What you need to know most of all is that the EU didn’t commit one more nickel to anything. The “grand agreement” is a patently obvious attempt to mollify the Germans and protect the French credit rating by doing it on the cheap: the only thing the EU agreed to do more of was meetings.

The first fantasy is that the EU committed $1.4 trillion to fight the debt crisis. The number that was everywhere in the headlines is completely off. What the EU agreed to (kind of) is a scheme to use existing money already appropriated (about 240 billion euros remain) to insure the first 20% of new bonds. Thus the money is “leveraged” by five times, because by guaranteeing only the first 20 cents on the euro, it could insure about $1.4 trillion of new sovereign bond issuance. It’s a maybe – the details aren’t final.

This leaves out the lesson we learned over here in 2008: leverage doesn’t save you when times are hard. In fact, it makes things worse. A 20% loss on the bonds would wipe out the insurance fund. Put another way, $240 billion of writedowns would wipe out the insurance fund, and the Greeks alone have $350 billion of bonds outstanding. Throw in Portugal, Italy, Spain, Ireland, and you begin to appreciate why it didn’t work before – and why the tipping point can be so destructive.

The second fantasy was that holders of Greek sovereign bonds agreed to a “voluntary” haircut. The IMF hasn’t agreed. The ECB hasn’t agreed. But the private banks agreed under threat of total default instead. This bit of fraud was perpetrated to avoid triggering the credit default swaps – the first insurance program written on the bonds – written against the Greek bonds. The banks agreed to this “voluntary” program because the greedy blockheads wrote the CDS contracts themselves. They’re on the hook for either all of it, or half of it. Not all of them, but enough of them (especially in France) to wreck the system.

The third fantasy is that the credit markets won’t notice that the first insurance program was rigged at the last minute to not pay off, yet will blindly believe that the second insurance program will be paid off – by the very same people that torched the first program. How’s that? The bond markets didn’t buy it one for one second: the very next day, an auction of Italian bonds showed a surge in yields of twenty basis points, a very big move in the world of government bonds.

The fourth and perhaps grandest fantasy is that having declined to spend any more of their own money on saving themselves, the EU will get other countries to put up the money instead. As John MacEnroe would say, “You can’t be serious!” Yet the EU leaders whipped themselves into such a state of finding this magic way out that French President Sarkozy was practically running from the podium to give the good news to the Chinese (for those of you familiar with The Death of a Salesman, a true Biff Loman moment). Any contribution the Chinese make would be the most Faustian of bargains, while Brazil flatly said no. Vladimir Putin should be an easier touch, though. He won’t want much in exchange, maybe just Poland and a fifty-percent cut of the Mediterranean coastline.

The fifth fantasy is that the EU can just tell the European banks to raise capital, then sit back and wait for the money to arrive. Hank Paulson was after the US banks to recapitalize themselves throughout the first nine months of 2008, but as events showed, it isn’t so easy to raise equity for banks in a falling economy. The EU still hasn’t faced up to the fact that preserving its system is going to cost more money.

The Wall Street Journal’s weekend headline was “Doubts rise on EU Deal,” and they are indeed growing. Yet Monday is the last day of the month, and the market has staged a month-end rally every month this year but July. We would guess that last week’s rise was at least partly fueled by traders looking to ride the same wave again. After Thursday’s big relief rally, the big brokerage houses leapt into action with buy recommendations on some of the beaten-up momentum stocks that had disappointed on earnings and guidance, like Amazon (AMZN) or Acme Packet (APKT).

October 31st is also the last day of the fiscal year for most domestic mutual funds. Those holdings go into the annual reports, so the managers aren’t exactly motivated to stand by idly and watch their holdings go down if any selling starts. The 30th of September, though, which was the last day of the third quarter, did see a sell-off so it isn’t clear if the fund boys and girls will have enough ammunition to have their way.

The market is seriously overbought and due for a pullback, but longer term there is little doubt that much of the Street is still trying to whip up a panic performance run for the last two months of the year. The IPO window has been mostly shut and trading volume way down. There is a certain financial desperation to start writing buy tickets. Whether Europe is really fixed or not isn’t the issue for this group, just whether the EU can manage to stay off the front page until the end of the year. Sure it may all blow up next year, but let’s worry about this year’s bonus first, and let next year take care of next year.

As Thursday’s GDP figure showed, the US economy isn’t doing all that badly. It isn’t doing all that great either, but speculators will try to get as much mileage as possible over the 2.5% print. Third quarter earnings have been mixed, with some companies doing well but many prominent names putting up big disappointments. There is also a clear slowdown going on in Europe that isn’t yet priced into the market.

But Wall Street has a clear incentive to delay that recognition, so expect a lot of effort to push the tape higher. Ironically, the potentially biggest fourth-quarter event of all, the debt-ceiling deadline with its inevitable trench warfare, has scarcely been talked about. Yet it is rapidly looming, with the super-committee report just over three weeks away and no sign of compromise.

Get ready for the air pocket, and try to decide whether efforts to buy the imminent dip can succeed. That end-of-year trade mentality looks a bit overcrowded already, but the Street has demonstrated many times that it can manage a six-week (i.e., post-pullback) vacation to la-la land. Ignoring both Europe and the debt-ceiling battle is going to be a bigger challenge.

The Economic Beat

You will probably read Monday morning about the freak October snowstorm in the Northeast that knocked out power to millions, though perhaps not that Avalon’s own global headquarters was affected. Such was the case, and so this week’s Economic Beat will be in condensed form.

The most interesting report was the first estimate of third quarter GDP. It was higher than we expected, but about even with consensus. What stood out to us was that GDP was led by an outsized jump in health care – in fact, one-fourth of the increase came from that sector. That’s a bit of a puzzler, and may not be the most robust basis for sustainable growth. Another part of the increase was led by an increase in utility spending – again, not the soundest basis.

Others pointed out that the increase in consumption expenditures is at risk from falling incomes, and indeed real disposable income fell again in September. But business investment continues at a solid basis, and business capital goods spending rose 2.4% in September. It seems that businesses remain willing to invest in technology, but reluctant to hire.

The weak consumer confidence surveys last week don’t bode particularly well for employment, and the manufacturing surveys haven’t show much labor strength either. Claims have risen somewhat, but the increase has leveled off. The all-important jobs report comes out next Friday.

That will be preceded by one of the market’s other favorite reports, the national ISM manufacturing survey on Tuesday. The non-manufacturing part follows Thursday. Both are expected to be mildly positive. The FOMC meeting will be in between, and market participants will be looking for teaser hints of a potential QE3. Given the GDP number, though, and the recent rise in the market, it’s become more difficult for the Fed to make any nod in that direction.

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