The general themes right now:
-Collapse of the eurozone
-US banking bill that could dramatically reduce financial sector profits
-Insolvent US states and municipalities (e.g. California about to heavily cut spending again causing serious strikes)
-Massive money printing from EU and US and credit growth in China may be inflationary (possibly causing a big rally in gold)
-China entered a bear market and is about to enter credit tightening cycle; they won’t lead the world to strong growth
Over the weekend, the European Union and International Monetary Fund (IMF) shocked the world by a announcing a roughly $1 trillion bailout of Europe. The European Central Bank (ECB) began buying government bonds on Monday morning with no limit. Despite this nearly infinite backstop, Greek bonds are still trading far below March levels. In other words, the market is saying that even with every bullet fired, the EU may be unable to prevent default. The bailout caused a roughly 4% rally in equity markets, and a 1% rally in the Euro. There is a general perception that the eurozone is now “all-in.”
Fundamentally, this is tremendously bearish for the Euro, and all but guarantees its eventual demise. The EU could have chosen to let the weakest countries leave the EU to retain the Euro. Instead, they’ve thrust the entire region into a debt crisis. The Maastricht treaty requires that all EU countries run fiscal deficits of less than 3%. Every single European country is currently running a deficit over 3%. Even Germany is running a deficit of 5%. The ECB recognizes that if they want to avoid kicking countries out of the EU, their only choice is to monetize the debt. When the central bank issues new currency to buy debt because other investors won’t, it is inherently inflationary and frequently hyperinflationary. I took the last of my short Euro position off at an exchange rate of 1.26, because while the fundamentals are very bearish for the Euro, the market may already be pricing this in, I don’t know.
I believe the “middle path” in the inflation/deflation debate has been eliminated. Within 3 years we will either have very severe inflation (12%+), or a depression with deflation. I wish I could pick between those two paths, but both still seem possible to me.
A complex financial reform bill is making its way through the Senate. We can't be sure what final form it will take, but it looks likely to eliminate a good chunk of big bank proprietary trading. Many of the big banks claim that only a small percentage of their profits come from trading. A closer look at their financial statements reveals this is false. Distinguishing trading from brokering can be difficult and subjective, but this bill could reduce the profits at some banks by as much as 50%. Any estimate of the fundamental value of a bank based on current earnings is flawed, because the basic business model is about to change. The US government leaked to the WSJ Tuesday that they are investigating Morgan Stanley (NYSE:MS) for criminal fraud. There's going to be a lot more litigation and a lot more regulation. Summary: beware the financial sector; investors are far too sanguine.
I wrote 9 months ago that the ratings agencies (i.e. Moody’s (NYSE:MCO), S&P, and Fitch) were a primary cause of the crisis and it was crazy that they were continuing business as usual; I predicted their business model was doomed. These 3 ratings agencies have a government granted oligopoly to judge the credit worthiness of financial instruments. Many investors, like pension funds, are required to purchase assets rated highly by one of the three agencies. The agencies are paid by banks to rate their products. There is therefore an obvious conflict of interest since the ratings agencies compete by offering absurdly high ratings. Finally, it looks like my prediction is starting to play out. Senator Al Franken proposed an amendment to the financial reform bill in the Senate that will eliminate the oligopoly. The bill will also randomly assign a ratings agency to banks so that they will not compete by offering higher ratings. The amendment has broad bipartisan support and looks very likely to succeed. Additionally, the SEC is investigating Moody’s for ratings fraud. I believe these businesses will lose at least 60% of their value within the next few years.
We have a little more information about last Thursday’s plunge. There was no fat finger or unusual trading error (according to the exchanges and major trading firms). The quick plunge was primarily a result of stop market orders being triggered and causing a wave of self-fulfilling selling. The exchanges are scrambling to put systems in place to prevent a similar plunge; for example, they will coordinate their circuit-breakers (brief pauses in trading after large moves). I think the simplest (partial) solution would be to eliminate stop market orders and replace them with stop limit orders.
Finally, China is in a full bear market. This is remarkable, because credit in China grew at a record rate again over the last few months. This has put great pressure on the Chinese central bank to hike interest rates and allow the Yuan to appreciate to avoid inflation. It’s not clear what impact a hike in the Yuan will have, but my best guess is that it will cause commodities to rally over the medium term and increase US inflation.