Greece Is Defaulting; Recession Is Imminent. Play Defense

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Includes: EUO, FAZ, GLD, NBGGY, SDS, SLV, SPXU, SRTY, TVIX
by: Bio Insights

While many of us have been waiting for ages for Greece to default on its insurmountable debt, it looks like the wait might be over. It's now been realized that Greece isn't going to make its deficit targets that were agreed upon when the country took its loans from the IMF and European Central Bank. While the deficit was originally supposed to be only 7.8% of the nation's GDP, due to slowdowns and poor forecasts, the deficits will now be a whopping 8.5% of GDP. This is putting even more pressure on the already fragile nation, which is even closer to a default as the deficits continue to eat away at the nation's economy.

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Greece has been living luxuriously for a long time, to say the least. I read an interesting article that provides some details as to just how unsustainable Greece has become. It includes a description of an essentially free subway system in Athens, which is "bankrupt beyond comprehension," absurdly high compensation of government employees, very early retirement ages (50 for many government workers), and a huge pension of 95% of their salaries, guaranteed by the state. This, on top of countless stories of tax evasion and fraud that have been popping up all over the Internet, would make anyone furious over the situation. Although Greece's government is attempting to stem the bleeding through increased austerity measures, it simply won't be enough.

The euro really has no easy way out of the situation. If the ECB continues to bail out Greece, it will only make the eventual default more painful and put downward inflationary pressures on the currency. If Greece finally does default on its debt, not only will contagion potentially topple large sections of the banking system in Europe, but the fact that one of the eurozone nations actually defaulted would probably send huge shock waves in the forex market, which would induce a massive rout for the euro. There is no safe haven from an event like this, as a rally in the dollar would cause significant deflation in the short term. (As I've described in another article, deflation is toxic to the world economy and could contract the economy significantly.) In addition, the destruction of wealth in European countries that are highly exposed to Greece would add even more to the negative feedback loop. It's quite hard to predict just how much damage this could cause to the global economy, but it would certainly impact the United States to some degree.

Remember, just because Greece is in the eurozone doesn't mean that the United States is safe. Although our banks are stated to have minimal direct exposure to Greece, not only will the fall of the euro hit our market hard from deflationary pressure as described above, you can never underestimate the raw power of fear in directing the stock market. In addition, I acknowledge that it was wrong of me to evaluate banks using the conventional analysis in some of my older articles. As we've seen from Bank of America's hidden $10 billion lawsuit lost to AIG this summer, the big banks have a huge number of aspects that investors and the government still are completely blind to. The real exposure to Greece and the rest of the PIIGS is hard to truly define, as CDS data isn't easily available. It is awfully reminiscent of the mortgage bubble, isn't it? Bank equity analysts aren't helping either, by retaining their preposterously high estimates of the worth of these firms.

In addition to the proximity of the Greek default, the latest ECRI has called a recession in the US that is only the tip of the iceberg. While last week's jobs claims (which can be revised this week) and GDP estimate were solid, the long term picture does not look good. Unemployment has not recovered at all, despite efforts by the Federal Reserve, and GDP isn't a great measure to begin with. I think that employment is a much better measure of the organic growth of an economy due to the fact that GDP is simply a measure of spending.

Yes, the United States and its government has maintained its massive spending levels, but not only are there likely more unemployed people than before (due to people that may have left the labor force) but our debt is getting scary high. We are way over our heads, and when the stimulus measures stop coming from the government we could easily see economic contraction in addition to potential deflationary pressure due to fallout from the European situation. Without any political strength in Washington to lead our nation out of this mess, I wouldn't expect a recovery for quite some time.

I don't like being a doomsday prophet, but it's hard to feel optimistic when confronted with the situations that will unfold going into 2012. Even as I write, the euro continues to fall to yearly lows against the dollar (a proven bearish indicator for the stock market). Even the gold safe haven has deflation keeping a lid on its rebound. Greece is on the verge of toppling, which could cause an unprecedented amount of damage to the eurozone through contagion. The United States is very likely to be in a recession, and in practical terms already is due to the unemployment situation. This is not a market I would want to invest in. Although we've fallen far from our August highs, there's reason to believe we're going much further down before we hit those highs again.

The major argument against the market:

  • Greece looks to be extremely close to a default
  • Everyone (especially citizens of the eurozone) is sick of paying for the bailouts through inflation and tax money
  • The further the euro falls, the higher the dollar goes (causing deflation)
  • If we aren't already in a recession, deflation will induce one
  • The Fed is out of bullets, save QE3, which would probably do what QE2 did (nothing)
  • Don't expect any political support from Washington lawmakers - they've proven generally useless and it's hard to expect this factor to change.

Despite all this bad news, there is great potential in the fear that is being spread around Wall Street. If you're willing to risk it, you can short the euro through EUO. You can short the stock market with some leverage if you're feeling very bearish (SPXU, SDS, SRTY). If you think people will be as afraid of the financial sector as I am, you can short the financial sector too, via FAZ. Shorting Greece's main bank, National Bank Greece SA (NBG), could double your money if the bank defaults, although you can see major volatility due to the speculative nature of that bet. Betting on general volatility can also be an immensely profitable play. You can do this through TVIX -- a ridiculously volatile fund that skyrockets during moments of panic on Wall Street (it is not for the faint of heart).

While GLD has been a strong holding in the long term due to its historic reputation, I think that deflationary pressures might make the yellow metal available at a lower price in the near future. The long-term trend is still intact, but the bullishness of gold investors has been rather overwhelming. We might see another correction before the metal continues its crusade against the fiat currencies. The same goes for SLV, but since silver is a quasi-industrial metal, there is reason to believe it could suffer immensely if data indicates demand for silver is dropping. Its intense rise over the last year is based in large part on speculation.

If you're not willing to short this market, at least reconsider staying in this market. Yes, stocks are cheap by fundamental metrics like P/E. I've written articles which have used this basis in the analysis, but we may be on the verge of a major economic contraction, which overrides any of these simplistic measures of a company's worth. Only the most defensive sectors of the economy (utilities and healthcare) are safe, as investors will be flocking to these stocks due to their high dividends and completely inelastic demand relative to price fluctuations of any sort. There may be a time to pile back into risky stocks, but the stakes are just too high given the current situation.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in EUO, SPXU or TVIX over the next 72 hours.