"On The House: Bill Gates And Walton Family Combine Net Worth To Bail Out Most Productive EU Countries"
"Top 5 U.S. Banks Pledge To Divert Bonuses And 100% Of Non-Operational Cash To Small-Business Lending"
"Warren Buffett, Google, And Apple Transform Businesses into Non-Profits; Goal Is To 'Pay Off All Underwater Mortgages Until This Thing Is Over,' Buffett Says"
In the event that any of these three headlines appear on the front page of The Wall Street Journal, a precipitous rise in the stock market would be expected to follow. An unexpected drop in the unemployment rate from the current 9.1% to somewhere around the neighborhood of 6% or 7% would also be a justifiable cause for celebration.
There are several reasons one should be careful not to lump "S&P 500 Extends Biggest Monthly Rally Since 1974 On Europe Deal" with the preceding (imaginary) headlines.
Following the announcement about the eurozone's labyrinthine attempt at debt resolution—which has little to do with genuine debt resolution—a narrative has already congealed regarding the immutable and limitless potential of the S&P 500. The speed with which uncertainty and anxiousness has transformed itself bewildered optimism takes the notion of herd mentality to new heights; it is no less than an act of transubstantiation for financial markets.
Today I even witnessed Bill O'Reilly and Lou Dobbs relentlessly encourage investors to hop back in the frying pan. Of course, this cheerleading was not accompanied by any analysis—only a mention of that little thing in Europe that is now out of the market's way.
So put on your seat belt! Right?
I recognize many who are currently long on equities may equate my viewpoint with Black Swan hyper-paranoia. However, this misses the point entirely. Truth be told, in this unprecedentedly volatile market, a genuine Black Swan event would be the sudden and abrupt emergence of enduring stability, certainty of growth prospects, and an instantaneous sovereign debt resolution without being accompanied by a fear of inflationary blowback or other types of feedback loops. Here is a list of topics to plug into before you decide that the surgical precision of "Merkozy" was successful in addressing all macro-structural issues the global economy faces.
In all seriousness, do yourself a favor and take a moment to look at the circumstances as they are, and not as you would like them to be. "Dow poised for biggest monthly gain since 1987!" is not a reason to get back in. Here are a small handful of reasons to stay out.
Sovereign Downgrades (Excluding the U.S.)
There is no need to parrot the well-understood fact that the ratings agencies were a major component behind the fiasco in the mortgage markets. However, so were the Federal Reserve, first-time homeowners who lied about their income, the Treasury Department, Wall Street executives, and Barney Frank—and guess what? The guilt of these groups in causing the problem does not mean they no longer influence current circumstances.
The fact of the matter is that the ratings agencies are the ratings agencies, and they are the ones that rate sovereign governments. If you want to pretend their pronouncements are null and void in their weight, think again. There is a reason the EU is toying with the notion of banning the ratings agencies from rating PIIGS countries that eat from the bailout trough.
U.S. Sovereign Downgrade
While this news item did not fly to far under the radar, it still is not getting the notice it deserves. Bank of America Merrill Lynch (NYSE:BAC) is predicting that another ratings agency will downgrade the United States before the new year (see above for issues with rating agency credibility), not to mention the possibility the forgotten S&P statement about downgrading the United States of Amnesia -- again.
Understandably, many will insist such a move is uninformed and politically motivated, questioning whether markets would really care about an additional downgrade (see: "what happened the first time"). In the event that another downgrade occurs, however, the U.S. will find itself in the company of other AAers, such as New Zealand and Qatar.
European Debt Crisis
I will go against the grain of my nature and say the following without trying to be clever: Nothing has been resolved in terms of the EU debt crisis. There are several reasons to be wary of any EU pronouncements which are supposed to quell all of our fears.
For starters, the EU's alleged overnight resolution to a problem which took about a decade to cultivate raises more questions than it answers. The failure of the EU summit, and its baby, the EFSF, is distilled to its essential points by ZeroHedge.com, namely:
- A lack of substance regarding the unnamed source of the higher-than-expected fund size (somewhere in the neighborhood of $1 trillion is the shock-and-awe number)
- The loose and malleable definition of "leverage" being used to describe the way the fund will give itself a steroid shot
- The cause célèbre for world markets was not the EU summit's accomplishments of any long-term objectives; rather, only that Lehman Brothers 2.0 did not occur around the anniversary of Black Friday.
- While these are just a few of the more salient aspects of the bad deal, check out the full extent of EU gimmickry here.
Investors also forget that the EU is more than Greece. The way the story has been spun, the EU debt crisis has really become the Greek debt crisis. There's a reason contagion is feared, you know. By contagion, of course, I am referring to the phenomenon by which the problems of a small, debt-ridden nation spread to larger debt-ridden nations. In particular, I am referring to Italy, whose GDP is approximately $2 trillion—over four times the size of Greece's (although Spain and Portugal could also end up playing the role of Archduke Franz Ferdinand in the inevitable meltdown). It is true that while Italy's debt to GDP is only 120% compared to Greece's (nearly 200%), the sheer size of Italy's economy ensures an entirely different level of magnitude in collateral damage.
Most reactive investors were far too bemused by the S&P 500 on Thursday to take notice of the subsequent rise in Italy's bond yields. Apparently, those who invest in EU debt did not enjoy the boost in sentiment as experienced across the pond.
Another thing concerning the sorry state of the EU: credit default swaps abound. While I do not want to belabor something that even mainstream news agencies have mentioned, fears about the CDS market is a huge aspect of the melodrama playing out before our eyes. Now is not the time to go into what credit default swaps are in any detail, but think of the debt crises—both in the U.S. and the EU—as being an atomic bomb. Credit default swaps—are the massive, global tangle of tripwires that will ensure maximum collateral damage in the event that Merkozy clips the wrong one.
What activates a credit default swap? Failure to pay out to a bondholder who is owed an interest payment. Does that seem like it could be a possibility during one of the biggest periods of global deleveraging?
Don't sweat it, though. As with the threat of ratings agencies who dare to describe a bankrupt government as it is—bankrupt—Merkozy, et al, offer this clumsy solution: ban the creation of more credit default swaps, and simply pretend existing ones do not exist! Never mind the fact that they are simply bilateral contracts between two parties. Reggie Middleton, who runs BoomBustBlog.com, does an excellent job at explaining the perilous absurdity in ignoring the role of the CDS market in this crisis.
The problem with EU officials making such overtly stringent attempts to keep everyone silent should be obvious: more attention ends up being drawn to said matter.
Finally, anyone who has followed the news with some consistency over the past few months have come to realize there is a certain amount of theatrics involved in the EU debt situation. Whether it's the beggar nation referring to Germany as being a nation of "Nazis", Nicolas Sarkozy telling David Cameron to "shut up", fist-fights within the halls of Italy's parliament, or abrupt "rainchecks" by EU officials, a lot of extra volatility is added fuel to the fire by those officials who are supposed to be leading the way towards debt-reduction utopia. Who knew the MSM had such a fierce competitor in fear-mongering?
Formal Pronouncement of a U.S. Recession
Prior to the EU debt crisis taking center-stage in the financial news circuit, there was serious talk of a global recession, induced by the United States. At some point in the timeline, the issue of a domestic recession became conflated with the EU debt crisis, and was eventually shoved out of the narrative altogether. Yet, with the faux resolution of the EU crisis, everything seems to have magically been solved.
Deliberate or not (most likely not), this sleight of hand in the MSM narrative conceals the likelihood of an enormous risk. In late September, Lakshman Achuthan, an economist for the Economic Cycles Research Institute (ECRI) was patently forthright in his prediction about what kind of economic headwinds the U.S. was facing, telling Bloomberg that "the U.S. economy is tipping into a new recession," and that "leading indicators across the board" were all pointing towards a dire economic circumstances.
It is worth pointing out that Achuthan predicted both the 2001-2002 recession and 2008 recessions, months ahead of the curve. Each time, the ECRI bucked against the majority view of economists and lagging indicators. Not only that, but each prediction was followed by a subsequent rise in the market, only to be met by huge declines in equity indices (about 42% in 2008). If you are thinking about immersing yourself in market noise and going long following the EU hoopla, it may be worthwhile to give a listen to the ECRI.
Occupy Wall Street
Depending on one's political inclinations, this one may seem out on a limb, but I honestly believe that to overlook the significance of the OWS movement in shaping the macro-financial climate (at least within the United States) is to miss a major red flag. Occupy Wall Street (or wherever, I suppose) is significant not because of some ridiculous Leninist-like revolution or anything like that, but because of the overt rhetorical acknowledgement and backing it is receiving, courtesy of the American Left. Like it or not, OWS is manufactured to one significant degree or another. As the 2012 cycle ramps up, there is a good possibility that banks are going to assume a role of a punching bag. In an environment which is already volatile due to economic and market factors, the MSM-assisted demonization of financial institutions is sure to compound things.
This is not intended to be a bullet-point of indisputable reasons why you should stay out of the market over the next several months. It is just a short list of things to think about before you commit yourself to what many are inclined to see as the beginning of Dow 40,000. I have taken license to omit other red flags (Bank of America's abrupt shuffling of its worst derivatives, the possibility of recession in China, current and potential QE policies in the UK and U.S., respectively). Taken together, these things paint a market in which the risk of market downside is overwhelmingly higher than the potential for upside in the medium-term. If you have recouped lost value from August/September or salvaged a chunk of your 401k, congratulations. Now get out. For the brave, greedy, and/or stupid: good luck timing what history is sure to record as a gigantic head-fake.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long puts on XLF and BAC.