Readers want actionable advice that can be traded immediately. Not necessarily a short-term day trade, but an opportunity immediately present and called for, not one which requires patience. Ah the virtues of trading. To see the opportunity, one must first understand the overall global macro dialogue. Only then from a top-down approach, can we find precisely where to place our bets. First some analysis of the global economy by focusing on overseas news broadcasts, financial banter and of course, the raw data. Events surrounding the Euro and smaller nation-states like Greece are highly fluid. 2008 taught us a butterfly can in fact trigger a tsunami on the other side of the world.
The Euro is shackled by irresponsible governments, poorly designed economic infrastructures and restrictive "bands" preventing flexibility with rates during times of systemic stress. The once all-mighty "dollar killer" destined to be the uber-reserve currency and savior to non-aligned countries finds itself under threat of demise. Was it all just an experiment? Should hedge fund managers be jumping for joy as the potential return of individual currencies brightens the prospects of all portfolio managers? There's no doubt Germany holds all the cards in this game and Merkel is poker faced as ever. The key question: is the end game a fait accompli or are there other possible outcomes which don’t involve the unwinding of the Euro? Conversely, will the Euro become a relic of the past, her demise returning competitive advantages to individual nations and a lot more trade opportunities for hedge fund managers? The Euro was supposed to get rid of localized economic advantages by achieving price parity across borders. The Euro was much despised by the Germans for the same reason as the crumbling of the wall devastated the economy of West Germany. The influx of unemployed, post-communist laborers unaccustomed to hard work hit the Germans with a recession lasting a full decade.
West Germany, although dreading the short term realities of the economy, wanted reunification at whatever cost. These hardships were suffered for the greater unity of the nation. The sacrifices made for the Euro by discarding the Deutschemark had no nationalistic overtones. The streets weren’t filled with celebrations of victory over the cold war. When the Euro came into existence, it did so at the tail end of the long road to recovery for post-Soviet Bloc economies. If South Korea and North Korea reunited now, it would be a victory for humanity, but the economic impact to South Korea would be devastating, requiring at least 8 to10 years to recover from. The tsunami of refugees fleeing south expecting to find work are low skilled laborers and won’t find work as easily as their dreams suggest.
Prior to the Euro, the Deutschemark was a sign of stability and German ingenuity as one of the largest exporters in the world. The conversion to the Euro forced Germany to absorb an economic blow as the Central Banks tried to coordinate an appropriate conversion that would, in theory, achieve price parity across Europe. Since that didn't work, it seemed the founding governments of the Euro chose to speed the process of rapid expansion all the way to the footsteps of Russia. Germany holds the key to turning back the clock and creating a smaller, more centralized Euro comprised of a half dozen key players in the Eurozone, while releasing the economies on the margin to return to their former national currencies. Such an event would trigger free falls in the currencies kicked out of the EMU, but is that not what they need to help them turn their economy around? Several countries will surely fall right behind Greece, but is that not what free market capitalism dictates must happen or is this all a supranational, idealistic plan towards global socialism?
Unemployment in Greece, coupled with risky asset lending and a severe recession in shipping dry and wet goods, main engines of the Greek economy, have created the perfect storm for a sovereign debt default. The ECB is not mandated to inject capital into Greece. Instead, any bailout must come from other Euro participants such as Germany. We can compare it to Texas bailing out California, which would never happen. Thus, individual actors must consider the "greater good" of the entire system rather than their individual economies. This makes taking action difficult because it requires a radical social change.
Consider a German citizen who loses his job due to austerity measures taken after Germany bails out Greece in order to offset the currency spent on the bailout. That unemployed German has no recourse. On the other hand, because of direct German support of Greece, previously unemployed Greek citizens may find work. This mobility of capital does nothing to help the mobility of labor and does a lot to contribute to the potential of moral hazard. In the US, we scream bloody murder when the Fed steps in to bail out banks or large hedge funds to prevent systemic financial calamity, but we have a much louder bark than we bite here in the States. In Europe, it's the opposite. Their citizens scream bloody murder when the ECB and its individual constituents don't come to the rescue. Whether the problem is contained in Greece or evolves into a true "crisis" by knocking out one of the larger economies like Italy, expect the Euro to fall faster as money rotates out of Euro denominated assets, triggering the laws of the “Theory of Reflexivity” as described by George Soros in “Alchemy of Finance”.
One way to trade this global macro theme is short EUR vs. Yen, leaving the USD out of the currency component but remaining overweight in US equities, especially on sharp pullbacks or when prices hit the lower range of the band from 10,500 to 13,000. The Japanese economy continues to show modest strength as most of Asia has avoided sharp declines in GDP, most because they are tied to the USD, others because they have a growing consumer giant in their backyard; China and its burgeoning middle class. Without a central government, and an institution like the IMF to enforce needed reforms, the Euro system lacks an “escape hatch” like the USD and JPY, which used unorthodox quantitative easing tactics to stabilize the foundation while they worked on the rebound. In the US, if policymakers anticipate a recession, they focus on national averages. If NY is booming but California is on the brink of bankruptcy, fiscal and monetary policy remains focused on the national welfare of all 50 states. It's unusual to see inflation in one state due to lowering of rates while the same item could be bought cheaper in a part of the country experiencing a recession. Price parity in the United States is a given; a way of life.
The Founding Fathers gave individual states power and autonomy to govern themselves according to the wishes of their constituent residents. California is a perfect example as the state presently faces a severe but slowly improving budget deficit. The state can't go knock on Oregon's door and ask for money, or other states which have their own laws. Some have enacted laws that dictate surplus revenues be saved for times of budget deficits which is the appropriate thing to do. However, quite the contrary, most states spend their surpluses at the peak of great economic expansions and act in contradiction to the laws of free markets. Surpluses during booms should be placed in trusts like the Social Security Fund, not necessarily “saved” as governments don’t want to become savers of tax payer money, otherwise, taxpayers would start asking for it back. In contrasts, California spends surpluses on unnecessary public works projects rather than entitlement expansion or saving and investing for the inevitable downswing. Instead, money is spent on public projects at a time when the state doesn’t need to create a demand for labor thus competing with the private sector. It’s backwards economics.
They can't contain much in Europe because they are trapped in a circle of meetings for the sake of meetings. It's hard to agree on what to order for lunch let alone figure out how to handle this mess. Spreads on German Bunds and Italian Bonds have widened to record levels, which sets up potential spread trades as the velocity of spread differential has accelerated to 4 Sigma (standard deviations). But LTCM is a lesson in committing financial suicide because spreads exploded to 7 Sigma and wiped them out. If something like this happens in the Euro Zone, as opposed to Russian spreads (which blew out LTCM), then we'll see the inevitable downward spiral pick up velocity. If this causes a blow up in demand for Chinese products and their GDP growth drops to low single digits, their economic model cannot sustain anything less than 7% GDP growth and they're falling fast. If China blows out, then so too will the rest of Asia, setting off Asian Contagion II, but instead of Russia lighting the fuse, it'll be the other "controlled capitalist economy". China's impact will have ramifications several times greater than Russia. If China allows the Yuan to depreciate more rapidly, then you'll see controlled devaluations in the developing economies of Vietnam, South Korea, Singapore, Malaysia, Hong Kong, Taiwan, etc...
The play is to focus on US markets since we're near the 2007 highs. Having failed to breach those highs recently, the Dow appears stuck in a rather wide and tradeable range somewhere between 10,500 and 13,000. Money Market and Cash Call rates are low and generating more spending and investing while reducing savings rates. This is why Obama’s trillion $ tax cut came in the form of reduced tax deductions that took less and less out of each pay check, making the individual feel times were getting better and they could spend a little more rather than the single checks Bush sent out, which induced people to save it as a cushion. This tactic was a nod to modern economic thinkers focused on the theories and concepts put forth by Behavioral Economists and Behavioral Finance. Even though the Nobel Prize in Economics was given in 2006 to an Economist who had been researching this area for over 2 decades, similar ideas had been put forth way earlier, even “contrarian investing” is a form of behavioral finance.
This seems to be a bonanza for US companies especially in the energy and technology sectors as fears of rising inflation have abated while labor costs have subsided to bring down production costs and increasing top line revenue. All of which will continue to benefit from a weaker dollar. However, if there is a breakaway of even 1 country out of the ERM, then global asset markets will take a beating. US stocks are over-priced. They've been shrugging off negative news and trading as if they are in a vacuum, untouched by global financial events.
Germany has been keen to let the Euro depreciate before executing a full bailout, if that is in fact their intent. The fog is thick with respect to European Debt but I'm still not ready to declare it a "crisis" like the talking heads on TV. The focus for asset traders should be US equities, vulture real estate and the type of grave dancing corporate debt that Sam Zell perfected. Like LTCM, step in early to trade these widening spreads with leverage and risk total blow up. If Greece is forced out, I think we'll witness a major bear raid on the Euro followed by a drastic recovery as the world realizes the end result will be a stronger, smaller but more centralized Euro with the flexibility and muscle to become a true reserve currency. This will help Euro Zone economies at the expense of Asia; at least that’s the hope.
What happens in Greece will decide the fate of Italy, Portugal and even Spain. If Germany doesn't contain it in Greece, Italy blows up and then we'll have a real "crisis". Right now, it's just a bad mosquito bite in the bosom of the Germans. It's a matter of whether they'll scratch it and make it worse, or if they'll contain it by pouring money into Greece and buying Greek debt as a matter of defending the Euro.
On the other hand, this may be what the majors in Europe want: An event to cause the Euro to tumble to around 1.15 to the Dollar. This will force China to speed up their devaluation and the rest of Asia will follow, ex Japan. The monarchies of the past several hundred years played the same game. They inflated money supply by benefiting from increased velocity of capital lending. Then they devalued in order to pay off the debt with cheaper currency. PayPal was invented by Peter Thiel to prevent countries from being able to do this to their citizens. A noble dream never achieved.
If you read the book "The Panic of 1907", it'll be like reading about the Panic of 2008. Trading is like war. Forward looking analysis is like the fog of war; difficult when we're seeing present events unfold as rapidly as they are while understanding the Euro mechanism is bureaucratic non-sense at its worst, which has paralyzed the ECB. The conundrum being thus: lower interest rates will trigger inflation in Germany and other "big" economies, causing problems down the line; or raise rates to slow down that possible inflation and end up suffocating smaller economies on the margin, pushing them out of the Euro and potentially destroying the Monetary Union. Cut off an arm to save a hand, or shoot yourself in the leg so you can stop running so fast? Which will it be? That's the stark reality of the situation.
From a trading perspective, I would focus on the energy sector, or more specifically, drilling companies like Nobel (NYSE:NE) as they benefit from new oil and gas discoveries around the world. I also think the US interest in East Africa is crucial to watch. African frontier economies have remained immune for the most part and if China takes a beating, they'll reduce their wide footprint in Africa and leave an opening for US companies to rush in. Also, aerospace companies like Raytheon (NYSE:RTN), General Electric (NYSE:GE), and Lockheed Martin (NYSE:LMT) are also interesting long-term because they are benefiting from a new generation of weapons thus permitting greater sales of prior generation weaponry to countries that wouldn't have had these options 10 years ago. The Singapore and Dubai Air Shows and Aerospace conventions are basically huge bazaars for arms dealing.
If you've been focused on US stocks since we backed up the trucks during the bottom in March of 2009, then you're keen to be short biased a bit right now, closer to 60/40 on the short side after we approached the 2007 highs but failed to surpass them, or even test them. From Thanksgiving to Christmas, we could see a continued drop in liquidity as US based funds pullback to lock in gains and their bonuses for the year. Don't push it when there aren't any bets to be made. If you show patience, the opportunities will present themselves by mid-January through the end of February. Stay tuned for Part II where individual trades, some plain vanilla, some a tad more complex, will be presented for SA readers to tear apart and scrutinize. Without Part I, I guarantee Part II will be more difficult to grasp because you’ll be missing the overriding investment theme required for an appropriate top down strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.