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Michael Terry, CFA has nearly 20 years of experience in the investment management industry focused on the analysis, investment and management of fixed income and preferred stock portfolios. Over the years, Mr. Terry has analyzed and invested in both public and private companies around the world... More
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  • Peter Tchir On The Bear Case 7 comments
    Jul 26, 2012 12:42 AM

    Read this article on and thought it was worth sharing.

    How Dumb is Draghi?

    Peter Tchir.

    The bear case continues to make a lot of sense. We have a global economy that is slowing. Profits are slowing. I see that and generally agree with it. I think housing may be stabilizing more than people give it credit as many of the problems slowly work themselves out, but in general I have no problem with the bear argument, especially for U.S. stocks which have priced in so little bad news relative to stocks in the rest of the world.

    The problem I have with the bear scenario is that part of it hinges on Europe failing to respond to Spain. The argument is basically that the EU will fail to help Spain. Spain will continue its collapse and bondholders will lose money dragging down banks and insurance companies. The losses in Spain will scare investors out of Italy, causing the same wave of panic. I think I am more pessimistic than most on what happens if Spain reverts to the Peseta or the Greece exits in a fit of anger.

    I think that Europe breaking up at this stage, when everything is so interconnected and so little preparation has done will lead to a global economic slowdown. In fact, I cannot find anyone who really disagrees with that. The only disagreement is how deep the recession would be and how long it would last?

    But if we can all see that, surely the ECB can too? This isn't a "fringe" argument. The "doomer" argument makes sense and is very logical. But it is so obvious, how can we expect the ECB to not see it and not react to it?

    The markets sometimes get hung up in short term moves. Spanish 2 year yields are out 70 bps, the world is ending! Well, almost no one is affected in the short run by those moves. Spanish borrowing costs don't move up materially. It only affects their new issues, which are a small portion of their total debt. At this stage, virtually every bank has tucked away their Spanish bonds in hold to maturity accounts so there is no immediate P&L impact. It may cause some sleepless nights, but let's be honest, the sort of banker that has loaded up on Spanish bonds isn't the sort of banker who loses sleep worrying about risk.

    And the markets are thin. My understanding is that Spanish bonds are trading less than €1 billion a day. So we are pricing €700 billion of debt on less than €1 billion of volume. It might be as little as 0.1% of the market trades on any given day. There are NO buyers on the way down and NO sellers on the way up. The Spanish 2 year bond is 48 bps tighter this morning. It just isn't a market and is hard to read much into. While the moves have been scary, they have been amplified by a complete lack of risk taking throughout the trading system.

    With even the EFSF 10 year bond trading at 2.35% there is a lot of capacity between the ECB and EFSF to help Spain reduce their rates. The EFSF is backed by Spain and Italy (not exactly given the math as we've explained before) and can still price 10 year bonds with such a low yield.

    The ECB could do a lot with its existing SMP portfolio. The ECB is not a "for profit" organization, yet it has been more obstinate in bond negotiations in Greece than the private sector. It hasn't budged an inch.

    There is so much the ECB could do easily and the problems of not acting seem so obvious, so the big bear case is really betting on Draghi being inept. I'm not making that bet.

    Why the Fed may act, and why it would matter if they do?

    I think the Fed will act. Lots of excuses are given about why they won't - most hinge around the U.S. election and the fact that the S&P is at 1,340. Those arguments don't make much sense to me. Bernanke has told us what he focuses on. He focuses on inflation, which is apparently non-existent and jobs, which are also apparently non-existent. He wants to do QE. His entire academic career was based on central bankers not doing enough soon enough. He wants to act and has told us the criteria he is looking at. I don't think he will let the election or stock prices hold him up if he thinks the outlook for economy in general and jobs in particular deteriorate.

    Then there is the argument that QE cannot do much. There is discussion about "diminishing" returns. Operation twist was a joke in terms of QE. Only money creation QE has a real impact. QE isn't about rates, it is about flooding the system with so much money, that the dollar decreases in value, helping the exporters and creating so much money with so little investment opportunity that it gets put to work inflating asset valuations of all types. QE has nothing to do with rates and everything to do with creating asset inflation. We haven't had a real QE since 2010 so it is hard to argue that it has diminishing returns. Operation Twist was not real QE so looking at performance of the economy and the markets during that time, doesn't prepare us for the impact of real QE.

    Anyone who still believes the Fed's "stock of balance sheet" is more important than "flow of balance sheet" was wrong to begin with and is now ignoring 4 years of data all pointing to fact that flow is far more important to size in driving asset prices. I'm not sure either do much for the real economy, but the Fed seems to think so.

    I would not underestimate the potential that we get real QE and I would not underestimate its impact for asset prices. I don't think it will do much for the economy, though it will probably produce some nice "export" related headlines as the dollar weakens.

    Europe is More Important to the Bulls than the Fed

    The bull thesis relies far more on Europe getting their act together than the Fed doing anything. The ECB should be able to act, and Europe stabilizing would be good for all global economic data. It would take some time to filter into U.S. and Chinese data but ultimately it would. The problems in Europe are impacting everyone. This is the easiest to improve. Fed actions would just be the "icing" on the cake, at least in terms of risk assets.


    Not much to say, but on a morning when Apple is down hard on a significant earnings miss, it is impressive that credit and the S&P are better. IG18 is 1.5 bps better, and HY is up about a ¼ point.

    The euphoria with AAPL may finally be over. They make cool products, but other companies are catching up to them and they are hitting a saturation point in many of their markets. For stocks to do well here, we will need some other group to take leadership.

    It is hard for our indices to do well if AAPL remains weak since it is so large, particularly for QQQ's, but maybe banks are finally getting over the initial LIBOR fears now and can lead the charge?

    It is a very tricky market where the earnings story is bad. The economic data is weak, but all it takes is a few new policies and hundreds of billions of money from central banks and it will be hard to get the sell-off that we logically deserve.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Comments (7)
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  • Peter Tchir
    , contributor
    Comments (1257) | Send Message
    26 Jul 2012, 10:32 AM Reply Like
  • expatsp
    , contributor
    Comments (271) | Send Message
    Great insight, Peter. I've been missing your articles on SA.
    26 Jul 2012, 11:41 AM Reply Like
  • Rubicon Associates
    , contributor
    Comments (1972) | Send Message
    Author’s reply » Peter, Great commentary - useful rather than academic. Discussing the reality of the situation is refreshing.
    26 Jul 2012, 01:29 PM Reply Like
  • User 447425
    , contributor
    Comments (1686) | Send Message
    Terrific article and perspectives provided.
    26 Jul 2012, 01:28 PM Reply Like
  • Tack
    , contributor
    Comments (15972) | Send Message
    Just a note about QE, my seeming perpetual pet peeve, these days:


    TARP was a masterful stroke, preventing worldwide financial meltdown and deflationary calamity, which would have seen us still deeply mired in a true depression. And, maybe, the first QE could have been justified to further attempt to prime the pump by increasing liquidity further to offset the attendant decrease in monetary velocity during the recession. However, now, the persistent employment of QE has no residual value and is even counterproductive, although some still wait for its announcement with bated breath, as if this would stimulate the economy.


    It's more than apparent, everywhere one looks, that liquidity is bursting at the seams. Cash balances are burgeoning for corporations at all-time record levels, and even consumer balances are increasing while debt levels decline. With that being the case, it's simply not stimulative to add more liquidity; instead, one needs a force to encourage the more-than-abundant existing liquidity to flow and be put into play. The way to do that is by allowing rates to rise gradually.


    When rates increase, numerous salutary events will occur: 1) borrowers will get motivated to make those postponed purchases to lock in low rates, 2) lenders will get more interested in lending, as rates rise, 3) the dollar will rise, making consumers more inclined to spend money on domestic and imported goods and/or travel, as the dollar buys more, 4) inflation will be tempered, 5) Europe will rebound, as their exports advance and more foreign dollars arrive in travel, etc.


    The Fed, to its credit, has curtailed QE, an, as stated in the article, Twist does nothing to increase money supplies (in fact, M2 has shrunk since QE ended and Twist started). This has been a good policy, but hasn't gone far enough. Rates must be allowed, even encouraged, to increase.


    The very last thing the economy needs is new impetus to create liquidity and to lower rates or maintain low rates for even longer periods. In fact, if QE3 is announced, I am confident that any momentary surge in markets will be followed by a steep sell-off. Let's hope we don't see any.
    26 Jul 2012, 02:13 PM Reply Like
  • jhooper
    , contributor
    Comments (7287) | Send Message
    "In fact, if QE3 is announced, I am confident that any momentary surge in markets will be followed by a steep sell-off. "


    In fact, I'm counting on it.
    26 Jul 2012, 02:23 PM Reply Like
  • untrusting investor
    , contributor
    Comments (9903) | Send Message
    Good article and commentary. But even if the ECB & EFSF do act and buy Spanish and Italian bonds, so what? How does that in any way improve or help the Spanish or Italian economies, except for some relatively minor interest savings. The issues are structural in the weaker southern EU countries and these take a long time to address and turn around, even if they are willing to attempt to do so.
    5 Aug 2012, 02:06 AM Reply Like
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