We live in a financial world swayed and dominated by the sound bites of pundits who do not fully grasp the depth of the issues and by the remarks of leaders who promise actions that might cure symptoms, but not the underlying disease.  Many times the leaders simply need to agree to meet in the future to discuss a framework for solving a problem and markets react like a final resolution is a fait accompli.  In reality, it’s really just a head fake.

As I mentioned last week, in late June EU leadership grandly pronounced a new solution without substance or a means to enact it.  For instance, the powers-that-be espoused the creation of a central European bank regulator without any real ideas as to how to put it into place.  Never mind the fact that Spanish banks have already made an enormous amount of bad loans or that European banks are already replete with the debt of weak sovereigns.  Talk about a day late and a dollar short!

Markets have routinely responded to these proclamations as if the leadership can somehow work magic and “poof” all of the problems would disappear.  These are not generally the markets of yesteryear that would have been much more skeptical of these announcements and forced leadership to make real reforms.  Last week saw Italian and Spanish bonds get crushed and the euro get flushed as it became clear that, once again, EU leadership had done nothing the week prior except parade around in front of cameras pretending to be wise stewards who were diligently working on real solutions.  Spanish ten-year bond yields rose above the 7% level, which has proven to be a critical threshold for other nations which ended up asking for aid. 

After Friday’s very weak U.S.jobs report for June, markets initially sold off, but then rallied as rumors abounded about how our Fed would certainly have to embark on QE3 to save the world.  We have witnessed numerous herculean efforts both fiscally and monetarily to help the economy, yet all we are left with is another $5 trillion of federal debt and a quasi-recessionary economy.  June retail sales were the slowest in two years and ISM numbers indicate that industrial America is no longer in growth mode,  but U.S. markets act as if the next round of QE will be the dose that works.

While some equities in the U.S. are beginning to price in recession, the overall indices and the majority of the markets refuse to correct for fear of missing another QE-induced sugar high.  It is a dangerous mix.  The Russell 2000 small cap index resides near record highs in spite of a plethora of earnings warnings from numerous significant companies.  In contrast, commodity markets, which were for a long time thought to be the place to be to counter an inflating Fed, seem to have none of this giddiness.  Also, emerging equity markets including China and India remain sober by comparison.  European equities have been decimated.  Most interesting to us was the ho-hum market reaction to monetary easing in China and Europe last week.  Maybe the central bank magic is gone.

U.S. equities stick out like a sore thumb on the global investment scene.  Our concern is that a day of reckoning is coming for U.S. equity investors when they realize that we need a much “bigger boat” to fix the world’s troubles and that Europe’s problems and China’s slowdown are going to affect U.S. companies in a powerful way.  At Strategic Balance we do not want to be far from shore in a dinghy when the reality sets in that we do not just need a bigger boat; we need a battle ship and maybe an aircraft carrier.  Protecting our capital until these major risks have been contained, while also investing for the long term when the math makes sense is the only wise course we can set.

Scott Brown, July 10, 2012

I would be remiss if I did not mention Europe here, if only to say that last week’s pronouncements are nothing but “hot air,” befitting the sweltering temperatures we are experiencing.  The biggest failing of the current plan is that Spain’s banking problem is much more than the roughly $100 billion mess EU leaders discuss in public.  Spain will likely need four times that or more to keep its banks from collapsing into the abyss.

In order to keep this discussion brief, I will just cut to the chase and say that the Eurozone can remain in its current format only if German taxpayers are willing to foot an enormous bill.  Of course, I am not even sure the German economy is big enough to carry that weight.  I suspect the next grand scheme will be an effort to lever current rescue funds in the ESM and EFSF through the creation of a bank, which could then buy the bonds of Spain and Italy in the open market to avoid a meltdown in the near term.  Yes, another Ponzi scheme.  That plan would not fix things either because the basic European problem is too much sovereign debt and uncompetitive economies in the south.  Debt restructuring and write-downs are the only answer, along with real productivity reforms in places like Spain and Italy.

Scott Brown, July 2, 2012