An Umbrella, Just In Case

By: Michael Ashton | Thu, Feb 16, 2012
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Greece, Greece, Greece. I've had it up to here with Greece. I'm tired about writing about Greece. Apparently, I am not alone; after the conference call today, Jean-Claude Juncker said that he was confident that a "decision" on a bailout for Greece will be made at the next meeting...on February 20th. Gee, that would be great, Jean-Claude. If it's not too much trouble, you know.

I grow more confident by the day that the Greek default is reasonably imminent. Today there was also talk about the possibility of a 'bridge loan' to get Greece past the March bond payments. Aside from the fact that the mere possibility of a bridge loan will keep holders of the March debt from agreeing to the PSI (gee, get paid at par or get paid 30% of par. Hmmm.) in the hopes that they get paid out, and the fact that (as TF Market Advisors points out) paying the March redemption would add about €8bln to the total cost of the bailout, my question is: what good does more time do? Have the last months and years not been enough, so that another month will allow you to reach a solution? If that's the case, then by all means fritter away another €8bln, but that's one heck of a leap of faith if the only thing they could resolve on the conference call today was to have another meeting on February 20th. Can I hear an 'Amen?'

More likely, the foot-dragging now is to figure out how best to effect the default so that it has the most salutary (or least-hurtful) effect on the political careers of those currently on the stage. For example, a certain French President announced today that he is going to seek re-election, a prospect which is fairly dim at the moment since Sarkozy is trailing the Socialist candidate (Hollande) by a healthy 7-9 points in the polls and, more importantly, losing by a huge 59-41 margin in a hypothetical head-to-head runoff matchup with Hollande. It isn't clear what Sarkozy can do to salvage his re-election, although with two months to go anything can happen, but I can't imagine it would hurt to stop shipping French taxpayer money to Greece. What do I know, I'm not French, but my point is that the political pain of keeping Greece may finally be outweighing the political pain of sending her on her way.

There are more reasons to be wary of the equity market here. As readers know, I've been reluctantly long in this rallying (but expensive) market, but this is no time to be a hero.

One of the other reasons is the news this evening that Moody's is considering cutting the ratings of Morgan Stanley, Credit Suisse, and UBS three notches, and Goldman, Barclays, BNP, Deutsche, JP Morgan, Credit Agricole, HSBC, Macquarie, RBC, and Citi two notches each. Oh, and for good measure, Bank of America, Nomura, RBS, and Soc Gen are potential single-notch downgrade targets. They also acted today to cut some European insurers' ratings. While we all know that ratings should be taken with a shaker of salt (if not altogether ignored and replaced with actual analysis), in a world of CSA (collateral support annex) ratings triggers, downgrading the whole financial system would have the effect of pulling a Lehman/AIG on the whole mess. All of these counterparties would suddenly have to post large amounts of additional margin with each other. Financial companies' leverage has declined markedly over the last few years (in contrast to households, for example, where leverage hasn't changed much), but this could still conceivably require a strong, concerted central bank liquidity injection of massive proportions.

A 3-notch downgrade to Morgan Stanley would put them at Baa2, which it might share with Citi and Goldman only slightly better at Baa1. Now, in 2008 both MS and GS became commercial banks, so they have access now to the Fed window - a Bear/Lehman moment would thus be unlikely. However, either or both could conceivably be in a BOA/Merrill shotgun wedding situation.

I don't want to sound alarmist, because no ratings actions have yet been taken on the banks. And I obviously don't disagree with Moody's reasoning, when I have said as much here myself. They said

Capital markets firms are confronting evolving challenges, such as more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions. These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms.

Yes, agreed, but the point here is that the ratings downgrade itself can cause a contagion, because of the existence of (well-intentioned) credit triggers. Those credit triggers are the papier mâché palm trees in the Coconut Grove.

I haven't the faintest idea where those triggers are, and which ones may be triggered. And because no one else does either, it will not surprise me a bit if interbank lending grinds to a halt again. And this time, JP Morgan can't step in as the big man on campus, because they're in the same boat.

That's not the only reason that the landscape suddenly looks less inviting for investors. Let's talk about Apple. Now, I am a big fan of Apple products. I will note the Graham and Dodd admonition that a good stock differs from a good company in that a good stock is also cheap, but I'm not passing judgment on the valuation of Apple stock. Frankly, it's not even a stock I watch very much, because it doesn't pay a dividend and stocks of that type don't generally interest me (firms that distribute dividends historically have tended to have a higher ROE). But today, when a highly-touted stock hits a new high and then reverses on huge volume - especially in an otherwise-somnolent market - it is a bad technical signal. When I say huge volume, I don't just mean it was the highest share volume since January of last year. Keep in mind that the price is also some 45% higher now, and also keep in mind the aforementioned sleepy-market context. The chart below shows what I mean: Apple's dollar volume today (with no news evident that I could see), on a day it set a new high and then reversed, was an absurd 5.2% of the total dollar volume traded on the Nasdaq. And frankly, that understates the point since I valued the dollar volume as the total shares traded times the closing price, and the closing price for Apple was the low of the day and more than 5% below the day's highs.

AAPL Volume versus NASDAQ Volume

So this is bad behavior from one of the generals.

Finally, back in geopolitics, Iran threatened to cut oil exports to six countries. It didn't cause much distress in the oil markets, since these are six countries that were already planning to embargo Iran in the summer. So Iran's "you can't fire me because I quit" routine should have scant effect. That said, Brent Crude was already at highs not seen since last summer, and NYMEX Crude was near the top of its recent range as well. I don't expect any spike (although the ideal time for an Iranian provocation would be in the midst of a Greek default-related turmoil in global markets, wouldn't it?), but it's another risk that is turning acute at the moment.

None of this stuff is deterministic. They are all warning signs, and they might be completely ignored tomorrow, outweighed if there is a strong report from Initial Claims (Consensus: 365k), Housing Starts (Consensus: 675k), the Philly Fed Index (Consensus: 9.0), or all three. But the possibility of a very bad payoff, and a worsening edge/odds calculus, implies that investors should be scaling back long-stocks bets. (I wrote something similar back on March 1, 2011 in a piece called "The Market's Pot Odds," which references in turn one of my all-time favorite article from back in 2010, "Tail of Tails," talking about the implication of the Kelly criterion for investing. I submit these may be worth reading if you are interested in the edge/odds reference I just made.)

Implied volatilities, as represented by the VIX, have recently begun rising again, but protection is still relatively cheap considering the risks. If you feel this is a passing thundercloud, it still might make sense to buy an umbrella just in case.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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