A Wild Week In Review

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After four frenetic days, today seemed almost calm by comparison.  Monday through Thursday marked the first time in stock market history that the Dow Jones Industrial Average changed by more than 400 points on four consecutive days: in order, -634, +429, -519 and +423, for a net decline of 301 points.  Today’s rather placid 126-point gain reduced the week’s loss to a mere 175 points, masking the excitement from those not privy to the daily roller coaster ride.

The intra-day swings were even more dramatic with much of the action unfolding into the close.  Approximately half of Monday’s massive decline, about 300 points, disappeared in the session’s last 45 minutes.  Tuesday saw a rise of about 640 points in the last hour and half, turning a big loss into an even bigger gain.  That late-day enthusiasm was reversed by a 300-point decline on Wednesday’s opening, and the day concluded with a 370-point loss in the final two hours.  Thursday looked great all day until the market shed 160 points during the last 15 minutes.  On this late-summer Friday, as floor brokers were making an early exit for the Hamptons, the market limped to an anticlimactic close.

While receiving far less publicity, the bond market was equally volatile.  As stocks bounced up and down like a hyperactive rubber ball, massive amounts of money fled to safety in U.S. Treasury bonds, notes and bills.  From last Friday’s close through late Wednesday, the yield on the U.S 10-year Treasury plummeted from 2.56% to 2.09%, an amazing three-day decline.  By week’s end, the yield had risen part way back to 2.24%.  While yields were declining and prices rising on top quality bonds, junk bonds–euphemistically called high yield bonds–headed the other way.  On a panicky Monday they lost 5.4% of their value in a matter of hours.  The ultimate in safety, the three-month Treasury bill, demonstrates dramatically how worried big money is.  The three-month bill closed the week with an annual yield of one-half basis point.  In other words, if you loan the U.S. Government $1,000, the government promises to return your $1000 three months from now with a return of one and one-quarter cents.  This is the quintessential example of the desire for the return of your money rather than the return on your money.

Despite the well-chronicled reduction of the U.S.’s debt rating by Standard & Poor’s, the primary concern facing the markets and the world economy is the growing danger of sovereign defaults in Europe and the resultant danger to the banks that hold that increasingly risky paper.  Governments and central banks worldwide are doing their utmost to offer reassurances that they have solutions and will exercise them as necessary.  It’s possible that they will succeed–at least in “kicking the can down the road”–but the probability of warding off default indefinitely and restoring these countries to economic good standing is unlikely in several cases and impossible in others.  Whether they can succeed even in deferring potential defaults will depend upon their ability to maintain investor confidence.  That’s looking increasingly unlikely.

The environment remains fraught with danger.  How highly unpredictable events unfold over the weeks and months ahead will largely determine the course of both equity and fixed income markets.  As others have stated, these are markets to rent, not own.  To protect and grow assets, we are continuing to boost portfolio yield with risk-free income while looking for strategic opportunities in both the equity and fixed income markets.  In a low-yield, high-risk environment, it is essential to keep capital properly protected.

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The Tide May Have Turned

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Quite a fortnight! On July 19 with the Dow Jones Industrial Average at about 12,600, we sent our second quarter commentary to clients (2nd Quarter Commentary). We made the case that the long weak cycle that began in 2000 was likely to continue for another five years or more. While it would likely include both rising and falling phases, we suggested that current conditions could easily soon lead to the next major declining phase.

Just two days later the Dow closed at 12,724. In the eleven market trading sessions since then the Dow plummeted almost 1600 points, or 12.5%, to today’s low. In the process, the Dow and all other major stock market averages gave up all of their year-to-date gains, broke down from “head and shoulders” tops, broke below their respective 200-day moving averages and violated their trendlines from the 2009 market bottom. Some analysts contend that the decline also confirmed a Dow Theory sell signal. None of these technical indicators by itself guarantees that the next major decline has begun, but in the aggregate they suggest that conclusion. The single strongest technical indicator that still points to new market highs comes from the venerable Lowry Research Corp.’s supply and demand computations.

It is noteworthy that the market decline we’re experiencing is hardly restricted to the United States. Stock market indexes for all major world markets are negative for 2011. And the leading emerging markets of Brazil and India are down in excess of 20%. China is down more than 50% from its 2007 high.

Problems are not limited to failing technical conditions. Employment, housing and consumer and business confidence in this country are at recession levels or worse. Still-surging corporate profits are the shining star in the fundamental picture. But measures of economic activity, both domestically and worldwide, are weakening dramatically. Another recession has become a very real possibility. And excessive debt burdens throughout the developed world are in the news daily.

Price declines have been so intense over the past two weeks, however, that stocks are extremely oversold and in a position from which at least short-term, potentially explosive, rallies can launch. That makes the day-to-day forecast highly problematic. On the other hand, longer-term technical and fundamental conditions are sending out clear warning signals. Investors need to evaluate carefully their exposure to risk. The last two weeks testify clearly to the speed with which markets can decline when conditions turn sour and investor confidence wanes.

Major European banks are beginning to have difficulty borrowing needed funds. Some traditional funding sources are closing. A similar liquidity squeeze was a prime contributor to the 2008 banking crisis which brought the financial system to its knees preceeding the government bailout.

As the markets sank over the past two weeks, cries became louder for further rounds of stimulus or rescue, both here and in Europe. While such rescue attempts have done little over the past two years to improve the world economy, they have been marvelous supports for the world’s stock markets. While further stimulus could promote another stock market surge, it is far from guaranteed. As repeated efforts to boost world economies are becoming increasingly ineffective, faith in the efficacy of such government efforts will logically diminish. At some point stock markets will reward only conditions that are likely to promote sustainable economic growth. Potential upcoming government aid is unlikely to have such a salutary long-term effect.

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Excessive Debt – Still The Biggest Risk

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At the end of the 1990s and in the early years of this new century, we were among very few investment managers voicing any alarm about excessive debt. Today, even the disinterested can’t escape the plethora of nightly news reports about how excessive debt is endangering our financial well-being.

As individuals, Americans over the past three decades have evolved from diligent savers to aggressive spenders. With only brief exceptions through the 1980s and 1990s, the U.S. economy expanded, consumers grew increasingly affluent and the need to save became a distant memory. Most in our society lost sight of the fact that our economy is cyclical and that savings were the cushion that sustained families in times of occasional unemployment. The two recessions in this century’s first decade revealed how unprepared most people were for a recessionary environment. Debt forced many into bankruptcy.

In a similar vein, many years of spectacular growth in real estate prices overpowered any concerns about cyclicality and led to the most remarkable surge in real estate speculation in U.S. history. Because real estate prices seemed to go in just one direction, debt was a trivial concern and was viewed simply as a method to magnify profits. All was good until reality intruded and cyclicality reasserted itself. When real estate prices declined, minimal equity levels were quickly eliminated, and many financially strapped owners were unable to retain their properties. Insufficient recognition of the destructive potential of debt submerged vast numbers of the financially unsophisticated as well as the allegedly knowledgeable.

Now debt crises have escalated to the national level. Less than two years ago Dubai initiated the march of debt-endangered sovereigns. Iceland, Ireland, Greece and Portugal have joined the parade, and growing numbers of analysts fear that Spain or Italy may also enter their ranks. Governments and central bankers have been working overtime to craft rescue plans to ward off defaults and to prevent contagion. Notwithstanding bailout pledges, the markets seem unconvinced of their potential for success. Telltale interest rates have risen to ominously high levels for Spanish and Italian bonds.

As I write, legislators in this country are wrestling with several options for raising the U.S. debt ceiling. Despite strong opposition from the most conservative members of Congress, passage seems highly likely, even if it should be somewhat delayed. Despite large projected deficit cuts, however, this bill will not solve our domestic debt problem.

In their classic summary of financial crises of the past 800 years, This Time Is Different, Carmen Reinhart and Kenneth Rogoff assert that countries are in danger of debt crises once government debt reaches 90% of Gross Domestic Product. Most commentators acknowledge that the U.S has become too debt-dependent, but believe that a prudent plan of deficit reduction is all that is needed to pull us back from the brink of danger. That may, however, be overly complacent.

It is widely recognized that publicly-held federal debt is about 64% of U.S. GDP, not an overly-worrisome level. The U.S., however, stands behind far more debt than that. The infamous Social Security lockbox holds promises from the government to pay that bring the debt total to 95% of GDP, already over the Reinhart/Rogoff 90% danger line. But most probably government debt doesn’t stop there. For decades the government has implied that it would stand behind government-sponsored enterprises like Fannie Mae and Freddie Mac, the financially crippled mortgage giants. Adding those liabilities brings the government’s debt-to-GDP ratio to 138%. Going one step farther, is it likely that the federal government would let any of the 50 states fail? That prospect adds even more to the massive debt burden. Clearly our government has responsibilities that put its debt-to-GDP burden far into the danger zone. Even the most aggressive of the currently-proposed deficit reduction plans will not cut into the debt over the next decade, and the debt-to-GDP ratio will remain at extreme levels as far as the eye can see.

Individuals learned the cruel truth during the past decade that excessive debt leaves one vulnerable to such unforeseen conditions as unemployment and real estate price declines. Nations around the world, the United States included, need to recognize the extreme danger that their current debt levels pose. Recessionary conditions would certainly heighten the risks, and the potential for recession is rising as economic conditions are obviously slowing across most of the world.

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Quarterly Commentary – 2nd Quarter 2011

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The Long Weak Cycle Continues

At the end of the 1900s, debt burdens in the United States had climbed to unprecedented levels relative to the size of the U.S. economy. Speculators had bid stock valuations to heights never before approached. Fear had been cast aside, and an ever more prosperous future was almost universally anticipated. In varying but lesser degrees, this script had played out domestically several times over the prior two centuries. Similar conditions had characterized the end of seven earlier periods of economic and stock market expansion. In each instance, euphoric peaks led to lengthy periods of correction both in economies and in markets. As the turn of the century drew near, we spelled out in considerable detail why then current conditions were almost certainly leading us into the next long weak economic and stock market cycle.

While we had no way to know how long such a cycle would last, the seven completed weak cycles in the nineteenth and twentieth centuries averaged just under a decade and a half in length. In the twentieth century, the cycles extended a bit beyond the average, with the shortest lasting sixteen years. Since the excesses built up through the 1980s and 1990s topped all that had come before, it was logical to expect at least a normal or longer corrective cycle.

So far the weak cycle is unfolding within normal boundaries. We have experienced two monumental stock market declines accompanying two recessions. These cyclical bear markets have been followed by two powerful, Fed-fueled cyclical bull markets. The net of a dozen years of fluctuating markets is that stock prices are today where they were in 1999.

Unfortunately, most investors are too impatient to identify very long-term trends and to invest in concert with them. Wall Street firms certainly will never talk about negative patterns that could last a decade or two. Imagine what would happen to a firm’s profitability if it correctly forecast that stocks would provide little or no return over the next decade and a half or so. Such firms obviously have to keep investors active. Whatever their longer-term beliefs, they must offer opportunities for short-term profit. And that matches the investing desires of most clients. Recognizing that there’s always a bull market in something, Wall Street firms play to the investors’ desire to pick the winners, even when most assets are declining. Of course, the ideal scenario is to be bearish and cautious when markets are declining and bullish and aggressive when markets are rising. When major market moves last for two or more years at a time, that seems reasonably easy to do. To verify how difficult it is in practice, however, all one has to do is review the performance of investment managers in the twenty-first century-to-date. Few have made much; many have lost money. We are pleased that over that time span our clients have made about 70% before fees, which vary based on portfolio size. And the long weak cycle is still unfolding.

Every long weak cycle since 1800 has contained one more major decline (cyclical bear market) than major rally (cyclical bull market). So far this current cycle has seen two of each. This cycle could end with one more major decline, but in light of its eleven-year length to-date, it is certainly possible that it could incorporate two more major declines bracketing another strong rally.

Of most immediate concern is whether or not the cyclical bull market that began in March 2009 has further to run. As I pointed out in some detail in my May 27 blog post, the average length of cyclical bull markets within secular bear markets (long weak cycles) has been 26 months. That pattern would almost perfectly align with the market peak reached in early May. No market has to conform to historical averages, but such data can provide helpful guidelines for reasonable expectations.

When we look at the current situation, we see a confluence of conflicting factors. Corporate earnings continue to grow strongly, and emerging economies are providing demand for many of the world’s goods and services. Governments and central banks are working overtime to provide stimulus to keep business humming. On the other hand, the reason they have to provide such stimulus is that the world’s crushing debt burden is throwing sand into the gears of much of the world’s economy. Several countries are insolvent and are being kept alive with outside funding. Several others are suffering from severe liquidity squeezes and likewise require prodigious amounts of rescue money. Major banks around the world hold the debt obligations of these struggling sovereigns. Should the ongoing rescue efforts fail–and they certainly could–the world might again regress to the dire straits in which it found itself at the height of the 2007-09 financial crisis. At that point the gears of the world economy essentially ground to a halt, only to be reenergized by the greatest bailout in history. Should faith in the banking system be sufficiently shaken again, the likelihood of a second successful bailout would be significantly lower.

The rating agencies that evaluate the probability that debt will be fully repaid have accorded several European peripheral countries junk bond ratings. In the past week they have also put the United States’ formerly sacrosanct AAA rating under review for possible downgrade. The immediate reaction from European politicians and central bankers has been to castigate the rating agencies for calling toxic debt toxic. The agencies are merely holding up a mirror to reality. Many of these countries are in serious danger of near-term default. They are in a Catch-22 situation. To get further bailout money, they must approve and implement serious austerity measures. Unfortunately, under the mandated austerity budgets, there is virtually no way that the endangered countries will be able to grow their economies fast enough to service their debts. In this country, no politician is offering a plan that would actually solve our debt problem. Even the most aggressive proposals would leave us with huge deficits and growing debt a decade from now. We have wedged ourselves into a corner from which we have no good options. We find ourselves in the same Catch-22 situation as does Europe. Any appreciable cuts in spending will diminish the GDP growth necessary to generate enough revenue to reduce debt in the long run.

Most readers can sympathize with pleas for not cutting into what different constituencies identify as critically needed government programs: health, Social Security, defense, veterans, education, etc. Talk about cutting or eliminating such programs is cast as unfeeling and immoral. On the other hand, we have long ignored the immorality of satisfying our current needs with money from future generations who have no voice in today’s deliberations. Agreement on these hot-button issues may be extremely difficult to reach, which will severely complicate all attempts to come to a meaningful debt reduction solution.

Stock market activity in recent weeks demonstrates clearly how responsive traders are to prospects for further government rescue or stimulus. Prices moved up or down in direct correlation to the perceived progress toward an agreement in the Greek debt crisis, in hopes that contagion to other European countries and major European banks can be avoided for now. Over the next two weeks, we are likely to experience a similar traders’ watch on the prospects of Congress reaching agreement about raising the U.S. debt limit.

So far there has been remarkable complacency in the markets in the face of conditions that could lead to the banking system’s collapse, as nearly happened but for a successful government rescue in the 2007-09 financial crisis. If European sovereign debt ends up being marked to market rather than being accorded an artificial value of par, the European banking system–and by extension major banks around the world–are at risk of insolvency. The market seems to appreciate the risks at the bank level, as prices of leading banks have been pummeled in recent months. The broader effect on the financial system at large, however, is so far invisible. Investors seem to be counting on governments and central banks again “kicking the can down road” and sovereign insolvencies again being deferred.

Perhaps deferring a recognition of reality will be successful for a while longer. Can betting on that outcome, however, be called investment, or should it be recognized as the speculation that it is? Should circumstances force us to face reality and a failed banking system now, could anyone credibly ask: “Who could have seen that coming?” That was the rhetorical question asked by many who were penalized for large equity positions in the 2007-09 collapse, which was precipitated by excessive debt that we had warned about for years.

As with equities, today’s fixed income situation presents a serious quandary, albeit a different one. Our U.S. Treasury bond yields are near historic lows, despite our country’s serious debt problems, while yields on endangered European debtor countries’ bonds are skyrocketing. How much of the U.S.’s low rates can be attributed to the Fed’s having purchased 60-70% of new Treasury issues over the last few quarters? What will happen to interest rates in the Fed’s absence now that QE2 is finished? Can we rely on investors’ perception of the U.S as a safe haven if our legislators are unable to cobble together a politically acceptable debt ceiling agreement and the U.S. falls into default, even for a brief period? What would happen to interest rates if Standard & Poor’s follows through on its threat to downgrade U.S. debt, should Congress not reduce the projected deficit by a sufficient amount? What happens if Europe experiences a debt default, which leads to European bank insolvencies and in turn to insolvencies of financial institutions around the world? Would central banks crank up the printing presses to bail out the banking system again? Would China and other emerging country buyers of western debt shy away from such bonds if debtor countries continued to devalue their currencies through money creation?

Inflation has been rising, which logically leads to rising interest rates. It’s happening, however, in a weakening world economic environment, which typically leads to lower interest rates. Which force will prevail? The answers to many of these questions are dependent on policymakers’ decisions, not on natural market forces. That subjectivity adds considerable guesswork to current fixed income analysis. At today’s historically low yields, there is more loss potential should rates rise than profit potential should rates remain stable or even decline further. As a result, we are not maintaining a permanent bond position, but we continue to look for strategic bond opportunities when interest rates rise intermittently.

On the equity side, while we are adding individual stocks which meet all of our value-based selection criteria when we can find them, we are not stretching those criteria just to add more names. Things continue to play out in the long weak cycle that we correctly forecast a dozen years ago. Notwithstanding being significantly risk-averse during the two strong rallies of the past decade, our clients who have been with us over the full cycle have far outperformed most portfolios. And the long weak cycle very likely has some years yet to run. Ours will remain a task of defending portfolio values in major market declines, adding risk-free income as we have over the past few quarters, and seeking opportunities for strategic equity ownership where we can identify companies at attractive prices.

While the long weak cycle is still well short of average length, conditions are reaching potential disaster realization points. Will they be successfully deferred again or not? We urge all readers to avoid risks that could lead to losing irreplaceable assets should the debt crisis come to a head soon.

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Markets Looking For Government Help

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This week’s stock market trading demonstrated once again investors’ Pavlovian response to hints of additional government rescue or stimulus. 

In recent weeks stock prices have risen or fallen in concert with prospects for the success of the pending Greek debt rescue.  For some time, while acknowledging the seriousness of the debt crises in peripheral European countries, analysts have made the case that apprehension would intensify should Spain or Italy be added to the mix.  Conditions in both of those countries have worsened, and the near-term rollover of Italian debt became the financial cause celebre early this week.  The debt cloud growing over Italy and the ramifications it could have around the world knocked Dow futures down about 150 points in Tuesday’s pre-dawn market.  Unconfirmed rumors then began that one or more governments or central banks were prepared to step up to buy Italian bonds, and perhaps Spanish as well.  Voila!  The 150 points were recovered before the opening.

Once open, the market drifted down early in the day until the announcement of the most recent FOMC meeting minutes.  The mere suggestion that QE3 was not completely off the table produced an 80-point bounce in the Dow in about 20 minutes.

Demonstrating that the same story can play more than once, Fed Chairman Bernanke’s testimony before the House on Wednesday was largely responsible for a 160-point Dow rally.  While he said virtually nothing that had not already appeared in the earlier FOMC minutes, his actual statement that QE3 was still a possibility set off a rapid rally just after the words left his mouth.

In his Thursday testimony before the Senate, Chairman Bernanke clarified his message.  While not taking QE3 off the table, he enumerated the dire economic circumstances that might necessitate its implementation.  His qualifying statements turned a morning rally into a loss for the day, a 160-point turnaround.

These moves are not coming from investors but rather from short-term traders, many not even human.  Algorithms directing order flow can be keyed to such factors as Bernanke’s tone regarding the potential for further stimulus.  Clearly the trading community’s knee-jerk response is still positive when further rescue money is proposed.  At some point, however, investors might begin to focus on the negative underlying fundamentals that could lead to an additional bailout.  QE2 was implemented when the initial quantitative easing was originally scheduled to be withdrawn.  Fundamentals were so weak, however, that the withdrawal had to be swapped for a second round of stimulus.  QE1 failed to accomplish its objective.  Imagine how weak fundamentals would have to be for the Federal Reserve to take a third similar step, adding even further to a debt level that increasingly endangers the financial survival of future generations.  What confidence could investors and citizens in general have in the success of a rescue program that had failed twice before?  As those concerns move to the forefront, traders might hesitate to push the “Buy” button when the next rescue is proposed.

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The Consumer Is Key

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Almost every financial forecast published in the last several weeks anticipates a second half economic pickup, some a relatively strong improvement. The vast majority of these seers had to revise down more enthusiastic forecasts for the first half of the year as data became increasingly sluggish over recent months. While many have recently tempered their levels of enthusiasm, almost all maintain a firm conviction that the economic expansion will soon pick up speed. While they could turn out to be right if no countries or major international banks go belly-up in the near-term, their rationale for confidence is flimsy. Many point out that most post-recession recoveries last longer than the current one so far. All else equal, that leads one to expect a longer expansion, but it provides no reason for improving growth rates.

A number of astute analysts have offered a litany of reasons that they contend will lead to a stronger second half. Most include the non-repetition of the anomalous Japanese earthquake and tsunami, plus horrible weather in the United States. Many more automobiles are scheduled to be built in the next few months. Defense spending is likely to be ramped up over the next two quarters. Banks are laden with money and their lending standards have become less restrictive. The ability for businesses to expense 100% of capital equipment purchases will be diminished in 2012, providing an incentive to make such expenditures in this year’s second half. That could pull forward some purchases that would otherwise be deferred, but it would merely be borrowing such business from the future.

The great majority of economists appear to be making the mistake of treating this recovery like all others in their experience. They fail to see this one as a bounce-back from an economic event that has seared the consciousness of consumers like no other in generations. Through the end of the past century, consumers adopted personal financial management standards based on the assumption of ever-rising securities and housing prices. They saw no reason to save. Debts were not worrisome. Beginning with the stock market crash at the onset of the past decade followed by the bursting of the housing bubble a few years later, consumer attitudes began to change. Especially as unemployment ramped up, debts became more than worrisome. Excessive debt began to overwhelm large segments of our population. Foreclosures and bankruptcies proliferated. Fear of an uncertain economic future led to deleveraging and increased saving. Consumers put their wallets on the hip and abandoned many of their carefree, “What, me worry?” spending habits. Those profligate spending patterns are unlikely to return quickly.

Most economic forecasters are concentrating on supply-side factors as the rationale for their second half confidence. I suspect they are grossly overestimating the willingness and ability of the consumer to return to a free-spending mode. No matter how significant tax incentives may be for additional capital expenditures, most businesses will avoid making major commitments to new equipment and especially to increased employment until they are confident that demand is rising for their goods and services. The consumer is the key, and the consumer is unlikely to reemerge rapidly.

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Stocks Will Rise or Fall On Confidence Levels

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A worldwide sigh of relief was evident this week when European governments and banks were able to fashion another temporary rescue of the failing Greek economy.  Without the continuing rescue efforts, Greece was prepared to default on obligations coming due in two weeks.

The consortium of governments and banks determined once again that they could not afford to accept the reality that Greece is insolvent, not merely suffering from a liquidity squeeze.  The decision-makers faced the dilemma of either bailing out the Greek economy again or bailing out their own banks and the European Central Bank itself, which hold the toxic Greek paper.

Violent demonstrations erupted immediately in the streets of Greece, as many Greeks expressed disdain for the austerity measures to be enforced as the quid pro quo for the new bailout money.  If the taxpayers in northern Europe fully understood the implications of the bailout, we might well have seen demonstrations on the streets of Germany and France as well.  These taxpayers will be the primary source of the bailout funds that will keep the Greek government alive for a while longer.  We in the United States have the privilege of contributing as well.  As the largest funding source for the International Monetary Fund, we also get to wear an “I bailed out Greece’ button, with whatever degree of pride that entails.

The unfortunate reality, however, is that the Greek debt has not disappeared.  The bond restructuring has merely deferred the ultimate due date.  This is another blatant example of the “extend and pretend” practice that we and many others across the globe have exercised with respect to real estate loans.  Deferment doesn’t change the underlying reality.  It simply buys time, giving both debtors and creditors hope that circumstances may sufficiently change to enable repayment.  In Greece’s case, that hope is a pipe dream.

Greece is but the most open sore on the life-threatening wound that is excessive worldwide indebtedness.  But for government rescue, the entire financial system was on the verge of collapse less than three years ago. The pledge of a seemingly endless stream of money boosted investor confidence and has led to a two-and-a-half-year stock market rally.  This week’s powerful price advance is further testimony to the continuing ability of central planners to rev up investors’ animal spirits.

Unfortunately the long history of governmental attempts to rescue economies in crisis is not rife with examples of pain-free success.  The normal path is marked by lengthy periods of economic tribulation.  When investor confidence is high, stock prices can soar, but they can’t ultimately break the bonds of struggling economic fundamentals.  In the United States, we are still faced with an unprecedented level of foreclosures and the worst unemployment situation since the Great Depression of the 1930’s.  Even under the most optimistic of scenarios, we will be experiencing deficits and growing debt as far as the eye can see.  When the fundamental safety net is unsound, any event threatening confidence levels can lead to dramatic price declines.

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A Week About Greece

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Other than those planning vacation cruises, very few people in the United States spend much time thinking about Greece.  Suddenly, however, Greece is all over the news.  Financial television spends considerable time evaluating the political fortunes of Prime Minister Georgios A. Papandreou.  Network news covers protests and violence on Greek streets.  Tiny Greece is assuming a level of importance not seen for centuries.  What happens in Greece this summer may determine the health of the world economy and securities markets. 

Having lived well beyond its means for many years, Greece now finds itself unable to repay its debts coming due.  It has already received a massive infusion of rescue money from its European neighbors in exchange for a promise to mend its profligate ways and run a tight financial ship.  Grateful for that earlier rescue, but not enough to mend its ways, Greece finds itself begging for another giant handout to meet bills coming due in mid-July.

In the grand scheme, it would seem that a default by tiny Greece would be inconsequential.  Why are its much bigger neighbor countries jumping through hoops to prevent a default on Greek debt?  It’s complicated.

For one thing, Greece was accepted into the European Union despite the country’s lengthy history of financial imprudence and default.  The fact that it shares a common currency with its European compatriots prevents Greece from a unilateral devaluation, which would lessen its debt burdens.

Why not just kick Greece out of the group of Euro nations and let it sink under the weight of its own financial folly?  Sorry, that’s complicated, too.  Bond defaults would affect far more than the Greek government, Greek banks and the Greek people.  These Greek bonds are held, of course, by Greek banks.  But very large amounts of these issues are in the portfolios of German, French and other countries’ banks as well as the European Central Bank itself.  If Greece isn’t saved from default, the Euro countries will have to rescue these banks, whose capital would be significantly impacted by a failure of Greek debt.  That Angela Merkel and Nicholas Sarkozy are advocating another Greek rescue is not out of the goodness of their hearts or some feeling of duty toward their European neighbors to the south.  They are choosing what they perceive to be the lesser of the two evils.

Having received a vote of confidence in parliament this week, Prime Minister Papandreou faces the more perilous task Tuesday of winning parliamentary approval for the monumental austerity budget, the quid pro quo for the proposed bailout package.  Should the austerity vote succeed, there is still the prodigious task of getting acceptance and compliance from the Greek people, who are accustomed to strong social support systems and benefits, not austerity.  The presence of huge crowds in the streets and intermittent strikes testify to the difficulty of obtaining that acceptance and compliance.

European Central Bank President Jean-Claude Trichet this week described the European financial picture to be on “red alert.”  Closer to home, Federal Reserve Chairman Ben Bernanke said that U.S. financial interests are not significantly affected in a direct manner by a potential Greek debt default.  The ripple effect, due to the impact of such a default on European banks, however, could be significant.  He specifically referred to the potential deleterious effect such an event could have on even conservative investments like money market funds, which have substantial exposure to European banks.

It’s hard to measure the extent to which the Greek debt crisis is weighing on the U.S. stock market.  We obviously have our own debt problems here, and current wrangling about the expansion of the U.S. debt ceiling is keeping our problems on the front page.  It was interesting to see, however, how quickly the market reacted on Thursday to the announced agreement of the bailout package between Greece and its lenders–subject, of course, to Greek acceptance of the austerity conditions.  The Dow Jones Industrial Average jumped by about 140 points in less than fifteen minutes.  The fact that virtually all of that gain was given back on Friday points to the probability that most of the bounce could be attributed to short covering.

Clearly the week ahead could see violent market reactions to events that those closest to the Greek situation say could go either way.  Investors unable to bear the downside volatility if events unfold negatively should reduce their risk exposure.  The risks are severe, and there are events on the calendar that could potentially turn those risks into a negative reality.  Should the European countries skate past this week’s events without damage, the problems will not have gone away.  They will have been deferred.  Markets might react favorably to relief from immediate danger, but the overhanging debt danger will remain.

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Will Bureaucrats Determine Your Investment Success?

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Equity market investors almost universally consider themselves capitalists in favor of free market economics.  Most are vehemently opposed to anything but minimal government regulation and interference.  As we head into the weekend, the three open questions most capturing investors’ attention are:  Will European governments and central bankers cobble together a further rescue plan for Greece?  Will Democrats and Republicans reach an agreement to permit the U.S. Government to continue borrowing to pay its bills?  Will the Federal Reserve or the administration concoct another form of stimulus to keep the struggling economic expansion alive?

Because an affirmative answer to each of these questions is likely to provide at least a short-term boost to equity prices, we hear very few strong voices in opposition.  All too many investors apparently embrace selective free market principles.  We wish to stay the hand of government except when it at least temporarily fills our wallets.

It’s not that difficult to understand many investors’ eagerness to welcome government rescues.  Most simply don’t understand the probable long-term consequences of trying to solve a debt crisis with more debt.  More cash in hand today is tangible; possible long-term debt consequences are nebulous.

It’s more difficult to excuse policy makers.  While it’s possible that some truly don’t understand the negative implications of what they are doing, it is far more likely that they are making deliberately self-serving decisions.  Saving their own bacon, whether reputational, financial or political, is more important than the welfare of existing creditors or future generations to whom they will bequeath the burgeoning debt loads.

It must be obvious to any perceptive investor that we are not dealing with free markets and a free economy.  When economic and investment success depends heavily upon the actions of bureaucrats, we are speculating, not investing.  There is nothing wrong with speculation, but it is critically important that those who cannot afford the attendant risks recognize the distinction.

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Does Anyone See A Pattern?

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Dow

The graph above shows the progress of the Dow Jones U.S. Total Stock Market Index from 1994 to present.  This capitalization-weighted index is comprised of all U.S. equity securities with readily available prices, essentially the entire U.S. stock market.  I have added the horizontal and slanted trendlines.  No graph shows conclusions, but rather presents a picture of the past from which the technically-oriented may choose to draw conclusions.

Each vertical line represents the monthly price progress of the index.  The two descending lines in the upper right hand corner of the graph depict the 7½% decline that the index has traced out since the beginning of May.  Because of the steepness of the trendline’s slope connecting the March 2009 and mid-2010 lows, the index is rapidly approaching that trendline just six weeks after hitting a new high for the current rally.  While there is no certainty that prices will continue down to or through the trendline, it is instructive to note how aggressively prices fell after penetrating the trendlines supporting the two prior multi-year rallies.

So persistent has the selling been over the past six weeks that most short-term measures are substantially oversold and in need of a rally to relieve that oversold condition.  Intermediate and long-term measures are not oversold and could certainly accommodate lower prices.  The lack of any meaningful rallies over that six-week span has produced short-term bearish sentiment readings that normally spawn a recovery rally.  Those bullish factors notwithstanding, if markets don’t rally when such conditions are in place, there is danger that investors panic and throw stocks on the market at any price, creating waterfall-type declines.  So while a short-term rally is the more likely prospect, there is danger that the rally might not materialize until prices descend far lower.  Next week should provide a resolution for this short-term tension.

The graph illustrates that the two prior major market tops in 2000 and 2007 took several months to develop.  One could argue that the current market has been building a topping formation since February, but it certainly looks less well developed than its predecessors.  Because so much of this rally has been based on confidence that the Federal Reserve would not allow the economy to fall back into recession, the rally’s durability is probably dependent on that confidence remaining high.  Should the deteriorating global economic condition undermine that confidence, market declines could unfold rapidly.

For those who look for technical patterns on graphs, it is easy to see this as a possible developing giant head and shoulders pattern.  I’ve drawn horizontal lines connecting what could be both shoulders and the neckline.  There is considerable symmetry in the pattern, with the 2007 head clearly at the top.  Obviously there is no necessity that prices decline beneath the neckline, but this would certainly form a classical picture, should that pattern unfold.  With numerous countries on the verge of bankruptcy and governments and central banks taking huge financial risks to keep them from default, almost any kind of market response is possible.  While it is conceivable that central planners will yet keep economies and investment markets afloat, the risks remain extremely high.

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