The long bailout saga continued again this week. European Central Bank President Mario Draghi followed through on his recent promise to do whatever it takes to keep the Euro alive. Over the objection of Bundesbank President Jens Weidmann, Draghi pledged unlimited ECB bond buying to support Eurozone countries so fragile that they cannot float debt in unassisted markets. The King Report this morning humorously analogized that action “…like a guy bragging that he will watch unlimited football on TV while his wife controls the remote control.”
Draghi’s pledge, plus anticipation of Federal Reserve Chairman Ben Bernanke’s follow-on stimulus in this country, prompted an explosive worldwide stock rally late in the week as shorts ran for cover. For the moment at least, investors expect that central bankers will be able to offset the effect of weakening fundamental conditions throughout the world. With the vast majority of investment managers trailing market benchmarks in 2012, the “hold your nose and buy” approach appears to be taking hold. Many short-term oriented hedge fund managers in particular cannot afford to trail such benchmarks at the risk of losing significant amounts of compensation. With year-end in sight, the need to earn bonuses is prompting a more aggressive equity allocation. That position may or may not result in better full year performance, depending upon how long confidence in the power of central bankers remains in place. Bonus greed is hardly a sound criterion for increasing equity exposure. It certainly increases the risk of dramatic portfolio declines, however, should the best central bank efforts prove ineffective.
As I have voiced many times in these entries, investors in today’s market need to evaluate carefully both their exposure to risk and their ability to withstand a potentially sharp and relatively permanent asset price decline. Markets are not dealing with normal economic concerns. Should ECB efforts prove insufficient, investors could wake up one morning to learn that one or more countries have left the Euro by choice or by command. The possible effect on banking systems throughout the world is unknowable but certainly great. And after delayed openings, securities prices could open at fractions of their prior closes.