Sunday, September 18, 2011

Investment Implications of Marco Polo’s Return

If you scratch a securities analyst, an historian will bleed, or that is my belief. Analysts and most investors rely on the certainty of the past, even if they are portrayed inaccurately. Histories are written by the victors and read by those who wish for simple narratives and conclusions; in other words, they usually read about the side that had the best public relations.

One of the stated impetuses to the sharp rise in markets around the world early last week was the rumor that the Chinese were going to intervene in the Euro markets, and more specifically, the sovereign debt of Italy. Apparently this was untrue. Nevertheless, rumors have value in that many believe it could have been true. When I was first conscious of the rumor transmitted as fact, I thought it was, in effect, like the return of Marco Polo.

The simplistic version of the Marco Polo legend was that of an Italian returned from many years of traveling within Asia; who brought back remarkable tales of the technologically advanced society of China. He was introduced to among other things, paper money. (There are some who believe that paper money, or in today’s terms, electronic money, is the ultimate weapon in destroying the strength of developed countries. I will let others debate the value of fiat currencies, but it is an important issue for the transfer of wealth to future generations.) Marco Polo is credited by many with bringing to Europe, the wonders that existed in Asia and the intellectual accomplishments of its people. As usual, the real story is a great deal different. There were a number of merchant traders who worked the Silk Road before young Marco joined his father and uncle on their journeys that took them to Kubla Khan’s court in what is today’s Beijing. The reason for the fame of Marco Polo is he had many years to tell his stories to a cellmate in a Genoa jail. Copies of these tales then circulated throughout Europe.

What interested me this week was the irony of Italians once again benefiting from the temporary, and perhaps lasting success of China. According to Harry Mount writing in Friday’s Financial Times, Italians invented deposit accounts, double-entry book keeping (as distinct from two or more sets of books for tax authorities and business partners) and the letter of credit, as was demonstrated in Shakespeare’s “Merchant of Venice.” He further informs us that bank, bankrupt, and risk are words derived from Italian.

Italian implications for investors

Italy is the third largest economy in Euroland. There is a particularly close relationship between Italy and the French banks, and to a somewhat lesser extent, the German banks. European governments use, and in turn are beholden, to their banks. If interest rates on Italian debt reflected the true risks of some type of default, Italian borrowers could not afford to borrow, and perhaps more importantly, banks around the world would have to mark down the carrying value they have put on Italian debt. For some, and perhaps many banks, they would appear to be swimming without appropriate attire when the debt tide runs out. In many cases they would be considered under-capitalized, as warned by the lately courageous head of the IMF. The threat of a global banking crisis of insufficient capital would be destabilizing to say the least.

Later in the week there was the announced three month coordinated dollar loans to the European Central Bank (ECB) from American, British, Swiss and Japanese central banks. These activities initially buoyed the markets, however these loans are only one answer to the immediate liquidity needs for dollars of a number of European banks. While this may give some time to the individual countries to meet their budget crises, the weekend news is not encouraging. Liquidity is the surface level of the crisis, but as we learned from the Lehman Brothers’ debacle, at the end of the day the need for fresh capital is critical.

Conspiracy thinking

In a saga that began with Marco Polo almost 800 years ago, one should look beyond the shadows of what could also be happening now. Did the four central banks move in a coordinated way to rapidly scotch the potential Chinese intervention? Some may feel that at this time a more dominant Chinese player, as the world’s second largest economy, could demand too much ceding of Europe’s economic/financial power. As with good shadow players, all will deny that this was a motivation. Unless the deficit reduction issues start moving to a reasonably fast solution, we might see the long term implications of Marco Polo’s return while the world marches to a Chinese rhythm.

What should you do now with your long-term investment portfolio?

First, enjoy the 4-8% gain in your stock portfolios, depending how much of the portfolio was in technology and financial services. Second, you need to separate possible tactical from strategic moves. Many rises in stock prices are often labeled short-covering rallies, and then the market continues to rise. In this case, I see a lot of evidence of shorts rushing in quickly to cover their bets. On August 31st, the short interest ratio for stocks on the NYSE rose to 3.2 days. This compares with 2.1 days two weeks before. A much smaller rise was seen for NASDAQ listed stocks. The biggest single change was a 70 million share increase in the short position on Bank of America, which was an almost 50% increase in fifteen days, and placed the stock as the third most shorted security behind two general market ETFs. BofA was not the only unloved financial. The Financial Select Sector ETF was the fourth most shorted security on the “Big Board.”

All of this suggests to me that now would be a good time to make switches, particularly out of depressed stocks that have inordinately rallied. The key to this maneuver is that it is a switch, not a reduction to the proportion of your portfolio in equity and equity funds. For a stock investor who sells out of a company with deteriorating fundamentals, a temporary move into either a generally diversified or a more focused mutual fund (not an ETF), would make sense.

On a strategic basis, paying up to get into better companies would be a good thing to do now for the long term. The other matter that all investors should consider is the paragraph above on conspiracy thinking. In the long term, I believe that portfolios need a materially bigger strategic weighting in favor of Asia over Europe. To the extent that Latin America and Canada are exporters, I would include them in my Asian focused investments.

What do you think?

To read last week’s Blog from Mike Lipper, click here.

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