Sunday, July 8, 2012

Investment Traps: More Evidence


Last week’s blog suggested that the surge of Friday, June 29th could have been a trap for unwary investors. There were three different baits in the trap. They were the relief caused by the US Supreme Court’s decisions on Obamacare, the surprise and pleasure that the latest European summit led to some agreements on loans to troubled banks, and favorable market enthusiasm and market volume. Today we examine each to see whether they are baits or poisoned fruit.

The Supreme Court did not provide needed answers

This is a blog for investors that have substantial, for them, investment portfolios; not for lawyers nor politicians, even though they have been known to have large portfolios from their private sector investing. The implications going forward are that there will be a tax that some wish to call a penalty. (Aren’t all taxes penalties?) The Court’s focus should be interpreting the US Constitution and the conflicts between state and federal law, not to make overt economic judgments. Nevertheless, the decision that taxes or penalizes people for not buying medical insurance has large and unknown economic impacts.

More to the point, I have little confidence in the supposed results of Obamacare. The annual costs to society will be large and disruptive, creating uncertainty in the reactions of individuals, businesses and the medical world. Thus far I see nothing that will lower the society’s cost or more importantly, improve the quality and quantity of healthcare. From an investment viewpoint the Court’s decision leaves open the impact of its actions and thus makes it easy to continue the indecision on the part of employers to hire employees. Over time I suspect that it will lead to more work being put out to small contractors that have exclusions in the present regulations. Bottom line, I see no reason that the markets should rise on the basis of the decision. 

Summit agreement is illusory

By the end of the day Monday, we will learn from the meeting of finance ministers in Brussels how they are going to create a single European bank supervisor. This is not a trick question but a trick that Germany played on the supposed agreement to allow the European Central Bank fund to grant loans directly to banks. This single supervisor would supervise the safety and soundness of all banks in the seventeen countries that use the lamented Euro and by implication all banks in the other countries within the European Community, e.g., the UK. With both the Finnish and the Dutch governments looking for specific collateral and other terms, there does not appear to be much confidence in the existing financial statements of at least some banks. In voting their support for these loans, the German legislators insisted on one of their pet projects: a European (and from their viewpoint, global) transactions tax. London is having enough trouble holding on to its prominence as a financial center with the growing LIBOR scandal that would prevent it from buckling under any continental scheme in the foreseeable future.  The highly respected but controversial economist from Citigroup, Willem Buiter, is quoted as saying “the EU summit measures still fall far short of what is ultimately needed to ensure survival of the Euro area.”

Read with skepticism and believe it won’t happen

I wonder whether we will see the burial of the “Too Big to Fail” concept and recognize the inevitable; that while painful in the long run, it is cheaper and more efficient to let various banks go under. Their smaller replacements will be sounder. I am probably too premature, but the odds are improving every day that this historic approach is still the best one.  I recognize that letting banks fail could in turn lead to some governments defaulting, perhaps as in the past after extraordinary attempts to inflate their way out. After inflation eventually comes deflation; either quickly or agonizingly slowly as in Japan. The lesson from distressed investing is that the quicker the filing for bankruptcy, the smaller the losses sustained by the creditors.

Probably all or nearly all of the summit participants will fight against the fundamental recognition of the structural problem. Thus the ministers in Brussels may find a way to paper over these issues on Monday, but confidence is once again low. (Even if gold drops to a bottom of $1200 an ounce before a subsequent rise as some predict, the trading loss will probably be less than holding so called high-quality paper, the principal reserve element in lots of portfolios.) 

Market mechanisms no longer favorable

On the 29th the reported volume on the New York Stock Exchange was 4.1 billion shares. This week the average daily volume was 2.7 billion shares, or a retrenchment of more than one-third. After Friday’s release of US jobs numbers, the lack of enthusiasm was palpable; pundits were stating that we have entered a stall speed. Experienced pilots and other flyers know that crash landings are probable in a stall unless there is rapid acceleration. 

We are seeing an increasing number of money market funds as well as hedge funds leaving the business. I am also seeing a small number of active equity funds being replaced by their shareholders or management companies with Index funds or ETFs.

To some degree all of this bearishness is a good sign. Bull markets begin when almost all are discouraged. Based on the past however, we need to see capitulation which we have not yet seen. We might if interest rates were higher.

Please share with me your views as to the opinions expressed.
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