May Rout Leads to June Rally


On April 6th, just after US stocks touched a high for the year and climbed to within 10% of the all-time high set back in October 2007, we wrote: "The market will do one of three things over the rest of the year:

  1. Trade flat for the next 9 months - not likely.
  2. Surge into a "buying panic" as investors finally jump back into stocks, which would leave the market up 20% or more by year end.
  3. Plummet as some exogenous event (like last year's Japanese tsunami or the Greek credit crisis) cause investors to retreat to cash once again."

We got three "exogenous events" in May:

  1. Greek credit crisis resumed, with Greece likely to exit the Eurozone this summer.
  2. JP Morgan Chase lost $3 billion on Credit Default Swap trading.
  3. The FaceBook "FacePlant".

And on June 1st, the Labor department reported a minimal gain in jobs, which has economists worried anew about the United States returning to recession.

So from the high on April 2, to the low on June 1st, US stocks sank 9.9%. Unfortunately, human nature focuses more on losses than on gains. Stocks remain 81% above the March 9, 2009 low, and 18% above the October 3rd low. But as we saw today (best one day return of the year,) universal bearishness tends to lead to outsize upside returns.

Many, many questions from our clients:

What is going on with Europe?

As we have said many times, the Europeans spent 30 years building to the current situation, and it will take at least a decade to straighten things out. The situation in Greece is the "canary in the coal mine." Greece is an artificial country cobbled together by the US and Great Britain at the end of World War II to prevent the Soviets from getting warm water naval ports on the Mediterranean. As of 2010, Greece had about the same GDP as Maryland, now probably 20% less. The country has three important industries: agriculture, tourism and shipping. These industries did not generate enough cash flow to purchase what Greeks wanted to buy, namely, German cars and dishwashers. Germans were anxious to keep exports booming, so helpful French and Italian banks stepped in to lend money so that Greeks could buy German exports (and build super-highways and other modern infrastructure.) The bankers felt confident in making loans despite the Greek national tendency to not pay taxes because a.) the loans were denoted in Euros, not some trashy third world currency like the Drachma and b.) scores of hedge funds were willing to write Credit Default Swaps on Greek debt (more on CDS below.) The bankers did not consider that their purchase of CDS did not eliminate their risk in buying Greek debt. It only transferred that risk from a junky country to junky hedge funds, which, as history has shown, tend to close shop when a payment is owed.

Over the last two years, bankers, governments, hedge funds and the Greek people have played "hot potato" as to who ultimately takes the loss on tens of billions in Greek debt. Thus, time and again a "deal" is declared, which is replaced by another deal a few months later, and another and another. The latest deal will most likely be rejected by a new Greek Parliament elected June 17th, 2012 and Greece will exit (or be forced out of the Euro.) 50% of young Greeks will emigrate over the next 3 years as unemployment remains in the +20% range.

The real threat is that Spain (the 12th largest economy in the world, ahead of Texas but behind California) goes next.

Is Greece the next Lehman Brothers?

No - two distinctions:

  1. Lehman was central to the world banking system, Greece is peripheral to the Eurozone. When Lehman failed so did AIG. Merrill Lynch, Morgan Stanley, Goldman Sachs, Barclays Bank and Deutche Bank were right behind. Only a miraculous intervention by the US Treasury and Federal Reserve to payoff AIG's liabilities in CDS (there's that word again!) saved the day. As of now, Greek debt has already been written down by 75%.
  2. Lehman was there Friday afternoon and gone Sunday afternoon, leaving its counterparties no time to react. Is there any investment manager in the world who hasn't expected to Greece to fail for a year now?

What is a Credit Default Swap?

Once upon a time, managers of bond portfolios believed it was their job to adequately evaluate the credit quality of their bond investments and diversify accordingly. Then, in the mid 1990's, JP Morgan bankers created a nifty bond put option. In the event that an issue failed, the writer of the put option would pay the buyer of the put option the difference between the issue price (par) of the bond and any residual value of the bond.

But wait, why are these contracts called "Credit Default Swaps," and not "Bond Put Options" or "Bond Failure Insurance?" Because in securities law, writers of put options are required to put up initial margin and increase that margin if the markets move against the options. The collateral requirements for anyone writing "insurance" are even more stringent (which is why no insurance companies failed during the financial crisis.) JP Morgan sidestepped the whole issue of collateral by coining "Credit Default Swap" as the name of the new product.

CDS are custom, illiquid, non-transparent and uncollateralized. In 2003, Warren Buffett wrote that these and other derivatives were "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system. "Nonsense," said Alan Greenspan, who was head of the US Federal Reserve system at the time, and who blocked regulation of the new industry (he changed his mind in 2008.)

How did JP Morgan lose $3 billion

JP Morgan invented the CDS market in the 1990's and remained the dominant player through 2010. Unlike AIG, which lost $180 billion on nominal exposure of $3 trillion in CDS exposure, JP Morgan skated through the 2008-9 financial crisis relatively unscathed, and still controls about 30% of the CDS market. The problem for JP Morgan is that the other 70% of the market is now filled with ex-Morgan employees who know how the models work and have taken those models to new employment in hedge funds.

We still don't understand exactly what a single trader nicknamed "the London whale" was trying to do, but he sold national exposure of about $100 billion against the default of investment grade corporate bonds with an average maturity of 2017. Hedge funds ganged up on the other side of the trade. As the Morgan position sank into the red, the trader doubled and redoubled his position, but was finally forced to admit a loss of $2 billion in May. When the trades are closed out, the final cost is likely to be $3 billion. Not the end of the world for JP Morgan, which earned $5.6 billion in Q1 2012. But a black eye for JP Morgan head Jamie Dimon, who had been aggressively lobbying against the new regulations coming out of the 2010 Dodd-Frank legislation. If nothing else, we now have a test case as to whether JP Morgan violated the "Volcker rule" provisions of Dodd-Frank prohibiting "proprietary" trading (as opposed to trading "necessary to accommodate normal market making operations.")

What happened with the FaceBook IPO?

We generally avoid IPO's for two reasons:

  1. We invest almost exclusively in "seasoned" companies with at least three years of financials as publically traded companies.
  2. For every Google (which tripled in the first year as a public company) there are a hundred Vonage's (which peaked on the first day of trading and is now down 90% from that day.)

It was already a tough year for Web 2.0 IPO's (GroupOn down 51%, ,Zynga down 43%). When we heard that Morgan Stanley had "magnanimously" agreed to increase the allocation of stock to retail investors, we knew this one would be a stinker - institutional investors were shying away. And indeed it was, down 40% from the high on 5/18 and down 32% from the IPO price of $38.

Average retail investors don't understand any of this. Hundreds of thousands put in orders for $1,000-$25,000 of stock and immediately lost a bundle. Worse, technology problems at NASDAQ caused many investors to receive MORE shares than they thought they ordered, compounding their losses. Straightening that out will cost $40-100 million. Time and again, average Americans have been "hosed" in their dealings with Wall Street. Absolutely no-one in Washington, not at the SEC, not at the White House, not in Congress, seems to have any interest in bringing Wall Street to account.

Does anyone wonder why average Americans have pulled $400 billion out of stock mutual funds over the last 5 years?

What about your "Obama wins in 2012" forecast?

Last month we described 5 circumstances where Romney might win. The most important:

"Unemployment surges. If average Americans can see their lot improving even if current conditions are poor, Obama wins. If the economy turns down over the summer, Obama loses. On that basis, we see Congress doing absolutely nothing to boost the economy over the next 6 months."

A few more months of jobs reports like the one we got last Friday, and it's "game over" for the Obama administration. And no, Congress refuses to do anything that would boost jobs growth.

Shouldn't we give up on stocks and only buy bonds

Of the hundreds of billions pulled from stock funds in the last 5 years, many billions have gone into bond funds, which have maintained or even increased values as the Fed pushed interest rates to near record lows (only lower during the Great Depression.) In 2014, or perhaps now in 2015, the Fed will allow rates to rise. Medium or long dated bond funds are going to get killed. For long term capital needs such as retirement, the 3-4% current yield available from bond funds simply isn't enough to grow the pot. Also, if inflation ever returns, that 3-4% nominal yield might only be 0-2% real return.

Our strategy remains: Stock and commodity investments for cash needs at least 5 years out. Bond investments for cash needs 1-5 years out. Money markets for cash needs of less than a year.

Why should we be optimistic? Everything we read implies "the end of the world."

Drives us crazy! Media outlets get eyeballs when things look like disaster. Good news is no news. Unremarked in the last three months: Oil prices down 25%; gas prices down 10% and still falling. Decreasing inventory, a slowing foreclosure rate, increased buyer interest implies that 2012 is the true floor of the housing market, with modest gains expected for 2013. Average Americans have 5 times as much wealth tied to housing as to stocks; any gains there have positive implications for the rest of the economy. The US auto industry, which many observers were ready to write off for good in 2009, reported record profits in 2011. Huh!

Over the next ten years, the US economy is likely to grow by 50%. The Chinese economy may well grow by 100% in the same time span, but the US will still be the largest economy.

Isn't there some way we can jump out of the market at the highs, come back in at the lows?

We get this question every time the market pulls back. "If we thought the market was over-extended back in March, why didn't we raise cash so we could preserve gains, come back now." Market timing is wonderful in principle, but in practice, we have yet to see a firm that has a sustainable advantage, even before backing out trading costs and commissions. At our firm, we mechanically rebalance 1-2 times year to our target allocations, which achieves our long term goal of selling high and buying low. This works very well for our "retirement bracket" clients (60-85) who have benefited from having a high bond allocation over the last ten years. It has been a lot tougher on our "accumulation oriented" clients (45-65) who feel like three steps forward in stocks is followed by three steps backward.

If you were our client who went off on Safari at the end of last year, got back today and called for an update on the markets, we would tell you that the S&P 500 is up 5.6% YTD. "Cool," you would say, and get back to sorting your laundry. It's the up 13%, down 10%, up 3% gyrations that make people crazy. Our fix: turn off CNBC and do something more interesting with your life.

"Should we invest in hedge funds?" Those firms are making leveraged directional bets. Most do well for several years, wipe out in the fifth year. A few make it ten years. A tiny percentage (about 0.1%) makes it 20 years. Those firms do what they do very well, but it's irrelevant to most investors as the funds are closed. The rest are a good deal for the managers, but a lousy deal for investors.

"Should we invest in High Frequency Trading?" As individual investors leave the markets, HFT firms are left trading against each other (Darth Vader vs. Ming the Merciless.) HFT firms make their money scalping the trades of individuals and mutual funds. No trades? No profits!

"Should we invest in private equity?" This strategy depends heavily on leverage, generally "creates wealth" for the general partners, and "destroys value" for pretty much everyone else. With bank financing dried up, the private equity game is pretty much over.

All these options are illiquid, non-transparent and have high management fees. We won't recommend them to any of our clients.

Will 2011 be a repeat of 2012?

Last year, US stocks started off well in the spring as employment grew and the GDP numbers kicked up. The summer was a miserable slog of bad news out of Europe, and by December 31st, the S&P 500 closed with a gain of only 2.1%. Clients' overlay this year's chart on last year's and wonder if another "year of suck" is in the cards. If you want to play that game, why couldn't 2012 be like 2010? That year, stocks had a strong rally in the spring, sold off sharply hitting a low for the year in July, but rallied to close out the year with a gain of 15.1%.

What we do know for sure is that the market will not end up like 2008, with stocks down 37% and still falling because the conditions that created extreme risks at the start of 2008 are not present. JP Morgan's loss on CDS could not have come at a better time to remind politicians that banks need firm regulation, just as the provisions of Dodd-Frank were in danger of being watered down.


We feel less certain about the outcome of the US presidential election compared to two months ago. That means we are less certain about many other aspects of the US political economy. The biggest unknown is US tax policy in 2013. At present, US personal income rates will automatically return to higher levels January 1st, unless Congress and the White House can form a bi-partisan consensus prior to the election. Forget about that!

US stocks however, were a good value a month ago and a better value today. With the weak hands forced out by the recent 10% pullback, we are moving forward with investments in stocks. We have talked to so many prospective clients who went to all cash in March 2009. While these prospects have missed out on most of the gains of the last three years, it is reasonable that if they invest today, they will make a decent return by year end. Our forecast remains 12% in the S&P 500 by year end, versus today at 4.6% YTD.