A must read for equity bulls (and bears) courtesy of Fat Prophets

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A good friend of Angus’ who holds a senior position with a major US investment bank in private equity forwarded us an email that had been sent by someone else in financial services. It was the article we referred to last week published by Nouriel Roubini. We think this reinforces our argument that pessimism is reaching extremism and is now widely pervasive. It is easier to give in and “join” the consensus bearish view than somehow buck the trend a go in an opposite direction.

Such is the nature of financial markets.

Angus’ friend is not necessarily a bear, but market participants (traders, fund managers, private investors, superannuitants, etc) are now influencing and self reinforcing each other in the present climate of negativity and pessimism. Of course the process becomes reality in a bull market.

But herein lay the opportunities.      

Reading Professor Roubini’s article one can only come to the conclusion that the world is about to experience a global financial apocalypse that will end in depression for all of us. He doesn’t specifically state that conclusion, but his inference is clear.

Marc Faber, John Mauldin and other well-known economists draw similar conclusions. Marc Faber has written books on the subject and is a well known bear – who we might add has been right on many occasions. As has Nouriel Roubini, although he came to public attention much more recently in 2006/7 following the bursting of the property bubble in the US and Europe.

But this does not mean that they will all be right on this occasion.

What we do know is that during the present time equities are very cheap relative to fixed interest investments and cash. “Return of capital” is valued more highly than “return on capital” as market participants become conditioned by fear.

Return of capital takes precedence as US 10 Treasuries sell for the most expensive prices in history




We are always suspicious when markets become polarized by human emotion (greed or fear) because it often at these times inflection points are reached. We believe that at some point – the tipping point – holders of equities will become indifferent to some of the wider macroeconomic forces that are subduing the markets today. The bears will argue that markets will go much lower if Europe falls apart – and they may be right for a while, but our argument is that an asset that has value will always be worth something.

If the price of the asset is already heavily discounted, then the point of indifference when market participants become exhausted on the sell side will be that much closer. With equities now commanding some of the cheapest valuations in decades and offering the best relative value to bonds in history, we would argue we are getting close to that point of indifference.

In Japan on Friday the Nikkei was virtually flat with the market ignoring the Dow’s 250 point drop on Thursday. The yen weakened which provided some positive impetus, but generally most of the large multinational companies such as Sony, Toyota and Nomura actually finished in positive territory. We think market participants in Japan have now reached that point of indifference.



Now with US 10 year bonds paying 1.5%, and German, Swiss, Norwegian, Danish, Swedish and Japanese bonds paying negative yields or very little, we would argue we are getting close to the point of indifference in equities.  German Bunds are now paying zero percent.

There was more positivity in the air on Friday as US markets eked out gains after the Thursday’s selloff. The S&P500 and Dow rose 0.7 percent and 0.5 percent respectively. While Moody’s came out with bank dowgrades, there was relief that these were ‘no worse than expected’. This is telling when a stock, sector or market fails to decline on bad news and is a further sign of investor indifference.

Banks rose the most among all the S&P sectors, rallying 1.5 percent. The prospect of downgrades had weighed on the financial industry since Moody’s said in mid Feb that it was ‘reviewing 17 banks with capital-markets operations because of fragile confidence and tighter regulations’ that was pressuring revenue.

So as a result we saw the main US banks rally. Morgan Stanley rose 1.3 percent as its credit rating was cut by two levels rather than the anticipated ‘three’ grades. Bank of America gained 1.5 percent and Citigroup also ticked up even though they were both lowered to within two levels of junk.

Morgan Stanley rose on better than expected “bad news”



Even so the reaction was symptomatic of the fact that the much of the bad news is already in the price of the banks (and indeed equities in general).And certainly as Warren Buffet for one has been at lengths to point out the US/global banks are in a much better position than their European counterparts and are cheap at current levels.

Meanwhile earlier in the day European indices finished lower, however there was some cause for optimism. Particularly following the ECB decision to ease terms for collateral, boosting speculation the central bank will announce a third set of long-term loans.

There was speculation that Spanish policy makers are considering forcing investors who hold equity and junior debt in banks to absorb losses in a restructuring.  

Greece is also putting on a squeeze on its creditors. Greece is pushing lenders to extend fiscal deadlines under the country’s bailout program by at least two years, according to a policy document drawn up by the three parties in the country’s governing coalition.

The coalition wants to pull back on some of the austerity measures, which is probably not surprising given the pressures made to bear in recent elections. The new government wants to scrap plans to cut 150,000 public-sector jobs. The policy document underlines that cuts envisioned for 2013 and 2014 should come from ‘public spending and clamping down on tax evasion and not from pension and wage cuts or from the public investment budget.’

The tension between the ‘have’s and have nots’ also surfaced on Friday in central bank circles. The Bundesbank had another swipe at the European Central Bank’s plan to help ailing financial institutions. The Frankfurt-based ECB said it will cut the rating thresholds and amend eligibility requirements for some asset-backed securities.

The issue of ‘looser collateral’ is one that continues to divide European leaders ahead of this week’s EU summit. Italian Prime Minister Mario Monti said has come out and said that the rescue ‘must succeed or risk a bond-market selloff’. German policy makers are meanwhile reluctant to put too much wood on the table to help debt-strapped nations before they fix their own budgets and banks. French and Italian leaders are pushing for a wider range of crisis-fighting tools.

On Monday Europe will focus once again on Spain as it formally asks Eurozone partners for up to €100 billion to recapitalise the banking system.

Although agreed in principle, the ‘devil will certainly be in the detail’, with opinions split over how to apply the bailout and best restore investor confidence in the country’s debt. Voices continue to be heard on whether the aid money should go to the Spanish government or its banks directly. 

There would appear a growing belief that given Spain’s difficulties in raising money via the sovereign bond markets that it could become the fourth member of the Eurozone after Greece, Ireland and Portugal to need a full rescue.

So Spain will certainly have to come to the party with a credible recovery plan. At the very least Spain’s Eurozone partners are likely to require a deep restructuring of the domestic banking sector. And we could well see a return to the creation of one or more “bad banks” to house property assets.

While uncertainty remains over exactly how the problems in Europe will be fixed, we remain encouraged that they are at least being addressed.The acknowledgment that ‘there is a problem’ is the crucial first step in fixing any problem. We are seeing this increasingly by the day as it pertains to the peripheral countries in Europe. However financial bailouts will be more medicine than cure. Ultimately we expect that European leaders will move towards some kind of “banking union” within the Eurozone as well as towards the integration of fiscal and economic policies.

These are indeed trying times, but as highlighted in these notes, these are also times of great opportunity. We think it was one of the Rothschild’s who once said to “buy on the sound of cannons, sell on the sound of trumpets”. 

This Philly is no Black Caviar

The Philadelphia Fed Index (The Philly) surprised the market when the data for June was released in the US on Thursday. The market consensus for June was plus 0.5 with a range of forecasts from negative 3.0 to plus 4.0. The actual June number came in at -16.0. The negative surprise in June outcome caused a sudden surge in risk off sentiment and the Dow Jones fell two percent by its Thursday close.



The Philly measures the Mid-Atlantic manufacturing sector of the US, which is clearly in contraction mode. Unmistakably, the June figure is now also points to a contraction in manufacturing in the Mid-Atlantic region. From the June figure it would appear that the US manufacturing sector, or at least the region measured by the Philly, is in for a torrid summer.

The anecdotal data is now also turning south with the surprise June Philly collapse joining the Empire State Manufacturing survey which was, as we commented last week, weak in May.   

The Fed throughout most of 2012 has been running a quantitative easing (QE) rhetoric game. Playing off anecdotal data such as the Philly and the Empire State Manufacturing survey (which were pointing to a modest recovery), and hard data such as the state of US industrial production which fell unexpectedly in May.

“Information received since the Federal Open Market Committee (FOMC) met in April suggests that the economy has been expanding moderately this year.”

What the Fed delivered from its June FOMC meeting was an Operation Twist version 2 of US$267 billion to support US yields buy buying long and redeeming short. Operation Twist version 1 started in September 2011 and pushed US$400 billion into US treasuries. The evidence was looking reasonable that the US economy was in mild recovery mode as a result. However, the positive tide has perhaps turned just a few days after the conclusion of the June meeting.

The next FOMC meeting starts on 31 July. What will be key is whether the US economy and investors can wait that long. However as we remarked last week, a lack of willingness to act is not the question – the Fed is at the ready – the question is more one of timing.

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