Posted by Karl Denninger
To follow up and expand upon my other writings regarding the ECB/Euro bailout package of last weekend, I want to focus on why I believe the markets responded to the north as strongly as they did – and why believing in this may be dangerous to your portfolio.
Markets try to suss out the impact of events based on history. The more recent the history the more impact that event has in the collective consciousness. This is true in all human endeavors where psychology is a factor, and the equity markets are the epitome of human psychology interacting with money.
About 18 months ago the United States Congress passed TARP, and The Fed opened unprecedented policy actions (many of which I have argued were illegal, and still do.) But the markets, at least initially, did not respond. Indeed, it was not until about six months later, when FASB changed mark-to-market accounting rules and thus allowed financial institutions to lie about balance sheet values in the United States, that the “recovery” of the markets really took hold.
The pundits, however, all point to “easy money” and “monetization” (whether true or not) as the reason for the market turn. I disagree, and point to the fact that both consumer and business credit have not turned around. We can therefore disregard that claim as mathematically deficient (incidentally it was correct in 2003, as the numbers show.) It didn’t work this time because the market is (still) debt-saturated, which is why we entered the recession and housing crash in the first place.
I have spent many hundreds of hours studying the credit crunch and the alleged “recovery” therefrom thus far, which has led me to my primary thesis for the stock market rally and alleged “stabilization” in the US Economy. The truth is found right here in my favorite (of late) chart:
That is, we didn’t “recover” in the stock market because of a “bottoming” in the economy nor, in the main, because of ZIRP. We can exclude the zero-rate policy as a recovery catalyst as it didn’t work in Japan, which tried the same thing and got two decades of deflation and a stock market stuck at 2/3rds off all-time highs in response.
So what “moved the needle”, at least temporarily?
- Blowing budget deficits wide. Japan had them before, thus their budgetary profile just continued to deteriorate – they lacked the ability to make meaningful additions to that program and move the needle. We could, we did, and it mattered – for now.
- FASB changes. They were a game-changer in the short term, but are ruinously bad in the intermediate and longer term. The game has been and continues to be to allow banks to claim valuations that don’t exist in the hope that (1) they can “earn” enough to close the gap or (2) asset values will recover. The latter is an idiotic premise as the values were never real in the first place and the former won’t work because instead of rebuilding cash reserves with these “earnings” the banks have instead bonused out all the money! But in the short term it all looks good, and most of these stocks have doubled – or more.
That’s where your rally came from and it’s also where your positive GDP prints have come from in the US. My belief that the government couldn’t get away with (1) for more than 12 months or so, by the way, is why my original belief that this move upward wouldn’t have the power or duration it has proved incorrect. Sadly, it also means that when the pump wears off the collapse will be significantly worse than if they had left it alone – they’ve blown the money but the debt is still there.
By the way, for those who argue differently – show me the math. Specifically, show me how blowing a budget deficit from 3.5% of GDP to 11% of GDP does anything other than what’s happened, and how allowing firms like Wells Fargo to maintain $1.7 trillion off balance sheet without a market price for those “assets” fails to cause people to “believe” that the firm is solid and stable, and thus be willing to buy their stock (along with the rest of the financial sector.) I’ll take that analysis on the latter point in the form of actual valuations of those assets against the market and compare the divergence against these firm’s Tier 1 Common Equity (and I’ll wager all will print a number in parenthesis if you do that.)
Now let’s analyze against the European/ECB announcement.
First, the ECB announcement is the exact opposite of point #1 above. That is, the announcement contains formal claims of austerity for governments, which means reducing the debt-issuance spike to GDP. Whether through tax increases, spending cuts or both, the impact will be the same, and it will be materially negative on a macro economic level. There is no possible way to avoid this if the actual austerity measures are taken, and yet the “bailouts” are conditioned on them so it is reasonable to assume that either (1) they won’t be taken and the bailouts won’t happen or (2) they will be taken and the effects will flow from them.
Second, European banks were already lying about asset valuations. That is, there’s no “goose” that can come from that here in this case, as Euroland banks were never honest about their leverage or asset valuation levels to the degree that US banks used to be. Thus, there’s nothing to “rig the market with” there, as the impact of that rigging has already been had years ago.
The FX markets have already figured this out and reacted accordingly; indeed, the Euro traders figured it out in less than 12 hours. But the bond and equity markets haven’t – yet.
Putting off the collapse of a sovereign bond market by buying their bonds when you are sterilizing the buying doesn’t work for long. The credit markets will call that bluff sooner rather than later, and when they do spreads will start to force open again.
At that point the ECB has a problem: If they try to increase the size of the package they will have to deal with those who claim there’s a credibility problem in that they haven’t yet funded the original program (and might not be able to!); if they instead turn to raw monetization of debt the entire underpinning of the Euro and ECB goes down the drain and the risk of defections grow substantially. Indeed, there may already be some hints of that with Germany – if the German people haven’t figured out that this program, led to its conclusion, inexorably requires them to transfer their wealth to the PIIGS simply to keep the Ponziconomy in Europe going, they soon will.
In short this doesn’t look like a stability measure to me, it looks like an instability measure. There’s nothing worse than “reassuring” the market with something that turns out to be BS, as we saw back in 2008 with Fannie, Freddie, and Bear.
I think we’re due for another example, and would be protecting all long-side positions accordingly.
Thursday last may have been nothing more than the Fat Lady clearing her pipes.