In the spring of 2010, I appeared on CNBC and Bloomberg TV and
spoke about the revelations for markets concerning French bank
exposure to the Greek debt crisis. I was one of the first to say
that Europe's sovereign debt worries were then growing from a mere
government problem to a systemic banking crisis very similar to the
US one.
At the time, it was considered a fairly big deal
that France's top three commercial banks owned such a large
majority of Greece's public debt totaling over $80 billion. This
month, as the fortunes of Italy and Spain tremble, we have learned
French banks own debt of theirs totaling hundreds of
billions.
This is why, of course, European officials stepped
into markets Thursday with a ban on short-selling of banks and
other financial institutions. Will it stem the tide of losses and
erosion of capital ratios?
Probably not any better than it worked here in
2008. But the more interesting questions I’ve been pondering are,
"If it was so bad, why weren't these banks in free-fall months ago
and why is the euro currency still holding up so well above
$1.40?"
Will the Euro Survive?
I wrote a piece reviewing some of these questions
in June (linked above). Based on how well Europe's banking system
had weathered the mud of its PIIGS for 18 months up to that point,
I thought their crisis would have little effect on our economy.
And maybe that's what lots of other big investors
and strategists thought too. Here's what I wrote in June...
"And you have to consider that from crisis,
often comes a new equilibrium. When you accept that Europe has its
own unique problems, just like the US and its burgeoning municipal
debt crisis, it's hard to say how things will resolve.
Who predicted the near collapse of the US
financial system? And who predicted its amazing recovery from the
abyss? Not many.
As Moody's Investor Service warned last week,
three of France's top banks could be in for a credit downgrade as
they continue to use cheap US dollar funding to roll their large
exposure to Greek debt.
BNP Paribas, Crédit Agricole and Société
Générale may all be playing hot potato with debt of a deteriorating
quality, borrowing over $75 billion on the short end to finance
their longer-term holdings of Greece government paper."
Tip of the Iceberg
This was the mood of quiet toleration (heads in the
sand?) before we learned how much Italian debt they owned. So the
selling of these top three banks really didn't even begin until
July, weeks after the Moody's warnings and awareness of "the
Italian problem" heated up.
Here's a summary of their declines before the
short-sale ban (priced in euros) since July 1, when two of the
three were close to their 52-week highs and the third, Soc Gen, was
still within 20%.
BNP Paribas (BNP:FP) -- 55 down to 33 euros
(40% decline to lows)
Societe Generale (GLE:FP) -- 42.50 down to
20 euros (53% decline to lows)
Credit Agricole (ACA:FP) -- 11 down to 6
euros (45% decline to lows)
Chanos Chimes In
Notorious short-seller Jim Chanos gave an
interesting quote to Bloomberg.com for its story, "Short Selling of
Stocks Banned in France, Spain" by Howard Mustoe and Jesse
Westbrook:
"EU policy makers don’t seem to understand the law
of unintended consequences. The vast majority of short-selling
financial shares is by other financial institutions, hedging their
counterparty risks, not speculators. The interbank lending market
froze up completely in October to December 2008 -- after the
short-selling bans."
This is exactly what we learned back then. I was
working for a large options market maker in Chicago and the
"unintended consequences" were numerous and obvious to us,
especially as market makers were at first not exempt from the ban,
eliminating their ability to hedge and provide liquidity to markets
in both options and stocks.
The Europeans got the market maker part right this
time, but volatility may still rise because hedge funds who
normally try to strike some balance between long and short
positions will be leaving the market, the Bloomberg story goes on
to explain.
A Moby Dick of Fears, Besides GDP
So, while I have been writing for two weeks about
this sell-off being mostly a function of lowered growth
expectations since the awful GDP revisions of July 29, I should
consider that the banking crisis finally unfolding in Europe has
been a big catalyst too.
Like a sea monster you can"t see under the surface,
the vaguely familiar unknowns trouble institutional investors who
remember 2008, even if our economy and banking system are much more
sound.
We grew accustomed to Europe's debt crisis, as if
it were unfolding in slow motion. Just another part of the daily
headlines, it didn't bother us as much. And as with all crises of
confidence, especially those involving banking, they don't really
matter until they do and things implode. In other words, until the
creature bumps into your boat and makes its presence very real and
known.
The Big Question Now for the US Economy
If Europe's crisis does devolve into a wholesale
systemic crisis that freezes their markets and economies, what
impact will that have on a US economy at stall speed?
Everyone talks about the impact of fear on the
American consumer, as if we can collectively talk ourselves into a
recession with negative headlines that weaken and dispel confidence
-- and spending. But I think the American consumer has proven
amazingly resilient since our crisis. His and her expectations
about jobs and credit and growth are much more reasonable and
realistic, if subdued. That's good right now.
I am more worried about the impact of fear on these
two groups of spenders: institutional investors, primarily equity
portfolio managers, and CEOs and their purchasing managers. If
these people are uncertain about the future and lack confidence in
growth prospects, this will become a self-fulfilling feedback loop
that can cause recession.
Earlier this week, I wrote "QE3 and the Probability
of Recession" in which I shared a chart of the Federal Reserve's
last growth forecast from June. And while I look forward to their
update since they got it wrong -- and got the bad news to prove it
on July 29 -- I am even more eager to see and hear the projections
and concerns of money managers and heads of industry.
Since the S&P derives 45% of its earnings from
abroad, and Europe's contribution is easily one-third of that, a
fallen EU is a big blow to the US economy. Viewing the current 15%
correction in equities (I'm using the drop in the S&P 500 from
roughly 1,350 to 1,150 to get 15%) as an extremely quick
discounting of the increased "probability of recession," I still
expect the market to trade sideways for the next few weeks until we
get more information.
Pricing in Blah
Here are some numbers to keep in mind until we
start to get lower growth forecasts and downward earnings estimate
revisions after Labor Day:
Estimates as of August 1 were for the S&P 500
to earn about $98 per share in 2011. Let's say that realistically
the best we could expect now is $95 EPS. At an index level of
1,200, that's a "working" P/E of 12.6.
If you bump EPS down to $85, at 1,200 the S&P
still looks cheap at 14 times. The catch is that if earnings and
GDP are still declining, then money managers and CEOs will continue
to price in lower expectations. Right now we wait for more
data.
In "How Long Will the Correction Last?" from August
5, I wrote the following about where we stand...
"I think the highest-probability scenario is a
'wait and see' by institutional investors. That means to me that
the S&P will range trade between 1150 and 1250 for the next 2-3
months, in waves of pessimism and optimism, until more visibility
on GDP, jobs, cap ex, manufacturing, and corporate earnings rolls
in.
What are the chances that this advance 'pricing-in
of the recession' heats up and we dip below S&P 1,100? I'll say
about 40%, right around where I think the probability is for an
actual recession.
Use my probabilities as a rough guide and trade
your own view accordingly. Many strategists from major investment
houses, managing trillions of dollars in aggregate, have similar
projections.
The hard part is that on big sell-off days, they
look like they are more scared than they really are."
Investing Without Certainty
During this tumultuous two weeks, I've done many
interviews with financial media, both TV and print. When asked by
AARP what I thought senior investors should be doing with their
money, I became very cautious, thinking of my own parents and their
retirement concerns.
But then I just stepped back and framed the
question as any investor should by moving away from emotion and
just thinking rationally about time horizon. Here's what I said on
Monday...
"If one has ten years left in the market, it's a
no-brainer to be putting money to work in stocks. There are lots of
buying opportunities to take advantage of right now in stocks like
Apple (AAPL), Eaton (ETN), and National Oilwell
Varco (NOV).
If you have five years left for your money to work
for you, there are still stocks and sectors like energy,
technology, and materials that one should be accumulating at these
levels. But for those who need their money in the next two years,
it's a good time to just sit back and see how this unfolds into
October earnings season.
Given a 40% chance we slip into recession,
institutional investors -- who move the market in aggregate with
the trillions of dollars they manage -- will be waiting for more
bloodwork on the economy and earnings before they return to the
business of investing."
Kevin Cook is a Senior Stock Strategist for
Zacks.com
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