By Jeff Snider, President & CIO, Atlantic Capital Management
There Is Little "Value" Under Untenable Circumstances
Even now, in the third year of the recovery without a recovery, there is still a good deal of mystery as to why and how US investors should be wary of Europe. The intentional opacity of the global banking/financial system contributes to this effect, but all that is taking place in Spain and Italy will directly impact US asset prices at some point. The biggest lesson of the Great Depression was supposed to be limiting the spread of “contagion” through bond market prices, yet the modern interbank wholesale money system of securitization and financialization has gone far beyond what they ever dreamed possible in the 1930’s. The connections between Spanish insolvency and the fallacy of the US dollar safe haven have never been greater, and given the propensity of sovereign euro debt to act as a global catalyst, it pays to at least review why US stock investors should be extremely mindful of monetary flows in seemingly unrelated global pockets.
On one side of the Atlantic, there is the “bull” case for US stocks as a safe haven from the European turmoil, particularly since stocks are supposedly cheap compared to corporate earnings (more on this below). On the European side, there remains faith in policymakers to finally coalesce around a workable and serious solution. But that faith misses what might be the unmovable object in this financial equation, just as the irresistible force of contagion is unleashed, again.
The real worry about the Spanish banks, as it has always been, is not even solvency, per se, it is that 1930’s-style contagion of pricing. With Greek debt, Eurozone banks were afforded the margin to at least unload or even sit tight and take their mark-to-market losses; it was never going to rise to a fatal amount. But Spanish and Italian sovereign and bank debt remains embedded within Euro banks, particularly those in France. These are bonds that are, from what I have seen and given how this unraveled with Greece, currently embedded within "bank books" - not "trading books" - which means free from mark-to-market losses. OECD sovereign debt itself is still considered risk free, and thus not applicable in a mark-to-market structure. That is, until a market "event" which forces banks to recognize and legitimize any impairments. That is the fear of Spain, as a restructuring event akin to Greece would probably destroy several large institutions (how close were we on December 8, 2011?) under the weight of previously "undisclosed" losses that are currently tucked away in “bank books” everywhere. It has been amazing over the past four years just how assets go from perfectly fine, valued at or near par, to serious other-than-temporary-impairments overnight.
The more likely it appears that Spain needs to restructure, the more likely the Eurozone banking system ends up taking these large embedded, but still unmarked, losses. As far as Spanish banks, we know that they are overexposed to the sovereign, including being over-represented in the LTRO's, so we need only go back in time to see what prices they were likely buying at. We also have some idea as to the extent to which the Spanish banks are still holding local RMBS (and especially CMBS of land developers) unmarked in their bank books through institutions that have already been “outed” in failure. Bankia's EUR5bn capital shortfall quickly turned into EUR9bn and then EUR15bn on the way to EUR19bn. Those bailout losses are unmarked assets that are getting "reviewed" by the national “receiver” - thus the company's small posted profit for 2011 is completely reversed into a multi-billion euro loss on a mark-to-market, ex post facto basis. Bankia is/was a conglomeration of 7 previous regional cajas, so it is not likely unique and therefore gives us some insight into the intentionally opaque world of Eurozone banking in 2012. What we need to know now is the proximate cause of Bankia's fall - a loss of retail deposits or no access to repo funding (because there was no unencumbered/quality collateral left to be pledged at acceptable terms).
What is driving fear here is not whether Europe can solve its debt problems, but how to do so without bankrupting large swaths of its own banking system. Even if Spain had the leeway to restructure its debt, it would still not be enough since losses at Spanish (and other) banks would be catastrophic, and would be spread throughout the global system. Thus the game has been played out at the ECB of trying to get sovereign bonds to float at "reasonable" levels (the SMP purchases, LTRO's), while bailing out each country to avoid a restructure that triggers mark-to-market. That process has always been finite, and was even intended to be due to the overconfidence of policymakers in the efficacy of their own policies and interventions. The question for them was how much growth they could “engineer” and how much bank capital breathing room would follow before that shelf-life expired. As that over-confidence has faded into the reality of the structural economic overhang and very real re-recession (even in the core; see Holland), market gullibility has fallen in proportion. Just in these past two weekends we have seen a Spanish bank “bailout” and the “right” Greek election result, but no massive relief rallies in both credit and equities. If anything, credit markets are marginally worse, at best no better (see Swiss bond yields).
This is a complete change, ominously, from the 2011 pattern. The market is very fickle right now with how it is reacting to the same old playbook. What worked well in stoking investor gullibility last year, providing breathing room then, does not seem to possess the same type of market magic. There have been no two-standard deviation up days in concurrence with each “positive” event.
As all this unfolds in Europe, the calls of US decoupling and the safe haven of US stocks grow louder. Yet, it would be a huge mistake to forget that the "safe haven" of the US stock market has experienced at least an 18% decline in each of the past four years, largely as a result of the dollar overhang/dollar shortage. Euro-based banks’ modus operandi has been "hub and spoke" for more than two decades, meaning that they have gathered local deposits in their domestic areas, swapped them for dollars (creating the dollar shortage/crowded trade) and investing those phantom eurodollars in US dollar-denominated assets (they were a major source of housing bubble credit, and the shortage of dollars due to the hub and spoke was why the Fed was forced into the dollar swap business in 2008, and again in 2011/12). The dollar overhang has been problematic in the breakdown of the interbank wholesale money markets as institutions find themselves periodically unable to easily rollover that dollar shortage. As that inability to find dollar financing rises systemically, banks are pushed into a forced short covering of the dollar swaps/shorts (the dollar rises not in a flight to safety, but a short covering rally), including the wholesale selling of dollar denominated assets.
In the Spring of 2012, however, the dollar rollover problem may be intersecting with local deposit funding means. If retail deposits are fleeing from afflicted institutions, that “spoke” issue will put even greater pressure on the “hub”. No one knows just how big the dollar shortage is, but even the IMF has estimated that it is likely greater than $2 trillion (with upper bound estimates of $6.5 trillion). In a crowded trade, that is a hell of a lot of marginal selling pressure into what conventional wisdom says is a “safe haven”.
The optimistic, bull case always falls back on company earnings, but market earnings, in and of themselves, do not drive markets. Earnings do drive individual stock prices, but I do think there is a fallacy of composition here (and I hate the fallacy of composition usage in economics). Market prices are driven by the supply of money related to psychology. For example, at the last bear market nadir, in April 1980, the PE on the S&P 500 was 6.79. As late as 1973, the market PE was 18+. Over the intervening seven years, earnings on the S&P 500 grew 135%. Nominal prices over the same period fell 12% (including that pretty severe correction in 1974). The rise in corporate earnings was no protection against conspiring economic forces; in this case inflation. You can actually extend this analysis backward to 1971, the PE-apex for the decade, and even to 1961 and the cycle PE peak (22.5x). Despite a very good economic run in the 1960's, including corporate earnings, at best the market PE fell slightly throughout the decade (or at a more exaggerated pace, dependent on your start date and end date).
Close to the bottom of the 1937-38 re-depression, the market's PE had risen to 20x. Over the next four years of turmoil, largely unrelated to the global economy as it somewhat recovered (including the Keynesian uber dream of government spending for large scale war), the market PE fell to 7.69 in 1942, despite the fact that earnings rose 62%.
Earnings are secondary considerations to investors' collective perceptions of getting paid for the risk of holding equities, and that risk perception is, historically speaking, largely unrelated to earnings fundamentals themselves (the converse is true for rising market PE's where earnings largely do not keep pace - the dot-com bubble, for example, had little to do with corporate earnings growth).
Currently, despite the overall move of the market higher since 2009, markets are more concerned with factors independent of earnings, namely gaming monetary intervention episodes. That non-fundamental driving factor is balanced by the potential psychological parameters that "council" avoiding US stocks, especially the four straight years of large systemic declines (this massive volatility is very much on par with inflation of the late 1970's in terms of the psychology of investor avoidance of stocks). Add in the demographic shift to usage of retirement assets (particularly as that shift is being forced by the lack of wage income) and we really do not need double-digit inflation to see a single-digit PE in US stocks, perhaps even a sustained low multiple.
The evolution of investor perceptions of financial risk is really just the continuation of the secular bear market process that began twelve years ago. Everything that has happened in the financial sphere during this run is but a reminder that long-term risk prospects are not on the side of simply holding equities.
So the intersection of that long-term trend with the analysis of this bear market rally is the point at which all this monetary intervention reaches that inevitable shelf-life. The near-term bear market rally succumbs to the longer-term bear market gravity at some point, and I think there are any number of candidates in this discussion alone to demonstrate such an inflection (especially, again, the seeming change of asset markets to accept these policy interventions at face value - that is the essence of what this bear market rally has been and it seems to be reversing before our eyes). For the market to keep moving higher, to get to 1600 on the S&P 500, for example, will require, in my opinion, full removal of all economic (statistical estimates of unemployment below 7.5% on a sustainable trajectory lower) and financial uncertainty (stable funding regimes). Or hyperinflation.
We "enjoyed" the past three decades of eurozone dollar creation (the London hub of the eurodollar market), now we (US dollar assets) are stuck with the millstone of euro problems. Earnings growth or strength in US companies simply will not mitigate against this potential wholly unrelated selling pressure, particularly since strength of earnings has been little comfort in each of the past two years. Add to that the fact that the very investors that would be buyers of stock fundamentals are exactly the ones that are exiting due to demographics and a plain lack of funds.
Outside of the financial sphere, the real economy is less and less a source of comfort, though mainstream economists will remain optimistic all the way to the end. Just as they were convinced the recovery was finally at hand in early 2012 (for the third time in as many years), they will remain stalwart optimists adhering to the textbook principles of monetary “science”. One of these days low interest rates will work since that is Chapter 1, Page 1 of the monetary handbook. As the Beveridge Curve and Okun’s Law undergo significant revisions (http://www.zerohedge.com/news/guest-post-its-far-deeper-broken-okun), perhaps the monetary handbook will get a rewrite in the face of the epic failure of Extend and Pretend. In the real world, however, the uncomfortable payroll report for May has been matched by an almost universal downward trend in the real economy from the US to Europe to China. The latest JOLTS survey merely confirms the unexpected deterioration in growth prospects; right on schedule.
If we put all of this together, we are seeing a warning signal, a confluence of trends that portends an abnormal summer. In the context of the post-crisis, volatile markets of the non-existent recovery, that is saying something. In the context of financial risk, optimists are simply betting on reflation through monetary intervention overcoming the financial gravity of a continuously contagion-prone system that cannot seem to find sufficient quality collateral despite the trillions in fresh government borrowing globally. The financial risks to asset prices in so many markets are tied directly to the utter chaos and mess of the intractable problem of euro bank symbiosis to their local governments because financial markets still largely operate under textbook economic and financial assumptions. This is also true, to a large extent, of investor expectations of asset prices and financial risks.
The revaluation that is underway now is beyond the simple scope of corporate earnings valuations, going to the very core of the system itself. Just like the equity pricing regime (and investor expectations for equity assets) needs to adjust to the twelve-year-old bear market reality, pricing within the global banking system as a whole needs to adjust to the reality that the artificial growth of the economic textbook is not replicable. The economic truth of 2012 is that much of the science of economics, and the foundation that gives to finance and financial pricing, was a temporal anomaly befitting only those specific conditions of that bygone era. In other words, the entire financial world needs to reset itself outside the paradigm of pre-2008. The secular bear market in US equities is one strand of this changing landscape, perhaps the first stirring of the collapse of the activist central bank experiment.
In the end, the potential selling pressure of the dollar shortage is irresistible, no matter how “cheap” stock prices are to earnings, but none of it may matter in the grander scheme of a dramatic reset to the global system. The inability of that global system to escape this critical state, to simply move beyond crisis and function “normally” again, demonstrates conclusively, in my opinion, the foundational transformation that is still taking place well beyond the stock bear. Everything is a locked feedback loop of negative pressures in this age, no matter how much we want to see “value” where and how it used to exist. Paradigm shifts are rarely orderly, but there are warning signs.