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A Fundamental Restructuring is Needed

(April 29, 2010)

Quotes of the Day

“God made the world in 4004 B.C. and it was reorganized in 1901 by J.P. Morgan” – Wall Street Journal

“The difficulty lies not so much in developing new ideas as in escaping from old ones.” – John Maynard Keynes

Dear Subscribers and Readers,

We sent our subscribers a real-time “Special Alert” email early Tuesday morning outlining why we were shifting from a 50% long position to a completely neutral position in our DJIA Timing System.  Our reasoning is not the Greek fiscal crisis per se, but rather that: 1) Investors – unlike immediately before the Dubai “scare” late last year – have remained very complacent about the Greek fiscal crisis.  In other words, no one has priced in even the possibility of a Greek default in other parts/asset classes of the financial markets; and 2) The spiraling of the Greek fiscal crisis into a possible contagion event for Portugal and Spain is a signal that politics have trumped cooler heads in the Euro Zone, and lest we forget, this also occurred in Europe and the U.S. in the early 1930s.

Despite the total rout in the market on Tuesday, investors remain extremely complacent.  For example, the daily equity put/call ratio closed at 0.57 for the day, and declined to 0.53 at the close on Wednesday.  Similarly, the ISE Sentiment Index declined to 109 on Tuesday (which is oversold but not overly so), but recovered to a reading of 130 by the close on Wednesday.  Make no mistake: investors remain very complacent during Tuesday's decline, as exemplified by the following chart (courtesy of showing the 10-day moving average of the equity put/call ratio vs. the S&P 100 index:

10 Day Moving Average of Put/Call Ratios - Amazingly, the 10-day MA of the equity put/call ratio still stands at a hugely overbought 0.50, despite Tuesday’s decline.  This reading is even more overbought than those experienced during prior market peaks!

As mentioned in the above chart, the 10-day moving average of the equity put/call ratio is actually still at a highly overbought level of 0.50, despite the extreme sell-off on Tuesday.  In fact, the current reading of 0.50 is even more bought than those experienced during prior market peaks – suggesting that the liquidation of assets due to the European fiscal crisis is likely not over yet.  This is why we decided to shift to a completely neutral position in our DJIA Timing System.

From my vantage point, it looks like that the current European monetary union – consisting of not just “core” countries like France and Germany – but those on the “peripheral,” such as Greece, Portugal, Spain, and Ireland, is outliving its usefulness.  The Bretton Woods System lasted for over 20 years and in turn, created a globally stable currency/financial/trading system that allowed countries like West Germany and Japan to thrive after the end of World War II.  Even California's Proposition 13 (the one that governs state property taxes) worked well for over 20 years (up until the early 2000s before the housing boom got underway).  All systems eventually outlive their usefulness – but the Euro, in just its 11th year, seem to be setting a record.  In addition, in retrospect, the European monetary union simply created underlying excessive risks (where banks, pension funds, and insurance companies bought Greek, Spanish, and Irish bonds irrespective of the underlying default risk) and a system which allowed countries like Greece, Portugal, and Spain to borrow as much money as they could in order to fund consumption.  In this sense, the European monetary union is no Bretton Woods.

German lawmakers have repeatedly refused to approve the German portion of an IMF/EU package that was rumored to total around 45 billion Euros.  Yesterday, it was rumored that the IMF briefed German lawmakers that as much as 120 billion Euros would be needed over a three-year period to bail out Greece, and this is just a guestimate using current data.  Does the IMF seriously think this proposed 120 billion Euro package will fly after German lawmakers have repeatedly refused to approve a 45 billion package, especially ahead of the May 9th elections?  Moreover, the Greeks are not exactly thrilled of this development either.  Undoubtedly, more austerity measures would be imposed, and the Greek economy could conceivably spiral into a deflationary bust, especially since the country's structural growth is low (given horrible demographics and the lack of capitalistic incentives).  Interestingly, a majority of both German and Greek citizens believe that Greece leaving the Euro Zone may be in the country's best long-term economic interest.

Most worryingly, as shown in last weekend's commentary, the long-term indebtedness of the Euro Zone remains bleak.  A Greek bailout would no doubt bring about an eventual Portuguese bailout (given the moral hazard issues), and would add to the Euro Zone's indebtedness further over the next few years.  The combination of an aging population and lack of productivity growth will make this indebtedness very difficult to come out of, unless the European Central Bank resorts to an inflationary policy.

When a system has outlived its usefulness, one should logically restructure said system.  Nevertheless, as Keynes said, getting out of old ideas is very difficult, but as crucial time passes, the financial markets may ultimately force the hands of the Euro Zone's respective governments.  The damage is already done.  There's no sense in prolonging the process.  It is time to let Greece go.

Signing off,

Henry To, CFA

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