July 22, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Putting Band-Aids on Serious Wounds. Take note of these two events in Europe: A) a default, and B) a new architecture for bailout. In our opinion, this is the first of many bailouts. The equivalent of the IMF has been born in European garb – the “EMF” as Sarkozy has dubbed it (using the previously established EFSF more flexibly) – in response to the Greek default.

The bailout fund will be available for secondary market intervention suitable for current needs, but insufficient for future market intervention. The fund will need to be 3-5 times as large to be of any real help beyond the relatively small Greek issues. Spain and Italy are the larger problems due to scale. Not only is the EMF born, but the European version of the “Plunge Protection Team” has been given new life. Do you remember the Hebraic idea of the golem? Like Shelley’s Frankenstein, golems are beautiful in the eyes of the creator – and usually wreak havoc in the end.

What specifically has been agreed to for the Greek bailout? You the creditor are allowed to “freely” choose from the following menu of options:

-Wait and see what happens; you may get paid on time with all your investment dollars returned.

-Extend your maturities to 30 years and accept a 4.5% coupon with a principal guarantee component.

-Extend maturities to 30 years, discount your bonds by 20%, and receive 6.42%, also with a principal guarantee.

-Extend to 15 years, take a 20% haircut, receive 5.9%, and get a partial guarantee of principal.

Of course, a 20% haircut may sound uncomfortable, but with principal values already having slipped to 55% of the face value and interest rates hitting 40% this week, investors are getting a deal – far more than 20% is already gone. This is an enticement to avoid a CDS meltdown.

The International Swaps and Derivatives Association’s David Geen believes that, with these four choices being made “voluntarily,” there should be no triggering of credit default swaps. Indeed, the cost to insure against default has significantly declined in the last 24 hours. So do we still have concerns?

A default has occurred; we have concerns. There may be a string of legal cases to determine if CDS contracts have in fact been triggered, requiring payment to various counterparties. That could take months to determine. Is a “selective default” distinguishable enough from a standard default to technically avoid legal ramifications?

EU politicians with a grand vision of unity will run head first into a more locally (nationalist) inclined set of economic concerns. Politics will be anything but usual in the comings months. The political conflict will likely stem from taxpayers being put on the hook for financial institution risk taking. Trichet has suggested that the EU will back Greek collateral, which implicitly puts Germany in an uncomfortable position. The Germans have the deepest pockets and the strongest European economy, and are therefore the real backstop in this EU directed bailout. Will German taxpayers go along with their assigned role in the southern European bailout?

A final thought. With EU ministers patting themselves on the back for a job well done, and another crisis averted, the price of gold pressed higher – mocking their presumption and telling you the investor something very important: Official pronouncements mean nothing. The gold market believes the problems persist and structurally unsound balance sheets are not better simply by re-categorizing liabilities and reassigning (socializing) responsibility for payment on debt. The end game is still ahead, says the shiny market vigilante.

2. Will This Ever End? While Rome continues to burn, U.S. Stocks fiddled higher – again. By week’s end, the broader U.S. markets rose an average 1.5%, the dollar fell 1.06%, while bonds and commodities were flat. A combination of factors seems to be responsible for the ongoing party in stocks; flight capital from Europe and Asia, Bernanke’s pledge to print, an “ok” earnings season, and short squeezes. Most would have expected the markets to run into trouble by now, but the closer Europe and the U.S. come to solvency resolutions, the more confident the markets become – or should we say, the more confident speculators are in the continued flow of free capital (QE/money) to the markets.

U.S. economic data remains a paradox to stocks. Long Term TIC flows fell apart in May. This measures how much capital foreigners are spending on our long-term debt. $40B was expected, $23.6B came through. Existing home sales came in at a less-than-expected 4.77M (vs. 4.90M) in June, while jobless claims and continuing claims dragged along at recessionary levels. The bright spots included housing starts and the index of leading economic indicators. Both showed marked improvement. However, more homes on the market only serve to depress prices further, and the LEI seems to have been influenced by overseas flight capital raising the heavily weighted M2 (money supply) component of the index.

Earnings were decent, as we suspected. Technology led by Apple and all related parts manufacturers (i.e. Intel) are the standouts. iPads sold came to 9.25m units, far exceeding estimates of 7.8m. iPhones also surprised with 20.34m units sold vs. expectations of 17.1m. Investors are concerned, though, about the drop-off in sales of Macs and iPods, which both disappointed. Apple guided lower for Q4. On the whole, though, the market cheered; Apple shares popped 11.18% for the week.

On the flip side, the banking shares are showing the true state of affairs. The manufactured “accounting profits” outweigh the real organic growth. It was Citigroup we mentioned last week. This time it was Bank of America, depleting loss reserves by $3.3B to juice their earnings for the quarter. Goldman reported earnings .40 cents below consensus, as fixed income trading lagged – apparently Goldman could be turning away from the Treasury market – facetiously, we wonder why.

Europe once again has kicked the can down the proverbial road with the latest bailout deal – markets overseas seemed to have finally approved this package. Greek bonds rose, sending the 10yr yield down several hundred basis points to yield 13.73%. Debt of the other PIIGS followed suit. Stocks in Europe also rallied hard Friday, stealing some of the thunder away from the action in U.S. stocks. What is of concern though, is that terms of the pre-existing bailout package of €440B were restructured, adjusting the cost of that debt substantially lower to accommodate the PIIGS. It prompts the question: If Europe is improving within the context of these bailouts, why the need to sweeten the deal?

The metals continue to oscillate in and around the ever-moving target that is world solvency – both here and abroad. Gold saw a net gain for the week of nearly $8 to finish near its all time high of $1601.27, but it was choppy arriving at that destination. One day, the U.S. debt ceiling issue draws near to a solution and gold falls. The next day, a stalemate is reached and gold rises. If a short-term solution is reached, postponing an eventual bankruptcy, the metals may take a breather for a short time. In the long run, though, these government solutions (bailouts) are highly inflationary, not to mention financially crippling – a fact the markets are becoming more aware of every day.

Best regards,

David McAlvany
President and CEO

David Burgess
VP Investment Management