We are up for a long weekend
It will be a long weekend. …Guest Post by Macro Story.
Good Morning. As we head into a three day weekend (US bond and equity markets are closed on Monday) were the fate of Greece as a member of the EU may possibly be decided I wanted to offer a less technical, more macro Morning Brief today.
But first a few technical points and securities to watch on option expiration day. This is a long post by the way but there is a lot going on this weekend in Europe.
That feisty AUD/USD currency pair is back at it again turning what looked like a bearish reversal into possibly another head fake. As of this post it stands only 50 pips from prior highs of 1.0845.
HYG (high yield debt) was weak yet again on Friday and putting in another lower low. This excellent market timer topped on January 26 in a rather bearish high volume double top pattern. Watch HYG to see if it continues to underperform equity. Also watch HYG relative to LQD (investment grade debt). HYG has been underperforming LQD as investor risk aversion has been growing.
Dow Transports topped on February 3 and has been putting in a series of lower highs and lower lows. Thursday the transports did outperform the dow for a change but from a technical perspective it was a simple inside day after selling off 2% on Wednesday.
EMD (mid cap futures) took out another resistance level on Thursday. The next resistance level comes in at approximately 990. EMD is still about 3% below the July highs versus the SPX which is slightly above.
There are currently two aspects to the EU and Greece working out a bailout before the March 20, 2012 deadline when the next bond payment is due. Failure to make that payment would constitute a technical default.
The first and most covered aspect is the austerity measures where the Greek government last weekend approved further cuts including lowering the minimum wage. The people were not happy for many reasons as witnessed by the country literally burning. I think sometimes we get so immersed in news we forget that these are real people’s lives being affected. Their hopes and dreams turning into despair and nightmares.
The next and equally important component to securing this aid package relates to lowering the debt to GDP levels to 120%. To do this Greece has been trying to get bondholders to forgive a portion of debt. But the key has been making this voluntary. If it is not voluntary then the insurance purchased by bondholders in the form of credit default swaps (CDS) will trigger. Sounds like no big deal right we all have insurance and heaven forbid a tragedy happens we file a claim and get paid.
Problem here is this type of insurance is different than our home or car insurance. This market is not regulated. No one really knows who owes what and more importantly you don’t have to pledge capital. Imagine losing your car in an accident and finding out the insurance company actually can’t afford to reimburse you. That’s the very real threat facing the global economy right now.
The entire derivatives market which includes CDS as well as interest rate swaps, currency swaps etc is over $700 trillion or 14 times the size of the global economy (no that was not a typo). When AIG failed in the fall of 2008 they could not honor their derivative obligations so the US taxpayer had to step in and make sure GS and everyone else was paid 100 cents on the dollar.
So when Moody’s downgraded two of the biggest European insurers on Wednesday evening they pushed Europe that much closer to an AIG moment. So now Generali and Allianz will face capital calls from creditors. Capital they don’t have just like AIG did not have. Their portfolio of sovereign debt in the event of a Greek default would plummet as did the value of MBS (mortgage backed securities) in 2008.
Bit of a sidetrack but there is a lot to this puzzle and it is far bigger than Greece. A Greek default would raise concerns about Portugal’s debt and when markets are scared they shoot first and aim second. To say things could get out of hand fast is an understatement. To say the central banks could diffuse a $700 trillion derivatives market now that is just pure comedy.
So now we have bondholders who have both bought Greek debt and CDS as insurance in case of default. They have a fiduciary responsibility to their investors to protect capital. I see no way they can both agree to a debt write down and to forego CDS which in some cases they may have paid 30% of par value of the bond. But Greece needs this write down. Without it they cannot get to a 120% debt to GDP ratio.
I’m a little fuzzy on Greek law (actually a lot fuzzy) but from what I understand they need 100% investor commitment of debt forgiveness. Without it their own remaining option is the “nuclear” one. Where they force a write down through a collective action clause (CAC). But not so fast. That would then trigger a credit event which allows CDS holders to be reimbursed for their loss. But ISDA the organization who declares such an event may try and say it is not an event of default.
But again, not so fast. Assume ISDA says no to a credit event. Imagine you own Portuguese or Italian debt and CDS as insurance. But the CDS is valueless because ISDA just told you a default is not really a default (figure that one out). So you do the only thing available and sell the debt. So now Portugal and Italy see skyrocketing yields and a vacuum of buyers afraid to touch truly toxic sovereign debt.
So you see this mess is really just that a huge mess. It is not contained. It is not going to be orderly. Someone somewhere is a black swan that no one knows about that will be unable to meet their obligations. Which brings me to my belief about what is going on in the markets right now. Banks globally are getting liquid. Anyone who may face a capital call (doesn’t even need to be a bank) could be a fund that uses sovereign debt as collateral in a repurchase agreement is getting liquid.
The time to get liquid is when asset prices are elevated. So perhaps Greece defaults in the coming days or coming months. It won’t be pretty. It won’t be contained. But it will be easier on the capital markets now that those who need to get liquid have had two months to sell assets in a much favorable environment. Name one time Wall Street has had retail investors best interest in mind? Just one. Please.
The last piece to cover relates to the ECB and their recent announcement that the “massive profit” they made on Greek debt will be used to bailout Greece in the future. Not making this stuff up. If I understood this convoluted, accounting gimmick some how the ECB takes Greek debt swaps it with Greece who issues new debt “trading at par” (or 100 cents on the dollar) and that is the profit realized by the ECB. Perhaps my assessment was wrong but figuring out the late stage of a Ponzi is not always easy. Somehow this is supposed to help bondholders feel better that Greece will be on a sustainable path to economic prosperity.
By the way one real simple question. Imagine you are hedge fund holding Greek debt. You agree to wipe out 70% of the liability. You also agree to forego the CDS you purchased. In exchange you are given a 30 year bond paying rates comparable to the US (which can print). Do you honestly think that bond will see more than a handful of coupon payments? Do you honestly think you will not be facing investor lawsuits?
Trade Strategy – Option Spreads
One of the simplest yet least understood income strategies is “call writing.” Sounds complicated but all it entails is using options to generate income against your long stock position. For example say you own AAPL stock that you bought at $300. With the stock trading at $500 you would generate income by writing (also referred to as selling) calls at perhaps $550 for February expiration.
You would earn income from the sale of those calls and worst case would be forced to sell your AAPL stock at $550 in three weeks. Is a 10% gain in one month really a worst case anyway? If you were not interested in selling your stock you could then roll those options into a subsequent month.
This strategy which I will discuss in the future at length is no different than the recent “vertical spread” strategies I have been discussing. The only difference is rather than owning common stock you own call or put options. Other than that there is zero difference.
The reason I am talking about this and other strategies is I want to help those new to it understand this technique. My goal as with all my writing is to take a subject that may appear too complicated and break it down. To simplify it and help you realize how easy it really can be.
An ideal investment strategy is one that utilizes a core investment combined with a low risk income generating strategy such as this.
Market and Economic News
AAII Investor Sentiment Remains Net Bullish
Investor sentiment for the week ending February 15, 2012 remains net bullish but came off the highs. Those with a bullish view over the next six months declined to 42.7% from 51.6% while those with a bearish view rose to 26.6% from 20.2% the prior week. Historic averages for bullish sentiment is 39% versus 30% for bearish.
Philly Fed Shows Expansion In February
The Philly Fed survey for February improved to 10.2 in February up from 7.3 in January. Improvement in the manufacturing sector is a positive and the internals of the report for the most part are also indicative of modest growth. There are three points worth discussing though.
A few months back the Philly Fed survey fell sharply and then has magically reversed course. What’s interesting is a similar move occurred in 2008 prior to economic contraction. Other data points have also shown similar moves prior to recession which can often mislead people that the economy has “dodged a bullet” and is now entering expansion mode.
The next point I want to make relates to inventory and margins. First notice on the report as highlighted in red the number of respondents expecting inventory levels to decrease. As discussed in previous posts the end of the inventory build cycle is one of the biggest risks facing the US economy as it has been the primary source of economic expansion. This is just another sign that the build cycle has in fact ended and inventory contraction has now begun.
Second notice the changes in prices paid and prices received. Margin pressure will continue to grow as pricing power is simply not there in the face of flat real income wage growth. Where this gets more dangerous is in the face of falling margins employers will be forced to lay off staff which further exacerbates the problem.
Greek President Fires Back At Germany
When a negotiation resorts to public ridicule of each other it is never a good sign. Greek President Karolous Papoulias finally had enough of comments from Germany and other EU members and publicly questioned their recent actions and statements about Greece.
Whether this is part of a negotiation tactic or politically motivated for the Greek people is unclear. What is clear though this level of communication is not one that often produces results. Especially when the one responding is the same person asking for bailout funds.
From the Telegraph, full story found here an excerpt is below
“Who is Mr Schäuble to insult Greece? Who are the Dutch? Who are the Finns?” retorted President Karolous Papoulias, himself a teenage resister against the Wehrmacht in Epirus almost seventy years ago – though he later took political asylum in Germany from the Greek junta and worked for Deutsche Welle.”