I have been quite shocked by investor complacency with respect to what is going on in the Eurozone.  Greece, Spain, and Portugal are in shambles.  Ireland and Italy are not far behind. Still, investors seem to be disregarding the dramatic risks the Eurozone faces in the coming quarters.  The MSCI EAFE index, which is heavily Eurozone weighted (about 50%), finished the first quarter of 2012 up 8.5% in Canadian dollar terms.  I can put it no better than Krugman and Moody's Analytics. In short - be afraid. 
 

Apologies all - since the "storm" hit, I have been quite pre-occupied at my regular 9-5 and unable to post.  It seems that some degree of rationality has imbueded the equity markets.  At the very least, investors are now starting to grasp the severity of the global macro-economic situation. 

Still, as I read so-called professional commentaries, I see countless claims of "cheap stocks" to be had in Europe and the US.  "Renault is so cheap, you are basically paying for its investments and getting the rest for free"; "dividend yeilds are higher than bond yields - buy equities!"; "the P/E on the DAX is only 7, Europe is so cheap!", etc...

What never ceases to confound me when analysts use price ratios (P/E, price-to-book, etc...) one-dimentionally.  Their anaylsis proceeds something like this: 

     1. the P/E on this stock (or market) is 8;
     2. the P/E on this stock (or market) historically averages 15
     3. therefore, this stock (or market) is cheap

This is a blatant syolgistic fallacy. Not only it is overly simplistic to simply rely on historical averages in drawing such a conclusion, it is totally wrong to focus on the "P" while ignoring the "E".  Let me explain.

A P/E ratio is an implicit discounted cash flow model.  It basically tells you how many dollars you are paying today for an annuity of $1 in corporate earnings.  So a P/E of 8 means you are paying $8 today for $1 in corporate earnings ad infinium.  The expectation is that the $1 will either be paid out as a dividend or re-invested in the company and eventually lead to capital gains (typically some combination of both). 

Clearly paying $8 for a $1 annuity is "cheap" compared to paying $15 for that same annuity, right?  NO!  What virtually every analyst fails to acknowledge, at least explicitly, is that the foregoing calculation is based on a PROBABILITY-WEIGHTED $1 in earnings.             

What those analysts minimize is the likelihood of that $1 in earnings dropping to 75 or 50 cents, which would in turn bring that P/E back up near or above the historical average.  This is where GDP growth estimates come in.  GDP growth roughly feeds into top-line revenue growth at individual firms.  Both "austerity budgets" and high debt loads compromise GDP growth.  How, then, does the so-called developed world continue to grow GDP? And how do its firms continue to grow their top-line?  Simple. They don't.  At least not for the next several years. Without top-line growth, the discounted cash flow model falls apart, and so do future earnings.    

I admit it, it is in my nature to be somewhat pessimistic, at least when it comes to the global economy.  I am, however, also completely open to a persuasive argument to the contrary, so long as it is backed by hard data.  In fact, I have recently even attempted to convince myself that things are not as bad as they appear.  Let me go through those nuggets of hope that I have uncovered, and then dash that hope with further analysis.

1.  Hope: The ISM Purchasing Manager's Index, both Manufacturing and Non-Manufacturing is still above 50.  This tends to signal economic expansion. Hope Dashed:  Both numbers have been trending downward, and the most forward-looking component of the index, Order Backlogs, has been contracting for several months.

2. Hope: Greece and Italy are getting "serious" about their austerity plans.  Hope Dashed: Austerity plans are almost certain to drive both countries into deep recession.  Debt/GDP is the issue here.  You need the top number to shrink relative to the bottom number.  Austerity is likely to cause the top number to shrink a bit and the bottom number to shrink a lot, so you end up in the same place, if not in a worse place, than before.

3. Hope: Obama is announcing a big new job creation plan today.  Hope Dashed: Even if the measure eventually prove significantly helpful, and even if the measures get passed by Congress and the Senate, two HUGE "if's", the lag time before significant job gains actually occur could be years.  

4. Hope: Bernanke will save the US with more monetary stimulus.  Hope Dashed: More monetary stimulus will do little, particularly in the long-term, except weaken the USD and drive inflation.  I've already written about this in a recent post.  

It is shaping up to be an ugly Fall.  Tactically, in terms of asset mix, it may be too late to make any significant changes; however, I will be selling foreign equities into strength and re-allocating to cash and corporate bonds.  I am currently underweight Non-Canadian equities by 10% (-5% US Equities, -2.5% Developed International Equities, -2.5% Emerging Market Equities) and over-weight cash, short-term bonds, and high-yield bonds by the same amount in roughly equal proportions 
      

Things appear to be going swimmingly with the equity markets over the last several days.  Both the US and Canadian exchanges have been rising, commodities have been creeping up, and stock pickers seem to be walking with an optimistic skip in their step.  All of this on the heels of (1) Ben Bernanke announcing no additional stimulus, at least for the time being; (2) paltry US employment data; (3) continued weakness in the US housing market; (4) dismal consumer confidence numbers; and (5) clear indications that short-term credit risk is rising. 

In the words of Mugatu, I feel like I'm taking crazy pills!

The bizarre rationalization I have been reading for this recent bout of investor optimism reinforces my feeling. It goes something like this:

"The worse the economy gets, the more likely Ben Bernanke will come to the rescue with a big stimulus package that will save the economy and the equity markets...oh and housing isn't that bad because prices are not actually falling off a cliff anymore, and employment is at least slightly positive, and really, who cares what happens in Europe. Plus, Warren Buffet believes in the American economy so why shouldn't I?"

I really don't know where to begin.  I have already summarized why additional monetary easing will not help the long-term prospects of the US economy. Counting on monetary easing is like an addict counting on his next hit.  It alleviates the pain for a while but it just makes a true recovery all that more difficult. 

Yes, it is true that employment and housing data are flat-lining, indeed rising slightly, which is an improvement over their precipitous declines of 2008-2010.  What some investors seems to forget is that these metrics should be extrapolated neither linearly nor parabolically.  This means basically that employment and housing data obviously cannot fall to zero, and as such their declines must at some point decelerate or flat-line.  The fact that they have now done so is hardly encouraging, and it doesn't mean they are on their way up.  This logical fallacy is like suggesting that a morbidly obese person whose health is in severe jeopardy has improved his condition by putting on no weight this year because he put on 100 lbs last year. Pass the crazy pills please.

For those who don't think Europe matters, I suggest they take a close look at the concept of contagion.  Here's a good introduction that focuses on contagion in the context of the Asian crisis.  Here is another.  Like it or not, Europe matters.  This will become evident when Greece, and perhaps Portugal and Ireland, officially default. 

As for Warren Buffet's investment in BoA, all I can say is what a sweet deal.  I wish I could have bought cumulative pref shares that yield 6%, pay a 5% recall premium, and come with essentially in-the-money warrants on a bank that is effectively backed by the US federal government.  I can't, however, and neither can you (unless you happen to be Warren Buffet...hey, you never know).  
    

We live in an era of acronyms.  I suppose it is the consequence of our over-worked, time-constrained lifestyles coupled with the information overload fostered by modern technology.  Still, the extent to which esoteric monetary policy processes have permeated colloquial lexicon confounds me.  

Alas, the media and the market seem to be fixated on these things at present, and in particular on Ben Bernanke's speech this Friday from the Jackson Hole, Wyoming conference of central bankers.  According to a number of prominent media outlets, the markets finished yesterday sharply higher on the apparently strong likelihood that Ben Bernanke will come to the rescue of the slowing US economy on Friday by suggesting some type of stimulative monetary policy action, such as another round of quantitative easing (QE3), a lengthening of the average term of US treasuries by rolling short maturity debt into long maturity debt (Operational Twist 2, or "OT2").  Some have even suggested that Bernanke may favour a cap on short-term treasury rates (no acroynym for this yet, so I'll coin one: "CTR" - watch for it on CNBC) . 

Ultimately, the goal of all such policies is to make cash cheaper to borrow and less attractive to hold so that both businesses and consumers will borrow more (or save less) and spend on goods, services, and investments that will stimulate the economy.  

The first problem with such a policy is readily apparent: why encourage consumers to spend borrowed money, however cheap, in an era of supposed de-leveraging and austerity?  Is that really a smart long-term solution to the structural problems in the US or Europe?  I would argue that doing so simply encourages a renewal of fiscal mis-management at the consumer level at a time when consumer balance sheets are starting to improve slightly.  

The second problem requires slightly more inspection to flesh out.  In aggregate, businesses already have mounds and mounds of cash, which they are simply sitting on because they cannot find compelling investments for that cash (e.g. expanding manufacturing capacity or headcount due to signs of increased demand).  What then will cheaper borrowing costs do for these businesses?  They don't need loans, they need damand to pick up.  

Therein lies the conundrum - the proverbial chicken and egg problem that monetary stimulus alone cannot ever hope to fix.  Consumers must drive demand for businesses to spend on things like hiring more staff but consumers don't have any money because 1 in 5 are underemployed and 1 in 10 have no job at all.     

A much more impactful weapon than additional monetary stimulus in the battle against the looming recession would be a massive tax code overhaul in the US that accomplishes the following:

       1. reduces corporate taxes and capital re-patriation taxes (i.e. the taxes incurred by US corporations when they re-patriate capital from overseas operations),

       2. increases consumption taxes (i.e. sales taxes), 

       3. reduces or eliminates payroll taxes,

       4. eliminates the tax deductibility of mortage interest and instead adopts the Canadian "tax-free sale of a principle residence" model; and

       5. re-aligns income taxes such that after-tax income utility is maximized (put another way, lower taxes on the middle class and raise them on the highest income earners because a $1 tax on a middle class earner is a lot more painful to that person than even a $10 tax on a very high earner).  

With respect to the last point, readers should know that I am apolitical, or perhaps omni-political is a better word.  Whether that makes me a centrist I'm not sure.  Irrespective of this, my recommendation to tax the wealthy more than they are currently taxed in the US stems not from a political ideology, but from an econometric one that is based in large part on the theory of the marginal utility of income.  If it were feasible to eliminate all income taxes in favour of targeted consumption taxes, I might be inclined to favour such an approach.  That is not practical.  Re-jigging income taxes is very practical.  Of course, it remains to be seen if the US federal legislative branch will actually become functional any time soon.