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Author Archives: Art
State of the European Banking Crisis at August 21, 2011
The banking crisis that is occurring in Europe is getting much attention. Much of the recent performance of the equities markets of the world is being blamed on slowing growth. While growth is slowing, I believe the way the equities markets are moving lower is indicative of a liquidity crisis driven by potential bank failures.
We can see this in the CDS markets, particularly in the CDS of Bank of America, Commerzbank, Societe Generale, UniCredit, and Lloyds, which I refer to as the “Failing 5″. What is alarming is that these 5 banks represent very large proportions of GDP (each having over $1 Trillion in assets on the balance sheet) of 5 of the largest economies of the world, respectively the US, Germany, France, Italy, and the UK.
Here’s the graph:
CDS of the 5 Failing Banks - BofA, Commerzbank, SocGen, UniCredit, and Lloyds
All banks are above their 2008 wides except for BofA which is very near its 2008 wide.
Not surprisingly, the banks’ equities are trading near their 2009 lows. Below is a normalized graph of the equity prices of each bank:
Equity Prices of the Failing 5 Banks - BofA, Commerzbank, SocGen, UniCredit, and Lloyds
What is alarming (or serves as a warning) is that while these banks are trading near their lows, the market is not yet. Important to realize is that the banking models simply stop functioning at these levels. Banks can’t fund themselves in the long run at these levels and keep a business model. Many clients only borrow money at spreads of 100-200bps. So at 300bps spread of marginal funding costs, the banks will have to start to de-lever rather than take on new business (this is an optimistic scenario). A worse case is that the market loses faith in the bank, and a bank run ensues (the Lehman scenario).
So while Equities on valuations-terms may look cheap, current valuations do not capture the distinct possibility of at least one important bank failure (much less 5).
They also do not incorporate the forthcoming negative earnings revisions, as currently very few earnings have been revised down on the single name level, even though GDP is being rapidly revised down throughout all Wall Street banks.
ECRI leading indicators are already starting to turn down, and it is likely that the SP 500 continues to follow the ECRI LI downward. Here’s the current graph:
ECRI Weekly Leading Indicator at 2011-08-21
It’s not a perfect comparison, and I have more sophisticated ways of looking at the market, but simplistically, given that the current correlation between ECRI and S&P 500 price level continues to hold, we can see downside in the S&P to the 1000 level as ECRI continues to deteriorate.
Latin American corporate bond spreads continue to widen, though recently it has just been that the treasury bond rally has not been accompanied by a rally in corporate yields. Yields themselves have stopped widening for now. Here’s the current picture for Latin American Bond Spreads:
Latin American Corporate Bond Spreads at 2011-08-21
We are at a real crossroads, just as we are with bank CDS’s. The current level of 400bps is not stable. Either we continue on the path to 800, or the world returns back to the 300bps level. Spreads look juicy relative to the last 2 years though a longer term chart demonstrates the razors edge where we now stand:
Long-term Latam Corporate Bond Spreads Screen Shot 2011-08-21
Given the lack of clarity and resolution that is coming out of the European leadership, my bet is that spread go wider and equities go lower in the coming days and weeks.
The one positive thing I can say is that the problems of the world right now are not due to Latin America where things continue to progress and slowly get better. Credit is still difficult here (in Brazil credit costs at least 1 percent per month) and so there is much less risk of a debt driven deflation directly. We are, however, still linked to the world and are unlikely to avoid slowing substantially with a US recession. If a European bank breaks, Brazil and the rest of Latin America will suffer from the rapid decline in liquidity as EM bonds get sold.
Investing right now is 90% macro, and the dominant macro factors are outside of the region – predominantly Europe with a heavy dose of the US thrown in and both are in trouble.
Be careful out there.
Abraço, Arthur O’Keefe, São Paulo Value
State of Latin American Corporate Credit Market at August 10 2011
So it appears the market has chosen to enter a liquidity crisis. Will run through the stats quickly:
Latam corporate bond spreads are at their May crisis wides:
Latam Corporate Spreads at 2011-08-10
Treasuries rates are at their lows:
US Treasury Rates at 2011-08-10
This is helping to maintain a steady yield in aggregate Latam Corporate Yields though this “calm” is not reflective of the dislocations occurring in the market as higher yield paper has no hard bids:
Latam Corporate Yields at 2011-08-10
The Latin American Corporate Bond Index is showing down 1.7% from its peak and down 1% month-to-date though I am not sure how much stale marks may play in these figures:
Latam Corporate Bond Index Value at 2011-08-10
According to my S&P 500 model, fair value of the S&P 500 is not 1220-1250, so the market is still in oversold territory by the model, but the unfolding banking crisis occurring in Europe (discussed below) renders statements about fair value extremely suspect:
S&P 500 Index Model at 2011-08-10
The state of the bank CDS market is extremely alarming. 5 year CDS spreads of Societe Generale (France) is bid at 260 – its 3 year high:
Societe Generale 5 Year EUR CDS Spread BID as 2011-08-10
Other banks showing similar type graphs are Unicredito (Italy), Commerzbank (Germany), and Bank of America (US).
To have one megabank in stress is bad enough. To have multiple spread around the world is exceptionally bad. This doesn’t seem to be getting much press – perhaps for fear of causing a bank run, but when one looks at the balance sheets of these banks (European banks are levered 15-20 to 1 and US banks are levered 10 to 1) and the recent equity performance of the banks, one should be worried.
The Fed’s recent announcement of keep rates low for another two years doesn’t address the problem of credit quality and leverage of the balance sheet of these banks.
If these banks start to have funding problems, the market will spiral down again.
To me this argues for very low leverage and moving as high up in the capital structure as possible, though the indications are there for a repeat of 2008.
Latin America is not the problem in all of this – its banks are strong and corporations are performing (more or less), but it should continue to trade in sympathy until capital reallocates.
On the whole, a bad situation….
Um abraço,
Arthur O’Keefe, São Paulo Value
State of Latin American Corporate Credit Market at August 7 2011
While the market decides if it is going to a enter a liquidity crisis, Latam spreads have started to widen in sympathy to the market. Spreads are 35bps wider month-to-date.
Latin America Corporate Bond Spreads for bonds in USD:
Latam Corporate Spreads at 2011-08-07
At the current level of 340bps the market is nearing the May 2010 (Greece part 1) liquidity crisis levels.
Treasuries helped make July a stellar month for Latin American Corporate Bonds, but, now that they are choppy, they are not helping as much to maintain a steady yield for the Latam Bond Index. 10 year US Treasuries are 20bps tighter month-to-date at 2.56%
US Treasuries:
US Treasury Rates at 2011-08-07
As a result Latam Corporate Bond Yields are roughly 10 bps wider from month end to yield about 6.00%:
Latam Corporate Yields at 2011-08-07
Given the duration of Latam bonds, this has driven the bond index down about 90bps month-to-date:
Latam Corporate Bond Index Value at 2011-08-07
Will see where this finds a bottom, but generally sell-offs in Latam Corporate Bonds, considering the growth characteristics and fiscal condition of the region, presents an attractive investment opportunity.
Another sign that things may improve for the asset space is that 26 week (6 month) correlation of spread returns (lately negative) to the returns of the S&P 500 (very negative) is approaching a high:
Rolling 26 Week Correlations between Latam Spread Returns and S&P 500 Returns at 2011-08-07
Given that the primary concerns are growth (and secondary concerns are the futures of various developed markets) we may see equities continue to lag while credit spreads may hold or rally given their elevated levels.
A variant scenario is that current fair value of the S&P is 1180-1315 with best guess of value at 1260, so with the S&P at 1200 we may see a relief rally which would aid Latam Corporate Bond spreads in tightening driving returns.
Current S&P 500 Model:
S&P 500 Index Model Valuation at 2011-08-07
S&P earnings are still strong and estimates have yet to come down, which is a very different scenario from 2008 when earnings were falling with estimates also being revised down by the time the Lehman led liquidity crisis struck.
On the bear side, a government/sovereign credit crisis is uncharted territory in recent times. I believe this last happened in the 30s.
So much more analysis and monitoring is required. Will keep you posted.
Abraço,
Arthur O’Keefe, São Paulo Value
Why is mainstream press financial writing so bad?
First, let me start with a source of pretty decent writing: itulip.com. I think their site is intentionally a mess graphically because Eric Janszen (EJ) doesn’t need to market, doesn’t “need” the money, has other income sources, intentionally wants to look anti-media, and greatly prefers to produce research rather than format it.
Still I think he could be a little less thrifty and pay up for a web-admin.
EJ’s latest article is entitled: The Big Bet revisited and is divided into two parts: Part I: Turkeys grounded and Part II: Mining memes for money. Part II requires a subscription which I recommend if you have some spare bucks to allocate to provocative newsletters.
The article is about how debates are reframed to benefit some controlling group (the group who pushes for the reframing of the debate) and how sometimes (maybe many times or always) there are unintended consequences of reframing and opportunities to profit knowing that this game of reframing is going on. EJ calls this “Meme Management”.
Janszen is rather direct (refreshingly so actually) and claims that he derives investment themes and subsequently profits knowing that “Meme Management” happens. His article is structured as an interview, and in it he states:
CI: You shorted the meme management?
EJ: Sort of. It’s more complicated than that, of course. But in effect, yes. I bet that the program to force a deficit cut deal using the debt ceiling as a political forcing function would succeed, but that the consequences would be the opposite of the meme-jacking originators’ intention. That will not always be the case. Sometimes we will trade with it and at other times against it.
CI: How does it work?
EJ: I’m not sure it will work in the short-term. Several past experiments have been successful, but not two are alike. There are no guarantees.
CI: What’s your methodology?
EJ: It’s not appropriate for me to explain how meme analysis investing works, how the machinery of meme management operates, how it can be deconstructed, and how it can be used to inform trades. That’s our secret sauce, plus it’s a highly complicated analytical process that is not at all easy to explain anyway. I will say that it grew out of my research phase of my book on the US media, “The Kazoo and the Bullhorn: The American System of Propaganda.”
CI: You are working on that book?
EJ: Not at the moment. I figure I could make a few hundred grand on a book or millions on the insight into meme analysis. Not so touch a choice.
The logic is interesting, and I believe that this goes on and that Janszen is successful at times. But regardless of wether or not the reader agrees that this takes place or with Janszen’s premise that this has occurred with the most recent financial crisis, at least one could argue that this MIGHT happen in general and therefore that reframing may or may not be taking place should in itself be newsworthy and a subject to be fleshed out in the public forum.
But this never happens. There is never a self reflection of the media that it may be hijacked or reframed or “Meme Managed” for someone’s or some group’s interest.
So why is mainstream press’s financial writing and analysis so bad?
The second part of EJ’s comment gives a clue:
CI: You are working on that book?
EJ: Not at the moment. I figure I could make a few hundred grand on a book or millions on the insight into meme analysis. Not so touch a choice.
Apparently report and raising issues in public forums doesn’t pay and never will.
On one level there is a cynical and depressing message in that. On another level, though, accepting that it does happen, and guarding against it happening to oneself allows one to identify the situation and at least protect capital and in other instances to make better investments.
The Lesson: On a larger scale, because media and other information sources are not all encompassing (covering every angle and bringing to light every fact), this contributes to market inefficiency (I am not an efficient markets believer) and is one reason why investment opportunities exist. Said another way, not all information can become widely distributed or emerges in a timely manner. One reason for this is that incentives are strongly in place for those with “the knowledge” to profit from it rather than to distribute it. It’s not nearly as profitable to distribute knowledge – in the form of blogs, books, newspapers, or otherwise – as it is to simply act on it.
EJ: Not at the moment. I figure I could make a few hundred grand on a book or millions on the insight into meme analysis. Not so touch a choice. [emphasis mine]
To the extent this remains in place (and I believe it always will), those who devote efforts to developing “knowledge” of markets and understanding interests of parties involved can have an edge to uninformed investors. And to the extent that there are 401k’s, retail mutual funds, and index funds, and other pure intermediary sources that don’t have 100% alignment of interest with the underlying investor, there will always be uninformed traders.
Invest accordingly and try not to lose money.
Abraço,
Arthur O’Keefe, São Paulo Value
August 5th close to mark short term bottom? SPY, XLV look intersting
Quick post:
Technicals of the S&P look very oversold. Fair value still looks to be around the 1250-1275 levels. Given the Fed meeting next week, there could be a short bounce to play of buying today at the close. The model is recommending to long at the close today.
S&P 500 Model at 2011-0805
We are in the midst of a liquidity crisis, but it is a different flavor from 2008 which was driven by corporate (bank) failures. Today we are looking at government failures. Corporations are relatively resilient still.
S&P 500 sales are rock solid:
S&P 500 Sales at 2011-08-05
Back in 2008, sales margin (earnings to sales) had already turned for a while. Today they are still at the peak:
S&P 500 Margins at 2011-08-05
Neither sales or sales margin are predicted to soften in the next 3 months.
Which means the big question is what’s going to happen to earnings multiple. Finally we are approaching a short term reasonable multiple which points to a tactical (short term call) bottom:
S&P 500 Price to Earnings (PE) at 2011-08-05
The cheapest sector that I can see is Healthcare (ETF: XLV) which is even more predictable that the S&P in aggregate. Healthcare is a defensive play is it does not have nearly the level of fluctuations in sales and margins. Here are all 4 graphs of the index underlying XLV:
XLV Healthcare Index Model at 2011-08-05
XLV Healthcare Index Sales at 2011-08-05
XLV Healthcare Index Margins at 2011-08-05
XLV Healthcare Index Price to Earnings (PE) at 2011-08-05
As a side note, tech (XLK) is also starting to look cheap, but I need to dig in more.
Good luck today.
Abraço,
Arthur, São Paulo Value
S&P bottom signaled with weekly close below 1275
Looking at the 10 year and earnings and recent trends in price to earnings, it looks like fair value of the S&P 500 is 1250-1275. A weekly close below 1275 would signal that a short term bottom is in place.
S&P 500 Model at 2011-08-04 with Fair Value 1250-1275
A red flag would be downward revisions in forecasted earnings (shown in red as BEst_EPS). Also a liquidity crisis would cause temporary stress.
I advocate being very cautious in this environment.
Cheap sectors are: Tech and Healthcare. Rich sectors are: Energy and Industrials.
Abraço,
Arthur, Sao Paulo Value