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Mark's Market Blog

3-2-14: Europe: a slow motion train wreck.

By Mark Lawrence

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After bouncing off the 1850 level for over a week, stocks finally broke through on Friday to make Yet Another New High. In 1987 when the markets crashed on Black Friday, I remember one newscaster emoting uncontrollably at a Berkeley economics professor, "25% Down in One Day! In One Day! 25%! In One Day! How Long Can This Go On?" The professor calmly responded, "About three more days." How long can the markets keep going up in the face of lowering Fed induced liquidity, bad weather, questionable economic data, emerging market crises caused by the Fed's new policy, and continued economic problems in Japan and Europe? Probably more than three days.


S&P 500 September 5 2013 to February 28 2014

Ukraine is in the coming apart stage. Their currency, the hryvnia, has fallen 20% against the dollar making default more likely than not. (During WWII Czechoslovakia and Ukraine were forced to sell off all their vowels to buy military equipment; they've nvr flly recvrd.) Russia has massed troops along the border to be prepared to invade to "protect Russian citizens trapped in Ukraine," and the Russian parliament unanimously approved sending them into Ukraine. Obama called Putin and spent 90 minutes protesting; Putin told Obama to take a leap. Russia then moved troops into Ukraine, surrounding a Ukraine military base in Crimea and telling them to give up their arms. Ex-president Yanukovich is in a Russian city under protection and says he's still the legitimate president; Ukrainians want him tried by the international court. Absent a Russian invasion it's extremely unlikely that Russia will come up with the promised $15b in aid; the IMF is in talks now about a bailout. The borders of Ukraine were drawn rather arbitrarily after WWII by Stalin, and include parts of what had been Austria, Poland and Russia. Eastern Ukraine is filled with ethnic Germans, Poles and Ukrainians who want stronger ties with Europe and an end to dependency on Russia; Western Ukraine is filled with ethnic Russians who want to stay in Russia's orbit. Drawing new borders might be a good start at a solution. Perhaps Russia will annex Crimea and parts of eastern Ukraine, which I think would be a good start to a solution.

The UK finance minister announced that the EU is ready to provide aid to Ukraine. It's estimated that Ukraine needs about $35b - about $500 per citizen per year - to continue to operate. My first reaction is that this is a lot of money, but it's less per capita than we give Israel, and less than Greece needed. I also think this offer is more than a little provocative towards Russia. My read on Putin is that he's not a guy I'd like to provoke. Or perhaps it's just meant to give Ukraine some leverage at the bargaining table, to help them get a better deal from Russia.

Is stock market margin debt a good predictor? Not exactly, but it's at nosebleed heights and obviously can't continue up forever. In September 1987, margin debt peaked at $44 billion, or 0.88% of GDP. On October 19 1987 stocks dropped 25% in one day. In March 2000 margin debt hit a new record of $278.5 billion, or 2.66% of GDP. Stocks started dropping and 28 months later the S&P was down 45%, the Nasdaq nearly 80%. Margin debt peaked again in July 2007 at $381.4 billion, or 2.60% of GDP. The market peaked in October 2007 then headed down. The S&P 500 fell 57%. In January 2014, margin debt hit $451.3 billion 2.69% of GDP, the highest ratio ever. What's next? I dunno exactly when, but I expect it won't be pretty. How are US stocks likely to look for the next decade or so? We can see how Japan has done - they have a 20 year history of an aging population, rising government debt, ongoing problems with deflation, and a central bank that prints massive amounts of money from time to time. In short, not a lot different from how the US looks today. After peaking in about 1990, Japanese stocks had a huge crash; since then from time to time their central bank prints money and fuels another asset bubble followed by another drop, with the market in long term decline. It would not at all be unthinkable for the S&P to bounce around in the range of about 800 to 2000 for the next ten to twenty years.

How bad is US health care? We spend two to four times as much as any European nation and if we joined the EU we would have the lowest life expectancy. Will Obamacare fix it? Nah. All it does is guarantee doctors get paid. No changes to drug costs, no reports of the effectiveness of procedures, no reports on the competence of doctors or hospitals, no reigning in lawyers, all they really do is tell us what to buy and what it costs.

Twenty-five years ago Gorbachev was trying to reform the USSR with his policies of Glasnost (openness) and Perestroika (reform). From that era we get the following Russian joke: A man comes home from the coal mines and asks his wife, "What's for dinner?" "Go the market and get a kilo of meat." He walks down, stands in line for 90 minutes, tells the babushka at the counter he'd like meat and gets told "We're out." He says, "Damn it. Perestroika, Glasnost, nothing ever changes around here. There was no meat before and there's no meat now." At the end of the counter is a handsome young man in uniform with an AK-47 who says, "That's not true tovarisch. Before I would have shot you for saying that." The man trudges home and tells his wife they're out of meat. She says, "Nothing ever changes around here!" With wide eyes he says quietly, "No. It's gotten much worse. The KGB has run out of bullets!" Below, in the nothing ever changes department, is a current picture of Venezuelans lined up for the hopeful privilege of buying some food.

Everyone is all excited about WhatsApp, a small internet business with 55 employees and $20m per year in revenue. Google offered to buy them for $10 billion; Facebook stepped in and bought them for $19 billion - 1,000 times revenue, or $400,000,000 per employee. The money wasn't evenly distributed, of course - the founder got $6.9 billion of the $19 billion. After the deal Facebook shares rose. And of course a bunch of wall street guys made out like bandits brokering the deal. Every stock market bubble top seems to be marked by some huge money deal that makes absolutely no sense: AOL / Time Warner, that wound up wiping out $100 billion in shareholder money; TXU, a Texas coal burning electric utility that was valued at $47 billion and is now on the edge of bankruptcy; and this time (so far) we get a business valued at 1,000 times earnings. How will it end? Here's a hint: WhatsApp has a lot of users, but the founders hate advertising and refuse to do any data mining. Facebook loves advertising and mines you for every little detail they can swipe. How long will Facebook keep their hands off? How long will WhatsApp users tolerate Facebooks relentless snooping?

JPMorgan says the future of banking is online:

Pittsburgh is changing their water treatment systems. Nearby fracking is resulting higher levels of bromide in their water. Bromide reacts with chlorine to produce carcinogenic chemicals. Now they're using a combination of chlorine and ammonia. This has the happy result of leaching lead from older water pipes and putting that into your water. If I lived in Pittsburgh I'd be looking into home water purification systems - reverse osmosis and activated carbon filters. Or perhaps I'd just put in a solar still and drink that. Unfortunately the most efficient way to get chemicals like this into your body isn't drinking, it's a hot shower where you breathe in the polluted steam. Anyway, our insatiable thirst for gasoline means we're burning up our corn crop, switching over to genetically modified corns to increase yields, messing up our air and water, and just generally making life more insecure. Perhaps Elon Musk has it right and we need to switch to electric cars. Or perhaps we simply need to live in a country with 150 million people instead of 310 million people.

While employment, demand, manufacturing and prices continue to stagnate or even deteriorate in most of the EU, Germany continues to roar to ever higher economic levels. Their business morale continues to rise, will poll results coming in even higher than expected. The EU is more and more bifurcating into a rich north - Germany and Scandinavia - and a stagnant or declining south - pretty much everyone else. It's also more and more difficult to see how this can continue with all these countries sharing a single currency and a single monetary policy. Current feelings among bankers across Europe and Wall Street are that the EU crisis has passed and the currency is here to stay, but for that to be true it continue to be obvious that Europe needs a strong central government that can tax the north and subsidize the south, something that is in direct violation of Germany's constitution. But then gay marriage is in direct violation of Utah's constitution; perhaps the German constitution will be marginalized.

The future of Europe: Mark's analysis.

  1. Europe has severely diverging economies: Germany, Norway, Sweden, Austria, Denmark and Switzerland are all doing quite well, each in their own way. Greece, Spain, Portugal, Italy and Ireland are all basket cases with youth unemployment that all but guarantees a lost generation; France is close behind. The northern countries are unwilling to fund what they see as the excessive social programs of the south, and the southern countries cannot live with the strong Euro favored by the exporting nations of the north. It seems clear the current structure cannot continue. I expect within a few years there will be cascading debt crises across southern Europe and France, resulting in some kind of split: the northern strong economies split off, or the weaker southern economies split off, or in some way they split the Euro into a northern and a southern currency with different values. I do not believe that the political climate of Europe favors a US style federal union with large monetary transfers from the north to the south.

  2. Switzerland recently passed an unexpected, provocative and somewhat shocking law, restricting immigration into Switzerland. Switzerland's strong economy and the Swiss Franc have made it compelling to move there for too many people: over 1 million Europeans live in Switzerland, about 300,000 Swiss live elsewhere in Europe. This new law directly challenges the EU ruling of free movement of people and goods: for example, Pakistanis can move to Belgium, then move to the UK, and the EU court has found that the UK must accept them and give them welfare. There is strongly growing tension in Europe over immigration, and anti-immigrant (read: anti-muslim and anti-gypsy) parties are in ascendency all over Europe: True Finns, Lega Nord in Italy, FPO in Austria, AfD in Germany, French Front, Golden Dawn in Greece, Freedom Party in Netherlands. The EU is comprised of appointed, unelected officials who are increasingly seen as an elitist and detached political class who are determined to regulate every aspect of life in the EU and eliminate regional and national freedom. This political tension is getting worse and does not seem, to my eyes, to have any damping factors. The Swiss vote is seen across Europe as a direct challenge to the unquestioned power of the EU leadership and is being watched closely.

  3. Several countries in Europe have, in my opinion, taken their socialism experiments too far. In several countries, most notably France, labor is so highly regulated that a businessman would have to be nuts to hire someone. Faced with no job growth and growing unemployment, governments have resorted to their usual trick: forbidding businesses to lay people off; hiring more government workers who, in the end, produce nothing; and placing more people on the dole. The result of this is higher and higher levels of debt with no end in sight. I hear arguments daily from the left that the debt of countries is not like the debt of a family: whereas a family that goes too far into debt will inevitably wind up bankrupt, a government can go into debt without limits or consequences. I don't believe it. When you have 58% youth unemployment (Spain) or 42% (Italy) and labor laws that effectively make it impossible to start a small business, your long term economic outlook is devastation. IMHO.

  4. Like the rest of the world, the various central banks in Europe are printing money like mad. However this money is not making its way into the economy as a whole: in the language of economists, the velocity of money is dropping almost as fast as the money is being printed, the bankers are deeply in a liquidity trap. In the language of more normal people, most of the money is sticking in the bank vaults, and what little escapes is being used to inflate asset bubbles: stocks and bonds are going up to what has historically been completely unsustainable prices with P/E ratios near record highs and interest rates at record lows. Essentially none of this money is working its way into the economy as a whole in the form of loans to businesses or individuals. We've all seen what happens to bubbles if you keep inflating them: they pop. The difference this time is essentially the entire first world is inflating bubbles: most of Europe, the UK, the US, Japan, and China are all printing money and all have one form or another of what strongly appears to be asset bubbles. It's not hard to imagine a scenario where one bubble pops and the contagion spreads across most of the industrialized world.

  5. Although the press is doing a better than fair job of covering it up, there are increasing demonstrations and even riots across much of Europe: Spain, Italy, Greece and France at times and in particular places look quite a lot like Ukraine. Most people have little in the way of economic training, and it's widely believed among many that the debt and welfare programs are all free. If unemployment maintains at current high levels or even increases, and then interest rates rise forcing a cutback in social programs, it's not hard to see several European countries degenerate into ungovernable messes. Lenin famously said "No country is more than three meals away from revolution." The only thing that's changed since Lenin's time is that now cable TV, cars and free apartments have been added to the list.

What does the future of Europe hold? I don't know in any detail, nor have a clue about timing. Keynes famously said "markets can remain irrational longer than you can remain solvent," and I think that's also true of governments supported by accommodating central banks. But the long term outlook for the current social-welfare states in southern Europe is, to my eyes, clearly unsustainable and will inevitably result in a substantial crash. These social programs started out as a "social safety net," a hand up, not a hand out; but for an ever increasing fraction of the population they've mutated over the decades into a multi-generational way of life. The most chilling statistic out of Europe, imo, is the youth unemployment numbers: increasingly, European 20-somethings have no choice but to live on the dole on the fringes of society. The way of life of inner-city blacks in the US is rapidly becoming the way of life for all young people in Spain, Greece, Italy. Europe assured us they could build a multi-cultural society where everyone, regardless of race, religion, sex, culture had the same chances, and it seems they've done it, by lowering everyone to the least common denominator. I'm not predicting the end of the world - we all survived the Great Depression a hundred years ago and we'll survive this. But the aftermath will be changes that leave Europe unrecognizable in many ways. It's noteworthy that the Great Depression ended with the War to End All Wars. We don't want a repeat of that little episode. With governments, the sad historic truth is that when the going gets tough, the tough start wars.

Of course, given my grim outlook for Europe, I'm distraught to see the US trending towards a social welfare state where fewer and fewer people work to support more and more people on disability and other entitlement programs, and more and more of our children are being raised by unemployed, uneducated and unmarried mothers. A strong argument can be made that in a rich society like ours no one should sleep hungry, sick, cold, unsafe, unsheltered just because of poverty. However, to my mind, no rational argument can be made that the people in society that contribute least should be the ones induced by government handouts to breed the fastest. People who cannot support themselves have no business adding children to their list of problems.

How's communism working out in Asia? Here's a picture from the International Space Station taken at night. Gunsan is a small port city in S.Korea with a population of about 280,000. Pyongyang is the capital of N.Korea with a population of about 3.5 million. N.Korea uses about 5% as much power per capita as S.Korea. On the plus side, N.Koreans are closer to nature - they burn more wood to heat their much smaller homes, spend far more hours working at agriculture, make much stronger use of family gardens, and starve on many years when weather is uncooperative. Nature is not always the warm and welcoming mistress that many seem to wish. . .

Detroit is talking about cutting pensions by 35%. However, if bondholders agree to take a bath, those cuts would change to 4% for police and fire and 26% for everyone else. I have no clue why police and fire would get different treatment, nor have I a clue how this motivates bondholders to take a bath. Chicago's pension payments are set to double next year to over $1 billion, which will nearly bankrupt the city. Pensioners argue that income and property taxes must increase. Chicago aims to raise the retirement age, raise employee contributions, and cap pension benefits for the highest earners. Their unionized workers aim to have nothing change. If the stock market drops substantially California will be the poster child for this problem, as California's pension funds Calpers and CalStrs are both highly invested in the markets, and California's tax base is highly dependent on Silicon Valley capital gains. In his latest shareholders letter, Warren Buffet warned that the next ten years would see an ever increasing number of states and cities finding themselves more or less bankrupt due to excessive pension promises.

Highly inappropriate joke: A guy says to his friend, "I had breakfast a couple weeks ago with my 8 y/o granddaughter. I said, 'Do you know what Monday is, Sweetheart?' 'Yes! It's President's Day!' 'That's right. And do you know what that means?' 'Yes! That's the day when Obama pokes his head out of the White House. . . and if he sees his shadow, we get another year of bullshit!'"

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