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Mark's Market Blog

5-7-10: Greece and the PIIGS: the dominoes of Europe.

By Mark Lawrence

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The market obliterated its 20 day moving average, made a very slight pause at the 50 day MA, and crashed through that. Next stop: the 200 day MA, an S&P of about 1100. I have very little trouble predicting we'll see that level in this correction - in fact we were temporarily below it during the mini-crash, and touched it again on Friday. The big question is, can Portugal's bonds hold up for the next couple of months? If they do, I expect this correction will be halted at the 1100 level or so. If they don't, then it's hard to see the bottom. My bet is on "don't." Yields on Portuguese two-year bonds topped 5%, way above the 1.3% they were yielding in January. Spain is a step behind at 3.6%.

S&P 500 November 10 2009 to May 7 2010

Thursday was fun. At about 2:40 EST, the market dropped 8%, 10%, I don't really know, a lot. However, just as the bottom fell out, my browser crashed (this happens about once a year and made me even more suspicious). When I got it reloaded, the market was back up to a 3% drop. The official story is that a trader at Citi meant to sell $16M in futures of Proctor & Gamble, but he accidentally sold $16B. Citi denies this. There are also lots of conspiracy theories out there, some claiming this was an attack by a foreign country, others claiming this was done intentionally to scare Europe into passing the Greek bailout. We worker bees will most likely never know the truth. In any case, since the glitch, volatility has been impressive. The spike triggered a lot of stop- loss orders and cost a lot of people a lot of money. Confidence in the stock exchange is pretty low right now.

S&P 500 May 3 to May 7 2010

The Market is flirting with the 200 day moving average. If the market crosses over the 200 day, it would be a signal that we're in for a protracted period of dropping prices. Since 1995 the market has only crossed this line eight times, four in each direction. These crossings often mark long-term changes in market sentiment and direction. I've said many times that the financials would lead us into the next major market drop, however this time the financials are just tracking the market as a whole, neither leading nor trailing. We'll find out in a couple weeks what this means.

S&P 500 v. 200 day moving average, 1993 to 2010

The UK voted Thursday, and none of the 3 major parties got a majority. This is very unusual for Britain, it hasn't happened for a couple decades. We are on the threshold of major currency / banking / debt crises all over Europe, including the UK, and they will have some form of shaky coalition government that will be unable to take hard decisions. This is a precursor to the US, where most likely after the November elections we will have republicans in charge of the house, and democrats in charge of the senate and presidency, guaranteeing that we'll be unable to take swift action or make difficult choices. Germans will be voting Sunday and have a chance to weaken Chancellor Merkel, which it looks like they will take. After spending $2T on East Germany reunification in the last 20 years, about a full year's GDP averaged over that time, Germans are understandably tired of bailing out others. The proposed German contribution to Greece of $30B is enraging voters. Of course the truth is that $30B will go to German bankers, not Greek retirees, but that's supposed to be a secret.

According to the Bank for International Settlements, France and Switzerland each have $79 billion of exposure to Greek debt. BIS data shows that French and German banks have roughly $2.9 trillion of exposure to the PIIGS. The Euro has led to the biggest misallocation of capital since the Soviet Union, leaving us with too many houses in Spain, too many factories in Germany, too many retired people in Greece, and too many civil servants in France, everybody specializing in what they do best.

There are growing concerns about the PIIGS. The bailout for Greece hasn't been put into place, and already it's seen as inadequate. The rest of the PIIGS are seen as at risk for similar breakdowns in the next few months. This leads to worries that Italians and Spanish will start moving their bank deposits to banks in Germany or Switzerland, causing a run on their banks. This has already happened in Greece, where there have been massive movements of capital out of the country in the last two months. Some are calling for a massive intervention by the IMF, but the estimates are that the required sums would be $1T or more, more than double the IMF's resources. Thus any such plan would require a concerted effort that would include Germany and France cooperating - unlikely in the extreme, as they have very different views of Europe and their responsibilities. Further, the IMF historically required a currency devaluation to increase exports and shorten any recession. However a devaluation of the Euro is not on the table, so it's unclear that the standard IMF program would work.

European banks have a spider-web of interlocking debt. Greece's debt is mostly held by France, Germany, Switzerland, UK. However, a third of Portugal's debt is held in Spain. When Portugal goes, it will have a big affect on Spain. The rest of Portugal's debt and most of Spain's is held by France, Germany, UK. If Italy also starts to go, France will be in real trouble - by then $850b of bonds held by France will be in trouble, a third of French GDP.

Five Enterprise Class Starships on a Collision Course

The head of the IMF is a French guy, Dominique Strauss-Kahn, who wants to be the next president of France. As I see it, the US just donated $8B to his election campaign - our share of the IMF bailout of Greece. Your share, if you're an average taxpayer, is about $50. I wouldn't give that to someone running for the US presidency, and I don't care in the slightest who's the president of France. And, this bailout isn't a done deal: it still has to be ratified by the EU members. Failing ratification, there will be a larger role for the IMF (read: US taxpayer.) Question: If a fortification is a large fort, why isn't a ratification a large rat?

The news is full of upbeat statements about how the Greek bailout is agreed, and everything is under control. Without a doubt, this is very much what all the governments involved wish us to believe. But it's simply not true. It's not at all clear that there is any solution available for Greece, and it's certainly clear at this time that there is no solution even proposed for Portugal or Spain. This crisis will continue to grow for the next several months until it reaches the panic threshold. In the US, we set up our $700B bailout fund, TARP. At this point all of that money has been repaid with interest, save for AIG, GM and Chrysler. The equivalent bailout fund for Europe would have to be 2 to 3 times as large, the money would have to be agreed upon by several different governments with very different agendas, and the likelihood of the money being paid back is pretty poor.

The Greek government is going to cut government employment, wages, and retirement payments. Protests are country-wide, and in at least one case have caused deaths. This is a preview of what is coming in the US as states fail to balance their budgets. 40 states are running deficits, 32 states have deficits of over 8% of their budget. 26 states have deficits of 13% or more - the same or worse than Greece. So don't feel too smug.

California Legislators were hoping revenue would exceed projections, forestalling deeper cuts and further tax hikes. But April's total take was 30% below what was expected, nearly $3B short, leaving them with few options to balance the budget.

Oakland Ca, where ex-governor Jerry "Moonbeam" Brown was recently mayor, is nearly bankrupt. Oakland is running a deficit of about 20% of budget (comfortably more than Greece). The city has not been funding their retirement funds and is now way behind. There will be a bill on the November ballot so that city residents can raise their taxes by about $25m per year so that retired police and fire fighters can keep sitting home drinking beer and collecting their pensions. Meanwhile, the city's teachers voted to strike if their new contract doesn't include a pay raise. This should be fun to watch. . .

Former Los Angeles Mayor Richard Riordan has been warning that the city he once ran would need to file for bankruptcy unless major policy decisions are made. The problem? City worker's pensions, which 10 years ago Mayor Riordan raised from 70% to 90% of last pay.

How bad is the BP spill? From May 4 1942 until December 1943, German U-boats sunk oil tankers in the Gulf containing a total of 900,000 barrels of oil. The BP spill would have to run for three more months to equal that amount. While the spill is pretty awful, it's not going to end life as we know it. And, by the way, oil is a good fertilizer in warm waters. Fisheries in the gulf have been declining for years, but 5 to 8 years from now they will be doing really well with fantastic diversity. You won't hear about that, all you're going to hear about is devastation and destruction by the evil oil companies.

In the 1989 Exxon Valdez tanker spilled 11 million gallons into Alaska's Prince William Sound. After the Exxon Valdez spill, an Alaska jury demanded $5 billion in punitive damages from Exxon. The thinking at the time was that the giant oil company should forfeit roughly a year's worth of profits. Exxon moved to protect itself by raising a $4.8 billion credit line from J.P. Morgan. J.P. Morgan, to protect itself in turn from an possible default by Exxon, came up with a novel financial instrument called the credit default swap. Now a $30 trillion international marketplace, credit default swaps were also at the core of the global financial market's biggest meltdown in decades. Who knows what Wall Street's wizards might whip up to protect BP?

Iceland's volcanic ash threatened European air space once again Tuesday, forcing Ireland and some North Atlantic islands to temporarily shut down airports. Iceland's Institute of Earth Sciences said the volcano's plume has risen this week to nearly 5.5 kilometers (18,000 feet) following several large explosions. It said tremors emanating from the volcano have intensified since Sunday night and the eruption that began April 14 shows no signs of ending. The last time this volcano erupted in 1821 the eruption lasted for over a year.

The American consumer has been taking a break for the last 18 months or so, busily paying off credit card debt and moving out of our foreclosed homes. The Chinese, undeterred, have simply moved their production from goods for the US to goods for Europe. Unfortunately, Europe is apparently now having their own financial crisis, which looks to be about two to three times the level the US faced, and with problems that are far more structural than the US problems. If Europe heads into a deep recession (looking more likely every day), and US consumers continue to pay off debt (pretty clear), China and their real estate bubble could be the next casualty.

China's exports to the US (gold) and EU (black)

We have just experienced a 12 months run-up in stock prices, a turn around in corporate profits, and if not an improvement in unemployment, at least a halt in the damage. So, why am I so gloomy? I think much of our last 12 months was driven by cheap money from the Fed, and the rest by the fact that Europe and Asia weren't hit as hard as the US. Greek bonds are up from about 4% to about 20% in the last two months, Portuguese bonds are up around 1.3% to 5% (a big auction is coming on May 12, that will give us a better picture), and Spanish bonds are up from 1.3% to nearly 4%. Money is about to get much more expensive. Questions about European banks are about to dominate the European markets. I think Europe today is about where we were in the summer of 2008. Greece will be their Countrywide; Portugal will be their Lehman. More importantly than what I think is that a lot of bankers and hedge fund guys think pretty much the same thing. The Fed has done a great job of keeping the US from falling into a depression, but Bernanke cannot hold the entire world when Atlas shrugs.

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