Sunday, September 25, 2011

CDS Implied Probability of Default – Be Careful

by Peter Tchir

Unless something changes in the next 24 hours, I expect we will hear more and more talk about default, not only of Greece but of other countries and of banks. Just in case that happens, here is some information that may help you make good decisions. There will be lots of chatter about the “likelihood of default” the CDS market is implying, but although it can be a useful statistic, it can also be very misleading. Before jumping into trades based on erroneous assumptions, it is worth spending a few minutes reading this. If all it does is confuse you, maybe that is a good thing in itself, because you won’t take a headline about default probability as fact.

Recovery is Key and is often assumed away making default probability calculations less useful
Let’s start with a simple example. You have bonds of 2 different companies, each maturing in the near term, both trading at 70. What is the probability of default of each of these companies? You don’t know because that isn’t enough information. You know the bonds are trading at 70, and without a default they would pay par, providing a 30 point return. What you need to know to figure out the probability of default, is what the recovery value will be. Let’s assume that the recovery value for one company is going to be 60 and for the other will be 10. Then in the first case, the default probability is 75%. There is a 75% chance an investor would lose 10 points, and a 25% chance that they would lose 30 points, giving an “expected” value of 0 (today’s risk free rate). In the second case the default probability is only 33% (66% chance of 30 point gain plus a 33% chance of a 60 point loss).

So recovery is a key element of determining what default probability the market is pricing in. Yet, although it is key, it is often assumed to be 40% or some other number based on historical averages. That is a reason to be very concerned when you see a default probability mentioned. It is useless without looking at the recovery value, and recovery value isn’t easy to figure out. Recovery value is figuring out the enterprise value of a company after it has defaulted. It is not any easier than figuring out enterprise value of a company that is not in default, so treat estimated recovery values with the respect they deserve.

In the CDS pricing model, there are 3 key variables: the spread, the recovery value, and the up-front premium. If you know any 2 of those 3, then you can solve for the other. The market trades with the assumption of 40% recovery. That let’s traders quote a spread, and then the up-front premium is just a calculation. This is done more out of convenience than anything else. Agreeing to a recovery rate on each trade would be time consuming, and 40% seems reasonable enough for the purposes of calculating the up-front.

For high quality (tight spread names) the up-front premium is not very sensitive to recovery.
For names that trade at 400 over (BAC for example), the probability to default over 5 years is 21% with a 10% recovery, and 51% with a 70% recovery. So you need to take any probability of default derived from CDS prices with a grain of salt. Without a rational assumption for recovery, the probability of default is somewhat meaningless. Since changing recovery would change the “up front” premium, you could try and argue that the recovery must be valid. I would argue that the smartest credit investors figure out what premium they need to earn to take the risk, based on their assumptions, and then figure out what spread in a 40% recovery model world gives that up-front premium.

At the other extreme, names will eventually trade in “points”. With a 40% recovery in the model, there is no spread that can give an up-front premium of more than 60. If a dealer was willing to buy protection and pay 55 points up front, or sell that protection at 57 points up front, most investors wouldn’t complain about the liquidity. It would be as good as in the bond market. On the other hand, if the same dealer quoted that market as 3470/4430 some client might argue that 1000 bps seems egregious. Also, if a company has a bond trading at 35, dealers will not want to floor recovery at 40 since a bond trading at 35 shouldn’t exist if recovery is 40. So as default becomes more likely, the model becomes less useful.
The Curve is also important

For simplicity and market convention, the 5 year cumulative default probability is based on a flat curve. As a situation deteriorates it becomes more important to look at each point on the curve. Two names trading at 1000 in 5 year CDS would have the same implied probability of default from the standard model. But if one is trading “inverted” at the short end, and the other is steep, then at the very least the timing of default that is being priced is very different. An inverted curve means the risk of default in the near term is much higher. If you, as an investor are going to make decisions based on default probability headlines, you need to look at the curve. The 5 year default probability is a nice headline, but the devil is in the details.
Sovereigns are even more problematic when divining default probabilities

Sovereign CDS for Eurozone countries trades in USD. CDS on US government debt trades in Euros. This helps explain why CDS trades so wide for many sovereign names. If you bought €10 million of a European sovereign at par, and it defaulted, recovering 40%, you would have lost €6 million. If you had bought CDS in Euro that trade would basically offset it. If you bought protection in $’s and the exchange rate was unchanged, you would break even on the trade. But many investors believe that a default of a European sovereign would cause the Euro to get a lot weaker. So let’s say at the time of the trade the FX rate was 1.40. You would need to purchase $14 million of CDS to cover the €10 million bond position. If the default occurs and the FX rate went to 1.20, then you would have made $8.4 million on the CDS trade, which when converted back to Euros at 1.2 is now €7 million.

If investors believe an FX move is highly correlated with default, they will pay more for CDS. They make more on their negative view than they would if the FX trade wasn’t embedded. Similarly they lose less if the market rebounds. Their position in the bonds will go up, while their losing position in CDS gets converted back into more expensive Euros, thus mitigating their losses.

So on sovereign CDS, particularly at times of stress where the market clearly believes that a default is bad for the currency, the CDS spread is not just pricing in default, it is pricing in default with a currency move, making implied default probability less useful.

On top of that, recovery for sovereigns is purely guesswork. Creditors have NO rights. There is nothing they can do to try and collect on their bad debts. It is purely a negotiation. That is why the distressed investors don’t do much in sovereigns, because they are used to playing by rules, and in a sovereign default there are no rules. In some sovereign defaults, shorter dated bonds have received better treatment than longer dated bonds. That is uncommon in corporate defaults, but not uncommon in sovereign defaults, making picking a recovery value even more difficult.
Cheapest to Deliver Bonds

For banks, financials, and sovereigns the cheapest to deliver option embedded in CDS has less impact on daily CDS prices because they are such frequent issuers. For companies with fewer bonds, the cheapest to deliver option can impact CDS prices, without really impacting probability of default in the real world. If two very similar companies existed, but one had only issued bonds at times of high coupons, and the other had issued when rates were very low, the CDS on the low coupon bond company should trade a bit wider. Investors who like the “basis package” where they buy bonds and buy CDS generally prefer to buy lower priced bonds because they can benefit from a “jump to default” and lock in their basis trade profits sooner than later.

SPY Trends and Influencers 9/24/2011

Last week’s review of the macro market indicators looked to bring more consolidation for Gold ($GLD) in a broad range, but with the bias to the down side if forced to pick a break direction. Crude Oil ($USO), the US Dollar Index ($UUP) and US Treasuries ($TLT) all also look to be headed lower in the short run. The Shanghai Composite ($SSEC) looks to continue lower while Emerging Markets ($EEM) consolidate further. Volatility ($VIX) looks to remain elevated with any break bias to the downside as Equity Index ETF’s $SPY, $IWM and $QQQ are set up to extend their gains. The QQQ is by far the strongest of these index ETF’s and should be watched for broad direction. The correlations to watch for driving the Equity markets this week are the inverse relationship to the US Dollar and US Treasuries. Should these areas reverse and move strongly higher Equities will likely fall. Gold should play less of a role as it is moving in a broad range.

The week began with Gold moving sideways before a massive collapse and Crude Oil falling lower. The US Dollar Index and US Treasuries also drifted before launching higher and as warned knocking the Equity Indexes lower. The Shanghai Composite continued to consolidate while Emerging Markets were sucked into the downdraft again. What does this mean for the coming week? Lets look at some charts.
As always you can see details of individual charts and more on my StockTwits feed and on chartly.)

SPY Daily, $SPY

SPY Weekly, $SPY

The SPY gapped lower out of its bear flag Thursday and then held that range Friday, at the closing low support since early August. The RSI is pointing lower and the MACD crossed negative on the daily time frame. All of the SMA’s are sloping lower on both time frames except for the 100 week SMA. The weekly chart also shows a bearish RSI but the MACD is diverging, starting to improve. It is not as certain of the flag break on the weekly chart. The bias is to the downside for next week with support below 112 at 110.26 and then 108 and 104. Any bounce above the gap level of 114 should see resistance within the bear flag and first near 116.

Rolling into the last week of the third Quarter, Gold and Oil are ready for more downside. The US Dollar Index and US Treasuries look to continue higher. The Shanghai Composite and Emerging Markets also look to continue their down moves. Volatility looks to remain elevated and possibly break higher. The equity Index ETF’s, SPY, IWM, and QQQ are all looking better to the downside. The QQQ again may be the key to holding the market together. If it loses support of the flag, the SPY and IWM could take the whole market lower. A spike in Volatility and continued moves higher in Treasuries and the Dollar Index should ensure it. Use this information as you prepare for the coming week and trade’m well.

See the original article >>

The 3 Most Vulnerable Sectors

These major market sectors are still looking very vulnerable and are likely to continue to underperform the S&P in the months ahead. Use careful risk controls to avoid big losing positions.

The late-in-session drop in the stock market after the Fed announcement was consistent with the deterioration in the technical outlook discussed yesterday. The McClellan Oscillator has broken below support, which makes a further drop very likely.

Three of the major sectors look most vulnerable to further selling and they are likely to underperform the S&P 500. Even though technology was also lower, it continues to show better relative performance, or RS analysis, which suggests the tech sector will hold above the August lows.

For the Select Sector SPDR – Energy (XLE), it is important to keep an eye on crude oil prices. As I have frequently pointed out, crude oil often leads the stock market on both the up and down side. November crude oil was down over $2 yesterday, and a break of key support would be a negative for the energy sector and stocks in general.

Chart Analysis: November crude oil completed its flag formation, lines a and b, on Monday, but so far, the short-term lows in the $84.65-$84.90 area are holding. The key chart support is now at $83.47.
  • There is further support at $79.76 and then at $76.61. The 127.2% Fibonacci retracement target is at $72.53
  • The on-balance volume (OBV) broke its uptrend, line c, on September 9 before rebounding sharply
  • Volume has been heavy over the past three days and the OBV now shows a pattern of lower highs and lower lows
  • Crude oil has resistance at $88 with stronger resistance in the $89-$90.63 area
The weekly chart of the Select Sector SPDR – Energy (XLE) shows that it is not far above the weekly uptrend (line d) and the 50% retracement support in the $59-$59.40 area. XLE completed a daily head-and-shoulders top formation in May.
  • The major 61.8% Fibonacci support stands at $54.50
  • The relative performance, or RS analysis, turned positive in October 2010, signaling that XLE was going to be stronger than the S&P 500. The RS analysis topped in May and is negative, as it is still below its declining weighted moving average (WMA)
  • The weekly OBV formed a negative divergence, line f, at the late-April highs. The OBV needs to break this downtrend to turn positive. The OBV is below its weighted moving average
  • There is initial resistance for XLE at $67.76-$69.90

The Select Sector SPDR – Industrial (XLI) has been one of the weakest sector ETFs, down 24.6% from the April high at $38.98. The daily chart shows a completed head-and-shoulders top formation, as the neckline (line a) was broken in July.
  • The daily chart shows next support at the uptrend (line b) in the $29.50 area
  • Major 50% retracement support stands at $27.40 with the downside target from the daily chart formation at $26.40
  • The daily uptrend in the RS (line c) was broken in May and still looks negative
  • Daily OBV confirmed the completion of the top formation when it dropped through long-term support at line d
  • Weekly OBV formed a negative divergence at the May highs and is still negative
  • There is initial resistance for XLE at $32.20 and then at $32.89
The Select Sector SPDR – Materials (XLB) closed below short-term support, line g, on Wednesday. This suggests it will continue to lead the market lower. The daily chart shows a completed top formation, lines e and f.
  • Major 50% retracement support is at $29.70
  • The daily chart formation has downside targets in the $28.50 area
  • The daily uptrend in the RS, line h, that goes back to the 2010 lows, was broken in early May. The RS is now dropping very sharply and XLB is acting weaker than the S&P 500
  • The OBV is in a solid downtrend, line i, though we may have seen a selling climax in early August
What It Means: These three key sectors have been the weakest over the past four months. The weakness in crude oil suggests it is ready for one more decline, but the longer-term technical analysis for crude oil suggests that this could complete a bottom formation. Therefore, the energy sector may bottom out first.

The industrials and materials sectors gave weekly sell signals in May (see “2 Key Sectors Top Out”). Both now look ready to lead the markets lower, and a resurgence of growth in the emerging markets is likely necessary before these sectors turn around.

How to Profit: I see no real profit opportunities at this time, but those holding stocks in these sectors should be sure to use stops on all positions to limit the risk. It is tough to come back from a 30%-40% hit in one position.

Dollar breakout ...

by Kimble Charting Solutions

Dow Reaches Lower Channel Line

The Dow has reached the lower parallel channel for the entire rally from the March 2009 low. The channel lines were created using the Andrew's "pitchfork" method with the November 2008 low as the origin and the January 2009 high and March 2009 low for the base. It is easy to see how well the Dow has followed the channel lines over the last two and half years. There is every reason to believe that some sort of intermediate term low is imminent near term based on this chart. A rally to the median line somewhere around 12,000 by late this year or early next year is the most likely next move.

I expect that after that rally the currently developing low will be retested by mid 2012. If that test is successful, another leg up in the stock market should follow. At the risk of sounding repetitious this process will last several more months. Be prepared for difficult choppy conditions and use more conservative trading targets.

Choppy Stock Market May Bottom Soon

After some big gains last week and a SPX 1216 close, the market gave it all back this week with a SPX 1136 close. Economic reports were light, but still mostly to the downside. On the positive were building permits, existing home sales, the monetary base and a downtick in weekly jobless claims. On the negative were declining housing starts, FHFA/NAHB housing prices, leading indicators, excess reserves and the WLEI. The big news for the week was the ‘sterilized’ Operation Twist. A $400 bln program to purchase long term debt with short term debt. The market apparently wanted more liquidity in the form of outright purchases. For the week the SPX/DOW were -6.45%, and the NDX/NAZ were -4.85%. Asian markets lost 5.0%, Europeans markets lost 5.2%, the Commodity equity group lost 10.3%, and the DJ World index dropped 7.7%. Next week will be highlighted by Q2 GDP, the Chicago PMI and Case-Shiller.

LONG TERM: bear market highly probable

When the markets start displaying a bunch of mixed signals it is best to step back and look at the overall picture. Between March 2009 and May 2011 the stock market doubled in a five wave advance, (SPX 667-1371). After the peak the stock market experienced a modest decline to SPX 1258 and then a fairly good rally to SPX 1356. While this was unfolding many foreign markets were starting to break down. After a review of the long term technical indicators we concluded these two waves represented the beginning of a new bear market. After posting these findings the US stock market started breaking down. The decline was quite swift, and within a month the SPX dropped from 1356 to 1102, or 18.7%.

The weekly chart signalled there was potential trouble ahead when the first decline, SPX 1371-1258, was quite oversold, (RSI red arrow). This typically does not occur during bull markets, as you can observe on the chart. When the market started breaking down the MACD turned negative. This also does not occur during bull markets. While OEW quantitative analysis has yet to confirm a bear market it certainly looks like we are in one. This is the reason we have been posting, since early August; “bear market highly probable”.

All bear markets unfold in three significant waves, ABC, not five. They are corrections to previous bull markets of a greater wave degree. The declining A and C waves may take the form of a five wave structure, as demonstrated by the 2007-2009 bear market. Or, more typically, a three wave decline, as demonstrated by the 2000-2002 bear market. Until the first signficant wave completes, wave A, either combination is possible. To cover these two possibilities we have been tracking an ABC decline on the SPX charts, and a 1-2-3 decline on the DOW charts.

Also of note on the weekly chart is the two green, wave structure, support lines. The first is at SPX 1011, the Primary wave II low. This level also represents a Fibonacci 50% retracement of the entire bull market. The 38.2% retracement level was hit exactly at the August low of SPX 1102. The second green line is posted at SPX 869, Major wave 2 of Primary I. This would be the logical wave structure support, should the first one fail. It represents a 70.7% retracement of the bull market. For the record there is one intervening level of support, the Fibonacci 61.8% retracement: SPX 936.

The overall picture suggests we are in a bear market with the first level of support at SPX 1011, the next level at SPX 936, and the likely maximum level at SPX 869. The market closed at SPX 1136 on friday.

MEDIUM TERM: July downtrend likely still underway

From the SPX 1356 uptrend July high this market declined in three waves: SPX 1296, 1347 and then 1102 on August 9th. After that the market went into a trading range between SPX 1121 and 1231 for five weeks. This week it took out the 1121 low on thursday when it hit 1114. Our first thought was the low of the range, SPX 1121 on August 22nd, ended the downtrend with a failed fith wave, (higher than the third). We then tracked the market as if it were a counter-rally uptrend. This approach worked quite well for the past four weeks, until the market started breaking down after the FOMC meeting.

Our counter-rally uptrend scenario suggested the market would hit the OEW 1240 pivot, and higher, from the September 12th SPX 1136 low. On tuesday, however, the market made a double top at SPX 1220 and started to decline. When it dropped through the OEW 1187 pivot, the previous short term support, on wednesday afternoon we knew something was amiss. Anticipate, monitor, and adjust. On thursday the SPX found short term support at 1114 and then rallied, from extremely oversold levels, to 1142 on friday. On thursday, however, the DOW made a new print low for the July downtrend suggesting it had resumed after several weeks of sideways activity. We then posted a special thursday night update:

When we take into account these recent events. The new print lows in the DOW, TRAN, and NYSE. The fact that OEW has yet to confirm an uptrend. And, the somewhat sloppy wave counts on the SPX charts. We have shifted the short term count posted on the DOW charts to the SPX charts. This is now the preferred short term count. The alternate count is now posted on the DOW charts. We should know for certain, in a week or so, which of these two counts is the market’s count.

The updated SPX chart is as follows. From the July SPX 1356 high the market has declined in four waves: Int. i SPX 1296, Int. ii SPX 1347, Int. iii SPX 1102 and Int. iv SPX 1231/1220. Int. i and iii were five wave declines, Int. ii was a zimple zigzag, and Int. iv was a complex inverted failed flat ending at 1220. We had observed these inverted failed flats during the previous bear market.


Support for the SPX is at 1136 and then 1107, with resistance at 1146 and then 1168. Short term momentum ended the week around neutral. Anticipate, monitor and adjust. When we take into account the preferred short term count the anticipated medium to long term wave structure changes just a bit. The long term supports, noted in the long term section, remain the same. The wave structure for this bear market, however, can now be either a 5-3-5 ABC, or an abA-B-abC ABC. Both options are again possible.

We did a Fibonacci analysis on the relationships between the Intermediate waves and arrived with the following numbers: @ SPX 1093 Int. waves iii thru v = 2.618 Int. i, @ SPX 1080 Int. v = 0.618 Int. iii, @ SPX 1074 Int. v = 2.618 Int. i, and finally @ SPX 1060 this third wave (trend) down = 2.618 the first wave (trend) down. Since we have OEW pivots at 1090 and then 1058, we’re probably looking at either the SPX 1093 relationship, or the 1060 relationship, for the end of this Int. wave v and downtrend. Best to your trading!


The Asian markets were all lower on the week for a net loss of 5.0%. China and Hong Kong made new downtrend lows.

The European markets were also all lower on the week losing 5.2%. The Stox made a new downtrend low.

The Commodity equity group all dropped substantially for a net loss of 10.3%. Canada and Russia made new downtrend lows.

The DJ World index made a new downtrend low as well and lost 7.7%.


Bonds continued their extended uptrend gaining 1.2% on the week. The 10YR dropped to 1.70% before ending the week at 1.81%. The 30YR hit 2.75%.

Crude tumbled 9.0% as its choppy attempt at an uptrend ended with a continuation of the ongoing downtrend.

Gold also tumbled, losing 8.4%. We had expected both Gold and Silver to be in downtrends and this week’s action confirmed it. In fact, Gold has already come down to our anticipated support zone $1650-$1700, and even dipped below it on friday. As soon as this downtrend ends the bull market will resume.

The USD continued to uptrend, especially against the Euro, and gained 2.5% on the week. The EURUSD lost 2.2%, and the JPYUSD gained 0.1%.


New home sales kick off the economic week on monday at 10:00. On tuesday we have the Case-Shiller index and Consumer confidence. On wednesday Durable goods orders, and then on thursday Q2 GDP, the weekly Jobless claims and Pending home sales. Friday closes out the week with Personal income/spending, PCE prices, the Chicago PMI, and Consumer sentiment. The FED has two speeches scheduled. FED governor Raskin on monday before the open at 9:15 AM. Then FED chairman Bernanke on wednesday after the close at 5:00 PM. With this week representing the end of the month, and the quarter, it should be quite interesting. Remember we’re probably in a bear market, so tread lightly.

Bull Bear Market Phases, Dow Theory Update

According to Dow theory, both bull and bear markets have three phases. Between each of these phases there are important counter-trend moves. Our Dow theory founding fathers explained that these counter-trend moves are misleading and tend to be taken as a continuation of the previous long-term secular trend. Based on the longer-term phasing and value aspects of Dow theory, the evidence continues to suggest that the last great bull market began at the December 1974 low and peaked in October 2007. This data also continues to suggest that the decline into the March 2009 low was merely the Phase I decline and that the rally out of the March 2009 low serves to separate Phase I from Phase II of a much longer-term secular bear market.

That's right, the rally out of the March 2009 low was not a new bull market or a continuation of the previous long-term secular bull market. Rather, it is part of a correction within a much longer-term secular bear market that began at the 2007 top. In fact, based on my longer-term bull and bear market relationship studies and other historical characteristics, the evidence suggests that once the rally out of the 2009 low has run its course, the Phase II decline should prove to be far more devastating than the Phase I decline. Therefore, from a longer-term perspective I remain very bearish.

More recently, on August 4th both the Industrials and the Transports closed below their March 2011 secondary low points. As a result, a Dow theory trend change occurred and since this is the first such trend change since the rally out of the March 2009 low began, we cannot take this development lightly. However, history shows that not all Dow theory trend changes are ominous and based on other technical data, there is a very good chance that the rally out of the March 2009 low has not yet run its course. If not, the rally separating Phase I from Phase II is not yet over. The details of these other technical studies are covered in the monthly research letters. Point being, the market is currently doing a bit of a technical high wire act in that while we do have a Dow theory trend change in place, on the other hand there is also other data that is actually still rather bullish and that suggests a higher level low is being made. This may or may not change and as a technician the key is to monitor the ongoing structural and statistical developments.

Based on the prevailing consensus, the current pessimism actually makes perfect sense. As a rule, the market does what it has to in order to confuse the most people. Ever since the decline into August began, it seems that the consensus has turned rather bearish. In fact, I personally know of no one that genuinely believes a move back above the May 2011 high is possible and maybe it isn't. But, I do find it very interesting that such bearishness is being seen in conjunction with such inconclusive technical data. As a result, it seems that the most confusing thing the market could do is to continue to rally.

I have again included the chart of the 1966 to 1974 bear market period below for comparison. The decline into the 1966 low marked the Phase I decline of the 1966 to 1974 secular bear market. This decline appears to be synonymous with the decline into the 2009 low. The rally separating Phase I from Phase II of the 1966 to 1974 bear market carried price up some 26 months into the 1968 top. I continue to believe that the rally out of the March 2009 low is synonymous with the rally into the 1968 top. Once all of the technical factors are in place I look for the fallout to be much the same as was seen following the 1968 top. I realize that the same old message and comparison is not exciting or sexy. But, the message of the market it is what it is as the bear continues to confuse the masses. Once the technical DNA Markers are all in place, the Phase II decline should get very very nasty. In the meantime, it currently appears that a much larger trap is likely being set.

When Stocks Yielding More Than Treasuries

On Wed. Sept. 21, the divided Federal Reserve voted to revive a half-century-old procedure to push down long-term interest rates and make it cheaper for businesses, municipalities and consumers to borrow funds. The Fed announced it would direct $400 billion from the sale of short-term Treasuries to investment in those with maturities of six to 30 years.

The decision came at a time when the yield for the S&P 500 exceeds that of 10-year Treasury bonds. As of Monday morning, the S&P 500 had an indicated dividend yield of 2.13%; 10-year Treasury bond yields were below 2%. (An indicated yield is the sum of expected dividends for the next 12 months divided by the stock’s current price.)

Sam Stovall of Standard & Poor’s pointed out the occurrence, observing, “On a quarter-end basis, this has happened only 20 times since 1953. The good news is that in the following 12 months, the S&P 500 rose by an average 20%. The bad news is that past performance is no guarantee of future results.”

Prior to 1953, the yield situation was reversed. Stocks had higher yields than long-term Treasuries. The chart below, and the yields behind it, can be found on the Historical Market Data spreadsheet in the Download Library. (This is the same spreadsheet I mentioned two weeks ago.)

There are a few ways you can look at this data. The first is that long-term Treasuries are not a great value right now. The second is that it makes sense to diversify your bond holdings. Corporate, municipal and foreign bonds can all help you get higher yields without much additional credit risk if you choose wisely. The third is that on a yield basis, large-cap stocks appear to be cheap.

I should point out a few caveats. First, a stock can stay cheap (or expensive) far longer than anyone expects. Second, if the U.S. economy remains in a slow growth mode for an extended period of time, interest rates could stay low. Third, bonds provide return of capital, something that stocks do not. Fourth, stocks offer more potential price return than bonds, so total return should always be considered when looking at stocks. Finally, stock and bond returns have been historically uncorrelated, meaning that diversification benefits can be realized when the two are held in a portfolio.

Thus, there is rationale for owning stocks and owning bonds, even in the current uncertain environment. If you are concerned about the economy, consider a mixture of fewer economically sensitive stocks (consumer staples, utilities, health care, etc.) and more growth-oriented companies (technology, energy, etc.). The idea is that you will lower your risk, but you still have the opportunity to profit should the economy turn out to perform better than you anticipate. On the bond side, you can offset interest rate risk by buying bonds with different maturities and reinvesting the proceeds as each bond matures—a strategy referred as bond laddering. Alternatively, you can buy a diversified bond fund with an intermediate duration (a measure of interest rate sensitivity), such as five years.

The Week Ahead

Just three S&P 500 member companies are scheduled to report earnings, all on Tuesday. They are Accenture (ACN), Jabil Circuit (JBL) and Walgreen (WAG).

August new home sales data will be published on Monday, starting off the week’s economic calendar. Tuesday will feature the September Conference Board’s consumer confidence survey and the July S&P Case-Shiller home price index. August durable goods orders will be published on Wednesday. Thursday will feature August pending home sales and the final revision to second-quarter GDP. August personal income and spending, the final September University of Michigan consumer sentiment survey and the September Chicago PMI will be published on Friday.

Minneapolis Federal Reserve Bank President Narayana Kocherlakota will speak publicly on Monday. St. Louis Federal Reserve Bank President James Bullard will speak on Monday and Friday. Atlanta Federal Reserve Bank President Dennis Lockhart will speak on Tuesday. Boston Federal Reserve Bank President Eric Rosengren will speak on Wednesday and Thursday. Philadelphia Federal Reserve Bank President Charles Plosser will speak on Thursday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

Multi-Trillion Euro Bailout Plan Allegedly in the Works; Plan Has Failed Already

by Mike Shedlock

The rumor mills are flying this Saturday regarding a Multi-trillion plan to save the eurozone.

Telegraph: European officials are working on a grand plan to restore confidence in the single currency area that would involve a massive bank recapitalisation, giving the bail-out fund several trillion euros of firepower, and a possible Greek default.

German and French authorities have begun work on a three-pronged strategy behind the scenes amid escalating fears that the eurozone’s sovereign debt crisis is spiralling out of control.

Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.

Mish: If that's the plan it, it has failed already. The crisis has already spread to Spain and Italy. In fact, one look at European bank stocks says it has spread to France and Germany as well.

Telegraph: Sources said the plan would have to be released as a whole, as the elements would not work in isolation.

Mish: Lovely. In a typical bicycle wheel if one spoke gets broken the wheel still works fine. In the proposed wheel, if a spoke breaks, the bicycle crashes.

Telegraph: First, Europe’s banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the €2.5bn (£2.2bn) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.

Mish: Will French leaders and French banks go along? Just last week they were insistent that French banks were well capitalized.

Telegraph: Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) – the eurozone’s €440bn bail-out scheme.

Mish: Recapitalized "by the state" means taxpayers. Will Germany, Finland, Austria, and the Netherlands go along?

Telegraph:The second leg of the plan is to bolster the EFSF. Economists have estimated it would need about Eu2 trillion of firepower to meet Italy and Spain’s financing needs in the event that the two countries were shut out of the markets. Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.
The complex deal would see the EFSF provide a loss-bearing “equity” tranche of any bail-out fund and the ECB the rest in protected “debt”. If the EFSF bore the first 20pc of any loss, the fund’s warchest would effectively be bolstered to Eu 2 trillion. If the EFSF bore the first 40pc of any loss, the fund would be able to deploy Eu1 trillion.
Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic.

Mish: This leveraged proposal with the ECB backing it up has already been rejected by the ECB. Moreover, such a proposal with the ECB taking leveraged risk would be in violation of the Maastricht Treaty.

Telegraph: Gathering turmoil in financial markets has convinced Germany to begin work of some kind of variant of the US plan, despite having initially rejected the notion as unworkable as threatening to compromise ECB independence.
The proposal would be hugely sensitive in Germany as its parliament has yet to ratify the July 21 agreement to allow the EFSF to inject capital into banks and buy the sovereign debt of countries not under a European Union and International Monetary Fund restructuring programme. The vote is due on September 29.

Mish: The current EFSF proposal is sketchy enough already. It will likely pass. However, Merkel may go down in flames because of it. The Guardian notes "Merkel looks sure to win the Sept. 29 vote on the European Financial Stability Facility because opposition parties support the bill, designed to give the EFSF more powers after an agreement by EU leaders in July. However, her job could be on the line if she has to rely on the opposition and fails to persuade rebels from her conservative camp and the Free Democrats (FDP), her junior coalition partners. Opposition parties have said Merkel would be finished politically if that were the case and have threatened to call for fresh elections. If that happened, the ensuing uncertainty would send shockwaves through the euro zone as it tries to tackle its debt crisis."

Bear in mind the above mess pertains to the existing proposal for 440 billion Euros. What would the vote be for a €2.5 billion proposal?

Telegraph: As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece.

Mish: Will the ECB, IMF, and France go along with that? What about the German parliament?

Telegraph: Officials would hope the plan would stem the panic in the markets and stop bond vigilantes targeting Italy and Spain, which European and IMF figures believe should not be in any immediate distress but are in need of longer-term structural reform.

Mish: So here we are, with a half-baked 2+ trillion Euro proposal, highly likely in violation of the Maastricht Treaty, that all 17 nations in the Eurozone would have to approve. Finland, Austria, the Netherlands, and Germany are already balking over various proposals and Finland in particular wants collateral.
This multi-trillion idea is "in hope the plan would stem the panic in the markets and stop bond vigilantes targeting Italy and Spain".

The plan is supposed to pass by November? Really? And the aim is to spend 2 trillion to stop something from happening that has already happened.

“Why I’m An Austrian In Economics”

By Thomas Mayer

This article is by Dr. Thomas Mayer, Chief Economist for Deutsche Bank Group and Head of Deutsche Bank Research. Before Dr. Mayer joined Deutsche Bank in 2002, he worked for Goldman Sachs in Frankfurt and London (1991-2002), and for Salomon Brothers in London (1990-91). Before moving to the private sector, he held positions at the International Monetary Fund in Washington D.C. (1983-1990) and at the Kiel Institute for the World Economy (1978-82).
We welcome Dr. Mayer to the Daily Capitalist.


The financial crisis has led many people to doubt the merits of free markets and a liberal economic regime. They blame markets for the financial and economic crisis and demand tighter regulation and, in effect, more central planning by governments as a remedy. We shall argue that both the analysis on which this view is based and the policy recommendations are flawed. This crisis has been caused by too much reliance on the effectiveness of economic and financial planning. Failure of the “liquidationists” to overcome the Great Depression of the early 1930s prepared the ground for an era of interventionist economic policies. Modern macroeconomics and finance nourished the belief that we can successfully plan for the future. But the present crisis teaches us that we live in a world of Knightian uncertainty, where the “unknown unknowns” dominate and our plans for the future are regularly thwarted by unforeseen and unforeseeable events. We have suffered from “control illusion.” We need to recognize the limits of planning for the future and the superiority of a market-liberal economic order, where states, firms and individuals can be held liable for the financial decisions they have taken.

The predecessor of today’s crisis

To develop our point we first take a look at the historical predecessor of today’s financial crisis, the depression of the 1930s. During the 1920s easy monetary conditions and an exaggerated appetite for risk, evidenced by extreme leverage in the popular equity trusts, fuelled the build-up of a stock price bubble. When monetary conditions were tightened eventually, the edifice of leverage came down and the stock market crashed in October 1929.

At the time, the authorities took the crash in their stride. Many policy makers felt that the crash and a possible recession afterwards were needed to eliminate the excesses and imbalances that had built up during the roaring twenties. Andrew Mellon, then US Secretary of the Treasury, brought this view to the point when he said:
“…liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.” (Hoover, Herbert (1952). Memoirs. Hollis and Carter. p. 30). Inspired by Mellon’s attitude, those sharing the idea that a recession was a “cleansing event” were later dubbed “liquidationists.”
The “liquidationists” could claim theoretical support for their view from the Austrian school of economics around Joseph Schumpeter and Friedrich von Hayek, which built its view of the business cycle on the work of the Swedish economist Knut Wicksell. Wicksell distinguished between a natural rate of interest, which reflects the return on investment, and a market rate, which reflects the borrowing costs of funds charged by the banks. When the market rate is below the natural rate, companies borrow to invest and the economy expands. In the opposite case, investment is reduced and the economy contracts.

The Austrian school used this idea to develop a theory of the business cycle that puts the credit cycle in the centre (see picture left). Low interest rates stimulate borrowing from the banking system. The expansion of credit induces an expansion of the supply of money through the banking system. This in turn leads to an unsustainable credit-fueled investment boom during which the “artificially stimulated” borrowing seeks out diminishing investment opportunities. The boom results in widespread overinvestment, causing capital resources to be misallocated into areas which would not attract investment if the credit supply remained stable. The expansion turns into bust when credit creation cannot be sustained – perhaps because of an increase in the market rate or a fall in the natural rate – and a “credit crunch” sets in. Money supply suddenly and sharply contracts when markets finally “clear,” causing resources to be reallocated back toward more efficient uses.1

The liquidationist approach to economic policy in the aftermath of the 1929 stock market crash – for which Mellon became the symbol – accepted the downturn in the early 1930s as inevitable. What they missed was that extreme risk aversion can keep the market rate above the natural rate even after ?the rottenness? has been “purged out of the system.” Franklin D. Roosevelt, who beat Hoover in the 1932 presidential elections, seems to have intuitively understood this problem. Perhaps the most important action Roosevelt took shortly after his inauguration in early 1933 was to guarantee bank deposits. As a result, cash that people had hoarded under their mattresses came back to the banks and improved their liquidity situation. When the Roosevelt administration later in the year recapitalized banks, credit extension picked up again and the economy recovered. It is interesting that there was no big fiscal policy stimulus in 1933 – the famous New Deal was felt only later. Hence, contrary to conventional wisdom, the spark that ignited the recovery of 1934 was the turn in the credit cycle (see chart).

The experience of the depression and the Roosevelt recovery induced John Maynard Keynes to launch a heavy attack on the Austrian school. In his General Theory, written in 1935, he made a strong case for government intervention. Fiscal policy should come to the rescue when the public feared deflation and hoarded money. Many students of economics today believe that it was the application of Keynes’ theory that ended the downturn of 1930-33. We do not agree. In our reading of events it was the policy-induced turn of the credit cycle that did the trick. Hence, the recovery of 1934 was more “Austrian” than “Keynesian”. Let us be clear: The liquidationists were wrong to allow the depression to happen as they failed to recognize that fear can beget fear. Roosevelt recognized this when in his inaugural speech he said “the only thing we have to fear is fear itself,” and he was right to intervene and stabilize the banks. But what he did – opening the credit markets – is what follows from an Austrian reading of the business cycle.

The Austrians have warned that a policy-induced extension of the credit cycle before all excesses have been eliminated in the economy will only delay the day of reckoning. But also they would have had to conclude that after the depression of 1930-33 one could hardly still see “excesses” in the economies of the western world. Nevertheless, the economy tanked again in 1937 when the monetary and later fiscal policy support was withdrawn. Most economic historians argue that the period of economic instability in the US only ended towards the end of the 1930s when the country prepared for war. The British historian Niall Ferguson has even argued, that Germany got out of the depression ahead of the US because of its earlier and more aggressive preparations for war. It seems that only in the anticipation of war the “fear of fear itself” ceased to be a de-stabilising factor in economic developments.

The historical review of the Great Depression leaves us with a disturbing conclusion: The Austrian credit cycle theory seems to have a better fit to events than Keynes’ theory of the liquidity trap and power of fiscal policy (see chart). What the Austrians seem to have missed is that an economy paralyzed by extreme risk aversion may need a jolt by confidence-building economic policy measures. But this was not what most economists and policy makers concluded.

Lessons from the Great depression: “Over to governments…”

At the end of WWII a number of western intellectuals and economists flirted with Soviet-style central planning. After all, the Soviet Union had prospered during the 1930s while the capitalist countries had been in crisis. Did this not prove that their economic model was superior?

Having lost the intellectual battle with Keynes and followers in the 1930s, the Austrians made a last stand against central economic planning with Hayek’s powerful book “The Road to Serfdom” published in 1946. They won the war of principles and the western world did not subscribe to Soviet-style central planning, despite the allure this model was exercising on many intellectuals after WWII. Even Keynes sided with the Austrians as far as the high ground was concerned and wrote to Hayek: “In my opinion it is a grand book … Morally and philosophically I find myself in agreement with virtually the whole of it: and not only in agreement with it, but in deeply moved agreement.”

Nevertheless, the Austrians lost the battle over economic policy in the post-WWII western countries. Keynes’ idea of “demand management” through fiscal policy became the mantra there after the war. Somewhat belatedly, in 1971 when he ended the link of the US Dollar to Gold, even Richard Nixon is reported to have said “I’m now a Keynesian in economics.”

From the 1950s to the end of the 1970s western economic policy makers used and abused fiscal policy as an economic management tool. Governments were quite happy to raise borrowing in economic downturns, but generally reluctant to bring it down in upturns. Towards the end of the 1960s, the use and abuse of fiscal policy created strains on government finances that could only be eased by the monetization of government debt. As a consequence, Richard Nixon on August 15, 1971 suspended the link of the USD to gold, and in effect launched the post-WWII system of fiat money.

During the post WWII period of the implicit gold standard under the Bretton-Woods System (where the USD was supposedly as good as gold), there was hardly any room for pro-active monetary policy (which, however, did not prevent the US government to use the money printing press as an auxiliary funding tool). This changed drastically after Nixon’s decision of 1971. The result was a bout of inflation as government debt and deficits were financed in part by the money printing press. As both growth and inflation disappointed, the word ?stagflation? was coined to describe the economic conditions of the 1970s.

… “over to the central banks”

The failure of the young new fiat money regime was that it lacked a monetary anchor. As a result, monetary policy ended up accommodating fiscal policy and wage policy developments. This was eventually recognized by policy makers in the early 1980s. In the seventies, Milton Friedman had proposed limits on the expansion of money supply and laid the ground for the introduction of independent central banks. As Stagflation killed the idea that there was a trade-off between inflation and unemployment, the time of monetarism had arrived. Federal Reserve Chairman Volcker used the monetarist demand to “gain control over the money supply” as a justification to engineer a deep recession that brought inflation down. Hence, the early 1980s were a period of repentance for the sins of Keynesianism committed in the late 1960s and 1970s. With the development of the theory of rational expectations and efficient financial markets, the pendulum seemed to swing back from the constructivism of economic policy before to a more market liberal regime.
But the straitjacket intended by Friedman for monetary policy did not hold long. In the course of the 1980s monetary policy freed itself from the Friedman straitjacket and turned pro-active. The great champion of this approach to monetary policy was Alan Greenspan, who followed Volcker in 1987.

The 1987 stock market crash was the first application of the proactive use of monetary policy. To fend off recession risks, Greenspan cut interest rates. The therapy worked and instead of decelerating the economy accelerated during the late 1980s. The next occasion to apply the Greenspan method came in the wake of the savings-and-loans-crisis at the end of the 1980s, which contributed to the recession of 1990-91. Again, the Greenspan Fed cut interest rates to support the economy and again succeeded in mitigating the downturn. In the following years, the Greenspan method was applied again to fight the Asian emerging market and LTCM crisis of 1998 and again when the bubble burst in 2000-2002. Until the great financial crisis that began in 2007, it seemed that the Greenspan method, the pro-active use of monetary policy to fine-tune economic developments, had succeeded in abolishing the business cycle as we knew it. Thanks to the art of central bankers, the age of the Great Moderation had arrived.

The great financial crisis that erupted in 2007 uncovered the Great Moderation as a great illusion. Nevertheless, the old reflexes led to the combined deployment of monetary and fiscal policy on a so far unprecedented scale. As the excessive leverage built up in the illusory age of the Great Moderation was unwound, the crisis moved from the US sub-prime mortgage sector to the money markets, the banking sector and more recently to the public sector (see chart). The principle has been to shift the unbearable burden of debt from weaker to stronger shoulders and lower debt service costs through monetary policy induced interest rate cuts. But in this process the previously strong shoulders have also been weakened. Somehow the old tricks seem to have lost their magic, and the crisis triggered by massive de-leveraging appears to be getting out of control.

The theory behind “Greenspanism”

What was the major flaw that led us into this crisis? The belief that even in a world of uncertainty economic and financial outcomes could be planned was in our view a major contributor. The assumptions of rational expectations and efficient financial markets laid the ground for overconfidence in the ability of policy makers, firms and individuals to successfully plan for the future despite the uncertainties surrounding us.

At the macro level, rational expectations and efficient markets theory laid the ground for inflation targeting by major central banks, which replaced the monetary targeting of the early 1980s. The economy was expected to grow in a steady state, if only the central bank ensured stable and low consumer price inflation. The overconfidence in the power of the central bank led Paul Krugman to claim in the late 1990s:
“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.”
When individuals had rational expectations and markets were efficient there was no need to worry about asset markets or regulate financial markets. After all, how could central banks or regulators know more than the market when market prices reflected all available information about the future? Anyone questioning the wisdom of the ruling paradigm was regarded as old-fashioned by the academic cardinals of the Church of Anglo-Saxon economics, which has reigned supreme. In retrospect, it seems a bit odd that academics overlooked financial markets’ obsession with central banks and the cult status they awarded central bankers. How could financial market participants hang on the lips of central bankers, when they so efficiently processed all available information in real time? But economists were too enamored with their theories to dwell much on such oddities.

At the micro level, rational expectations and efficient markets theory laid the ground for many highly leveraged financial products and risk management. Financial market participants saw only “known unknowns” that could be quantified with probability theory. In a world of “known unknowns” they felt that there was little need for contingencies for the truly unforeseen, the “unknown unknowns”.2 Hence, it seemed fully appropriate to raise leverage to the extreme. After all, risk managers could calculate continuously and real time the value that could be lost when the unknown happened. The feeling of being in control – of being able to plan ahead with good, if not perfect, foresight – laid the ground for the extremely high leverage that was built into financial products and the balance sheet of financial firms.

After the burst of “control illusion”

The collapse of these theories enforces the radical reduction of leverage. If we cannot anticipate the range of future outcomes with a relatively high degree of certainty, we need more slack and buffers in the system for unforeseen events, and hence cannot afford high degrees of leverage.
The helplessness of the economic profession in the face of the present crisis manifests itself by the recommendations of prominent economists for ever-stronger incentives for a renewed increase of leverage. They advise that fiscal policy turn expansionary again, central bank policy rates be kept at zero for a long time, and central banks purchase financial assets.

At present the central banks fight the reduction in leverage with the issuance of ever more central bank money. As outside money implodes inside money explodes. For now, the aim to reduce leverage depresses asset prices and leads to a flight into money. But the more the central banks succeed to replace the reduction of outside money through de-leveraging by an expansion of inside money, the more likely becomes the monetization of outstanding debt.

The desperate attempt to avoid an economic crisis caused by the necessary de-leveraging could eventually lead to a crisis of the fiat money system itself. On August 15 this year, the fiat money system celebrated its 40th birthday. Since Nixon cut the dollar’s link to gold on August 15, 1971, the dollar has depreciated by 98% against gold (see chart). Depreciation came in two stages: First during the 1970s, when the excess supply of US Dollars created towards the end of the BW-System and at the beginning of the new fiat-money system boosted consumer price inflation, and secondly after the implosion of the credit-driven ?Great Moderation? as of 2007, when bad assets started to move from private sector via public sector to central bank balance sheets.

When fiat money fails it may well be replaced by money backed by real assets that cannot be augmented with the stroke of the pen of central bankers. How could this happen? One possibility – which at present may sound a bit like science fiction – would be for China and other big EM countries to peg the value of their currencies to a basket of commodities. It would then be up to the industrial countries to try to stabilize their currencies against the Yuan, or accept the inflation that goes along with secular depreciation.

To conclude:

Modern macro- and financial economics are based on the belief that economic agents always hold rational expectations and that markets are always efficient, in other words, that the earth is flat. We now find out that this is not true. There are elements of irrationality and inefficiencies in the behavior of people and markets. Therefore we need to dump the flat-earth theories promising that economic and financial outcomes can be planned with a high degree of certainty and need to look at other theories that accept the limits of our knowledge about the future. A revival of Austrian economics could be a good start for such a research programme.

Unfortunately, however, the battle cry of the public and politicians is for more regulation: regulate banks, regulate markets, regulate financial products! But those who push for blanket regulation suffer from the same control-illusion that got us into this crisis. In our view, instead of more regulation we need more intelligent regulation. At the heart of such regulation must stand the simple recognition that we can at best tentatively plan for the future and must feel our way forward in a process of trial and error.

In a world where we need to reckon with “unknown unknowns” – in a world where Knightian uncertainty reigns – financial firms and investors need larger buffers to cope with the unforeseen, i.e. more equity and less leverage. In a world, where markets are not always liquid but can seize up in a collective fit of panic, financial firms and investors also need a greater reserve of liquidity. Regulation can help to achieve both objectives, but it needs to realize its limits. Regulation will create a false sense of security, unless firms and investors have the incentives to follow sound business practices. The best incentive to do so is to make failure possible. Hence, we need effective resolution regimes for financial firms.

In a world where people have imperfect foresight and do not always behave rationally, and markets are not always efficient, we need to accept that economic policy cannot fine-tune the cycle. All that policy can do is to lean against excessive exuberance and depression during the credit cycle and help avoid the excessive swings of risk appetite that we have seen over the last 10 years. It is unhelpful to pro-actively manipulate the market rate to achieve certain economic growth objectives. Instead we should try to create the conditions for a steady development of credit by allowing the market rate to closely follow the natural rate. When accidents happen, we need to prevent that “fear of fear itself” perpetuates economic crises by ensuring that the banking system is capable to satisfy the demand for credit.

Finally, economists should be more humble. For too long we have tried to be like natural scientists. Like they we like to develop our theories with the method of deduction – start from a few axioms and describe the world in mathematical terms from there. This was a little presumptuous, to say the least. We need to realize that we are to a significant extent a social science. Social scientists, like historians, use the method of induction. They observe, and then develop tentative descriptions of the world from these observations. Because we did not pay enough attention to economic history and relied heavily on formal models of the economy we repeated a number of the mistakes that caused the Great Depression.

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