Wednesday, July 6, 2011

Equities: What’s Next?

define the price cycle as the path that prices take from low to high and back again, and I use investor sentiment to help me characterize where we are in the cycle. For example, if prices are at their highs, then most likely investors are bullish; conversely, if markets are getting slammed, then investors are probably bearish. The use of investor sentiment isn’t so unique that I have any great insight, but it is how I use that data to help generate an edge. 

As you know, investors were extremely bearish several weeks ago, and this is typically a bull signal. As you can see, the “dumb money” indicator, which is a weekly chart of the SP500, is shown in figure 1. This was a bull signal, and as if right on cue, the markets lifted 5%. Holy grail? No, no, no.

Figure 1. SP500/ weekly
Now look at the same figure, but this time I put a slow stochastic indicator (in black), which can be found in any normal charting package, on top of the “dumb money” indicator. (See figure 2.) I don’t see much difference. Do you? Once again, there is nothing special about the sentiment indicators.

Figure 2. SP500/ weekly
However, let’s get back to the price cycle. Investors are likely to get more bullish this week such that the “dumb money” indicator is going to cross above the bottom blue line (in figure 1). So let’s set up the question to ask this way: 1) investor sentiment turns bearish and the “dumb money” indicator is below the blue line; 2) prices rise and the indicator crosses the blue line; 3) at this point, how often does the indicator go on to become extremely bullish and how often does the indicator rollover crossing back below the bottom blue line?

This is important because if the indicator always go onto become extremely bullish (i.e., crosses above the upper blue line) then we would know that extremes in investor sentiment always lead to higher prices. But this isn’t always the case. Referring back to figure 1, since 1990, there have been 46 times the indicator went from below the bottom blue line (i.e. sentiment is bearish, bull signal) and crossed above it. In 24 of those instances the indicator ended up crossing the upper blue line (i.e., sentiment is bullish, bear signal in theory). As expected, 23 out of 24 trades were winners.

There are 22 times the indicator just rollsover without extremes in bullish ever taking place. Or to put it another way, extremes in bearish sentiment don’t always lead to extremes in bullish sentiment, and in fact, it only happens about 50% of the time. So what happens when the “dumb money” indicator rolls over? 15 out of the 22 trades turn out to be losers.

So what’s next for the markets? We have a 50% chance of going on to new highs, which in all likelihood would be expressed by extremes in bullish sentiment. That leaves a 50% chance of the market rolling over, and about a 33% chance of seeing prices trade below the lows of a couple of weeks ago.

What is my opinion? It doesn’t really matter what I think, but I will to venture to take an educated guess. Despite the extremes seen in the “dumb money” indicator there was a lack of consensus amongst all of the sentiment indicators (i.e., dumb money and smart money) at the recent lows; since 2004, the best, sustainable price moves occur when the sentiment indicators are in alignment. In addition, my research shows and the most I can go out on a limb is this: that the lows from a couple of weeks ago should provide support for prices. If they don’t, then it is look out below.

The Promises That Cannot Be Kept

by Charles Hugh Smith

The Promises That Cannot Be Kept
The government's promises, for pensions and healthcare and everything else, cannot be kept. We as a nation will eventually have to have a truthful conversation about that reality.

The fact that the Federal government cannot possibly fund the entitlement/ benefit programs that have been promised to the citizenry is well-known, but remarkably unwelcome. I have addressed this difficult reality dozens of times, as have hundreds of other commentators, for example:
To Fix Social Security, First Ask Why It Is Deep in the Red (January 18, 2011)
Is the Recovery "Self-Sustaining"? Here's a Test (March 22, 2011)
If You Want Solutions, First Pin Down Where the Money Is Going (May 23, 2011)

Bruce Krasting recently penned a wonderful evocation of the bitter "I, Me, Mine" rage this reality triggers in Americans: I go to a 4th of July party (Zero Hedge).

The typical reaction is either denial, mixed with wishful thinking--if only we taxed the rich and cut out war spending, everything could easily be funded indefinitely--or rage against anything and everyone that threatens the individual's own share of the swag.

Krasting brilliantly depicts the net result, which I call internecine conflict between protected fiefdoms in Survival+: the constituency of each fiefdom--Social Security, Medicare, Defense, etc.-- will undermine the other fiefdoms to maintain their slice of the dwindling Federal pie. This leads to a profound political disunity which cannot be overcome with compromises, as that would require deep cuts in all government programs.

None of this is new. Richard W. Fisher of the Dallas Federal Reserve laid it all out very succinctly back in May 2008, before the global financial meltdown. Now of course, the situation is much worse: Social Security is already deeply in the red, for example, a condition that wasn't supposed to occur until 2017. If we removed Federal and Federal Reserve stimulus, the economy would immediately contract 11%.

The entire notion of entitlements based on age requires an ever-expanding population of working contributors and an ever-expanding economy. If either condition isn't met, then the programs fail. Fisher's message is clear: our entitlement programs will fail because there is no way to raise $100 trillion in additional taxes in a declining economy.

Storms on the Horizon:
Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the “funded” entitlement liabilities. Reduce or eliminate this income and the unfunded liability grows. Increase benefits and the liability grows as well.

To solve the entitlement deficit problem, discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact.
Though I've addressed this many times before, let's walk through it one more time. Let's start with the income side of the ledger, Total Personal Income in the U.S.:
Total personal income is defined by the United States' Bureau of Economic Analysis as income received by persons from all sources. It includes income received from participation in production as well as from government and business transfer payments. It is the sum of compensation of employees (received), supplements to wages and salaries, proprietors' income with inventory valuation adjustment (IVA) and capital consumption adjustment (CCAdj), rental income of persons with CCAdj, personal income receipts on assets, and personal current transfer receipts, less contributions for government social insurance.
In other words, total personal income includes all the entitlement spending and government benefits such as extended unemployment, Section 8 housing, etc. As Mish recently explained, personal transfers now eat up all Federal tax revenues: $2.4 trillion in, $2.4 trillion mailed out.

If we set aside our own fond hopes for Social Security checks being deposited into our personal accounts and Medicare to survive long enough to pay for our own care, we conclude this is a staggering imbalance. The promised programs are already consuming every dollar the government collects, and the Baby Boom has barely begun to retire.

Perhaps a few million of the 76 million Boomer generation has started collecting Social Security, and the first Boomers, born in 1946, are just now qualifying for Medicare. That these programs have already expanded to the point that they consume all revenues should give pause to anyone still in the denial or rage stage of the denial/anger/grief/resignation/acceptance cycle.

Earned Income is flat to down. Here is a chart of total income:

There are two components of income: wages and non-labor, which includes dividends, interest, capital gains, rental income, and other investment income.

Charts: Conerly Consulting

The handsome rebound in Corporate America's profits--roughly 11% of the entire GDP at $1.6 trillion--and the Fed-engineered "permanent rally" in stocks has goosed non-labor income for the top 10% who own these income streams, but it has also bolstered the pension funds that millions of state and local government retirees depend on. (When the stock and bond markets implode, so will all those pension funds' promises.)

Personal income has "recovered" only as a result of greatly increased Federal transfer payments. If we subtract all those government transfer payments, income has cratered:

Government transfers now account for 22% of household income, an unprecedented dependence on Central State checks and benefits:

Click on chart for full-sized chart in a new browser window.

Employment is down and is not recovering. I have addressed why many times, what author Jeremy Rifkin termed "the end of work." So any projections based on a rapidly growing workforce are not reality-based.

All the "growth" of the past decade was simply borrowed, as our private and public debt has soared. If you borrow cash from your credit card and spend it, is that really "income"? No. Here is the national "credit card" account. Does that look sustainable?

Notice how much of the decade's income was equity extraction during the housing bubble. That source of borrow-and-spend is gone.
The problem is that the benefit costs are not static; they're constantly moving ever higher because the programs are expanding 3, 4 or 5 times faster than the real economy. Here is a chart of local government healthcare and pension costs. Does this look remotely sustainable?
Here is a chart of our national healthcare (a.k.a. sickcare) spending. Compare this rocket-ascent path to the moon with the chart of declining income and the skyrocketing debt.

Many readers suggest that cutting Defense and raising taxes on the wealthy will preserve these entitlement programs. Unfortunately the math doesn't pencil out, for the reason noted above: when expenses are rising by 6% to 11% a year, every year, and your income remains flat to down, then in a very few years, those expenses will eat up your entire income.

But let's do the math. Let's knock a third out of the Defense budget of around $730 billion, saving $250 billion a year. (Never mind the fierce fight that fiefdom would put up.) Let's increase taxes on the super-wealthy (good luck getting them to pay it) and the plain old wealthy and you might raise $500 billion more a year.

That is questionable for a number of reasons, most saliently that the wealthy already pay most of the Federal income tax, which is quite progressive on earned income: The Problem with "Tax The Rich": It Won't Work (May 28, 2010).

The top 5% earn about 22% of the income, and they pay about 60% of Federal taxes. As many readers have pointed out, the total tax burden, including sales tax, property tax, etc. is heavier on lower-income workers as a percentage of income than it is on the super-wealthy (top 1%), who pay around 17% of income in taxes. But no matter how you slice the data, the fact remains that the top 5% already pay a hefty percentage of earned income in taxes, and they also pony up 60% of all Federal income taxes.

The top 1% could certainly stand to pay more than 17%, but the problem there is that capital is mobile now and anyone paying taxes on their global income in, say, Switzerland, cannot be made to pay taxes elsewhere on that same income. (Income and corporate taxes are low in Switzerland compared to the U.S. and Europe.)

We can rail against this reality, but capital will flow to the highest returns and lowest tax rates. We should impose the same tax rate on non-labor as we do on labor, and that would raise a a few hundred billion more a year. But let's also recall that the Federal government is borrowing $1.6 trillion each and every year, fully 11% of the nation's GDP and 40% of Federal spending, so even $500 billion more simply isn't going to rectify the budget shortfall or long-term situation.

Studies have found that taxes are remarkably stable at about 20% of GDP. It seems that attempts to raise taxes above that share of the economy trigger blowback in the form of tax avoidance, capital flight, voluntary reductions in income, etc.

But let's say you do manage to strip out $250 billion annually from Defense and Homeland Security/War on Global Terror (GWOT), and boost tax revenues by $500 billion a year (a 21% increase in total tax revenues). Together, that would generate $750 billion annually, or $15 trillion over 20 years.

I haven't found any firm estimates of the unfunded liabilities due in the next 20 years, but since 25% of the entire population (the Baby Boomers) will be retired and drawing on Social Security and Medicare within 15 years, I think we can reckon that about half that $106 trillion will come due in the next 20 years--and that is probably absurdly conservative.

$15 trillion down, $35 trillion to go. Do you see how utterly hopeless this exercise is when Federal spending rises by 6.5% every year even as the underlying economy muddles along at 2% in good years and -5% in poor years, if we subtract borrow-and-spend deficit financing?

In other words, $100 trillion in unfunded liabilities is the number now, but if spending continues rising at triple the rate of the real economy, then that number will only grow.

If we're honest about our accounting, then the U.S. economy hasn't grown at all since 2008; it's shrunk by $6 trillion, a sum we have masked by borrowing and spending $6 trillion in Federal debt, money that replaced the decline of private borrowing and spending.

Please look at the charts of healthcare and local government pension and healthcare costs again. Those rocket-launch lines shooting higher cannot be funded by a national income that is flat or declining.

We need a national conversation about reality, not wishful thinking. We need to grasp the nettle and talk about triage, about conserving Social Security for those with no other sources of income, and about devoting our scarce resources for palliative and preventive care. The Status Quo is completely, utterly unsustainable, but that needn't bring the nation to its knees--unless we actively insist that it does so.

The Broadest Rally in Over a Decade

by Bespoke Investment Group

The charts below compare the performance of the S&P 500 to the cumulative breadth of the 24 major S&P 500 industry groups. Even though the S&P 500 is still 2% below its May 2nd high, last week's rally managed to carry breadth to new bull market highs (this was also the case for cumulative breadth of individual S&P 500 stocks). 

Last week's strength of group breadth was also notable given the fact that all 24 groups finished the day in positive territory on four different days. Looking back at data over the last ten years, we found that there has never been a period where all 24 groups were up on the day in four out of five trading days. In fact, prior to last week, there was never a period where all 24 groups were up on the day in even three out of five trading days. Who would have thought that in the week leading up to the end of QE2 as well as a long Summer weekend that the S&P 500 would have ended up seeing what was its broadest rally in at least a decade? 

5 Reasons China's Bubble Will Burst

By David Magee

China raised a key interest rate for the third time this year as the country deals with surging inflation.
That the benchmark rate for one-year loans will be raised 0.25 percentage points to 6.56 percent is not such a big deal at face value. The country's interest rate is still manageable. It's the reason China has had to bump up rates a third time this year, just halfway through the year, that's alarming when combined with other pressing problems the world's second largest economy faces.

Here's five reasons why China's fast-growth economic bubble will burst:

Inflation is Gaining Momentum

Inflation in China hit a 34-month high of 5.5 percent in May, and economists think it rose even higher in June. Let's not forget, either, that China is a communist country and the government shades realities to the positive side. All economic growth figures and inflation figures should be adjusted in a more negative direction. Thus, China's true inflation rate is probably running at about 7 percent -- a dangerous figure for such a large country with wage-growth imbalance. Global food prices are rising and China needs a lot of food. Housing costs are rising, also. But wages are not growing that fast throughout the country to keep up. 

China has a Credit Bubble

Private sector forecasters say the mix of rapid growth and higher inflation in China means Beijing should further tighten access to credit. We know in America all too well what happens in too much credit is extended when asset values are inflated and wage growth sustainability is not a reality.
Pop goes the bubble.

Already, China faces massive debt problems in local governments throughout the country. In June, China's communist government announced that local governments in the country have piled up debts of $1.6 trillion, raising concerns of banks' health in the nation if the loans can't be repaid. The money was borrowed by local governments throughout the country during the boom period of the last decade as China's economy has emerged fast to become the world's second largest, bypassing Japan, to pay for construction and other spending. That means much of China's growth has been falsely stimulated, which means it's a bubble.

Even the government has concerns.

"Due to inadequate repayment ability, some local governments can only pay their debts by taking on still more debt," stated a report provided by China's National Audit Office.

A Real Estate Bubble Looms

As if it's not bad enough already with inflation and debt-ridden local governments, China is in the midst of a massive housing and commercial real estate bubble that is not sustainable. What goes up must come down, after all, no matter what the most hopeful bullish China investors say.

Consider only the words of renowned short seller Jim Chanos, the hedge fund manager who correctly called the implosion of Enron, Tyco, and sub-prime mortgages while the rest of Wall Street continued to pour money and praises upon both. Chanos appeared on Bloomberg's Charlie Rose program late last year and said China was on an "economic treadmill to hell."

Chanos began questioning China's economic foundation as early as 2009, when one global company after another was at the height of pouring billions into the economy through partnerships with the country's communist government. He told Fortune he and his company began looking at commodity prices and the stocks of big mining companies. The result: "Everything we did in our microwork (on commodities) kept leading us back to China's property market."

Chanos recalled being at a research conference in 2009 when an analyst enthusiastically cited numbers of China's robust building boom, noting that the country was experiencing building at a pace of "5 billion square meters of new residential and office space," on top of all that had previously been constructed in the country during its emergence over the past decade and before the globally-hyped Beijing Olympics.

Chanos did some math. He calculated the pace would result, divided by China's population of 1.3 billion people, at what amounts to one "five-by-five cubicle for every man, woman, and child in the country." That's when he began to play the drumbeat of a contrarian, stating flatly he sees China heading for economic bust.
He was right about Enron and Tyco and sub-prime mortgages, and he'll be right about China, too.

Wage Growth Will Slow

Personal income in China has been increasing at an estimated rate of 6 to 10 percent, according to estimates. The rise is directly attributable to the country's economic emergence, rising in the past year to become the world's second largest economy. But cheap labor made China an economic power and cheap labor will keep it that way. As businesses face rising costs, they'll do just as western companies do, and look to the one of the biggest cost areas to cut and control -- labor.

The Government Can't Solve All Ills

Some bullish-on-China observers who admit the country is in the midst of an economic bubble suggest there's little danger with China since the communist government will merely do all required to overcome the problem, at any cost.

Peter Morici, a public policy professor at the University of Maryland, addressed this very issue in an interview with CNNMoney, noting that China could easily buoy its economy should conditions worsen, flooding the U.S. market and world "with extremely cheap stuff" to provide domestic stimulus support. Although that equation doesn't address rising wages in China that may make such a move more difficult in the future as it was in the past, Morici was convicted that China's ability to make cheap goods, shipping them to the U.S. and throughout the world, provides the country distinct advantage.

"Remember," he said, "when we talk about bubbles, the stakes are the future of the communist party. They'll try to survive no matter what; and it could mean destroying other economies to do it."
Try is the operative word.

No question China's government will do all it can to avoid a complete economic meltdown, but let's not forget that while the steps are small compared to what most want, China has become more economically westernized through its growth period than what it once was. The more it mingles financially with the rest of the world, the harder it will be for the government to falsely buoy a bust.

Also, the argument that the government will just make a bunch of cheap goods and flood the market means wage growth in China will slow -- a problem in an inflationary environment.

That's why China's economic will burst sooner and with more harsh impact than many expect.

See the original article >>

Brazilian hiccups raise doubts over sugar surplus


Czarnikow raised doubts over forecasts for sugar's first output surplus in four seasons as the merchant joined observers warning that Brazil was set for its first drop in cane production in more than a decade.
Buyers, who had looked set to regain market power thanks to raised cane and beet plantings in many countries, are "instead once again facing the risk of lower supply" thanks to the setbacks in top producer Brazil, Czarnikow said.
With the country's supplies threatened by lower cane output and logistical hiccups which lifted to 74 the number vessels queuing at Brazilian ports for sugar at the close of last month, has left hopes for an easier world market "entirely in the hands of the northern hemisphere" producers.
And this, largely beet-based, output only starts to hit markets in November, and is "some way from being realised".
"As far as the market is concerned, this raises the question – will the return to surplus once again prove to be illusive," Peter de Klerk, Czarnikow analyst, said.
'Years of underinvestment'
The comments represent a sharp deterioration in Czarnikow's outlook, which last month had foreseen a "sharp rise" in world sugar output in 2011-12 to a surplus of 10.3m tonnes, following three seasons when production had fallen a total of 25m tonnes behind demand.
However, data last week showing that Brazil's sugar output had, in late June, fallen back into year-on-year decline crystallised concerns that the country was set for its first fall in output in more than a decade.
Czarnikow on Wednesday slashed its forecast Brazilian cane output in 2011-12 by 40m tonnes to 535m tonnes, 1m tonnes below a much-cited figure from consultancy Datagro.
The lower prospects reflected "several years of underinvestment" in the sector amid the world economic downturn which now rated, with the 1997 liberalisation of the ethanol market, as one of the major upsets to Brazil's cane industry.
The ageing of Brazil's cane, which has historically been replaced every three years or so, has left "agronomists wary of drawing firm conclusions as they are working with unfamiliar data".
Indian answer?
The merchant also poured cold water on hopes of India, the second ranked producer, filling the gap in raw sugar supplies, saying the country was focused on white sugar trade.
Meanwhile, in Thailand, the second-biggest sugar shipper, has like Brazil found "the ability to get product to the export market to be a problem" thanks to logistical hold-ups.
Nonetheless, raw sugar for October fell 2.1% to 27.01 cents a pound in New York, for October delivery, on profit-taking from last month's rally, and following preliminary clearance by the European Union of alternative sweeteners based on the stevia plant.
London white sugar fell 1.4% to $760.20 a tonne.

See the original article >>

The Fed As A Reverse Robin Hood

In today's edition of Bloomberg Brief, the firm's economist Richard Yamarone looks at one of the more unpleasant consequences of Federal monetary policy: the increasing schism in wealth distribution between the wealthiest percentile and everyone else. While the Fed's third mandate is by now all too clear: push the Russell 2000 to the highest possible level, one can now suggest that the 4th mandate is one that would make Robin Hood spin in his grave: "To the extent that Federal Reserve policy is driving equity prices higher, it is also likely widening the gap between the haves and the have-nots....The disparity between the net worth of those on the top rung of the income ladder and those on lower rungs has been growing. According to the latest data from the Federal Reserve’s Survey of Consumer Finances, the total wealth of the top 10 percent income bracket is larger in 2009 than it was in 1995. Those further down have on average barely made any gains. It is likely that data for 2010 and 2011 will reveal an even higher percentage going to the top earners, given recent increases in stocks." Alas, this is nothing new, and merely confirms speculation that the Fed is arguably the most efficient wealth redistibution, or rather focusing, mechanism available to the status quo. This is best summarized in the chart below comparing net worth by income distribution for various percentiles among the population, based on the Fed's own data. In short: the richest 20% have gotten richer in the past 14 years, entirely at the expense of everyone else.

Another indication of the increasing polarity of US society is the disparity among consumer confidence cohorts by income as shown below, and summarized as follows: "The increase in equity prices has raised consumer spirits, particularly among higher-income consumers. The Conference Board’s Consumer Confidence index for all income levels bottomed in February/March of 2009. The recovery since then has been notable across the board, but nowhere as much as for those making $50,000 or more."

Lastly, nowhere is the schism more evident, at least in market terms, than in the performance of retail stocks:
Saks chairman Steve Sadove recently remarked, “I’ve been saying for several years now the single biggest determinant of our business overall, is how’s the stock market doing.” Privately-owned Neiman- Marcus reported “In New York City, business at Bergdorf Goodman continues to be extremely strong.”

In contrast, retail giant Wal-Mart talks of its “busiest hours” coming at midnight when food stamps are activated and consumers proceed through the check-outs lines with baby formula, diapers, and other groceries. Wal-Mart has posted a decline in same-store sales for eight consecutive quarters.
The conclusion: the end of QE, for now, may help bring US society a little closer, however temporarily.
The withdrawal of Fed accomodation may eventually stop supporting a wider income gap. In the event that further support is needed for the economy, though, this result of monetary policy acting without fiscal support — food stamps, extended uninsurance benefits and so on — should be considered.
Well, further support will be needed, but since the bottom 80% of US society is largely irrelevant in all matters that matter, one can surely hope that this major strata of the population will get some more focus in the future. Although we certainly do not have big expectations.

See the original article >>

So, If(When) Greece Defaults, Then What?

This is a contributing European CDS trader's commentary on the BoomBustBlog research piece "Is Another Banking Crisis Inevitable?".

Note that this opinion was written before the rating agency vs. ECB/EU soap opera of this past weekend which essetially proves what we presented to our pro subscribers early last year - a zero coupon rollup created to restrucuture debt is..... a default! Reference Greek Default Restructuring Scenario Analysis with Sustainable Debt/GDP Limits and Haircuts and What is the Most Likely Scenario in the Greek Debt Fiasco? Restructuring Via Extension of Maturity Dates - both written over a year ago, and both quite prescient. In the meantime, enjoy this guests contribution, annotated as usual by yours truly!

At this stage i have a remark/question in your « the inevitability of a banking crisis »(dated when?) you were waaay too optimistic (!!) seeing 172bn of losses related to PIIGS. We may be over that only on Greece exposure!

Certainly, if we compare the fiscal trajectory of the Eurozone as a whole with the US, the US is not really on a better path. Austerity has started in Europe. US seems still in full spending spree.

I would argue as long as there is no bank run and voluntary secession, things even if shaky, will stay more on less under control by governments. Being anti-Euro can win elections, and there is a real chance that some country (Greece, Finland...) quit the Euro by themselves for not wanting austerity or not wanting to bail out other countries. But so far, its just talk. In Portugal they voted out the PM, well they still got austerity...Ireland is a total joke as well.

So if we step back, and ask ourselves who's going to buy this ever growing govt debt, well this is the banks of course !

Look (I didnt!) at the balance sheet of Japanese banks 20 years ago and now, many JGBs in their balance sheet, in place of those turned sour (real estate) loans...every $ or euro spent from the budget, ends up in a bank account, and the ALM officer of that bank, well, the only stuff he can buy with it, is a govt bond as its the only « safe » asset (what else would be ? Even if they bought all those google bonds...)

Well, if you take a look at how well that technique turned out for the Japanese banks, a widespread, long term bear trade on the banks may not be that bad an idea, despite how obvious the trade may be!

.. It is the reporting company’s responsibility to report, not to obfuscate. The big problem with this “hide the market marks” thing is that markets tend to revert to mean. Unless said market values fundamentally catch up with said market prices, you will get a snapback. That is what is happening in residential real estate now. That is what happened in Japan over the last 21 years!!! That’s right, it wasn’t a lost decade in Japan, it was a lost 2.1 decades!

This has been the first balance sheet recession that the US has ever had, but there is precedence to follow. Japan had a balance sheet recession following their gigantic real asset bust. They made a slew of fiscal and policy errors, which essentially prolonged their real asset recession (now officially a depression) for T-W-E-N-T-Y O-N-E long years! For those that may have a problem reading that, it is 21 long years. What did the Japanese do wrong?
  • They refused to mark assets to market
  • They attempted to prop up zombie banks
  • They failed to promptly clean up NPAs in the banking system
  • They looked the other way in regards to real estate value shenanigans
Now, for those of you who believe that the government's "pretend and extend" policy has any chance in hell of working, or better yet, that we are not following in the footsteps of Japan, let's take a pictorial trip through recent history. There are nearly no Japanese banks in the top 20 bank category on a global basis by 2003 – NONE (save potentially Nomura, which arguably survived in name, alone). As you can see, they literally dominated 90% of the space in 1990!

Click to enlarge…


... and well if the ALM officer doesnt buy those bonds, and buys something else, the money just ends up in another bank which will buy those bonds !

The system is full circle...there is no flaw as long as people keep their money in the bank.

Hmm, I'ver heard this argument before. This is not just a European perspective. Many in the states believe this is doable a well, reference FASB Appears to Have Bent Over For The Final Time & Accuracy In Financial Reporting Dies An Ignominious Death!!!More importantly, let's explore this full circle theory as exerpted from Do Black Swans Really Matter? Not As Much as the Circle of Life, The Circle Purposely Disrupted By Multiple Central Banks Worldwide!!!

As excerpted from Do Black Swans Really Matter? Not As Much as the Circle of Life, The Circle Purposely Disrupted By Multiple Central Banks Worldwide!!!, Bernanke et. al. have snipped the chrysalis of the US markets and economy one too many times. He has interrupted the circle of life...

I have always been of the contention that the 2008 market crash was cut short by the global machinations of a cadre of central bankers intent on somehow rewriting the rules of economics, investment physics and global finance. They became the buyers of last resort, then consequently the buyers of only resort while at the same time flooding the world with liquidity and guarantees. These central bankers and the countries they allegedly strive to serve took on the debt and nigh worthless assets of the private sector who threw prudence through the window during the “Peak” phase of the circle of economic life, and engaged in rampant speculation. Click to enlarge to print quality…

The result of this “Great Global Macro Experiment” is a market crash that never completed. 

BoomBustBlog subscribers should reference The Inevitability of Another Bank Crisis while non-subscribers should see Is Another Banking Crisis Inevitable? as well as The True Cause Of The 2008 Market Crash Looks Like Its About To Rear Its Ugly Head Again, With A Vengeance. All four corners of the globe are currently “hobbling along on one leg”, under the pretense of a “global recovery”.

In the worst case, banks leave their money in the Central bank which will underwrite bonds.
Thats also why Greek bonds being eligible to the ECB is a key political issue. As long as they are, the ECB can provide money against those bonds... Govts havent printed money directly so far (if they did, no more need to issue bonds, just issue money with no interest...), just bonds that can be repo-ed to the CB and thats really when money is created.

Doomsayers have been saying for 10-15 years that the Japanese financial system would collapse, well the game is still on, and could last another 10-15 years (or more, or less, i dont know !). To me its really a game of confidence. Indeed, if there was a real Greek default and bank runs, then it would sure have a strong impact on the public, and we could have a chain reaction, and thats what i think the European politicians want to avoid #1. cause if they can, the zombified financial system can muddle through for years.

Yes, but as you can see from the charts and graphs above, the kick the can methodology or reality rendering didn't necessary work that well for real asset pricing or Japanese bank global presence, valuation or competitiveness.

So where does this leave valuations and the European banking system ?
Well, on one hand we have this insolvent system, that tries to survive. But there are institutions too weak to be saved.

Bank of Ireland, RBS, … show the way... well end up having more and more govt participation and regulation. In some countries, the whole financial sector might end up being nationalized. Financial sector is dead. It used to be 10%-15% of the equity market capitalization, went up to nearly 40%-45%. on that metric alone, there is much room for downside (perhaps another 50% with the same level in the broad index). Basel III, even if its not enforced yet (and perhaps by the time it should there wont be many private banks left in Europe...), gives a clear message: banks need to raise a lot of equity. And that needs a discount as many banks need this money, the new business model will be less profitable because of less leverage. Banks will try to hike fees, and merge to save costs.

Maybe if we see some spectacular failures, we will see a big transformation, especially with new entrants focusing just on deposits and payments. In Europe, banks are « universal » you tend have your account, your credit card your mortgage, your car loan, your brokerage account with the same institution. In my opinion it would make a lot of sense for Carrefour (for example) to open a banking operation.

Or enter Glass-Steagal - Euro edition!!!

Because of this increase for competition and diminished returns (less demand for loans)... the only « business » which will be growing in banks, will probably, their ALM !! Where they will buy more and more govt bonds (and BASEL III makes sure their risk weightings are 0% and that they have to do so for their « liquidity coverage ratios » (LCR) so they favour those bonds. This will push yields down, and bank profits down as they have to buy more and more of those bonds to try to keep the same profits. EFSF or any kind of Euro bond would definitely be bought with no problem.

And here we go again! What happens when assets held as risk free (zero risk captial weighting) at 30x to 60x levereage are truly nothing of the sort. This exacly how a tiny economic entity such as Greece (whose economy is probably smaller than that of Brooklyn, and definitely smaller than that of the NY metro area) has managed to gut the entire banking system of a plethora of 17 separate countries and much of the continent. Reference:
  1. Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!
  2. Ovebanked, Underfunded, and Overly Optimistic: The New Face of Sovereign Europe
  3. and finally How Greece Killed Its Own Banks!
With govt yield downs the extend and pretend game can last for many more years.
That wouldnt prevent banking stocks to go further downhill, as it was the case in Japan, but it might not be a one-way street, and peripheral banks are not necessarily the ones who would suffer most from here in the long run (after all if the crisis is resolved, their underwater govt bonds will be reboosted). And both you and I know that banks know how to twist and inflate their accounting, and that theyre showing profits on what really are losses...

No!!!!! Say it ain't so!

Perhaps another nice short would be the insurance industry.

They might be hurt even more than banks, especially life insurers... especially it has benefited (in France) of a lot of tax rebates / subsidies, which enticed the public into it, and if there is a sovereign accident, I can smell a run there. (I myself cancelled my life insurance, and all the « smart » people around me did so as well.)

All in all, I think it was a great call so far to foresee the European debt mess. But I think its much more tricky for here to make bets. Even the EURUSD trade which looked as a no-brainer at the start of 2011 given how dire the situation was, proved to be much of a pain...( to be honest, I lost myself quite a lot on that one). that should be a warning signal to me that things arent that simple.

As I got gaffed on the artificial bank runup of 2009/2010. You see, the fundamentals have been marred by central planning of the markets on a global basis. Again, I request you reference Do Black Swans Really Matter? Not As Much as the Circle of Life, The Circle Purposely Disrupted By Multiple Central Banks Worldwide!!!

Structural Problems Cannot Be Solved Though Bailouts! As A Matter Of Fact, Bailouts Make The Situation Worse

Moody’s Investors Service cut Portugal’s credit rating to below investment grade on concern the southern European country will need to follow Greece in seeking a second international bailout.

The long-term government bond ratings were lowered to Ba2, or junk, from Baa1, and the outlook is negative. Discussions to involve private investors in a new rescue plan for Greece make it more likely that the European Union will require the same pre-conditions in the case of Portugal, Moody’s said in a statement.

“That’s very significant because not only does it affect current investors, but it is likely to discourage new private- sector lending going forward, and therefore reduce the likelihood that a country like Portugal will be able to regain access to the capital markets at a sustainable cost,” Anthony Thomas, a senior analyst at Moody’s in London, said in a telephone interview yesterday.

Portugal is the second euro country rated non-investment grade by Moody’s, joining Greece, after winning a 78 billion- euro ($113 billion) international bailout in May.

European finance ministers last week authorized an 8.7 billion-euro loan payout to Greece by mid-July, basing a second three-year bailout package on talks to corral banks into maintaining their Greek debt holdings.

The euro fell 0.8 percent to $1.4429 at 5 p.m. yesterday in New York, from $1.4539 the day before, when it touched $1.4578, the highest level since June 9.

Portugal’s government debt agency is scheduled to hold a debt auction today to sell as much as 1 billion euros of bills maturing in October.

Here is an annotated summmary of BoomBustBlog Archives (in reverse chronological order) regarding the Portugal situation over the past year. I invite, if not challenge those who question the utility of the higher end of the blogoshpere to compare BoomBustBlog opinion and analysis (as biting, cynical and hard hitting as it may be) to that of the mainstream media and the sell side analyst community of Wall Street to determine if independent, proprietarry research in the form of a blog is something that this country and the global investment community is in need of... or not!


Over A Year After Being Dismissed As Sensationalist For Questioning the ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What!

There has been a lot of noise in both the alternative and the mainstream financial press regarding potential risk to the ECB regarding its exposure at roughly 48 to 72 cents on the dollar to sovereign debt purchases through leverage, and at par at that. This concern is quite well founded, if not just over a year or so too late. In January, I penned The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults. The title is self explanatory, but expound I shall. Before we get to the big boy media's "year too late" take, let's do a deep dive into how thoroughly we at BoomBustBlog foretold and warned of the insolvency of both European private banks and central banks, including the big Kahuna itself, the ECB! The kicker is that this risk was quite apparent well over a year ago. On April 27th, 2010 I penned the piece "How Greece Killed Its Own Banks!". It went a little something like this...


For Those Who Failed To Heed My Warnings On Portugal, Visualize The Contagion That Causes European Bank Failure!!!

Impact of bank’s banking books on haircuts

EU banking book sovereign exposures are about five times larger than trading book. The table below gives sovereign exposure of major European countries for both trading and banking book. The EU trading book has €335bn of exposure while banking book has €1.7t exposure towards sovereign defaults. EU stress test estimated total write-down’s of €26bn as it only considered banks trading portfolio. This equated to implied haircut of 7.9% on trading portfolio with losses equating to 2.4% of Tier 1 capital. However, if the same haircuts (7.9% weighted average haircut) are applied to banking book then the loss would amount to €153bn equating to 13.8% of Tier 1 capital.


The Pressure On Portugal Increases As Ratings Agencies Finally Arrive To The Fire Before The House Burns Down

Events are unfolding precisely as paying subscribers should anticipate. A quick recap:

  1. Portugal Is On The Verge Of Tapping Out, UFC Style – You Knew It Was Coming, Here’s The Analysis! Thursday, March 31st, 2011
  2. ECB Swallows Massive Portuguese Bond Losses As It Is Clear That The Third State Will Soon Join The Bailout Brigade – Haircuts, Here We Come!!! Friday, February 18th, 2011
  3. The Coming Interest Rate Volatility, Sovereign Contagion, Geo-political Unrest & Double-Dip Recessions: Here’s The Answer To Valuing Global Real Estate Through This Mess Tuesday, February 15th, 2011

Portugal's biggest banks will stop buying government bonds and are urging the caretaker administration to seek a short-term loan to secure financing until a June 5 election, business daily Jornal de Negocios reported on Tuesday.

Of course, its very expensive throw capital down the toilet when your crapper is full AND you run out of capital!

The heads of Banco Espirito Santo, Millennium bcp and Banco BPI met with the governor of the Bank of Portugal on Monday to pass on their views, Jornal said.

"Game Over"

Jornal de Negocios ran a separate column on Tuesday titled "Game over, we have lost, Mr Engineer," referring to Prime Minister Jose Socrates who has insisted the country needs no outside help. Socrates vowed on Monday to keep resisting a foreign financial rescue for the debt-laden country, including the short-term loan suggested by the opposition.

Yeah! Okay...

Asked if a loan from the IMF was possible if the country faced immediate financing problems, Socrates told RTP television: "I don't know of any IMF financing line that would not enforce a programme with conditions. "All programmes that have been negotiated so far were very severe in terms of measures demanded from a country," he said.

What was originally borne from Europe may yet return. Am I the only one bold enough to hint at indentured servitude???

Comparison to slavery

Like slaves, [indentured] servants could not marry without the permission of their owner, were subject to physical punishment (like many young ordinary servants), and saw their obligation to labor enforced by the courts. To ensure uninterrupted work by the female servants, the law lengthened the term of their indenture if they became pregnant. But unlike slaves, servants could look forward to a release from bondage. If they survived their period of labor, servants would receive a payment known as "freedom dues" and become free members of society.[19] One could buy and sell indentured servants' contracts, and the right to their labor would change hands, but not the person as a piece of property.

On the other hand, this ideal was not always a reality for indentured servants. Both male and female laborers could be subject to violence, occasionally even resulting in death. Richard Hofstadter notes that as slaves arrived in greater numbers after 1700, white laborers became a "privileged stratum, assigned to lighter work and more skilled tasks."[20]See also: Black Codes in the USA

Have the Portuguese been Hoodwinked! Bamboozled! Run Amok? Led Astray?


Portugal Is On The Verge Of Tapping Out, UFC Style - You Knew It Was Coming, Here's The Analysis!

ECB Swallows Massive Portuguese Bond Losses As It Is Clear That The Third State Will Soon Join The Bailout Brigade - Haircuts, Here We Come!!!

Here is a sequence of events that I warned thoroughly about, and is unfolding like clockwork. Witness the massive destruction of capital, despite the fact that it could have been so easily seen at least a year in advance. Let's walk through just the past couple of months. In January, I posted "The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults". To wit...

About a month ago, I pulled the covers off of the speculation over whether Portugal would default or not. Most of the “experts” declared that a default was not in the cards. I strongly recommended that the so -called “experts” pull out a calculator and run the math. Not only will there be defaults, but the haircuts will look particularly nasty. See The Truth Behind Portugal’s Inevitable Default – Arithmetic Evidence Available Only Through BoomBustBlog followed by The Anatomy of a Portugal Default: A Graphical Step by Step Guide to the Beginning of the Largest String of Sovereign Defaults in Recent History (December 6th & 7th, 2010).


The Truth Behind Portugal's Inevitable Default - Arithmetic Evidence Available Only Through BoomBustBlog

You don't need a "" site to reveal much of the BS that is going on in the world today. A lot of revelation can be made simply by having motivated, knowledgeable experts scour through publicly available records. I'm about to make said point by showing that the proclamations of the ECB, IMF, the Portuguese government and all of those other governments that claim that Portugal will not default on their loans is simply total, unmitigated, uncut bullshit nonsense.

If you recall, I made a similar claim regarding the Irish government and posted proof of such, see Here’s Something That You Will Not Find Elsewhere – Proof That Ireland Will Have To Default… November 30th, 2010.

...BoomBustBlogger Nick asked:


Do you have any reason as to why they are choosing 2013 as a deadline ? Seems like an arbitrary date.

Well, Nick, just follow the money or the lack thereof…

So, what debt raising and servicing that was unsustainable in 2010 was lent even more debt to become even more unsustainable. The chickens come home to roost in 2013, post IMF/EU/Bilateral state leveraged into Ireland loan/Pension fund raiding bailout! What Angela in Germany was alluding to was what all in the know, well… know, and that is that Ireland is already in default and those defaults have been purposely pushed out until 2013. Angela simply (and wisely from a local political perspective, although unwisely from a global geopolitical standpoint) admitted/suggested was that the defaults will be pre-packaged and managed ahead of time. The EU politbureau insists that politics rule the day, and no prepackaged structure be in place for the Irish defaults to be. This means the potential foe even more carnage through the pipelines of uncertainty!

The Mathematical Truth Concerning Portugal’s Debt Situation

Before I start, any individual or entity that disagrees with the information below is quite welcome to dispute it. I simply ask that you com with facts and analysis and have them grounded in reality so I cannot right another “Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!“. In other words, come with the truth, or at lease your closest simulacrum of it.

In preparing Portugal’s sovereign debt restructuring model through maturity extension, we followed the same methodology as the Greece’s sovereign debt maturity extension model and we have built three scenarios in which the restructuring can be done without taking a haircut on the principal amount.

    • Restructuring by Maturity Extension – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having same coupon rate but double the maturity. Under this type of restructuring, the decline in present value of cash flows to creditors is 3.3% while the cumulated funding requirements and cumulated new debt between 2010 and 2025 are not reduced substantially. The cumulated funding requirement between 2010 and 2025 reduces to 120.0% of GDP against 135.4% of GDP if there is no restructuring. The cumulated new debt raised is reduced marginally to 70.6% of GDP from 72.2% of GDP if there is no restructuring. Debt at the end of 2025 will be 104.8% of GDP against 106.1% if there is no restructuring
    • Restructuring by Maturity Extension & Coupon Reduction – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having half the coupon rate but double the maturity. The decline in the present value of the cash flows is 18.6%. The cumulated funding requirement between 2010 and 2025 reduces to a potentially sustainable 99.5% of GDP and the cumulated new debt raised will decline to 50.1% of GDP. Debt at the end of 2025 will be 88.6% of GDP (a potentially sustainable).
    • Restructuring by Zero Coupon Rollup – Under this scenario, the debt maturing between 2010 and 2020 will be rolled up into one bundle and exchanged against a single, self-amortizing 20-year bond with coupon equal to 50% of the average coupon rate of the converted bonds. The decline in the present value of the cash flows is 17.6%. The cumulated funding requirement between 2010 and 2025 reduces to 100.1% of GDP and the cumulated new debt raised will decline to 52.8% of GDP. Debt at the end of 2025 will be 90.9% of GDP (a potentially sustainable).

The scenarios above were also calculated using the haircuts necessary to bring debt to GDP below a pre-selected level (user selectable in the model, 80%, 85% or 90% - please keep in mind that a ceiling of 60% was necessary in order to gain admission into the Euro construct). We have also built in the impact of IMF/EU aid on the funding requirements and new debt raised from the market between 2010 and 2025 under all the scenarios.

A more realistic method of modeling for restructuring and haircuts

In the previously released Greece and Portugal models, we have built relatively moderate scenarios of maturity extension and coupon reduction which would be acceptable to a large proportion of creditors. However, these restructurings address the liquidity side of the problem rather than solvency issues which can be resolved only when the government debt ratios are restored to sustainable levels. The previous haircut estimation model was also based on the logic that the restructuring of debt should aim at bringing down the debt ratios and addition to debt ratios to more sustainable levels. In the earlier Greece maturity extension model, the government debt at the end of 2025 under restructuring 1, 2 and 3 is expected to stand at 154.4%, 123.7% and 147.0% of GDP which is unsustainably high.

Thus, the following additional spreadsheet scenarios have been built for more severe maturity extension and coupon reduction, or which will have the maturity extension and coupon reduction combined with the haircut on the principal amount. The following is professional level subscscription content only, but I would like to share with all readers the facts, as they play out mathematically, for Portugal. In all of the scenarios below, Portugal will need both EU/IMF funding packages (yes, in addition to the $1 trillion package fantasized for Greece), and will still have funding deficits by 2014, save one scenario. That scenario will punish bondholders severely, for they will have to stand behind the IMF in terms of seniority and liquidation (see How the US Has Perfected the Use of Economic Imperialism Through the European Union!) as well as take in excess of a 20% haircut in principal while suffering the added risk/duration/illiquidity of a substantive and very material increase in maturity. Of course, we can model this without the IMF/EU package (which I am sure will be a political nightmare after Greece), but we will be recasting the “The Great Global Macro Experiment, Revisited” in and attempt to forge a New Argentina (see A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina).

Here is graphical representation of exactly how deep one must dig Portugal out of the Doo Doo in order to achieve a sustainable fiscal situation. The following chart is a depiction of Portugal’s funding requirements from the market before restructuring…

This is the same country’s funding requirements after a restructuring using the "Restructuring by Maturity Extension″ scenario described above…

And this is the depiction of new debt to be raised from the market before restructuring…

And after using the scenario “Restructuring by Maturity Extension″ described above… For all of you Americans who remember that government sponsored TV commercial, “This is your brain on drugs. Any Questions?

The full spreadsheet behind all of the calculations, scenarios, bond holdings and calculations can be viewed online here...

See the original article >>

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