NOTES FROM THE FRONT

WHAT I KNOW ABOUT THE EUR0
December 12, 2011

What do I know about the Euro that you might not and I can share with you? It is certainly not as much as many experts and others in the financial business, but a fair amount more than some. I can tell you that the Euro currency was created as a result of the Maastricht Treaty, which formed the European Union, and began its official life on January 1, 1999 as an accounting currency and came into daily use on January 1, 2002 with the introduction of coins and bills. The initial value of the euro in January 1999 was established based on agreement by the members, and exchange ratios agreed to for the respective currencies (franc, mark lira, peseta). During January 1999, 1€ was worth about $1.17. The euro traded below $1.00 at the end of 2001 and averaged in the $0.88 cent range in early 2002. Beginning in 2003, the value of the euro has traded comfortably over a dollar and trended upward during the decade. As a result of the present crisis of confidence, its value is presently about $1.34. Most of what I know I remember from our widespread travel to Europe, and in every year since, as it crept up in value, American travelers have faced rising prices and much more expensive tourism abroad as well as increasing prices for imports from Europe.

In pre-Euro days, Carol and I traveled to Greece when the drachma was Greece’s currency. I recall that we stayed in the Athens Hilton, perhaps the top 1st class hotel in Athens for something like the equivalent of $125 per night, and had a series of great meals on the Plaka with wonderful fresh grilled fish at around the equivalent of $10-15 per person. Today, the Greece that we read about daily is in crisis and in a state of economic collapse and uses the euro just as they do in Paris, Madrid, Rome and Berlin. The Hilton, still one of the top hotels, now starts at 350€ equivalent to $475 per night and the same grilled fish meal is apt to run at least $50 per person. Greeks now buy Mercedes Benz’s instead of old Datsun’s (pre-Nissan) like the one we rented on Crete and drink Champagne rather than the Retsina wine that we drank. The average Greek citizen can come to New York for shopping and stay first class and eat well using the euro as a strong currency as we did with dollar/drachma. One regret I have is that when I visited Delphi, I failed to ask the Oracle of Delphi about euro economics and made the mistake of relying on our Oracle of Omaha for his Americentric view.
When I made my first trip to London, Madrid and Paris as a college student in 1959, which was only 14 years after the end of WWII, I relied on the famous guidebook of the day, “Europe on $5 A Day.” It could be done. We had fewer dollars but they went a long way. Measuring purchasing power, roles have been reversed over the last 20 or so years, with Europeans (and Asians) now traveling to the US for budget vacations and cheap shopping while average Americans have pretty much had to retire their passports. I guess that’s why people enjoy the “Bellagio” in Las Vegas rather than the real one on Lake Como in Northern Italy. Turkey, a non-Euro country with its weaker currency and lower prices, now attracts American tourists much as Greece did years ago. I imagine that they are contemplating joining the EU as well.
The overall description of the European financial crisis includes weakening economic conditions and the inability of certain member states of the EU running large deficits to refinance their debts and borrow money at acceptable rates. Declining sovereign bond values have created losses for financial institutions and investors holding those bonds, and have damaged bank balance sheets. The crisis surfaced in the spring of 2010 in what are known as the PIIGS countries – Portugal, Ireland, Italy, Greece, and Spain. Now, the crisis has grown to include virtually all of the 27 EU members, and the future of the EU and the Eurocurrency is questioned. The European banking system is believed to be in great distress with a number of French and German banks rumored to be near insolvency. Lenders and investors are demanding that sovereign governments reduce their deficits and are pushing severe austerity measures, which are causing woes for citizen consumers.
The US stock market has been on a rocky road for the last year and spent November and early December in an extremely volatile trading pattern with days of huge gains and losses trading places as news and rumors about the Eurozone crisis were aired. The problem seemed to receive some good news and a victory on Friday the 9th as the European Summit reached an agreement to provide unified support to the EUR currency as well as a commitment to rework the EU treaty to correct some of the initial deficiencies in the structure. Unfortunately, both the perennial euro skeptics and deal-skeptics are equally disappointed in what is perceived as a deal which seems to be just another promise to do something while that something remains elusive.
It’s all quite complicated to explain and understand, but a major criticism about the creation of the European Union has always been that it was: a treaty of economic union only, without the binding political structure to insure unified action; a club relatively easy to get into but impossible to get out of, voluntarily or involuntarily; an organization inconsistent in its composition where some member countries such as England, Sweden, Norway for example, kept their own currencies and therefore had independent economic and monetary mobility, with currency actions open to themselves, while most of the others, such as Greece and Spain as prime examples, were tied to the Euro currency and realistically, tied to the German economy. In my view, the current economic crisis demonstrates unequivocally that Germany has accomplished the domination of Europe in peace, what Hitler failed to do in a terrible war, and is now facing what I believe could be viewed as a paraphrase of Secretary of State Colin Powell’s Pottery Barn rule. They (Germany) broke it, they own it, and they are responsible for fixing it.
George Soros wrote a piece in the October 13, 2011 New York Review of Books entitled “Does the Euro Have A Future” in which he presented his primarily negative views of the difficult crisis that was then still playing out and obviously before the action undertaken just a few days ago. Basically, his conclusion shares the general pessimism of many, and states that “without a common European treasury, there is no clearly visible solution to the Euro crisis.” There is nothing that I have read of the summit accord that establishes that common treasury. Moreover, Soros wrote, “Even if a catastrophe can be avoided, one thing is certain: the pressure to reduce deficits will push the Eurozone into prolonged recession. This will have incalculable political consequences. The euro crisis could endanger the political cohesion of the European Union.” It is fairly obvious that the ball is solely in Germany’s court and in my opinion, the euro is really the Deutsche Mark under another name,
As a result of a recent German Constitutional Court Decision prohibiting certain actions including infusions of new money and new arrangements without the authorization of the Bundestag, Soros writes that “there is no alternative but to give birth to the missing ingredient: a European Treasury with the power to tax and therefore to borrow. This would require a new treaty…” which he admits “presupposes a radical change of heart” and is unlikely. He goes on to say “The German public still thinks that it has a choice about whether to support the euro or abandon it. That is a mistake. The euro exists and the assets of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to maintain.”
What did come out of the meeting on the 9th was an agreement by 26 of the 27 members of the EU signaling a strong commitment to the currency and to the continuance of the organization by effecting a major change in the treaty to strengthen supervision and control by the majority over the individual members’ economic and fiscal controls and programs. This agreement falls short of Soros’ view of a new taxing authority and amended treaty. England was the lone dissenter and did not agree to the final agreement. Since the inception of the EU, England has always held itself aloof as an island nation, preserving its independent currency and sovereignty and generally afraid of diluting English culture.
I am certainly not expert enough to know if this agreement to agree, or commitment to commit, or however one might describe it has sufficient hard cash behind it to do what it takes to avert the collapse of the EU, and assuage the fears of the bond vigilantes. Nonetheless, people in good faith have, in fact, committed to a course of action to preserve the union. That has to be taken seriously. On the other hand, this agreement will have to be approved by the member governments through changes to their constitutions or through new laws. This issue and the question of the survival of the euro is not yet solved, as evinced by today’s (Monday, 12/12) market action. But what I think and even what the respected George Soros writes in NYROB are unimportant in the investment world compared to the action of the markets. And when Soros puts his words into actions such as what he is alleged to have done in shorting the British pound a number of years ago, the markets move. And when markets move, big things happen. In fact, one of Soros’ maxims in his theory of reflexivity that I adhere to and respect is that markets drive fundamentals, rather than the conventionally believed opposite, that fundamentals drive markets.
Through the action of the bond markets, the European crisis has most recently driven two established elected leaders from office in both Greece and Italy with possibly more to come elsewhere until a plan is established and implemented to restore confidence. These leaders have been driven from office by market movements without elections, carried out by bond traders in bond trading pits using the Credit Default Swap (CDS), rather than being forced to go on the streets such as was done in Cairo or Benghazi.
Our Omahan Oracle, Warren Buffett, has characterized the CDS, as a WMD, i.e. a financial instrument of mass destruction. The powerful, market moving CDS is a derivative financial product which enables big money positions to create a highly visible expression of fear or panic, of disgust and disapproval, just as a child might wail when troubled, or an unruly mob might set fire to a car on the street. In fact, the CDS is the instrument that converts the financial markets into a casino much larger than Las Vegas. More than that, the CDS is the perfect instrument not only to place a bet, but to almost guarantee the outcome of that bet. Neither financial market nor insurance regulators are currently empowered to regulate the CDS and it remains under no regulatory jurisdiction despite the advice and recommendation of experts and efforts by Democrats.
The CDS is essentially an insurance policy covering bonds and debt obligations. In theory and practice, a large investor owning a bond and seeking to manage risk, could insure that holding against default by buying a CDS from an opposite counter-party willing to take the other side of the risk in exchange for a financial premium. At this point, it all sounds pretty legitimate, much in the same way that Chubb or Allstate would offer a homeowner a $1 million fire insurance policy on the home he/she owns. “Insurable interest” is the terminology used in the insurance business that defines the homeowner’s right to purchase insurance on the owned home against loss. Generally, insurable interest is established by ownership, possession or direct relationship.
But suppose, hypothetically, that thirty strangers came along who each wanted to buy a $1 million fire policy on that same house, that they didn’t own, but to collect the same payoff if the house went up in flames. Under existing law, insurance companies would not sell the policies to those strangers because they had no insurable interest in the property – the house belongs to someone else - and if they did, they would be exposed to $31 million in losses on a $1 million dollar house. Under those circumstances, leveraged 30 to 1, it would represent more of a wildly speculative bet than actuarially-based insurance, and it seems pretty likely that, in an unregulated market-driven situation, that house would somehow soon mysteriously go up in flames.
Using Greece as an example, in the case of CDS’s on any specific debt instrument, it is permissible and standard practice today that anyone can buy a CDS in any amount that selling counter-parties are willing to sell without owning the underlying debt security, even in amounts far greater than the entirety of the particular issue of debt outstanding. The buyers of specific CDSs need not own underlying bonds of the issuer, i.e., have no insurable interest, but instead be using the CDS as a method of creating a short position in the specific instrument or class. Thus, the CDS could be considered to be a security rather than an insurance product. As buyers buy the CDS, the price action will rise reflecting demand, and as the market price of these signal instruments rise, implying an increase in the perceived risk of credit default, all hell will break out. Feed the fire with rumor, and you could easily see companies like Bear Stearns, Washington Mutual, AIG, Merrill Lynch or Lehman Brothers bite the dust whether through shotgun marriage or bankruptcy, which was exactly what, happened during the fateful week of panic in September 2008. All those companies were victims of the same fate as sharp increases in the prices of their CDSs set in motion a self-fulfilling downward spiral. It appears that the similar CDS trading pattern is in play today. I can remember that in 1981, the US Treasury issued 15 year bonds due in 1996, carrying a 16.125% coupon. I shudder to think what would have happened to the United States if the CDS product was then available to bond traders in 1981.
The failure of the markets to respond favorably to the EU agreement reached last week is an ominous sign and is likely to usher in a new period of market turmoil. Bond traders are not likely to sit back and do nothing for six months or a year or more awaiting concrete action promised under the agreement. CDS spread prices could rise sharply and be heralded by cable financial media as implying further weakness in vulnerable countries and suspect banks. Rumors may fly, unnamed sources may issue provocative headlines and the emotions of crisis may continue to roil markets. In the meantime, austerity measures and spending cuts are sapping the vitality of European economies, damaging consumer confidence and affecting world trade. All eyes will be and should be on Angela Merkel and Germany and everyone should raise their voices in unison like Tom Cruise in the 1996 film “Jerry Maguire” and shout: Hey Angela, “SHOW US THE MONEY!”
Peter R. Mack
December 12, 2011

KICKING THE CAN DOWN THE ROAD

In the last few weeks, the hands-down winner for the most used, hackneyed cliché in financial and political speech with respect to the federal debt and deficit has been “kick the can down the road” which is a folksy way of saying procrastinate. The expression probably derived from an old children’s game and appears to be the one thing that both Republicans and Democrats agree on, that they don’t want to be accused of doing. It seems that many politicians would rather be accused of emulating DSK rather than be called a can-kicker. DSK’s behavior has been seen before in DC.

The children’s game has been described as an active, energetic, happy game played by a few children at the same time, while the verb to procrastinate means “to put off until tomorrow what we could do today.” During this period leading up to reaching the nation’s debt limit, the anti-can kickers all want to be seen as serious men and women. They’re thinking of our grandchildren they tell us, forced to make the hard austere decisions that will bring tears to people’s eyes; profligates no more. Cutting benefits, yes, we must do that; raising taxes, no, we will never do that, better to kick the can on that one. Even President Obama joined the conversation declaring that he too would kick no can down the road and suggested he would kick something else in an attempt to get something passed.

All the posturing is the attempt to fashion a complex, long-term “permanent” solution to America’s operating deficit and outstanding debt problem, appending it onto immediate legislation that would extend and raise the ceiling imposed annually by Congress on the amount of US Treasury debt that can be issued and outstanding at any one time. The debt ceiling problem is an immediate one – Secretary Geithner claims that the Treasury cannot function and pay America’s bills after August 2nd.

Some Republicans, especially those representing “Tea Party” backers, including Michele Bachman, are opposed to any extension of the debt ceiling. In her new campaign ad she declared that she would not now nor ever vote for any plan to raise the limit. Many view the date of August 2nd as just a ploy by the administration to raise a false alarm. One senator contended that even without Congress raising the debt limit, the Treasury would have plenty of cash available to pay interest to bondholders first, and then could delay without consequence, Social Security, Medicare and other benefit payments, and government salaries. The dystopian view that bondholders must always get their interest paid before retirees or veterans or even soldiers can get their checks sounded like Marie Antoinette’s famous “let them eat cake” moment..

There are two issues at play – one an immediate problem, the other long term - and both are poorly served by a false linkage done for political leverage for both parties going into the 2012 elections. In my opinion, the debt ceiling extension is mandatory, immediate and must be passed. Without it, I believe that we risk a catastrophic event potentially equal to the market crash and enduring financial crisis that began with the major miscalculation by Secretary Paulsen that led to the Lehman Bros. bankruptcy filing. Extend the debt limit, I say urgently, and kick the the longer term problem down the road.

Realistically, no worthwhile, decent legislation can possibly be debated, understood and passed by the two branches of Congress before August 2nd. A poorly constructed long-term spending bill will be like the healthcare bill, controversial, reviled and propagandized from the start. The best outcome for the American people at this time would be for this can to be kicked and re-kicked down the road until the 2012 elections are over. After the elections, we should have a clear picture of true voter sentiment and political power in the country, whether it’s from the likes of an extreme Michele Bachman, a moderate Mitt Romney or Jon Huntsman, or the neo-centrist President Obama.If power shifts after 2012, any legislation enacted today will certainly be renegotiated or repealed

The consequences of Congressional inaction, of kicking the can, could, in fact, be quite beneficial and result in a balanced budget by 2015 says the CBO. I will repeat what I said: If Congress does nothing, the budget can be balanced in 2015 based on legislation currently in place. Surprisingly, this has not become part of anybody’s debate, probably, I guess, because it doesn’t serve the political strategy for 2012 of either party. It would by definition be kicking the can.

A few weeks ago on June 23rd, the CBO (Congressional Budget Office) issued its 2011 Long-Term Budget Outlook. The extensive report is fact-filled with accurate, non-partisan information and is generally considered to be reliable. Readers can access the report at www.cbo.gov .

The CBO presents the long-term budget outlook under two scenarios that embody different assumptions about future policies governing federal revenues and spending. Neither of the two scenarios is offered as a prediction of future events, since each scenario depends on a specific course of political action and prospective legislation that may be enacted. Following are the two scenarios:

In The Extended-Baseline Scenario, if current law is permitted to stand – which means that there is no repeal of the healthcare legislation; no further extension of the “Bush tax cuts” which have already been extended once and are scheduled to expire at the end of 2012; no repeal of the current health care legislation; and no new fiscal legislation - there is no immediate crisis. The budget deficit would disappear beginning in the crossover year of 2015 and continue balanced to 2035. In the CBO’s words: “That significant increase in revenues and decreases in the relative magnitude of other spending would offset much – though not all – of the rise in spending on health care programs and Social Security.”

This scenario offers the best reason in the world to kick the can down the road: A balanced budget with no new legislation. Adjustments can be made down the road as political conditions improve and events dictate.

On the other hand, the alternative is not so good. Under The Alternative Fiscal Scenario, the situation becomes “much bleaker” according to CBO. CBO assumes that there will be tax cuts, (changes to existing law such as a further extension of the tax cuts due to expire); the “reach of the alternative minimum tax will be restrained;” and that Medicare payment rates to physicians will remain at present levels rather than be reduced as called for under current law.” The CBO concludes that the “explosive path of federal debt under the alternative fiscal scenario underscores the need for large and rapid policy changes to put the nation on a sustainable fiscal course.”

A picture is worth more than all my words, so following are two charts prepared by the CBO that graphically depict the two scenarios.



The air of political uncertainty and constant talk of debt crises in Europe and the United States is infusing the stock markets with a sense of uncertainty. Fears of a double-dip recession are back on the front burner as growth slows. Yet, in spite of the psychological climate, the markets have produced gains for the year. Through June 30th, the S&P 500 is up 4.9% for the year to date, while the narrower Dow Jones Average is up 7.2%. In the second quarter, the S&P was down by 0.4%, while the Dow rose by 0.7%.

Much of the slowdown in second quarter economic activity can be attributed to shortages caused by the Japanese earthquake; a continued slowdown and double dip in housing sales; rising gasoline prices; rising local and state taxes; and slower consumer spending arising from continued high unemployment. Additionally, I continue to see correlation between consumer spending and stock market performance within the investing/savings class i.e., a rising stock market enhances economic activity; conversely, should the market decline if the debt limit is not raised, a new recession or worse may could begin.

A year ago (June 26, 2010), I wrote a piece called Reckless in which I expressed concern that political sentiment was pushing Washington towards austerity on a grand scale and simplistic assumptions by an uninformed public were pushing Congress towards a premature deficit reduction program. Unfortunately, it appears that the Federal government is aligning with the states and cities and beleaguered European countries in broad austerity thinking at a time when we need spending and stimulus. Today’s report of a rise in unemployment to 9.2% is throwing a chill on expectations. It is very interesting that at this same time last year, the economic problems of Greece, Portugal etc. and trading in the credit default swaps were in the headlines and rankling the markets, just as they are again this year. This is the story that keeps on giving. No CNBC day would be complete without worry for Greece or Portugal, and one year later, we’re still talking about the same things with neither a resolution nor catastrophe having taken place.

It is very difficult to maintain an optimistic short-term investment posture amid the complications of election politics at its worst and constant media focus on the direst outcomes. Aside from the very real possibility of political miscalculation, and financial accident, I am confident that the debt ceiling will be extended. Who could possibly believe that our political leaders would play games with the credit standing of the country? Through it all, I remain positive about the investment potential in our great country and I think the best way to approach capital growth and preservation in a zero-to-low interest rate climate and an inflationary future is to pursue equity investments in growth industries through what is now known as single-stock investing.

I continue to be optimistic about investments in health care. We are entering a period of personalized medicine using genetic identification to design of medicines and treatments on an individual case basis. This change could bring about smaller, shorter and thus cheaper clinical trials that will finish sooner and benefit the patient, the sponsor, and the public by reducing time and costs. Separately, human health needs are growing at a rapid rate: results of a recent study of diabetes showed that the present estimate of diabetics in the world now numbers 350 million, and accelerating rapidly, compared to just 250 million in the last study done just a few years ago. I and clients are invested in a publicly-held company that is awaiting final FDA marketing approval on an ultra-rapid acting mealtime, powdered insulin for both Type 1 and Type 2 diabetes delivered to the patient via a miniature inhaler (about the size of the pinkie finger): faster, unobtrusive, disposable, convenient and inhaled rather than injected. Its global potential could be significant. We also are invested in a publicly-held company, one of the pioneer stem-cell research companies that has recently received FDA approval and commenced human clinical trials using stem-cells to treat spinal cord injury and concomitant paralysis. The same company is conducting Phase II clinical trials of a novel peptide-drug conjugate that attempts to deliver anti-cancer drugs across the blood-brain barrier to enable the treatment of primary brain cancers and metastases. The blood-brain barrier prevents most medication from delivering to the brain.

I continue to be interested in the growth potential of electric-hybrid vehicles, and the stimulative effect the adoption of these vehicles will have on expansion of the power grid. Electricity usage is rising from the widespread growth of rechargeable gadgets, devices and autos. Hybrid electric vehicles available now can offer as much as a 100 mpg equivalent or even more depending on driving conditions.
One final thought: It is virtually impossible for the economy to attain an acceptable growth rate and satisfactory employment levels until housing begins to recover. It’s my feeling that the Financials are gearing up to become more proactive in dealing with foreclosures and seeking to work things out with troubled borrowers. We may see improved news in the next months.

Current consensus estimates of 2011 earnings of the S&P 500 companies are around $99.00 per share, placing the price/earnings ratio at roughly 13.5 times, and the earnings yield at 7.4%. Both measurements compare very favorably to the 10-year Treasury bond yield of 3.1%. The S&P 500 has risen 28% from 6/30/2010 to 6/30/2011 when I published Reckless. I concluded then as follows: “Investing in this economic maelstrom is as difficult as at any prior time in my 47 years in Wall Street. However, I do believe in a long term and I do believe that equities rather than bonds are the way to participate in the evolutionary process towards that long term. The continuation of a low-interest rate policy provides low income returns and I continue to believe that selling short-dated covered calls against an underlying quality equity portfolio is a low risk method of income generation. In retrospect, it was a good call last year and with caveats for unforeseen political accidents, I’ll stick with it again.

Peter Mack
July 8, 2011