Here’s A Potential Short
It Doesn’t Matter Until It Matters
Price distortions in financial markets are all too common, some small, some
large (Nikkei in 1989, Nadaq in 2000), but one thing is for sure — eventually
they are corrected. Sometimes it is because reality sets in, fundamentals “catch
up” or the underlying growth fits into the price at some point in the future.
Let’s be clear though — I am talking about investing, not trading. Trading a
security that you know is in a speculative phase is one thing, in fact it is
often more fun, since the moves are rather exaggerated; risking hard earned
capital by investing is quite another matter.
While it is tempting to want to forecast the ending of such price cycles, it
can be very costly. How many people got hurt trying to short the Nasdaq all
through 1999 and the first month or two of 2000? The same thing is probably
happening in the bond market currently. The important thing is to build a case
as to why the market is “missing” the obvious and let that be your guide in
terms of conviction when the time presents itself. This is a combination of both
fundamental and technical analysis. I would much rather be late to the party
then never go at all.
I think there is little doubt that the Euro is in such a place currently.
Versus the dollar, the Euro has had a great run since last November. Is it
because of:
1. Their robust economy and low budget deficits? Hardly
2. Is it due to their demographics? Nope, the population is getting much
older.
The fact is, people, institutions are buying the Euro for a variety of
reasons, and will continue to do so until such time that they don’t. It is then
that the short on the Euro will play out, and not until. It is just like a day
trade — the chart may be set up, but until the price action confirms that
reversal or trend continuation, there is no trade. The short in the Euro may
never play out, but if it begins to deteriorate keep the above points and these
in mind as a way to remain short and catch the “meat” of the move.
A look back to Japan will serve as a nice backdrop to add perspective. When
their economy began to sputter back in the late ’80s and early ’90s, the
Japanese government strong-armed the central bank into buying a large majority
of the bonds it was issuing. The result was a yield that went from 5% to 0.5% in
the past decade. This, as we all know is no enviable outcome, unless of course
you bought bonds with a 5% coupon, in actuality the government has been merely
managing a slow deterioration of the economy.
Fast forward to present-day Germany and you have a similar situation
developing. Companies are experiencing a cash flow issue, flat consumer
spending, poor demographic trends, a richly valued currency is putting pressure
on exports. Cutting back spending seems like one logical solution. This is
contra to what normally would happen when business is good and companies run
negative cash-flows for some time.
“So let us assume that German companies
will move to a positive cash-flow equal to 1% of GDP over the coming year. The
net effect on GDP (everything being equal) over the adjustment period is thus
going to be: -(-2) to +1= 3% of GDP. That’s quite a swing! So how will it be
absorbed?
1— Consumption?
Given the fact that Germany starts losing people from 2005 onwards, that
unemployment is rising, and that credit to consumption is simply not as
developed in Germany as in the US (it is very hard, for example, to re-mortgage
a house in Europe), a boom in German consumption appears unlikely.
2— Exports?
With the Euro at 1.17, a surge in exports would be surprising (and that’s a
polite understatement).
3— Government Expenditures?
This is what Japan did; Japan compensated for the
contraction in corporate spending by running a budget deficit. But is this
option open to Germany? After all, the German Budget deficit is already at -3.6%
of German GDP. Can the budget deficit move up to 6.6% of GDP for “all else to
remain equal?”
Source:Â GaveKal Research
“So, can the budget deficit go to 6.6% of GDP? Sure it can. It would be in
violation of the promises made at the time of the
Maastrich Treaty. The result of that decision, if made is not clear,
as GaveKal explains:
“….in Japan, the BoJ was told by the
Japanese government to buy JGBs, hereby helping to drive yields lower. But will
the French, Italian or German governments be able to tell the ECB to buy their
bonds? Remember that these governments will be in breach of their treaty
obligations and the ECB is most unlikely to look kindly on any request they
might present.
In 2001, the Argentine government could
not tell the US Fed to print more money in order to roll-over its debt and so
Argentina went bust. Japan was always able to tell the BoJ to print Yen and buy
JGS, and so JGB yields are at 0.47%. So what will happen in Europe? Low rates?
Or bankruptcy?”
Source:Â GaveKal Research
Either rates fall by virtue of buying the bonds and cranking up the printing
press, thereby weakening the Euro, or the ECB
sticks to its mandate, thereby driving yields higher and stifling economic
activity. Not an easy decision, and frankly not one that needs an answer at this
point. However, it is probably safe to say that the former option is the more
realistic outcome. Why? Simple. Nominal rates need to be lower than GDP growth
in order to avoid bankruptcy by virtue of the power of compounding interest. If
you are borrowing at 4% but only growing at 1%, it will not take long for
paralysis to set in and ultimately, bankruptcy. That being said, a lower
interest rate environment will not favor the Euro, just as our rate environment
and economic woes have plagued our dollar. Even under the scenario where no
policy changes are implemented and rates do not go lower, the Euro will likely
give way to gravity, albeit at a far more dramatic pace.
Given the scope of this commentary I will complete my thoughts on this
scenario in Thursday’s column.
| Support/Resistance Numbers for S&P and Nasdaq Futures |
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As always, feel free to send me your comments and questions.
Dave