“ It is generally inadvisable to eject from your aircraft over the area that you just bombed” -----  U.S. Air Force pilot’s manual

 Dear Clients and Friends,

 OMG !!!         I thought I’d seen it all. Get me some Xanax now.

 It appears that the tragic oil spill in the Gulf of Mexico has spread to the Mediterranean and Aegean waters. In other words, excessive debt loads from the Portuguese, Italian, Greek and Spanish governments (PIIGS) as members of Europe’s common is threatening to sink the EURO. The problems and ramifications associated with an unstable major world currency is being felt by ours’ and other world markets on a daily basis now. The worries are legitimate as  1.) European banks have a $1.2 trillion exposure to PIIGS debt.  2.) EURO weakness could have a strong impact on profits of some U.S. multi-national companies.  3.) The EU (European Union) is the #1 trading partner for China.   

 Why are these countries in trouble? For decades these countries have gradually moved down the path of Socialism by expanding government programs that have created structural problems from a corrupt, bloated and inefficient public sector to a less-than motivated, well-pensioned private sector (case in point is Italy where 1 in 5 people are on a  public pension and the birth rate is the third lowest in the world). The public debt in these countries is running at nearly 170% of GDP and that debt has to be financed by buyers from around the world. When buyers become skeptical of a country’s ability to pay, they demand higher rates or they simply back away (in the case of Greece short term government bonds were yielding almost 20% before buyers disappeared). At this point Greece has no choice but to be bailed out by the IMF (International Monetary Fund) and the ECB (European Central Bank). The conditions for the money include new and drastic austerity measures that must be implemented by the Greek government. As you can tell from the news reports, Greek government workers are not happy with their pensions being cut or even scrapped (as a case in point, two weeks ago the Greek Air Force went on strike)!   The Financial Times says that Greece should learn from the lessons of the past. King Phillip of Spain defaulted in 1557, 1560, 1575, and 1596. He died peacefully in 1598. Half of the nations of the world were in default during the Great Depression. Starting in 1826, Greece was shut out of the capital markets for 53 years. Its Depression era default lasted from 1932 to 1964. The Financial Times goes on to say that most economists and investors think that Greece should just get it over with….default and restructure. The fiscal arithmetic is too unpleasant and the Greek society to divided to deliver the cuts necessary. Not unlike Argentina in 1982.

The major concern at this point is that Spain, Portugal, and Italy are not far behind Greece with their heavy debt loads and this is causing the EURO to fall hard and fast. When wicked moves of this nature occur, holders of EUROs panic and sell EUROs, stocks (U.S. stocks too), commodities and bonds. They then take the cash and buy, in a flight to safety…… U.S. dollars, Treasury bonds and gold. In the last 2 weeks we have seen the Dollar rise by 8%, the yield on the 10 year Treasury fall from 3.92% to 3.39% and the DJIA drop by 7.9%. As unnerving as days like today was, we have seen this movie before. In 1982  we watched Mexico and Argentina default; Chile and Brazil in 1983, and in 1997, Russia defaulted on its’ sovereign debt triggering the collapse of Long Term Capital. Both of these “events” caused temporary breath taking 15 to 20% drops in stocks and proved to be corrections within a bull market.

It appears that today’s violent market action may have been triggered by a trading error and further enhanced by runaway computers, trading quantitative momentum models in the “third” market, not unlike what happened in 1987. Investigating Goldman Sachs is one thing but something must be done to curb the proliferation of non-human trading. Days like today do not instill confidence in anybody. That being said, there is no doubt that the stock market had to consolidate some of the past 5000 points of gain and we are now firmly in the midst of that correction, having pulled back 8%. If you count yesterday’s internal low, the market has pulled back 14% from the recent high.  I am not worried about a continued gut wrenching decline like we went through during our Great Recession. Right now America is back on top as a safe haven and symbol of stability as our economy continues to recover in an orderly fashion. Corporate earnings are very, very strong and that trend is likely to continue into 2011. These fundamentals usually serve to support stock prices even during times of uncertainty. In addition, it is not likely that a collapse of the PIIGS economies would derail our economic recovery since the combined GDP of those economies may equal the combined GDP of Texas and California plus, we simply do not export very many goods and services to those countries. Furthermore, it is in the BEST interest of France and Germany to intervene and stop the contagion and I expect this will occur sooner rather than later.  I don’t know if today was the end of the “risk adjustment” or not. My best guess is that our market will remain jittery until we have a resolution to the EURO crisis. What I do know is, as long as we continue to grow economically and from a profit standpoint, when the crisis fades, this market will resume its move higher. 

Right now, our portfolios are positioned well for the current environment. We still own a large % of high quality corporate bonds as well as a good position in government bonds, TIPS bonds and gold. The demand for these “safe havens” will continue as long as the crisis rages on. When things settle down internationally, there will be some great buys in the global and emerging markets that do not have a relationship with the PIIGS countries. Technology and raw materials companies have also created value again and I look to be a buyer of some of the high quality companies in these industries in the days and months ahead.

Best wishes,

Ken

Sources:   Vince Farrell @ The Street.com, The Financial Times, CNBC’s  “Fast Money”