Another Greek Drama and Making the Case for the Slow Horse

After a week like we’ve just had, with the S&P 500 pulling back 3.5% to close at its lows and almost given up the 2000 level, I bet you’re starting to think managing your equity allocation ahead of the year end isn’t such a bad idea after all. So where do you think the odds on favorites are going to be found in 2015? Given my known preference for increasing my European equity exposure in 2015, you’re starting to wonder just what the heck the Yinzer Analyst has been up to all week. Maybe spending too much time sampling the goods at our own local micro-distillery?

Why do I feel so optimistic about Europe? Did this week’s almost 5.5% pullback for the iShares MSCI EMU Index (EZU) ETF lower the damper on my fire? To be honest, this pullback helped ease my biggest concern about investing in Europe, that valuations were already sky high as investors anticipated the ECB’s upcoming QE program. First let’s look at the charts to breakdown this week’s price action.

First things first, let’s take a look at a chart of the most common ETF offering pure Greek-exposure, the Global FTSE Greece 20 ETF (GREK.)  Now study the chart carefully and tell me what you see.

GREKCould it be the fact that GREK has been steadily underperforming EZU since last spring?  From the high of June 6th to today, GREK is down 42.96% to the 14.72% loss for EZU.  Yeah, the chart above is the tame one but I like it because it shows the incredible volatility of GREK.  In fact, ETFG had it ranked on 12/5 with close to it’s highest short interest as a % of the free float and implied volatility in it’s history.  This thing, is to quote Gwen Stefani, bananas.  So the fact that Greece is a financial/market basket case is hardly news to anyone who’s been paying attention.

Now getting serious, let’s start off by checking out the hometown team using SPY as our proxy for domestic equity markets.  When I started this post on Thursday night I didn’t think we’d crack $202 so quickly if at all, but SPY plowed right through it late in the day to close just off the low on heavy volume with the price eliminating the divergence that had been forming with a steadily falling CMF (20) score since late November.

SPYIf you think that looks bad, avert your gaze from the drama in Europe where EZU also closed at the lows of the day, breaking through the support line around $37.75 and looking to challenge the downtrend line at $36.  The global risk-off trade didn’t help the situation, but the negative correlation with a rising FXE certainly did it’s part to pull a Harding on EZU.

EZUD

fxeThe situation looks no better on a weekly basis as the global rout signaled everyone holding a long position with a $38-$39 entry point from the fall of 2013 that it was time to take the money and run.  Having cracked the weekly downtrend line, the next likely stop is going to be at $35.75-$35.90.

EZUWeeklyWhat about relative momentum versus SPY?:

REL MOM WEKYou can see that for a brief period this week, EZU outperformed SPY to the point where it broke the downtrend line before concerns over the Greek contagion lead to a hard rout of European stocks. Try looking at the same chart on a daily basis.  You can see that try as it might, EZU can’t quite overcome the 50 day moving average.

50 DAYSo given the glum charts, why am I still so positive on Europe.  First it’s because despite the fact that Baron Rothschild never said anything about buying when there’s blood in the street, it’s still really really good advice to follow.  What do you think is the most important determinant to long-term returns?  It’s not technological growth or demographics or how quickly the money supply is growing, it’s the price you paid for the investment in the first place.

Ever since Draghi’s comments in early November about doing whatever it takes to expand the balance sheet, there’s been a steady stream of positive news reports from the ECB coupled with negative Eurozone economic developments that reinforce the need for additional monetary and fiscal actions to help combat a deflationary environment. The real question is whether the situation in Greece is significant enough to derail 2+ years of progress in combating the prolonged economic weakness Europe has endured. Honestly, doesn’t it feel like a story you’ve already heard before? Political uncertainty in Greece threatens existence of EU? Not quite as old as the Odyssey or even Oedipus Rex, but it has a familiar ring. My own theory is that all its done has been to shake out the weak hands (as much as I hate this expression) and restore valuations to a somewhat more attractive level. At the start of the week EZU has a trailing P/E multiple close to 18 and in the top decile of its prior trade history. According to ETFG the recent rout has pushed it’s valuations closer to historical median but I’d like to see a little more bleeding and improved momentum first.

Before you rush out to buy EZU or broader VGK, the latest Greek tragedy will play out over the rest of December which means that EZU could be retesting the $35-$37 range soon. But my investment thesis on Europe has more to do with long-term trends than technical or valuations.

The Case for the Slow Horse:

I’ve been of the opinion that the EU has been a slow-motion train wreck largely of its own making. Between an unwieldy monetary union, finance ministers who still think currency markets operate the way they did during the era of “golden fetters” and an obsession with debt-to-gdp ratio’s, Europe pretty much got everything wrong between 2008 and 2012. While heavily criticized at the time, the American decision to focus on saving the banking sector in 2009 to avert a loss of confidence following the forced mergers of 2008 proved to be the correct one. Thanks to Fed largesse and a change in mark-to-market accounting, the day of reckoning for American financial institutions was postponed until they were able to successful restructure their balance sheets and restore confidence that they were going concerns. Coupled with the American Recovery and Reinvestment Act of 2009 along with the on-going confidence lift from the QE programs, America was able to limp along until such time as it seemed that economic growth could be self-sustaining.

Contrast this with the situation in Europe where the response to the crisis was modeled on the Japanese approach of the last 20 years, incrementalism and subtly akin to Lyndon Johnson’s approach to Vietnam. Lacking a unified banking regulator, there was no consistent policy in place for backstopping weak financial institutions; instead the focus was on improving their financial condition by eliminating riskier debt and raising additional capital to comply with Basel III choking off what little lending there had been while doing nothing to address the concerns over their financial safety. Now European financial institutions are very well-capitalized, but with low loan demand and no prospect for NIM growth. And without a federal structure, the EU had no ability to effectively deliver stimulus aid where it was needed to resolve fiscal in balances instead forcing highly indebted EU nations to raise taxes and cut spending, the exact opposite of the Keynesian response typically employed during a recession.

As anticipated, economic growth weakened to nothing raising the specter of default, increasing volatility and forcing EU financial institutions to unload supposedly safe sovereign debt, igniting the Euro Bond Crisis of 2012. Only the addition of “Say Anything” Draghi as the head of the European Central Bank and the realization by German politicians of how close to the brink they were helped ease tensions within the Eurozone while also simultaneously restoring confidence. From the low point of the Eurocrisis in 2012 to the this summer, the iShares MSCI EMU index performed in line with the S&P 500.

So why am I taking the time now to dredge up what in this day is considered to be ancient history? Because the policy differences between the U.S. and Europe are set to become even more extreme and this time, the Europeans might be the ones with the better hand to play and that differential could mean all the difference for expected returns going forward.

We don’t need to sit down and derive the Kalecki-Levy profit equation from Macroeconomics 1 to understand that one of the biggest drivers of corporate profits over the last five years has been the Federal budget deficit. Although the steady decline in government hiring and spending has been acting as a drag when figured into GDP calculations, government spending has been a major boost to the economic recovery despite what you might hear on Fox News. Even though there are no truly “closed” economies, remember that government spending becomes private saving so government deficits are a source of revenue to the private sector while the federal surpluses of the late 1990’s withdrew capital from the economy. In fact, the on-going fight over federal spending and the infamous sequestration battle of 20XX were cited by Ben Bernanke as one of the reasons for Quantitative Easing in the first place even though he knew that loose monetary policy could only do so much to counteract fiscal tightening.

How this pertains to our current situation is that even with the recent swap in Congressional leadership, U.S. fiscal deficits are projected to remain fairly narrow at 3% or less of GDP for the next decade, removing a potent source for corporate profit growth. And while they may have narrowed substantially over the years, another source for profit growth, personal savings, is already close to historic lows. In 2012, personal savings bounced back above 7% before running even higher into the end of the year as companies rushed out special dividends ahead of the change in legislation from Bush-era on lower dividend tax rates. Since then, personal savings rates have hovered between a low of 4.1% to 5.3% (October was 5%) offering little hope of further profit stimulus from this quarter.

This leaves dividends and investments to help generate the profit growth necessary for the S&P to continue advancing but with dividend payouts and share buybacks already running at 95% (or over 100% depending on the source) of trailing earnings, there’s little room left for further growth unless earnings accelerate or more debt is added to finance them. But then what capital is available for further investments? Real gross private domestic investment is already running around a 4.9% year-over-year rate of change and while that’s above the 2% lows from late 2012 and early 2013, it’s down from the 8.7% level of 4Q 2013. That only leaves net exports and with a rising dollar and falling oil prices/falling oil demand, what’s the outlook for U.S. exports except for passenger jets and military equipment?

So does that mean there’s going to be zero profit growth in the immediate future? Not at all, if just means that any growth will be more limited for the immediate future. At the close of 2013, analysts surveyed by S&P estimated 2014’s earnings would grow nearly 28%, by 9/30/14 there were estimating instead they would grow 21%. So far, the 3Q/13 to 3Q/14 growth rate has been 12.3% with Factset reporting expectations for 4Q are already declined to 3%. If earnings growth does come in that low, the full 2014 earnings for the year will be less than 9%. Depending on where we close, it’s possible than 100% of the full years return will be driven by earnings growth rather than multiple growth. Where does that leave 2015? If the trailing multiple were simple to go from the current 19.5 to 17 and earnings grow 10%, we’re nearly fully valued for 2015.

European Contrasts:

And is Europe in such a vastly better condition you ask? No, but their position in the business or sentiment cycle is much better than ours. From my point of view:

  1. ECB Commitment to Expanding the Balance Sheet: This is the key, they’ve already agreed to a $1 trillion expansion and I agree with Andrew Smithers at FT, this isn’t nearly enough. Does that mean it’ll fail? No, they will just have to keep committing to more and more programs until it works. Sound familiar? If they did just that, it would be QE 2 and QE 3 all over again.
  2. Euro Destruction: The Euro has already moved south to the tune of 10.4% since May 5th and while the Greek anxiety has some covering short Euro positions waiting for the inevitable announcement of a new backstop to send it higher, any move to expand their balance sheet while the Fed stops expanding theirs could send the Euro lower. Besides improving the short-term Euro outlook, it acts as a major boost on corporate earnings. A Reuters piece on September 5th estimated that the then 5% drop in the Euro could lift corporate earnings 3%-6%.
  3. Loosening up the belt: After years of cutting spending and raising taxes, Eurozone leaders seem to be coming to grasp with the idea that they only way they can maintain target debt-to-GDP ratio’s is to focus on growing GDP and not Germany’s fixation on belt tightening. Never having reached the deficit depths descended to by the U.S., the Eurozone aggregate deficit in 2013 was only 2.9% with only France and Spain exceeding that average for the year. While government finances are relatively stable, the on-going tepid growth of the Eurozone, when contrasted either with the U.S. or the EU nations with a free-floating currency is astounding. While it’s irresponsible to think that this will change overnight, the recent discussions of new infrastructure and stimulus funds is a marked change from the recent past either in Europe or the U.S.

So if you were to ask me why, when presented with the choice of a long-time winner that looks a little sluggish and at terrible odds or a perennially also-ran that’s fighting the trainer and offering better payouts, why wouldn’t I take that bet?

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