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Who Wants the Truth?

June 27, 2011


Good morning. The SPY finished the week down .24 (call it flat) after having some wild moves on Wednesday and Thursday. A rally early in the week culminated in a Wednesday high of 129.81, only to sell off to a Thursday low of 126.19 before bouncing back strongly (after yet another announcement of impending settlement in Greece) to a Thursday close of 128.30. Based on the strength of that bounce you might have thought the rally would continue, but you would have been mistaken, or at least early. I think a lot of us have lost count of how many times in the last few months the affairs in Greece have been the main “headline” cause for either a rally or a sell off in U.S. markets. Sure seems like a lot for a relatively small country. Is it the actual magnitude of the problem in Greece, or is it the similarity of the Grecian debt and fiscal issues with other nations in trouble that is the issue? I think the latter, and the politics and pressures being brought to bear in devising the “solution” are very important going forward.

What, in layman’s terms, is the problem in Greece (or inject Ireland, Portugal, Spain. Maybe USA)? Very simply, the Greek government has run a significant deficit for quite a while, and now that has been combined with a slow down in the Grecian economy to bring the numbers to a crisis level. Unlike the US, however, Greece is unable to expand its monetary base unilaterally (meaning just print more money), and the growing risks of Greece being unable to pay back the principal or pay interest on its debt has caused the interest on Greek debt to reach levels significantly higher than the rest of Europe (Greek debt is paying over 10% higher interest rates than corresponding rates in Germany). The risk has also caused many investors in Greece to purchase Credit Default Swaps on Greek debt as a way to insure those bonds, meaning that any “default” would put the sellers of those Swaps at risk as well. From that simple explanation we can let the vitriol roll in regards to who is at fault and who should pay for the so-called “bailout.” To the talking heads on TV the fault obviously is with the Greek way of living, maybe not working as hard as others think they should, earlier retirement than most, etc. Greek people obviously feel that they have somehow paid for those “privileges” and the fault lies with the politicians that did not safeguard the funds as well as they should have. Foreign investors, very happy with the excess returns they are receiving in Greece, feel it is up to everyone to make them whole (Greek people, German and French governments and people, maybe even US Banks and investors). Right now you can purchase a two-year out Greek note for roughly 60% of value, and those purchasers actually believe that they “deserve” every penny of 100% of value in two years.

Add to this mess the fact that many European Banks (and some US as well) are running so close to the fine line in terms of capital that if they had to write down any significant portion of their investment in either Greek government paper or affected Greek or other Bank paper they might have capital issues. So, even with this rather simple explanation of the mound of “issues” in play, it becomes impossible to use the term “bailout” without asking a lot of subsequent questions. For instance, who is bailing whom out? Are the German and French governments planning on sending funds to the Greek government so the Greek government can turn around and pay off the German and French Bank investors? Should those jumping in today at 60% of value deserve 100% of value next week on the backs of the German and French (not to mention Greek) taxpayer? Do those sellers of Credit Default Swaps (akin to selling life insurance on third parties in some instances) deserve to be insulated from their own stupidity, or did they do it with the full knowledge that they had the political connections to have “their” risk be borne by other people when the time came? If you are starting to think that there are a lot of moving parts here, you are catching on.

My brother Dan and I were heading to a reception of the Illinois Lung Association last week, and we were discussing this very issue. Dan was talking about how it did not seem that the real facts were actually getting out (with all due respect to all of you who think that the internet has been the be all and end all to the truth). I think both of us agreed that the one major casualty, despite the eventual solution, would be the truth. Can you imagine a really truthful settlement, a statement something like this? “On this day the country of Greece, without any ability or inclination to repay the debts that we have accrued as a country, will pay those holding Greek paper an average of 30 cents on the dollar in principal and no further interest. To those who have been investors through the years and have not made up in increased interest the 70% cut you are now taking we are genuinely sorry. To those who have bought in for pennies on the dollar during the crisis hoping to force the political solution where you get paid in full, or those of you selling Credit Default Swaps, we say Screw you. From this day forward we have balanced the budget, so feel free and safe buying our new stuff. Now, the German and French governments have stepped in and are covering their Banks, who have once again foolishly invested and need to be bailed out on the backs of the rest of their societies that stood to make nothing on the banks transactions (of course all Bank executives and Board members will be paid in full and held harmless). The US Treasury has stepped in and covered the CDO’s their too big to fail group have once again sold and can’t cover, so good luck with that one Tea Party People and others.” Does anyone really want to hear the truth? Instead let’s meld some mess together where no one knows who is really bailing whom, but those of us that always end up paying actually do know, don’t we? Why do we put up with it?

As I mentioned earlier, Greece and the other members of the European Economic Union cannot create additional currency on their own. That means, much like states here, there is very little “buffer” when inflows from taxes do not equal expenditures. The deficit, much like Illinois or California, is right there for all to see. We are taking in X, we are spending twice X, and we would like to borrow from somebody to make up the difference. The lack of currency flexibility, like a state in the US,  can cause rather abrupt increases in either the cost to finance (interest rates) or the actual ability to finance when it becomes obvious that the numbers do not balance.. If you can create more money, like the US or EEU as a whole, the inability to finance future debt is at least put off a while, as the interest is covered by new money and people buy into the notion (maybe foolishly) that the whole fiscal problem is temporary. I really believe that a lot of the gyrations seen in the US markets attributed to Greece, Portugal, and Spain are caused by the nervousness of those looking at the US situation (almost as bad and worsening quickly). No one want to be reminded of impending bad news.

Is there any way that this whole mess can turn out bullish? I think it could if the politicians can surprise everyone and show some leadership and imagination. The feeling is so negative towards governments in general that an upside leadership shock might actually be possible. Should someone shockingly appear (might be a Roosevelt or Churchill or Marshal around somewhere) it would not only help in Greece, but may instill some degree of confidence on issues worldwide. Right now it a broad based business as usual among politicians and those who have “bought” them. It is the German and French Banks calling on their respective political puppets to rescue their problems yet again, preferably with the Greek taxpayer on the hook, but any taxpayer is OK. Maybe we will get something better in the midst of crisis.

How do we trade it? I think we stay range bound for a while, and somehow we have to get used to trading two way moves like last week. For those in the SPY Protected Index Program we used a diagonal ratio call spread to make a profit on the short-term move last week. In that case we bought 2 of the July 1 130 calls and sold 1 of the last Friday June 24 calls for a small credit. Fortunately the market moved down fairly rapidly and the decision was to just cover the position for a profit the next day. Another choice would have been to just cover the short side and play for the bounce back rally with the longs. If it seems like we are going to be locked in this up today, down tomorrow market all predicated by overnight moves overseas we may have to go for the two way profit in the same position. Essentially it would mean locking in the break even instead of the profit and playing for the bigger return on the bounce.  It is a different way of trading, and actually fairly difficult, to play for two directions in the same position, but if we are entering a range-bound market we have to use our experience to good advantage. I will have to say that last week was probably the first ratio diagonal spread I have entered in ten years, but if that what the market gives us we will do them until they disappear. I still think, now more than ever since QEII seems to be officially winding down, that sometime soon the Treasury will encounter rising interest rates as they borrow their monthly average of over $100B per month (those Greeks must be really jealous). The problems are not going away, but the recent market slide does make rallies (even brief bear market variety rallies) more likely on any breakout of good news, no matter how short lived.

Just for information purposes, no Employment Report on the normal first Friday, delayed for a week. Also, in case fund people want to dress up some of the big caps for the quarter, you might want to think about getting short next week if some run too far. I am talking about watching for excesses in the AMZN’s and NFLX’s of the world in case it gets too overdone. Obviously they are tough to short at those levels, but if it gets there we will discuss methods next week.