Who?s Fooling Whom?

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The Credit Strategist

This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist

“Recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested element of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead.”
Joseph Schumpeter1

Equity markets are exhibiting a remarkable degree of complacency. The VIX has rarely traded below 15 since the financial crisis, although it traded at an average of 13.6 during the 2004-early 2007 period. What that tells us is that the VIX is currently at extremely low levels and that it can maintain those levels for a long period of time. The recent rally is a great example of the Wall Street adage that markets climb a wall of worry. In fact, the worse things get in terms of the economic data, the higher the market goes on hopes of central bank stimulus. At this rate, the Dow will peak just as the world is coming to an end! The level of the VIX may not worry the markets but it worries me. It tells me that markets are counting on a degree of central bank support that may not be forthcoming.2

The other data point that could throw a wrench into the works is higher Treasury rates. Treasuries have sold off meaningfully over the past couple of weeks, and this morning the 10-year is back up to 1.76% and the 30-year up to 2.86% as this is being written. That is a significant move off recent lows. There are many cross-currents involved in parsing this data. Ordinarily, one would think that higher rates speak to an improving economy and/or inflation. In this case, however, rising rates are inconsistent with generally deflationary economic data (at least the “official” inflation data).

Surprisingly strong July retail sales (+0.8% versus -0.7% in June) have caught the eye of the media (and perhaps the bond market), but one month of data does not constitute a trend. The entire retail industry is experiencing an unusually competitive and paradigm-shifting phase that renders monthly data problematic as an economic barometer. In the current environment, higher rates are unlikely to impress the equity markets as a sign of economic strength or impending inflation. They might, however, cap the rally if they persist because that is what rising interest rates tend to do. But the world is still caught in a deflationary dynamic, and we do not view higher Treasury rates as the beginning of the long-expected sell-off in these certificates of confiscation.


Markets seem to be trading as though ECB purchases of Spanish and Italian debt are a done deal. Whether or not such purchases come to pass, they are merely another stopgap measure that would accomplish little. In the near term, it may lure markets into further denial, but in the long-run other such action will only further corrupt the ECB’s balance sheet. ECB President Mario Draghi has conditioned such repurchases on substantive reforms by Spain and Italy, and those countries have adopted serious fiscal and labor reforms. The problem, however – particularly in the case of Spain, which is in the midst of a true economic depression – is that the damage being incurred today is rendering the country worse off in terms of its future ability to repay its debt. Only a restructuring of Spanish debt in which creditors take haircuts will afford the country a genuine opportunity to revive and restructure its economy. Right now European authorities are merely engaging in triage when they need to undertake reconstructive surgery.

Talk of another LTRO is even more delusional since that program merely strengthened the link between sovereigns and their banks and added more debt to mountains of debt that can never be repaid. One rumor that has been circulating, and is likely to come to pass, is that the ECB will extend the maturity on existing LTRO loans from three to five years. Whether a term extension is done now or later, it is inevitable since few if any of the Spanish and Italian banks who borrowed from the LTRO will be in a position to repay these 1% loans after three years of recession/depression.

Some observers have written in the Financial Times and elsewhere that Mario Draghi’s huffing and puffing has laid the groundwork for Europe’s troubled countries to regain credibility.3 We have heard such promises too many times before to believe them. It is entirely possible that short-term events may shape up in a manner that will provide traders with an opportunity to profit, but the current policy path (even were Mr. Draghi to accomplish all of his goals, which is highly unlikely) will never fix what ails Europe. There is too much debt and too much intellectual and ideological detritus to overcome. Hedge funds abandoning their short euro trades are succumbing to the structural realities of their business (month-to-month performance reporting, potential investor withdrawals) at the cost of the high probability if not certainty of substantial long-term gains. Those who stay the course will be happy that they did. It took not only the 13 years since the European Union came into existence but the decades of intellectual debate and political maneuvering that preceded it to create the economic monstrosity that is inflicting untold damage on Europe today. It is unduly optimistic to believe that the Band-Aids being applied to this gaping wound will stanch the bleeding.

Technology stocks

Equity valuation is another form of money of the mind. While Wall Street invests an enormous amount of intellectual and marketing energy trying to justifying valuations, in the end the value of a stock is nothing more or less than what the market believes it to be. The market is as much a psychological as a computational mechanism, and therefore shares a strong element of the irrational, as all psychological (i.e. human) systems do. Nowhere is this better illustrated by comparing today’s valuations of large technology stock with their valuations at the height of the Internet Bubble. Buyers of Treasury bonds should take special note of this discussion.

Fred Hickey, editor of The High Tech Strategist, called attention to this phenomenon in the most recent issue of his invaluable newsletter. Mr. Hickey points out that while Apple Inc. (AAPL) has gained more than $500 billion of value over the last decade, Cisco Systems Inc. (CSCO) has lost $490 billion over the same period and is currently trading slightly above its 2002 low. Hewlett-Packard Co. (HPQ) stock is 86% lower today than its 2000 high; Dell Inc. (DELL) is 34% lower than its high, and its current market cap of $20 billion is 87% lower than its 2000 peak of $154 billion. Nokia (NOK) has lost 97% of its 2000 peak value of $289 billion; Alcatel-Lucent (ALU) has shed 99.3% of the combined $358 billion valuation of Alcatel and Lucent in 2000; Ericsson’s (ERIC) $30 billion valuation is 85% below its 2000 high; and JDS Uniphase’s $2.2 billion valuation is 98% lower than its 2000 valuation of $115 billion. Looking at a stock much in the news today, Yahoo! Inc. has lost 85% of its 2000 value, when it was a $100 billion stock (which we called ridiculous at the time). Finally, at their 2000 highs, the combined value of Intel Corp. (INTC) and Microsoft Corp. (MSFT) stocks was $1.1 trillion; today it is $375 billion and Microsoft is considered a value stock by many investors. These comparisons not only illustrate the extent of overvaluation that occurred during the Internet Bubble and the magnitude of investor losses, but the fact that it can take years for valuations to recover. In many cases, they will never come close to retracing their highs.

1. Douglas V. Brown, The Economics of the Recovery Program (New York: McGraw-Hill, 1934), reprinted in Joseph Schumpeter, Essays: On Entrepreneurs, Innovations, Business Cycles, and the Evolution of Capitalism (New York: Transaction Publishers, 1989).

2. Surprisingly strong retail sales in July further – although only marginally since it is only one month of data – reduce the odds of QE3 in the United States. As we have written before, QE3 would be a mistake. We do not expect Chairman Bernanke and his colleagues to act prior to the election in any event.

3. See, for example, Jerome Booth, “Europe must seize the day now that Draghi has acted,” Financial Times, August 8, 2012, p. 18.