Treat the Disease, Not the Symptoms

Good Evening: U.S. stocks retreated for the fourth time in five days on Wednesday as our capital markets struggled to digest both ill-advised trading policies out of Germany and weak economic statistics back home. The hopes that waxed so high last week that the massive EU rescue package would solve Europe’s debt problems are starting to wane. It seems that the more EU politicians attempt to build confidence, the more they undermine it. Similar hopes for a recovery in U.S. housing were also dealt a blow today when, despite our government’s best intentions to prevent home foreclosures, the U.S. foreclosure rate hit a new high. The tie that binds these debt-related stories together is that leaders around the world keep trying to treat the symptoms of over-indebtedness but not the disease itself.

Germany announced yesterday a decision to restrict various forms of short-selling that it deems harmful to its markets (see below). What was interesting about this attempt to echo what American authorities did with an outright short-selling ban after Lehman vaporized is that it had the unintended consequence of reminding investors of those panic-filled days in 2008. Unleashing the type of uncertainty and volatility that harms markets is a poor way to protect investors. Doing so unilaterally, and without the cooperation of other EU nations, only highlights the lack of unity behind the brave front the EU has tried to portray since Greece first ignited.

I’m sure German politics played a role in their decision to shoot the messengers of lower prices (short-sellers, a.k.a. capitalists), but it further underscores my point about fissures within the EU. It’s no surprise that prudent citizens in Germany are uncomfortable with the notion of bailing out their reckless neighbors in Athens and elsewhere. As the Stratfor article below points out, history works against those who believe people residing in the EU will shed their national identities for the good of greater Europe. Forming a super-state is tough to do during tranquil times, let alone when folks like the Greeks come bearing gifts of bills they can’t pay.

This latest display of disharmony in Europe saw most markets sink along with risk appetites overnight. Good earnings news from Hewlett-Packard and others helped stem the tide of red ink somewhat, but the major U.S. stock indexes drifted lower after testing the unchanged mark shortly after opening. Those looking for global debt problems to lead to deflation pointed to a negative CPI (which followed yesterday’s negative PPI reading) and a falling global equity markets as further evidence another equity crash might be in the offing. Their case was seemingly buttressed when mortgage both mortgage delinquencies and home foreclosures set new highs for the cycle this morning (see below). I’m of the opinion that the annoyingly named “flash crash” of two weeks ago makes another one less likely in the near term, but anything could happen if the May lows are decisively breached.

I think it’s more likely that the weakness we have experienced during the last five sessions is simply a retest of the May lows. The S&P 500, for example, held firm at 1100 today, a level which also represents its 200 day moving average. Bouncing off this area of support just before lunchtime, the S&P then led a subdued rally for most of the rest of the session. The 0.5% loss posted by the S&P was the best performance among the indexes, while the Russell 2000 (-1.25%) fared the worst. Treasurys, which had been sought overnight, actually sank as yields rose between 2 and 6 bps. The dollar index also retreated in the face of short-covering in the euro currency, finishing down 1.4% today. The CRB index took a hit even though crude oil was strong. A clubbing in the metals complex trimmed the CRB by 0.9%.

Just as notable as the curious internal divergence within the CRB is the sudden breakdown in what had been fairly dependable correlations of late. Stocks and bonds moved together today; the move away from the dollar was hardly universal (the Canadian and Aussie dollars were hit hard); and commodities all sang from different pages in the songbook. What these disparities in trading patterns means in terms of market direction isn’t knowable, but correlations often break down when a trend change is at hand. We could therefore be close to an inflection point where stocks either nicely recover or sink a lot further. I’m leaning toward the former because the gloom and doom chatter is so pervasive, but it does not pay to be dogmatic in this environment.

The reason the market backdrop is so fragile all over the world is debt, a term which is rising in the rankings of four letter words. When Alan Greenspan’s repeated dousings of market brushfires with ever lower interest rates led to the widespread belief in the “Greenspan put” during the 1990’s, individuals and businesses felt comfortable taking on more leverage. Fast forward to 2007 and the resulting excessive borrowings were most evident (and most dangerous) when it came to U.S. mortgages and Wall Street balance sheets. That overly burdened mortgagees and bank leverage ratios of 30 to 1 or more would cause major problems was virtually guaranteed. What was harder to predict was how all the unsupportable debt would be unwound.

It hasn’t been unwound; the burden for paying it back has simply been shifted. From 2007 to 2009, our government tried everything from lower interest rates and economic stimulus to mortgage modifications and an alphabet soup of lending arrangements cum capital injections. What all these so-called “solutions” had in common was that they treated the problem of too much underlying debt as a liquidity issue. But illiquidity was a symptom of too much borrowing gone bad, not the debt disease itself. Much like the EU’s rescue plan for southern Europe, or Germany’s ban on certain types of short-selling, most of the politically expedient solutions offered up around the world since 2007 have been targeting the wrong problem. Debt, not illiquidity, is the real problem. And the results are plain to see. Many private sector obligations have been absorbed by public sector entities. We keep trying to solve a debt problem by taking on more debt.

Fannie & Freddie, GM & Chrysler, AIG & the banks — all of them have turned to either the Fed or the Federal government for some form of aid for their burgeoning debt loads. Just as Northern Rock & RBS turned to the BOE and the British government, UBS sought help from the SNB and Swiss government. Now Greece & other PIIGS need help from the ECB and EU in order to prevent European banks from having to do the same. Japan has been applying versions of the same strategy for the better part of two decades and their national debt burden has only grown. What unites them all is the desire of each sovereign entity to take on these massive obligations while using Quantitative Easing as a mechanism to help fund them.

As we saw 14 months ago in the U.S., QE can work in the short run to buy some time. It can’t work in the long run because global creditors will eventually withdraw, interest rates will rise, and the printing presses will be forced to shut down. Currency volatility and even runs on certain currencies are all but a given. We and other developed nations need to use this time wisely to treat the underlying disease. We need to make the tough choices now and whittle down our debt burdens while we can still voluntarily do so. Let’s not wait for Mr. Market to force an even bigger crisis upon us.

— Jack McHugh

U.S. Stocks Drop on German Trading Restrictions, Foreclosures
Merkel’s ‘Moralistic Hysteria’ Ban Unsettles Debt, Currencies
Mortgage Foreclosures Hit Record as Job Losses Strain Budgets
Europe, Nationalism and Shared Fate

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