A bad week in the markets; where are we headed next?

By Edward Harrison On Jun 4, 2010

I’m going to make a change to the week in review post and talk a little bit about the week that was and how the posts from the past week fit into those events. This was a big week of posting and all of the links in this post are from the last week’s posts or related articles in the archives.

Long story short, I am very concerned about a double dip and the data from this week do not present an improving global economic picture.

Bad end to the week

Let’s start off with the obvious. It was a terrible week in the US, where the market lost 2%, marking a fourth weekly loss in six and taking the Dow Jones Industrial Average below that bizarrely mythical 10,000 figure. The week ended on an especially poor note, with losses in excess of 3% because of a surprisingly weak jobs report. After the markets closed, I noted that the Consumer Metrics Institute Personal Finance Index continues to deteriorate as does the ECRI Leading Economic Index, which hit a 43-week low. Consumer Metrics data even suggests double dip could come this year. Moreover, John Lounsbury revealed that Mortgage Applications have plummeted. Some of the numbers look good right now, especially in manufacturing. But this is not a normal recovery and it is definitely losing steam in the US. I highly recommend reading the Ray Dalio piece which takes a deflationary view for just that reason.

Meanwhile, contagion in the European sovereign debt crisis moved to Eastern Europe. In an admission reminiscent of Greece, Hungarian Prime Minister Viktor Orban’s spokesman Peter Szijjarto admitted the previous government had falsified economic data. The Hungarian central bank tried to reassure investors that the country’s budget was sustainable. But, Hungary quickly moved into the list of sovereigns with the highest default probability and both the Hungarian Forint and the Euro tanked on the news. The Euro now trades just below 1.20 to the US Dollar.

While some poor translations of the French Prime Ministers comments on the exchange rate led to the initial Euro weakness, the Euro remains un able to sustain rallies and it was the situation in Hungary which triggered the move below 1.20. In my view, the situation in Hungary is serious. My bearish view on Eastern Europe has not changed because of the global recovery. As I said when the sovereign debt crisis erupted in Dubai in November:

I continue to be more concerned about Eastern Europe than I am about Dubai. Yes, there could be a butterfly effect with Dubai here but contagion risk is more acute in Eastern Europe where large banks have much greater exposure than in Dubai. I see Dubai as Buiter does – a tempest in a tea pot; the real action is in Europe.

The exposure in Austria and Switzerland means that a debt default, currency devaluation and private debt defaults in Hungary would spread quickly via interlocking banking relationships. As with Greece, if the situation does not stabilize, the crisis will quickly spread throughout Europe.

Spain Started This

Frankly, I see the situation in Hungary as simply a further spread of events that had already built up elsewhere. It started in Dubai, moved to Greece and then stopped in Spain. It was in Spain where things were most dire earlier in the week. It started last week when the CajaSur nationalization made fragility of Spain’s banks topical. By the middle of the week, reports that even Santander was having trouble raising cash in the CD market had surfaced. Nevertheless, the political dithering continued as Spain barely approved austerity.

So last weekend Spain lost its AAA rating from Fitch, with more downgrades to come. At the beginning of the week, Edward Hugh then wrote a post Whither Spain – Towards Finland or Argentina? which outlined the dire choices Spain faced with two specific historical examples. But it is not clear the Spanish have the desire to see this through. That had Marc Chandler writing "Spanish Cajas Merging, but Are They Serious Yet?" The answer is no and the post Unemployed Down in Spain but Black Market a Problem for Austerity makes this clear. I fully expect Spain to continue to be under pressure going forward

BP situation

Switching gears to the environmental disaster in the Gulf of Mexico, last weekend I wrote a number of posts about the BP Deep Horizon oil spill: The first showed the Deepwater Horizon Gulf Oil Live Video. The second was a PBS video chronicling how Gulf Coast industries were being crushed by the Deepwater Horizon catastrophe. The most interesting post was the one showing the parallels between a 1979 Ixtoc I disaster and the Deepwater Horizon catastrophe. It’s as if we hadn’t learned anything in 31 years. To understand why companies like BP take the risks read How BP’s Deepwater Horizon oil find was originally reported in September 2009 which shows a similar project which uncovered one of the biggest oil fields in US history just last year. And it was also probed by the same Deepwater Horizon rig. As of today, it looks like the oil spill is getting bigger, with brown clumps already having made the beach in Pensacola, FL. Here’s a wind-up from an old BP campaign that has now has unfortunate double entendre (BP: We’re bringing oil to America’s shores). Read some of my links posts for a lot more stories.

Revisiting Macro

So where does all of this turmoil leave us from a macro perspective? I tried to get at this with What If It’s All A Lie? which asked what would happen if we did actually double dip. In such a scenario, I see a distinct possibility that the bailouts will then be seen to have been a failure and a waste of taxpayer money. My conclusion is that the Obama Administration had better do more to avoid this outcome. Likely, this would involve more stimulus, money printing and bailouts in an effort to reflate the financial insurance and real estate sectors.

But, take a look at what Marc Faber says in the hour-long video in Marc Faber: Mirror, Mirror on the Wall, When is the Next AIG to Fall? He thinks this recipe is doomed and gives you the more Austrian view of things.

Technology and Stocks

As for other topics I covered last week, the big thing was technology with a fun video on the iPad and Velcro that counterbalanced my Apple is screwing it up invective. Also see the Steve Jobs (Apple) and Mark Zuckerberg (Facebook) videos from the D8 Technology conference. Very good stuff. As Apple became the largest tech company by market capitalization, I have to agree with the downbeat sentiments in Casey Research’s Is Apple Ripe to Pick for a Short? Apple is significantly overvalued, but i don’t expect this to change anytime soon as long as they remain a market darling. Remember when eBay could do no wrong? Even former hot stocks Krispy Kreme and Starbucks got the same kid gloves treatment as long as they outperformed. If you tried shorting those stocks in their heyday, you lost a lot of money. It is only when you get a series of earnings misses that the bloom comes off the rose and the P/E ratio comes down to earth.

On the market overall, P/E ratios also look stretched as do profit margins. and since these variables are mean-reverting, I see low returns over the next decade. Fred Sheehan’s Should Investors Boycott the Stock Market? takes another bearish angle on the market. And to round out the bearish trifecta, read Hugh Hendry: Eclectica Fund Management Commentary, May 2010.

Gold Rush

The other odds and ends I recommend are:

Clearly, Gold is not a fiat currency because the definition of fiat is a currency whose value is unrelated to the value of any physical quantity i.e. something that can be produced by government fiat in unlimited quantities. My argument in favour of gold and any other hard asset is that governments will look to inflate their debts away by printing money since they can do so with a few clicks of a mouse via their electronic printing press.

bubble psychology is forming. But gold has a lot further to run as long – especially because the EU has joined the other central bankers in printing money. You knew we had a fiat problem when the Swiss went QE and are now attempting to manipulate their currency downwards.

As far as hard assets go, gold is not the only game in town. It is not even the only precious metal. Marc Faber talks about farmland. Platinum, silver and palladium all have good industrial uses as well and are alternatives. However, I am wary of paper gold via ETFs because I anticipate those funds without enough physical backing will run into problems.

And remember, even in a deflationary environment, hard assets are a good hedge. That was certainly the case in the 1930s. Just today, gold was up even as the Ten-Year rallied 18 basis points.

That’s it. Please feel free to comment.

PS. Definitely check out my TV session on RTTV with Max Keiser. I thought it was a good show.

Edward