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Greece Is The Word

Greece Is The Word
It has been a pretty wild ride in the markets since mid January. The January effect was in full force when bankers got wind of new regulations being imposed upon them, and the market sold off.

Just as that was being digested and the stock market entered into a rally, word leaked of problems in the Greek economy that might cause them to default on their sovereign debt. That brought up concerns about other weak European economies and Goldman Sachs developed the acronym PIIGS (Portugal, Italy, Ireland, Greece, Spain) to identify those European economies that were significantly outside the deficit guidelines for the Euro-zone.

Fears of sovereign debt defaults sent traders fleeing from risk-assets into treasury bonds, from Euro-denominated investments into dollar denominated investments, and the markets sold off in a second leg down.

Given that we have had our first failed rally since last July’s pullback, I’ve spent the past few days reviewing the various markets fundamentals and technicals to get a feel for where we are today and where we are headed.

Systemic Risk

One of the issues we had in the Fall of 2008 is that the entire worldwide financial system was in peril from the subprime mortgage debacle. We follow an indicator that has a pretty solid track record of indicating problems in the financial system that can lead to crashes: the TED Spread


The TED Spread represents the price difference between three-month futures contracts for U.S. Treasuries and three-month contracts for Eurodollars having identical expiration months. We use it as an indicator of credit risk because U.S. T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers. As the Ted Spread increases, default risk is considered to be increasing, and investors will have a preference for safe investments (like U.S. Treasuries) As the spread decreases, the default risk is considered to be decreasing and investors are willing to assume the risk associated with investing in corporate assets (equities and fixed income).

As you can see on the chart, in the Summer of 2007, the TED Spread spiked up from its normal level around 25. For clients that remember that time, we completely got out of our positions in the financial industry (stocks and bonds) based upon our experience with the TED Spread and the 1987 stock market crash and the fact that we were telling you about a little known issue that was bothering us, subprime mortgages. A jump in the TED Spread always indicates a problem in the financial system, and that combined with a mortgage problem meant to us that banks and brokers were likely going to see problematic times ahead (little did we imagine we were being the kings of understatement at that point).

That move turned out to be a wise one, but the big spike on the chart up to 475 that coincided with the bankruptcy of Lehman Brothers preceded the crash in the Fall of 2008. All asset classes, other than U. S. Treasuries, fell in concert. However, you can see that the TED Spread is back to its normal level of 25, indicating that the world’s financial system is healthy and dealing with the challenges. Based upon this indicator of systemic risk, the current correction pattern in the market is a normal part of the ebb and flow and not a return to market levels during the crash. Don’t get me wrong, a 10% or 15% correction is not fun – but it can be a healthy part of a recovering market that can allow new money to get in that had been sitting on the sides and push it index up to our target level of 1,250, or the level of the S&P 500 immediately prior to the Lehman Brothers crash.


I had previously written that I thought we were likely in a range bound market, but that the upper end of that range would likely prove to be 1,250 during 2010. I still think this is the case because the liquidity that has been pushing the market higher is not going to end, in spite of the jaw boning from the Federal Reserve. The Fed is very worried about the high level of unemployment and they will not do anything to increase it. They understand that raising interest rates is completely out of the question and they won’t consider it until the fourth quarter at the earliest – in fact, when they discuss ending the easy monetary policy they have been employing, raising rates is not even in the discussion notes. It’s always ending their quantitative easing program – another name for printing money by purchasing Treasury securities. In my opinion, they will be unable to do that because our Treasury will have to continue to issue Treasury Notes and Bonds to fund our deficit. The Fed has been the buyer of last resort in many of the recent Treasury auctions, which coincided nicely with the need to stimulate the economy.

Now that they may want to comfort the people that are afraid of potential inflation from too much monetary stimulus, they are talking a good game about ending quantitative easing, but the reality is they will not be able to do it. They may be able to employ a bit of bate and switch as we’ve seen in the past few months – they have bought shaky mortgage securities from China in exchange for China agreeing to buy Treasury securities. It’s a winner for China as they unload questionable mortgage bonds in exchange for Treasury Bonds, it’s a winner for the Treasury Department as their auction gets subscribed, it’s a winner for the investment markets as liquidity keeps flowing into the market, however the Fed ends up with lower rated securities as part of its balance sheet.

I’d look for the market to continue to bounce around as it tries to figure out the problems with the PIIGS, but that once that is determined to not be the next Lehman Brothers (if it was, the TED Spread would be telling us that it was), the market should move back toward its pre-correction levels – and eventually move up to the upper end of our trading range at 1,250.


The bond market has been in an upward trend as the stock market has been in a correction phase. This is mostly due to the problems with the PIIGS and their sovereign debt, but it is very likely temporary. Look at things from this perspective: if the Fed does in fact stop their quantitative easing program, interest rates will have to go up to attract foreign buyers to fund our deficit; If quantitative easing continues and the Fed stimulates too much causing a bout of inflation, interest rates will go up. In either scenario, bonds go down in value.

Once the current worries about the PIIGS subsides and investors move away from the historic safety of the dollar and Treasury securities, bonds will move back to early January levels and eventually much lower. This is a good time to buy Treasury Inflation Protection Securities as the rest of the bond market is strong. As interest rates move higher, TIPS will react positively to rising inflation.

The Dollar

The Dollar is reacting to the problems with the PIIGS as investors sell Euros and buy Dollars. This is temporary. Let me say this again – this is temporary. Our economy, with record deficits and borrowings, does not support a higher dollar. The European Central Bank is trying to force the PIIGS to swallow their medicine and get their deficits under control. Short-term, this is negative for the Euro as the pain is being inflicted instead of being kicked down the road as it is in our country. Intermediate- and long-term, this is positive for the Euro. So, the current situation can only be viewed as a good buying opportunity for emerging markets’ equity and debt.


The strong dollar is pulling money from gold, oil, and industrial metals. The TED Spread shows us that systemic risk is at normal levels, which combined with a slowly improving world economy, means that demand will again eventually outstrip supply. Any weakness in commodities can be viewed as a buying opportunity for a strengthening world economy.

Strategy Impact

I’ve written that we have had a number of stop loss orders fill during the current sell off. I have not yet begun to add new positions as we need to determine if any rally, like the nice 1.5% rally today, has legs that will take it back to early January levels. I’ll be discussing that on our blog and will let you know when we start initiating positions – I’m looking at industrial chemicals and Canadian stocks, which have shown impressive relative strength recently.

But looking at the charts I think we can move back to the 1,150 level of early January but we will probably test the 200 day moving average – the bottom end of our trading range for the market – at some point before we run up to the upper end of the trading range at 1,250.

If the market shows us that we can get a rally with legs, we will be adding equity positions (probably in industrial chemicals and Canadian stocks, and other areas that we’ll determine as we move along) but add new stop losses to holdings in weaker areas of the market in case we do move back down for some reason toward the lower end of our trading range at the 200 day moving average.

Your trivia for tonight is to tell me what future star of the movie Good Fellas was a compatriot of the singer in the video above in his early years in the music business.