Europe Hammering Out a Deal: Is the Euro in Trouble?

Europe is facing a staggering debt crisis much like what was experienced in the U.S. just a couple years ago. The problem with systemic crises that involve debt is they linger for years. Some speculate that the EU could be facing a multi-trillion dollar problem. Currently, they are uncertain on how to save ailing countries like Greece with a 1 trillion euro bailout fund known as the EFSF.

France and Germany have been in talks to lead Europe into a safe recovery landing. They are split on how to handle the problem though. France's Sarkozy would like to turn the EFSF bailout fund into a participating Euro zone bank enabling it to sop up printed money from the European Central Bank. Germany is opposed to this idea. Another suggestion was the creation of bond insurance for sovereign debt that is ready to default. Yet, many would say that insurance is only beneficial when there is not a concentration of bad debt.

So far Germany and France are calling for a 9 percent capitalization of banks and a 60 percent Greek write-down or "haircut," according to Reuters. These are steeper figures than before with 6 percent capital ratios and only a 20 percent Greek debt write-down.

This could spell disaster for the value of the euro, which is trading near $1.41 -- a very rich price considering the amount of trouble Europe is in. At that price, markets seem very complacent, or perhaps hopeful that a European bailout will fix everything like it did in the U.S. Yet, the numbers are becoming more and more drastic, and the problem seems to be more and more pervasive.

If France is under pressure of a credit downgrade, how are they supposed to be part of the solution? What's more, the U.K. wants nothing to do with any bailout. And according to a Reuters statistic, a 9 percent capital ratio, 60 percent write-down -- all else remaining equal -- there will be a bank shortfall of €257.4 billion, more than twice the projection given by the stress tests out of Europe. That equates to 67 banks failing without any intervention.

When banks fail, a lot of their assets unwind, which results in major imbalances in currency markets. Expect the euro to come back down to face reality, and even plummet with currency volatility spiking up.

Pair Trade Update; Buying NASDAQ, Selling S&P 500

In July of this year there was a good opportunity to put on a critical pair trade or spread between the NASDAQ and the S&P 500. The trade simply called for buying the NASDAQ index and selling the S&P 500. However you chose to do it was up to you and your portfolio capacity.

The results so far have been very consistent with only  5 losing days out of 73 trading days. Currently, the trade would have returned 3.58% from July 1, 2011. That doesn't seem like a lot, but it is and the results were very consistent.

Looking at the chart below it looks like the best time to make the trade again if you haven't already is when the total return since July 1 goes below 2.5%. Typically, all else remaining equal, this is a good trade to put on when the market has reached a perceived bottom and due to the recent rally we have not reached a perceived bottom but should in due time. That's because the NASDAQ moves with a faster momentum and volatility than the S&P 500 so when times are good the NASDAQ is really good, but when times are bad it's also very bad

Notice on the chart below that the peak of the trade was at September 23, 2011 with a cumulative gain of 3.88% during that time bounced off a critical level and went up a little afterward. Also notice on the trough formed on August 19, 2011 with a cumulative gain of -0.84% the market touched off the same level and bounced up again from that critical point. So for the spread trade the return will peak and trough during very volatile times in the market.

Important News

Trade Agreement With South Korea

Posted: October 3, 2011

The Key of "IC" in the ‘”DOFPIC” Mantra of Trading

The DOFPIC mantra of trading will make one successful in any form of deal-making—but especially trading. Most people know that successful trading requires discipline and other virtues such as patience but where does most of their knowledge or empowerment come from? Most of the time people find value and build virtue from outside sources as opposed from within. This is because most of the concentration or focus is centered on the logic of the trade or the quantitative side of things. "DOFPIC" is not meant to disregard that but rather balance that and also recognizing that knowledge of the truth or virtue is not necessarily what is the main thing. The main thing is that virtue is not affected by knowledge. In other words knowing this won’t necessarily change your virtue but will very much enrich your understanding of trading discipline and maintaining consistency in managing success. Do you know why? It doesn’t matter. That’s because the article is about the "IC" part of "DOFPIC". Assuming that you know about control in trading you know that the idea is not necessarily to prove a scientific fact or truth but rather to explore further to become a more sophisticated trader or business person. "DOFPIC" is a mantra that will help a trader remember and implement control and manage their trading as well as balance emotions with quantitative goals.

The key of IC in DOFPIC is impacted either externally or internally, either from outside sources or from within. The “I” and the “C” stand for independence and confidence. If you are truly independent then the confidence will come from within, this renews a cycle of the DOFPIC method, there’s a reason that DOFPIC begins with "DOFP" and ends with "IC". The whole process of this trading mentality and separating the logic from the virtue is part of human behavior that’s why "DOFPIC" becomes a mantra. You can repeat it to yourself even if you don’t know what it means; remember, knowledge is not going to affect your powerful virtue. Yet the world of trading is filtered by knowledge and information, that’s why the key of "IC" is to remain independent and if not you’ll know so and be able to find a source of power. After all, the beginning of power is recognition of its source.

If You Believe In the Luck of the Irish…

You may want to start considering investing in Ireland. Depending on your investment profile this may be the grand slam home run that your portfolio will need in the coming years.

The reason it may be a grand slam home run is because the Irish Stock Exchange (ISEQ) is deeply underappreciated. Granted, the country went through what was considered to be “the most expensive financial crisis in world history” and the country is experiencing pandemic liquidity problems alongside the other PIIGS nations which include Greece. Yet the semi-good news from Greece should be a hint that the market has bottomed for the PIIGS. 

Looking at the facts, the central bank of Ireland had to bailout the “Big 4” major banks of Ireland which include the Bank of Ireland. At the beginning of February, 2009 the Bank of Ireland ingested €3.5B in capital to maintain day-to-day operations alongside the other 3 major Irish banks. Now, the central bank of Ireland has commissioned a potential €70B in capital to the ailing banks.

Taking it into perspective, their crisis is ongoing; whereas in the U.S. people typically agree that there has been a recovery since 2010. Recall the U.S. bank bailout of major banks that were “too big to fail”. 

 

Citigroup had famously hit the tank breaking the barrier of a penny stock just like Bank of Ireland has done. Citigroup had increased five fold and garnered a market value equivalent to the amount of capital injected into it from the bailout, after an infusion of capital from the Federal Reserve. Markets like capital injections!

In the second week of February, 2009 after the central Bank of Ireland had received €3.5B do you want to guess what happened to the stock? It went up five fold. In fact, Bank of Ireland’s market value went up 29 times from trough to peak! This trough was the ultimate low that the company had experienced since its noble inception of 1783!

Of course you haven’t missed out on this once in a lifetime opportunity, if you think like a billionaire investing in Bank of Ireland would be a lifelong investment. There’s another reason you haven’t missed out though because the price has fallen to the ultimate low again of £0.12 as quoted on the London Stock Exchange.

And this time the central bank is potentially injecting 10 times what it did in February 2011 under the agreement that the “Big 4” shrink their balance sheets by the amount of capital procured; €70B. Speculatively speaking, investing in the Bank of Ireland is sheer gold especially when considering the stellar price recovery of distressed U.S. financial stocks.

Ireland’s situation is different given the austerity precept that pervades the industry now, and there may be a pledge for bank nationalization which would effectively be a government buyout of the company. The government has made a deal where they may own up to 70% of the bank. However, it wouldn’t be all too surprising to see the Bank of Ireland trading at 10 or even 20 times what it’s at now in the coming years. All emotions and speculation aside, this is a once in a lifetime opportunity to buy a stodgy bank for pennies on the dollar. Also, investing in Ireland is a very good idea.

 

UPDATE:

Bank of Ireland passes EU stress test with flying colors! They have posted a tier-1 capital ratio of over 8% which means they are well enough cushioned for adverse scenarios and would remain solvent. Currently, Bank of Ireland and Allied Irish Bank are awaiting EU clearance for more aid and they will have to remit a restructuring plan to the EU by the end of July.

Market Hinting a Bull-Flattening Cycle

The economy has recovered and just recently has been putting on the brakes, it's time to expect a bull flattening cycle in the bond markets. It's not only a secular thing that happens when the economy is in a slump it's mechanically going to happen based on the actions of the central bank.

One way to understand bull-flattening is to take the point of view of a bank who is no longer able to borrow and short-term rates and lend at longer term rates. Typically, banks are able to profit in normal bond bull markets this way, by lending at low rates and lending at higher rates. However, we are not in a typical scenario so the bond market is showing a atypical steepened scenario with the short-term rates near zero and the 30 year bond above 4%. That's very steep considering the projection for economic growth is moderate at best.

Mechanically, the central bank has implied that quantitative easing programs QE1 and QE2 have artificially steepened the yield curve.

Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points.³ Our analysis further indicates that a reduction in longer-term interest rates of this magnitude would be roughly equivalent in terms of its effect on the economy to a 40 to 120 basis point reduction in the federal funds rate. 

The last quote was pulled from the central bank testimony by chairman Ben Bernanke. Esentially, it implies that mechanically the quantitative easing has been lowering rates on an even scale. More of the long-term treasuries have been  less effected than the short-term treasuries. With that said the unwinding of these programs should continue to flatten the yield coinciding an already secular move towards a bull-flattening cycle.

A Pair Trade With NASDAQ

Looking at the hard facts as well as by smelling the sweet and sour aroma of money being made, technology companies seem to be poised to gain in this economic environment. 

Let’s assume a null scenario of the U.S. economy and make exogenous unpredictable events constant so that they do not effect our perception of the null scenario. Under our simplified economic precept we see:

• A beginning of a new economic cycle
• Aftermath of a debt crisis
• Inflationary pressures
• Distressed dollar   

We are technically undergoing a brand new economic cycle one that most likely will not be like the past three or four cycles. Experts in capital markets and the economy predict that the U.S. will experience what the Japanese have experiences for the past decade or there’s the possibility that we experience a Western Europe economic cycle. Most likely it will be a mix of the two depending on our level of productivity. Essentially, this is a top-down thesis of entrenchment that has been mentioned will be mirrored in the markets all else remaining equal.

There are also inflationary pressures which on balance have brought up the tide for technology companies via Google, Facebook, Apple, Sun Mic, Linked In, etc. What this means is there most likely will be a follow through of price appreciation assuming that this money from the lifted tide is recycled. And tech. companies have quite a desire for investments and capital markets!

Additionally, this fresh new economic cycle is coming off the heels of a pandemic debt crisis this is ongoing. Typically debt related recessions have lasting effects and so the wounds linger. Companies with a lot of debt and debt-related problems will only perform well during times of economic relief and stimulus. Simply put, a company with little to no debt has less risk and more ability to gain during duress. NASDAQ companies are ones with little to no debt on their balance sheets. That means that the NASDAQ will be better positioned to appreciate versus the S&P 500 which is more debt-laden.

Why not just buy the NASDAQ?

Even though NASDAQ tech. companies are positioned better and should do well they still hold risk. That risk includes liquidity risk and market risk. With that said, the pair trade ameliorates the risk profile of your investment because the short side negates the liquidity and market risk while still positioning for a gain.

All things remaining equal, the NASDAQ index is more volatile than the S&P 500 which means it would be best to put the trade on during perceived market bottoms. Although no one can predict the markets it’s a great way to measure into the investment because the trade does very well from the bottom going back up. Since we are bouncing off a perceived market bottom this trade is advisable now.