Worst one-day performance since July 2009 due to fears of credit risk contagion

2010-02-04

 

Stock market lesson:

Do not underestimate the ripple effect of something bad that happens at a seemingly small scale, because investors can extrapolate and magnify the problem to the point that it becomes a systemic risk.

How to invest:

Assuming that someone believes the thesis below, the investor might short European stock market indices, especially those of the weaker countries, e.g., Greece, Spain, Portugal, Italy, whose economies will have to correct (shrink) before they can form a sustainable base for recovery.  Index investing may be particularly relevant for many investors that do not have specific-country or industry knowledge but simply want to play a theme.  ETF funds can be found on the iShares website.

Today, the US market had its largest one-day drop since July 2009.  Market indices in some European countries had one-day drops reminiscent of the fall 2008 crisis, e.g., the Spanish market was down 8%.  And the Euro dropped to its lowest level in 8 months against the Dollar at $1.367 USD per Euro.  All this because of debt headaches in Greece!  Skeptics question that Greece can really have such an impact on the global markets.  After all, its economy is only $350bn (which has been eclipsed by mounting debt of $440bn).

So, how does this market correction make sense?  Greece is in a very tough spot: its economy has become non-competitive after years of low Euro interest rates that translated to rising labor costs in Greece.  In order to correct the imbalances, wages have to come down.  This means that spending will come down, the economy will contract, and asset values will decline.  In sum, the Greek economy has to shrink in order to become competitive again.  The market mechanism for correcting such fundamental economic imbalances is for a currency to depreciate against other countries, but Greece does not have an independent currency.  Therefore, contraction seems inevitable.  However, Greece also has Euro 30bn of debt that it needs to refinance by May 2010.  Who will backstop Greece, a shrinking economy with budget deficits?  Investment funds are currently taking the short side of the bet, purchasing credit default swaps against Greece's sovereign debt, which will pay off in the case that Greece defaults on its debt (primarily, if it stops making contractual payments).

Someone has to step up, and with the way sovereign credit default swaps and interest rates are trending, it looks like investors may be losing their appetite.  The options will eventually be to either leave the Eurozone or get bailed out by Germany and France.  The latter is the much more likely option, but politically it is very difficult.  Still, it's the medicine that the Eurozone will have to take.  However, the buck doesn't stop there.  Other economies with similar symptoms include Spain, Portugal, and Italy.  It is very likely that the rest of the Europeans will have to foot the bill for the rest of the Mediterranean EU members.  Overall, this burden and the required regional contraction is contagious and will most likely hold back Europe for a prolonged period of time.  Given how globalized the economy has become, an EU contraction can have a significant negative impact to the US and other countries.  This syllogism explains the seemingly overreaction of the markets.

Why did this happen today?  The biggest union in Greece approved the second mass strike this month and tax collectors went on a 2-day walkout, indicating that the proposed plan by the government is getting pinched on both sides: cutting labor costs and collecting more taxes.

The Dow was down 268 points (261 bps), the S&P500 was off 34 points (311 bps), and the Nasdaq dropped 65 points (299 bps).  The worst-performing sectors were materials and energy (commodities, which react negatively to a global slowdown because there will be slower demand pickup), and financials (because their survival and capital adequacy rely on inflation at this point, which comes to question when economies have to shrink first).  Interestingly, US banks suffered more than most Greek banks: you can buy JP Morgan at a price below book value and 6-7x 2011 earnings, while the Agricultural Bank of Greece trades at a high premium to book value, more than 10x 2011 earnings (which most likely will have to be revised lower), and will not make money in 2010.

The cherry on top of the cake was the disappointing unemployment claims number, which was 480K in the Jan 30 week, compared to an expected improvement from the prior week's 470K to 455K.  The actual number actually exceeded the high end of the consensus range of 440-475K.

 

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