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Solving the Eurozone bank problem might not be very expensive


Reader "brodero" points to a website that generates this graph. I can't vouch for its accuracy or completeness, but it tells a pretty interesting—and very optimistic—story about how easy it should be to fix the Eurozone sovereign debt crisis.

The values I've selected above roughly reflect the current prices of PIIGS debt. For example, Greek debt is trading at about 60-65 cents on the dollar; assuming that is a "fair" price, then in a restructuring, debtors could expect to get a "haircut" on their Greek debt holdings of about 64%. The other haircuts I've selected are also in line with current market pricing of each countries' debt. For Ireland, however, I've selected a zero haircut, since I think Ireland is well on the way to emerging from this problem intact, via a very aggressive and successful austerity program. Bottom line, if all PIIGS' debt were restructured in line with current market pricing, then Eurozone banks would need a capital infusion of $135 billion or so in order to remain in compliance with a 7% Tier 1 capital ratio. If the required ratio is 8%, then the additional capital needed would rise to $225 billion. These are big numbers, but $225 billion is less than 2% of Eurozone GDP. That's a drop in the Eurozone GDP bucket, and it shouldn't be too hard to come up with that much money in order to resolve a debt crisis that otherwise threatens to bring down the entire global economy, should it?

If this calculator is accurate, then the only way of understanding why there is so much angst in the markets is to assume that markets are pricing in a cascading series of defaults that become far worse than current market pricing of PIIGS' debt assumes. That's not impossible, of course, but once again we see that the level of fear and pessimism that is impacting market psychology is extreme, to say the least.

Jobs increase more than expected


The September jobs report was much better than expected, and upward revisions to past data wiped out the much-touted "zero" jobs number that was reported last month. But the best that can be said for private sector jobs is that they are growing at the rate of about 1% a month, and that's not enough to bring the unemployment rate down (it remained at 9.1%), nor is it enough to make anyone excited. But at least it refutes (as have lots of numbers of late) any notion that the economy is slipping into another recession.

Private sector jobs rose by 137K (vs. the 90K expected), according to the establishment survey. The household survey, in contrast, reported a very large addition of 412K jobs—which in the chart above you can see is basically "payback" for very large job losses in prior months. When you abstract from the monthly noise in both these series, you end up with growth that has been running somewhere in a annualized range of 0.7% to 1.4%. Call it 1.0%, or about 120K per month over the past two years. Not impressive, but nothing like a recession.


This chart shows that one of the healthiest features of this recovery continues: the public sector continues to lose jobs—about 600K since the recovery began. This is the most extended and the largest decline of public sector jobs since the 1980-82 recession. It is contributing to the unusually high and sticky unemployment rate, of course, but this is a good problem to have since the public sector had grown like Topsy in the years leading up to the last recession and needed to be cut back. A smaller public sector will eventually make it easier for the more-efficient private sector to grow.

Given the degree of pessimism embedded in the market (see yesterday's post for the gruesome details), today's jobs report should equate to a sizable positive shock. It shows the economy is still on a sustainable growth path, and growth is an important source of stability when the solvency of large borrowers (i.e., the PIIGS) is in question. The world as we know it is not even close to coming to an end.

Panic update

The Eurozone sovereign debt crisis has struck great fear and trembling into the hearts of investors around the world for the past several months. Fearful that defaults could lead to bank failures, and bank failures to a global financial market collapse, and financial collapse to another global recession or even depression, investors have been willing to pay almost any price to escape the consequences of what might prove to be the "end of the world as we know it." Following is a quick recap of how the key U.S. indicators of investor panic stand at the moment. Bottom line: fear remains intense, but there are some preliminary indicators that conditions are no longer deteriorating.


Yields on 3-mo. T-bill have fallen to zero. Investors are willing to accept no return on their money in exchange for acquiring the world-class safety of T-bills. The last time this happened was at the end of 2008 when risk-aversion was at extremely high levels and the world was braced for a massive depression.


Yields on 10-yr Treasuries have fallen to their lowest level on record, lower even than the lowest yields in the time of the Great Depression, and lower even than the terrible lows that occurred at the end of 2008, when there was a widespread perception that a global calamity was in the making. Yields this low only make sense if you expect the future growth prospects of the U.S. economy to be downright grim, if not totally depressing. It is somewhat encouraging, however, to see that yields have appeared to stabilize in the past few weeks.


As I explained last month, it appears that about $400 billion of deposits fled the Eurozone banking system in favor of the U.S. banking system beginning in mid-June. The good news, as shown in this chart, is that this apparent run on Euro banks has run its course. M2 surged at an unprecedented annualized pace of as much as 40% in early August, but over the past four weeks, M2 growth has settled back down to a mere 4.6%.


Corporate bonds have been victims of massive, indiscriminate selling which has driven option-adjusted credit spreads to levels only seen during times of outright economic recession. Since there are no signs yet of a recession, much less of any rise in corporate default rates, this is just one more sign of how markets have panicked. In effect, the bond market is pricing in a pretty serious recession. Whether that proves to be the case is the key issue for investors today. If the economy manages to avoid a recession, corporate bonds offer extremely attractive risk/reward characteristics and very substantial yields—the current yield on HYG (a popular indexed high-yield bond portfolio), for example, is 7.75%.



The forward PE ratio on the S&P 500, shown in the above chart (i.e., current prices divided by one-year forward consensus earnings estimates) has plunged from almost 14 to just under 11, a decline of over 20% in the amount investors are willing to pay for a dollar of future earnings. This ratio was a just under 10 at the height of the Lehman panic in Oct. '08, and it is a bit higher today than it was at the stock market bottom of Mar. '09. This, despite the fact that corporate profits today are at all-time record highs in real, nominal, and GDP-relative returns, having more than doubled from their year-end 2008 levels. This therefore represents an extreme degree of pessimism in regards the future, with the market essentially forecasting not only a recession/depression, but a monster collapse in corporate profits. As with corporate bonds, if the economy experiences anything short of a major recession, equities offer extremely attractive risk/reward characteristics. The current earnings yield on the S&P 500, for example, is 7.8%.



Gold is sharply off its recent high, having fallen $300/oz. last month. But looked at from a long-term perspective, gold appears to be following a constant upward growth rate averaging about 20% per year over the past 10 years. Commodities have also suffered a correction of late, but they remain at very elevated levels from a long-term perspective. The recent corrections in gold and commodity prices undoubtedly reflect liquidation of speculative positions, as speculators "pull in their horns" faced with the sudden onset of deep uncertainty about the monetary, financial, and economic growth fundamentals. When investors rush for the T-bill exits, not many speculators are willing to hold on to leveraged positions at historically high prices.

Wrapping things up, what we are witnessing today is nothing short of a mass and extreme panic. Prices and expectations have reached historically extreme levels which have rarely been seen in the past. That's the bad news. The good news is that given the extreme degree of pessimism and panic that has been priced into the market, we can reason that it would probably take an outright catastrophe—something like the collapse of Western civilization—to not only vindicate the market's fears, but to reward those who currently stand on the bearish side of expectations. With that said, I remain comfortably on the side of the optimists because I can't bring myself to believe in, or speculate on, the end of the world as we know it. There are a lot of unknowns surrounding the Eurozone debt crisis, but there are also many things that can be done to avert a catastrophe. I don't think this is the time to throw in the towel.

UPDATE: According to Mervyn King, Governor of the Bank England, "This is the most serious financial crisis we’ve seen, at least since the 1930s, if not ever. We’re having to deal with very unusual circumstances, but to act calmly to this and to do the right thing." If there's any comfort after hearing those words, it's that the market seems to have already figured this out.

Eurozone crisis update


This chart remains one of the most important ones to follow these days. It compares the level of 2-yr swap spreads in the U.S. with those in the Eurozone. U.S. swap spreads are still within the range of what is considered "normal," but Eurozone swap spreads remain dangerously high. Spreads of almost 100 bps mean that the Eurozone financial system and economy are exposed to an unusually high level of risk, because the market demands an unusually high premium for accepting counterparty risk in a swap transaction. The U.S. economy is not really suffering from any systemic problems, but the market worries that there could be some contagion from Europe. So we see caution in the U.S., but real fear in the Eurozone.


It may not seem like much, but I think it is important to note that Eurozone swap spreads have been relatively stable for the past month, as shown in this second chart. The first step towards turning around the escalating sovereign debt default situation is stabilizing things, and that may be what is happening. The ECB is stepping up its efforts to backstop the banking system, and national governments are pushing for bank recapitalizations. Austerity measures have been implemented quite successfully in Ireland, but they are still facing an uphill battle in other countries.

If we are to avoid an end-of-the-world-as-we-know-it scenario, then we will need to see some combination of aggressive measures on the part of the ECB, aggressive measures to recapitalize banks, aggressive and credible measures to curtail government spending, and most likely some form of controlled default or restructuring of Greek debt. If done right, these steps can defuse the situation and remove a gigantic source of the uncertainty that has depressed stock and corporate bond markets, and sent Treasury yields to historic lows, cash yields to zero, and gold prices to the stratosphere.

Unemployment claims show no sign of a recession


Initial claims for unemployment last week failed to rise as expected. At 401K, they have been lower this year in only 8 weeks—most of those in the Feb.-Apr. period, when the waters were muddied by faulty seasonal adjustment factors. On an unadjusted basis, last week's claims were the lowest of the year so far (329K). Clearly, there is no increase in unemployment claims under way, and no indication therefore that the economy is weakening, much less slipping into a recession.


As this next chart shows, the number of people receiving unemployment insurance continues to decline. I view this as a positive, since a) it reduces government spending, and b) it removes a disincentive for the unemployed to seek and accept job offers. Since the peak in early 2010, the number of people receiving unemployment benefits has declined by 5.4 million, or almost half. That's significant change, and it is continuing.

Steve Jobs, RIP

I'm deeply saddened by his death. At the same time, I am comforted knowing that Steve Jobs' greatness was fully recognized in his lifetime. He changed the world, and the world acknowledged that fact before his untimely passing.

Steve Jobs' legacy will be this: that any person, anywhere, at any time, no matter how humble, can aspire to change the world if they follow their heart, pursue beauty, and are willing to work tirelessly to achieve their vision of a more perfect world.


Image source
HT: Gabi

Eurozone contagion recap

The big market moves in the past few months have been all about Europe, as I've been pointing out since early August. The above chart should make that as clear as a bell. It compares the value of Eurozone bank stocks to the yield on 10-yr Treasuries. You couldn't find a better fit between two entirely different variables if you tried. A quick summary of what's been happening: As the sovereign debt crisis has intensified, as Greek yields have soared, as PIIGS default risk has soared, Eurozone banks—who are stuffed to the gills with PIIGS debt—have been crushed. The prospect of a PIIGS default leading to a Eurozone banking collapse has electrified the world, creating huge and even unprecedented demand for the safety of Treasuries. Moreover, it's a good bet that almost $400 billion of deposits have fled Euro banks for the relative safety of U.S. banks since last June.


The market value of Eurozone bank stocks has collapsed, down almost 80% from the high of 2007. In fact, Eurozone bank stocks are now trading at the same level as 17 years ago; that's 17 years of effort wiped out in just four years, thanks to the banks' careless assumption that they could put their entire capital at risk by investing in the bonds of Greece, Portugal, Italy, Spain, and Ireland. Greece may not have defaulted yet, but the market fully expects that, and more, to happen sooner or later. Banks' shareholders have suffered huge losses, effectively giving up a tremendous amount of their wealth to subsidize bloated bureaucracies in neighboring countries. The damage has been done, and it's all over but the shouting. The only thing we don't know yet is whether this mess will end up infecting the rest of the world.


As this next chart shows, the recent weakness in Europe has already spilled over into the U.S. equity market (and the bond market, as the first chart showed). Fortunately, the damage to the U.S. to date has been mainly reflected in market psychology, and not yet in any serious deterioration in the U.S. economy. 10-yr yields have collapsed, the Vix Index has soared, and PE ratios have plunged; but there is no evidence yet that the U.S. economy has entered another recession. Everyone is bracing for what could be a catastrophe, but it's far from certain that one will occur. Meanwhile, it is at least somewhat comforting to note that U.S. stocks have held up much better than their Eurozone counterparts.

More signs the economy continues to grow


There are two ISM indices that track the overall health of the service sector (the non-manufacturing index, and the non-manufacturing business activity index), and this is the one I have long preferred. It shows that things have actually picked up of late, if only modestly. This is one more economic index to add to the list of recent signs that not only is the economy not entering a recession, but it might actually be picking up a bit. The others would be: weekly unemployment claims, corporate profits, the ISM manufacturing index, auto sales, the ADP employment index, and capital goods orders.


The prices paid index slipped a little in September, but remains well above 50, indicating that there continues to be some upward pricing pressure in a large part of the economy. This is significant, given that the economy in aggregate remains well below (at least 10-12%, according to my estimates) its potential or trend output level. Despite so much in the way of idle capacity, firms are still able to make higher prices stick. This can only reflect the monetary accommodation that the Fed has struggled so hard to achieve. There is no shortage of money out there, and this is a good sign for cash flow forecasts and a welcome relief to all those who are struggling with large debt burdens. Inflation is a debtor's best friend.


The employment index was the only significant disappointment in today's ISM release, since it fell below 50, which implies a modest deterioration in firm's willingness to hire. It's not really surprising, however, given that we already know from last month's payroll report that hiring has been relatively weak.


This is offset to some extent, however, by today's ADP report, which was somewhat stronger than expected, and which provides a good reason to believe that the economy is still on an upward jobs-creating path.


The September surge in announced layoffs, according to the folks at Challenger, Grey and Christmas, might ordinarily be a shocker, offsetting all of the above good news. But the outsized increase was entirely due to the Army's planned troop reductions and Bank of America's decision to thin its ranks. Furthermore, since government cutbacks account for the lion's share of announced layoffs so far this year, I count this as a positive. A smaller government means more room for the more-efficient private sector to grow. As noted in the press release:

It would be easy to look at the September job-cut figure alongside some of the other less-than-stellar economic news that has been reported lately and draw the conclusion that the economy is indeed headed for a double dip. However, it is important to keep in mind that 80,000 cuts, or nearly 70 percent of last month’s total, came from just two organizations: Bank of America and the United States Army ...

My next iPhone

I'll be ordering an iPhone 4S this Friday morning, and expecting delivery within a week. This gadget looks great: very, very tight.

AAPL is down almost 4% as I write this, so it would seem that some folks were disappointed with Apple's unveiling today. No iPhone 5? I don't see that as a problem, since the 4S model they announced can do just about anything that was envisioned for a 5 model, except for the lack of LTE hi-speed data support (i.e., 4G data speeds). I wasn't expecting 4G anyway, since a) the coverage is still in the early stages of being built out, and b) the technology to put 4G in a handheld devices has not advanced enough to avoid draining the battery in a matter of hours. In any event, Apple has tweaked their antenna technology in a way that will allow much faster data transmission using 3G. Not having 4G is not going to make much of a difference to the great majority of people.

The only real disappointment was that the screen size was not bigger, as many had rumored. But it's still the best screen on the market. You will have to settle for a far more powerful processor.

I had been thinking of replacing our compact Canon camera, since it suffered from a fall when we were in Argentina earlier this year. But now, with the camera in the 4S, there will be no need for a hand-held. If I want to take professional shots, I'll use my Canon DSLR. For everything else, I'll have my 4S always handy in my pocket.

I'm excited about iCloud, since that is going to make it effortlessly easy to share and access my documents, photos, apps, and books between my 6 Apple devices (iPhone, iPad, MacBook Pro, and 2 iMacs). No more cables needed to download photos, update my iPhone, or display the HD movies I take on the iPhone on our 48" screen. I won't have to update my wife's iPhone anymore, since it will update itself automatically.

The Siri voice recognition and personal assistant feature is almost certainly going to revolutionize how people use and interact with computers. The concept alone makes it a killer app. If you don't like using Apple's on-screen keyboard to tap out texts and emails (I agree that sometimes get very tiring), just tell your phone "Send a message to my wife telling her I'll be 15 minutes late for our dinner tonight."

Apple currently has only a 5% share of the multi-billion-size global cell phone market. This is likely to grow by leaps and bounds. Pretty soon all those billions of phones will be smartphones, and Apple is likely to stay in front of the smartphone pack. The iPhone is going to go viral, and Apple has plenty of upside.

AAPL looks pretty attractive right now, selling for only 14 times current earnings, and 13 times expected earnings. And that's not counting Apple's huge stash of cash, which is approximately $75-80 per share. Take that out and the stock is just plain cheap.

Full disclosure: I am long AAPL at the time of this writing.

Back to '08 valuations


This chart shows Bloomberg's calculation of the S&P 500's PE ratio using 1-yr forward consensus earnings estimates. By this measure, the market today is only a shade less pessimistic about the future than it was towards the end of 2008, when a multi-year global recession/depression was widely expected.

What this tells me is that if you are still bearish about the stock market's prospects, then you must also believe that the future is going to be even worse than a global recession/depression. If the global economy ends up experiencing anything less than what is almost a nightmare scenario, then stocks are selling for bargain-basement prices.

Auto sales still booming


September vehicle sales blew past expectations (13.04M annualized rate vs. 12.6M expected), while registering a sizable 11.2% increase in the past year, and a 14.3% increase since last June's low. This, despite the Japanese tsumani earlier this year that caused extensive supply-chain disruptions and resulted in a huge drop in sales from February through June. Suffice it to say that auto sales do not conform at all to the current narrative about the economy being on the ropes.

September sales were 40% higher than the low registered in February 2009, which works out to a 13.8% annualized gain.


UPDATE: At the suggestion of Mark Perry, I put together this chart of light truck sales, which account for just over half of total vehicle sales. The recovery in light truck sales has been a good deal stronger than for total vehicle sales, and sales were disrupted far less this year, since domestic light trucks account for about 85% of total light truck sales (less tsunami impact). Since the low in April '09, light truck sales are up by an impressive 58%. Definitely no sign of a recession here!

Construction remains flat


August construction spending came in higher than expected (+1.4% vs. -0.2%), but that was only good enough to keep overall construction spending roughly flat for most of this year. Not much happening here, and the residential sector continues to represent a minuscule 2% of the total economy, about one-third of what it was in 2005. The best we can say is that there appears to have been no further deterioration in the construction sector.

Manufacturing continues to expand


Going into today's ISM report on the manufacturing sector, the market was fully expecting more weakness. After all, isn't Europe imploding, isn't China's economy slowing down rapidly, and isn't the U.S. economy on the cusp of another recession? I've been amazed at the pervasiveness of pessimism of late. How could we be in a recession, if weekly unemployment claims continue to decline? To get a recession you really need to see a loss of jobs, and for that to happen you almost have to have an increase in unemployment claims.

So it is with some satisfaction that I note that the September ISM manufacturing report released today not only beat expectations, but contained no signs of any imminent recession. Life goes on in the U.S. economy, even as Europe struggles and China slows down a bit. As the top chart shows, the ISM manufacturing index is consistent with real growth in the third quarter of 2-3%, which shouldn't be too difficult to achieve, and would mark a welcome acceleration from the 1.3% growth of the second quarter. The U.S. economy is not slowing and about to enter a recession, it is probably in the midst of a modest acceleration from the very weak levels of the second quarter.


September export orders picked up, which suggests at the very least that the rest of the world is not in free-fall, and is probably continuing to grow as well.


The employment index also picked up, though it remains a lot weaker than the robust numbers we were seeing early this year. That's not surprising, since jobs growth has since slowed down in recent months. Most likely, this number is suggesting we aren't going to see a further slowdown in jobs growth.

To be honest, I have been expecting the economy to be somewhat stronger than it has been. But I haven't been expecting any significant improvement, only growth in the 3-4% range, which would still leave the economy substantially below its long-term trend or potential. Growth has been disappointingly slow so far this year, but this report lends support to my belief that we are in the midst of a modest acceleration. More importantly, perhaps, this report once again disproves the widely-held perception that the economy is entering another recession. Things could be a lot better, but they aren't nearly as bad as many seem to fear.

Commodity update

It's a nice quiet day at the beach. Blue sky, a few wispy clouds, only a slight breeze, and relatively small waves. It's been a relatively cool summer in general, cloudy more often than not, but today it's almost hot. In the past few months we have had lots of heavy surf which severely eroded the beach. Today I noticed that the sand has come back in size—more than I've seen for a long time. One thing I've learned from living at the beach is that the beach survives, even though sometimes it looks like it will never recover from the beatings. This might be a good metaphor for the commodity markets.


Here's what I think is the best long-term chart of key commodity prices, plotted with monthly data through last Friday. The first thing that jumps out is that gold and spot commodity prices do a pretty good job of tracking each other over time, with gold sometimes leading the way. Plus, gold's price swings, on average, have been more than double that of commodities—note that the right y-axis has double the span of the left y-axis. Both gold and commodities have suffered big setbacks of late: gold down 15%, CRB spot down 12% from their recent highs. But the correction in gold hardly shows up on this chart; in fact gold still looks like it's in an uptrend. Meanwhile, commodities are still higher than they were at the peak in 2008; the correction has been painful but hardly the end of the world. With the Fed in super-accommodative mode, it would be incredible if commodity prices were not the object of speculators' desire. And after having scaled heretofore unimaginable heights, it shouldn't be surprising that they get knocked down every now and then.


Let's zoom in on copper prices. Copper has dropped by a hefty 32% since its February all-time high. But it's still worth five times what it traded at in late 2001. If you had told someone in 1996, when copper was trading at $1.20 a pound, that in the next 10 years it would hit $4, they would have called you insane. Something like that could only happen if the U.S. were ravaged by inflation! And so with copper today at just over $3, we are supposed to be worried about deflation?


Crude oil prices have dropped by a sizable 30% since their late-February high, but that's peanuts compared to the collapse that occurred in 2008. And oil today is still worth six times what it traded for in early 1999. In constant dollar terms, oil today is almost as expensive as it was at its early-1980s peak.


Thanks to new drilling technologies which have hugely boosted U.S. natural gas production and proven reserves, natural gas prices have collapsed by 75% since hitting an all-time high in late 2005. That's a serious decline. But is it deflationary? Hardly. Gas is still three times higher than it was in 1992. Moreover, cheap and abundant natural gas both here and in the U.K. has the ability to transform manufacturing industries, as Mark Perry notes in a recent post.


Natural gas is now cheaper relative to oil than at any time in the past 20 years. It's difficult to imagine the eventual magnitude of the impact this could have on manufacturing and economies in general. It's certainly not something to worry about, with oil still trading at relatively expensive levels. Cheap energy is a big deal.

All of this leads me to think that it's not the recent drop in commodity prices that is a concern. If anything, we should still be focused on how expensive most commodities are relative to their historical trends. Finally, it shouldn't be surprising that commodity prices are still quite elevated, since, as the last chart shows, the dollar is still plumbing all-time lows in real terms against other currencies. Easy money, weak dollar, strong commodity prices; they all tie together, and that's still the dominant theme, even after all the turbulence of recent months.