Put On Your Ponchos

 | Jan 23, 2012 | 7:30 AM EST  | Comments
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The U.S. market is surging this month, and that's welcome, of course, to anyone long the market. I'm among those players, as I run two long-only strategies that are generally fully invested, one being the dividend-capture strategy with which you all are familiar -- so do keep in mind I really do want to see the U.S. markets higher this year.

Having said that, I'm trying to figure out if I'm on the same planet as are the investors bidding the S&P 500 higher. On the margin, the U.S. economy is looking a bit better. Housing is no longer a drag (but neither is it contributing), manufacturing is doing OK and labor still suffering but at a "declining rate." What's not to like?

Naturally, in one word it is: Europe. There seems to be a sense that whatever is going to happen in Europe, it is "in the market" and therefore doesn't matter to returns going forward. I suppose this is like knowing Hurricane Katrina is swirling offshore. Since we can see it's coming, we can all now relax?

The next few months are going to be horrifically bad for Europe, and when this financial hurricane makes landfall I am not convinced the rest of the global economy and markets won't convulse in reaction. Here are the stages that appear inevitable to me. (Click the links to understand the names.)

Sea Diamond: We all know Greece will be the first to go -- but, when it goes, it will be far uglier than anticipated. There is really no choice: Either all Greek-debt holders will lose 75% or more on their holdings, or Greece leaves the euro and all Greek debt-holders will lose 75% or more on their holdings.

I see no scenario in which Greek debt can be rolled over and "grow" into what is left. The economy is sinking into depression, and cash and assets are leaving the country as quickly as possible. It is a slow-motion meltdown. We even have a set date for this dénouement, March 29. You don't need a Mayan calendar to see the end of their world. Although many pundits declare as impossible a withdrawal from the euro, a move back to Greece's own currency seems most likely. Perhaps to keep a nostalgic connection to the euro, they can call it the "gyro."

Douro: Portuguese yields hit 14% last week. The bond markets know that if Greece "gets out of jail free," the other prisoners will follow. I put the probability of Portugal making good on all of its debt at 0%. Portugal CDS are at 1270 basis points, although I don't understand why anyone would trade in them, considering that the market has been rendered worthless with these "voluntary" haircuts. I am guessing Portuguese bond holders will lose at least 50%, and the dénouement will happen soon after that of Greece.

Na Trioblóidí: Ireland is Iceland with an "R." The problems were huge, but limited mostly to an over-levered real estate bubble that was bailed out by the government. Ireland is fixing its structural issues, but will need to get rid of the 70-billion-euro overhang from the bailout. If Greece and Portugal escape, the Irish will assert their right not to bail out their fat-cat bankers. I see Ireland ending precisely as Iceland did, with a repudiation of the bank debt and a fresh start that shows results three to five years out. However, Ireland will be the third domino to fall in the European cascade, and may be the tipping point at which it all unwinds.

Costa Concordia: Italy has already run aground, gashed the hull of its fiscal ship, and is slowly listing before it sinks. However, unlike the Concordia's cowardly captain, the European Central Bank is supporting HMS Italy -- the ECB is monetizing its debt like crazy (not that they will ever admit it). Italy faces massive refunding needs this spring, on the order of 90 billion euros, which it could never complete without the ECB taking on a good majority of the debt.

Italy will end up defaulting the old-fashioned way, by currency debasement. As the first three countries default and Italian debt becomes obviously nonrefundable, the ECB will spring into action and the euro will start its decline relative to other currencies.

Lorca: The financial earthquake about to hit Spain should be a surprise to no one, given the preceding problems noted above. What can you say about Spain? It's in a depression now, with unemployment above 20%, the economy receding, and budget deficits increasing faster than the government can cut. To "grow" out of your problems, you actually need some growth, and Spain doesn't have it. As with Italy, the ECB will need to intercede in order to keep Spain's interest rates artificially under 10%.

While I can't quite figure out why the U.S. markets are not bracing for the coming storm, I believe U.S. investors can weather it by reducing any and all European exposure they have, and be short the euro, either directly via futures or indirectly through other currencies. Put on your financial rain ponchos -- this is going to be a very difficult year.

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