Bull runs and crashes since 1999

Troughout the year I have been checking our performance against main indexes in U.S. and Europe. I have thought that we will do badly this year against our benchmark (MSCI All world country index or 'ACWI') until I actually checked out ACWI net performance this year in euros. Currently it's only slightly above year end 2016 level. Given continued bull run of broad U.S and European indexes in 2017, this seemed strange at first.

Then I checked dollar vs. euro and that partially explains what I am seeing.

USD to Euro in 2017 to date with 100 day moving average.

Chart courtesy of StockCharts.com.

Since I am measuring ACWI in euros decline of dollar against euro smoothes out bull run of dollar denominated investments.

Our market and currency exposure is heavily tilted to European markets and euro compared to ACWI being exposed much more heavily to U.S market and dollar. That's why falling dollar is tail wind for us.

If we look at the entire history of Euro (since its birth on 1.1.1999), we can see that euro had bull run from 2002 to 2008 which pushed dollar far from parity. Since 1.1.2009 dollar has climbed back towards parity, but not reaching it.

USD to Euro from 1.1.1999 to date with 100 week moving average.

Chart courtesy of StockCharts.com.

The bull run of both Nasdaq and Dow Jones indexes have been phenomenal from 2009 onwards. The crashes of 2000 and 2008 are clearly visible in the Nasdaq chart. Since 2000 was tech bubble it obviously does not show up in the DJ chart.

Nasdaq Composite index from 1.1.1999 to date with 100 week moving average.

Chart courtesy of StockCharts.com.

Dow Jones Industrial Average index from 1.1.1999 to date with 100 week moving average.

Chart courtesy of StockCharts.com.

Compare above two U.S indexes with Euro STOXX 600 index:

Euro Stoxx 600 index from 1.1.1999 to date with 100 week moving average.

Chart courtesy of StockCharts.com.

Quite a difference. It would be easy to jump into conclusion that European markets are still moderately priced in comparison to U.S markets that are far above their 2008 level. I am not going to do that just by looking at these charts.

Also, since our investments are either to individual companies or specific market segment ETFs the market as a whole isn't really meaningful yardstick. Outside of emerging markets, we do not invest via broad all-market-index tracking ETFs or other such instruments.

I am sure there are individual companies - especially within Nasdaq - that are priced sky high.

However, Looking at companies within our U.S portfolio (Micron, Intel, ..), I do not see alarming P/E or P/B levels when looking both at current and forward levels combined. Berkshire Hathaway is our highest priced investment in U.S. in terms of P/E and that's around 20, which is still fair valuation to that company in my opinion.

[finwiz.com was used to check P/E and P/B levels]

When the Euro crisis will end?

Not a day goes by that something is written about the "Euro crisis" in newspapers. Now it seems that Spain is joining Portugal, Ireland and Greece to ask for some sort of emergency funding. There seems to be speculation about the amount of money needed between tens of billions and 100 billion euros. Anyway - lot's of money.

I have lost track of all the "facilities" through which funds are directed to the countries in need. Also, it seems that there is a dangerous pattern of declaring "emergency over" after "stress tests" or simply spending XX billions on the problem. The confidence isn't just quite restored yet. I have no idea when it will be and have come to a conclusion that probably nobody knows fully what is ahead of us.

Greece started the show in 2010 with getting emergency funding worth 45 billion euros in March and additional 110 billion in May. Ireland followed with 67,5 billion euros late 2010 and then Portugal got 78 billion euros in May 2011. Last summer Greece came once more back and total funding to that direction has ballooned to 285 billion euros. So there is already one example of a country coming back for more.

Thus, it's a bit hard to believe 100 billion is going to solve all of the problems in Spain - a much bigger country in terms of population and economy than Greece. The s**t will really hit the fan if Italy comes in and completes the pejorative acronym "PIIGS" used by many to reference these countries.

Our defensive posture with regards to portfolio allocation looks better every day.


Source for emergency loan figures and timing: Helsingin Sanomat 9th of June 2012

Who pays the bill?

A group of 97 prominent Europeans published an open letter to eurozone leaders on Wednesday 12th of October 2011. In the letter they called upon the governments of the Eurozone to agree in principle on the need for a legally binding agreement to: “1) establish a common treasury that can raise funds for the Eurozone as a whole and ensure that member-states adhere to fiscal discipline; 2) reinforce common supervision, regulation and deposit insurance within the Eurozone; and 3) develop a strategy that will produce both economic convergence and growth because the debt problem cannot be solved without growth.”

While this proposal could work long term, it will take ages to negotiate and faces opposition in countries like the one I live in (Finland). That’s why they insist that the European Financial Stability Facility (EFSF) and the European Central Bank (ECB) would guarantee and eventually recapitalize the banking system.

Sounds easy – but is not. Otherwise, the crisis would be over by now - right?. It’s still about who pays the bill (accumulated losses). Not all countries behind EFSF and ECB are easily going to guarantee everybody else. A joint recapitalization of the entire European banking system is not too popular in countries (like Finland) that do not have banks with big pile of soon-to-be-rotten debt.

George Soros, one of the 97 people behind the open letter to eurozone leaders, published an essay “A routemapthrough the eurozone minefield” the following day. He does not believe banks will be recapitalized by banks themselves or by national governments. Instead Soros believes that the only sensible path is for ECB to solve all problems. He goes actually further than the joint letter and claims that EFSF is actually not even needed short term.

Again: If it would be so easy, why it is not being done?

Europe's debt crisis as seen by 9-year old

Michael Cembalest, the Chief Investment Officer of J.P. Morgan, describes the European debt crisis in a funny but understandable way in the "Eye of the market" letter dated September 6th, 2011.

For the debt crisis in the European Monetary Union as seen by a 9-year old" see page 2 of the letter.

  

"If today’s diorama analysis borders on the absurd, so does maintaining the fiction that accumulation of massive public and private sector claims in Europe can somehow be engineered away."

Thoughts on stress tests for European banks

Eight of the 90 banks failed the stress tests. 16 came close to failing.Not bad?

Well, the main question is that were the tests tough enough. I have an engineering background and I have long worked with mission critical systems (i.e. systems in which a system-wide failure is not an option). The very basic questions with these type of systems are: What happens if X fails? What happens if X and Y fail simultaneously? And so on..

Therefore, a real stress test for European banking system should include atleast a single failure (i.e. default by one eurozone country). An even better test would take into account multiple failures and the resulting financial panic.

The now conducted stress tests simulated what would happen to bank finances during a recession where growth falls more than 4 percentage points below EU forecasts.

That sounds of a bit soft scenario given the number of countries facing serious debt problems. You got the usual suspects from Europe, but also USA with its debt ceiling talks and then there is Japan..

Rocking The EU-boat

The faith of Portugal-bailout by EU is now in the hands of these three Finnish political figures. One of them OKs the rescue package, one of them said NO to all kinds of bailouts (for any country) and one of them isn't quite sure.

Here they are from right to left in terms of political views:

Jyrki Katainen

Jyrki Tapani Katainen (born October 14, 1971) is chairman of the Finnish National Coalition Party (Kokoomus) and the Finance and Deputy Prime Minister of Finland. He wants to bail out Portugal and has been the Finance Minister in charge of previous EU-bailouts. He doesn't like it, but he says that it is the lesser of two evils (the other being another EU/World-wide financial panic).

source: Wikipedia

Timo Soini

Timo Juhani Soini (born May 30, 1962) is a Finnish politician, and co-founder and current leader of the True Finns party. The party combines left-wing economic policies with strongly conservative social values. They are basically against EU and not surprisingly against any EU-level bailouts. Just a few months ago, the party was a rather small player, but is now third biggest party and very close to #1 (Finnish National Coalition Party) and #2 (Social Democratic Party). It will be extremely hard to not to let these guys to next cabinet.

source: Wikipedia.

Jutta Urpilainen

Jutta Pauliina Urpilainen (born 4 August 1975 in Lapua) is the Chairman of the Social Democratic Party of Finland (SDP). She is the joker in the deck. It is basically up to Social Democratic Party whether the EU-bailouts get a green light from Finnish parliament. So far SDP have demanded that investors of Portugal and other EU-countries in trouble will be made partly accoutable. However, it seems that there is no way to re-negotiate the already negotiated EU-bailout packages. Therefore, it remains to be seen what SDP and Urpilainen does.

source: Wikipedia

Jyrki Katainen have been forced to invent an ad-hoc process to get the Portugal bailout approved. The ex-Prime Minister Mari Kiviniemi has said that they won't advance the matter and she will not present anything to Finnish parliament regarding bailouts. Her party lost big time in the election - a lot of their seats in parliament went to True Finns. The position taken by Kiviniemi and Soini puts Jyrki in a tough spot. The solution that he came up is to try to get approval from each party separately. Without the support of Jutta and SDP it looks like he will not get majority behing the package.

What happens if Finland does not support the bailout is unknown.

The Helsingin Sanomat newspaper listed today some pros and cons if Finland rocks the EU-boat big time. The pros include:

• People living in EU and Portugal in particular will remember that Finland is part of EU.
• Finnish citizens have been wining for a long time that why Finland needs to always be the model member of EU. Not anymore.
• EU gets slap in the wrist and reminder that the national parliaments still have a lot of power.

OK. Maybe so, but the list of cons is a long one and at the extreme end of it looms another financial panic. The cost of yet another panic would by likely be much larger than any foreseeable cost of bailouts.

By 13th of May we will know.

I am glad I have put together a fairly defensive portfolio. At the moment I am also letting cash to pile up.

Financial crisis 2.0

“After all, you only find out who is swimming naked when the tide goes out.”

- Warren Buffett, 2001 letter to Berkshire Hathaway investors

When making the comment Mr. Buffett was speaking about insurance business in post 9/11 world and the very complex chains of reinsurers after reinsurers. “A single weak link can pose trouble for all”, he said. He might as well have been speaking (today) about investment banks or banking system in general.

As pointed out by many, subprime crisis might have been just a “prelude” to a much bigger crisis. As the “tide” is slowly going out more and more entities appear to have been “swimming naked”. Not just banks, but entire countries. Many countries were heavy on debt even before the crisis. Now all eyes are on Greece, but the deficit & debt problem is far more widespread than that.

It is not just so called “PIIGS countries” (Portugal, Ireland, Italy, Greece and Spain) that may in for trouble. Also other European countries, Japan and USA have significant debt levels and budget deficits. Check out this chart.

In his recent article titled ”A Greek crisis is coming to America” Harvard professor Niall Ferguson painted a gloomy picture of a potentially rolling debt crisis. I was compelled to listen to “Moonlight sonata” by Beethoven while reading it. And that masterpiece has some pretty seriously sad and anticipating sound to it.

Basically Mr. Ferguson says that what we might be witnessing is a beginning of fiscal crisis of the whole western world far worse than what followed the subprime tsunami. To me the most striking claim was that the “US will never again run a balanced budget”. So I just had to look it up. And sure enough, CBO projects large deficits throughout 2020. What might make US situation even worse is anticipated second round of mortgage defaults.

Markets are nervous and who knows what might set of the next panic. Hopefully all this goes away as I’m still pretty heavily exposed to stock markets right now. In anticipation of some sort of recovery hiccup I have sold the riskiest assets that gained heavily in 2009 and reinvested to more defensive index funds and stocks.

Nobody predicted the financial crisis?

Have you bumped into claim that ”no one predicted the financial crisis”? I have, several times. It is easy to prove the claim wrong by finding just one who did so: Peter Schiff.

He is probably not the only one, but since I recently completed reading his book “Crash Proof 2.0”, I will concentrate on him in this post. The book I read is 2009 update on a book “Crash Proof” that was published before the crisis in February 2007. The 2.0 version is otherwise same except contains additional 2009 commentary in the end of each chapter.

By following the link you can read six first pages from the book. They pretty much summarize the problem described in the book. Chapter 6 of the book deals with exactly the problem that caused the crisis.

It is disturbing to see how well Schiff described the problems in US housing and lending market well in advance. It is also disturbing to see clips from CNBC and FOX where they basically laughed in his face when he indicated that there were serious problems brewing in housing market and in the bank sector.

However, the book is not about the financial crisis we all came to know so well. It is about something far worse. It is about downfall of the US economy and the US dollar.

In retrospect, and especially after reading the book by Schiff, I can not understand why the housing bubble was not spotted or burst long time ago. Rather embarrassing for all those economists, politicians and reporters who regularly follow, study and comment financial issues. Perhaps that is why claims like “nobody predicted it” are made.