The Greek bailout didn’t take. Two-year Greek government bonds recently traded at cents on the dollar, resulting in yields of 25 percent. The market is clearly pricing in some element of default in the securities.
Effectively shut out of the credit markets, financial pressures have mounted in spite of guarantees and bailout promises by other European Union member countries. As a client put it to me at lunch, the Germans aren’t going to keep working to age 65 to pay for overly generous Greek pension policies that allow their peers in Greece to retire at age 57.
After last year’s original bailout, markets recovered and eventually rallied. But our fear is this is similar to the September 2007 U.S. stock market rally when government policies tried to address — but didn’t really solve, or even admit to — the seriousness of the crisis and the market peaked soon after. The ramifications of Eurorisky behavior have implications for a U.S.-oriented portfolio as well.
The first thing we’ve done for clients is to try to avoid “ground zero” exposure. Most client portfolios have little exposure to international equities. Interestingly, European stocks are among the short-list of asset classes that our discipline considers “buyable” based on recent market performance. For the moment, however, we’re not real interested in adding what could be the next Lehman Brothers back into the portfolio. We’ve owned international in the past. We’ll own it again in the future. Right now, though, we remain skeptical — of Europe in particular.
We recently took steps to reduce or eliminate our exposure to the insurance sector as well. The big problem with the profligate spending habits of Greece, Spain, Portugal and other large governments running disastrous deficits — those countries shall remain nameless just in case there remains one more clueless U.S. treasury buyer because I wouldn’t want to be the one who causes our own house of cards to tumble prematurely — is that the eventual default by Greece could threaten many European banks with insolvency. For more on this issue, Google “John Mauldin” and “Dysfunction: Thy Name is Europe.”
If a European bank defaults and that bank is a counterparty to a credit default swap (CDS) owned by a U.S. bank, then the virus jumps over the pond faster than you can say “derivative.” Since we haven’t done much of anything to restrict CDS gambling by the best and brightest on Wall Street (probably former Lehman bankers hired by Citigroup), then the risk of what the Fed terms a “systemic problem” remains. And because we bailed out rather than imprisoned most of the criminals responsible for the 2008 subprime crisis, there remains little incentive for banks to cut back on their gambling with depositor savings. This includes a great deal of gambling with big, “safe” European banks on the other side of the bet.
Once the banking crisis starts again, it would likely affect nearly all big banks in the sector because they’re all “black boxes,” can’t accurately measure their CDS exposure and have lied to shareholders so many times before no ones believes a word of what management says. Our guess is the selloff will once again spill over into the insurance sector, which demonstrates some of the same tendencies toward gambling that hurt banks and investment companies in 2008.
We’re not saying the sell-off will definitely be a repeat of 2008, only that it could be as painful. Moreover, insurance stocks would be much too close to the center of the crisis. In late May, insurance stocks began trading down more than the market — along with banks. We believe the problems in Greece are the reason. Until we can see the crisis in Greece isn’t ramping up, we’d rather reduce or eliminate that particular risk from the portfolio.
What to buy with the proceeds remains a problem. The market remains narrow, although a few new asset classes have risen to “buyable” status. In general, however, the market is becoming very defensive for whatever reason. If that’s signaling further weakness ahead, perhaps holding a bit of cash will help preserve capital instead of using it to buy “defensive” stocks that merely fall less than the market in a selloff.
A year ago, we made a mistake during the first Greek crisis by being more defensive than we should have, given 20-20 hindsight. We could make the same mistake again. It’s difficult to know what to hope for at times like this. We hope the bureaucrats in Europe find a solution to the Greek problem. We’re not comfortable relying on them to do so, though, and have adjusted the portfolio a bit over the past few months just in case the Greek crisis continues to get worse.