The rally has legs. Or not
October 24, 2011

The rally has legs. Or not - Zélia Cardoso de Mello

In the current environment the million dollar question is if the USA is facing another recession or a "double dip". The billion dollar question is if Europe will resolve their problems and stop being a threat to the world with another financial crisis.

On Wednesday the 19th of October, the FED released the Beige Book, which is an assessment of the activities in 12 districts around the country, this time for the weeks between August 26 and October 7th. The report said many districts showed "modest" or "slight" growth with a "weaker or less certain" outlook. Home prices remained flat or declined, and home sales remained weak. That could be qualified as a muddle-through economy. Yet the Beige Book didn't give any signs of an imminent recession.

A week before, Bernanke said that the economy was soft and the FED was ready to intervene if necessary, but also didn't mention any looming decline. It is well known that economists are, most of the time, wrong in their forecasts. However, there are a few who have a good record of being right more times than others. The truth is that the data has been mixed, making any forecast difficult. But one economist known for being right in the past, Nouriel Roubini, thinks there is a 50% chance of a recession. Another entity, - one which also has been right most of the time - the Economic Cycle Research Institute, believes a recession is coming. Its managing director Lakshman Achuthan says that "It's either just begun, or it's right in front of us". ECRI has correctly predicted all recessions in the last 15 years and has never issued a false alarm.

Roubini compares what is going on with an airplane in the air, which starts to stall. At that point the pilot can either accelerate again and recover speed or do nothing and wait for the free fall. The chances of doing something, as we know, are very small. We are in the age of "austerity" everywhere: austerity is the remedy governments are proposing in Europe and in the USA. Interestingly enough, austerity has not brought anything good for Greece, or Ireland or the United States. Despite that, austerity is still the "mantra" employed by these nations.

So we may or may not be going into a recession. Despite that, and despite the daily swings, stocks were up 5.8% in October. In fact, all assets had staged a recovery from the losses in the previous quarter. Earnings seasons have started and so far the results are mostly very good. Those results, alongside the news of a possible resolution of the European problems, helped the good performance. Also, Operation Twist probably played a role: as the FED buys bonds, portfolio managers can sell them at a higher price and then invest in more risky assets.

What is next? Would the rally survive? Will the markets be able to surpass the top of the trading range that has been between 1120 and 1220 for the S&P? It depends on the developments in Europe and in the United States.

In Europe there are 3 problems to address in the short term: saving Greece, recapitalizing the European banks and increasing the size of the EFSF (the bailout fund) to help other countries, particularly Italy and Spain. Each of the objectives is very complicated and sometimes contradictory. In the long term the question is how to restore growth and prosperity. Europeans leaders are still trying to save Greece with more austerity and more lending and at the same time there is a split on how much of a haircut the bondholders should take in order to prevent a default. They should go from the 20% agreed in the past to maybe 50% or 60%, and apparently that is the agreement that is been reached as I write this newsletter. Of course, more money to Greece means less money to the others if there is no increase in the EFSF. In my humble opinion, the best solution for the Greeks would be an orderly default and an orderly exit from the Euro, but of course that won't fly with the banks. The second problem is the European banks, particularly the French banks. They need to be capitalized and the question is how much is needed and where is it coming from. Banks don't want money from the taxpayers because that will result in more regulation. The third problem is the increase of the size of the ESFS (the bailout fund) from €440 billion to maybe €2 trillion or €3 trillion. Again, the source of funding is the problem. France can't increase guarantees to the EFSF because that would jeopardize its AAA credit rating. As it stands, half of the resources are committed to Greece, so what happens to Italy and Spain?

Italy and Spain have a liquidity problem; they are not insolvent like Greece. They have much better economies. What has been transpired from the weekend meetings is that they are looking for some financial engineering to boost the ESFS and guarantee that Italy and Spain continue to have access to credit .As time's passes and they don't reach an agreement, the problem gets bigger. When does it end? Maybe it will end this coming Wednesday.

So, despite the news of a plan to have a plan that the markets received with relief, nothing really happened so far, to make things better.

In the US, the jobs bill President Obama proposed was rejected last week and nothing was proposed instead. The only thing that Republicans in the Congress do, despite their rhetoric of jobs creation, is to obstruct any bill coming from the Obama administration. (Aside: Republicans are so irrationally against Obama that this week they didn't even give him credit to the end of Gadhafi's regimen: they praised the British and the French!!!) The same applies to the Republican candidates: a lot of talk about jobs creation but no concrete proposals except cutting taxes or reforming the tax code. That would be fine and a lot of people would agree with reforming the tax code, but the millions of Americans that are out of a job cannot wait for that or for a new Government to be elected. It is necessary to do something now. So, like in Europe, there is no light at the end of the tunnel.

What does all that mean to investments? It means that the causes of the losses in August and September are still here, nothing has changed and we are not out of the woods yet. However, the rally might continue, if the earnings continue to be good and more important, if the earnings guidance is positive, if the indicators continue to be mixed, if the FED continues with its operation "twist" and if the Europeans continue to release comforting statements.

Let's enjoy the ride while it lasts!

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