Bubbling Up...

1) Buffett’s Favorite Valuation Metric Surges Over the 100% Level by Cullen Roche @ Pragmatic Capitalism

For the first time since the recovery began, Warren Buffett’s favorite valuation metric has breached the 100% level.  That, of course, is the Wilshire 5,000 total market cap index relative to GNP.  See the chart below for historical reference.

I only point this out because it’s a rather unusual occurrence and the recent move has been fairly sizable.  It happened during the stock market bubble of the late 90′s, but then occurred again just briefly during the 2006-2007 period when the valuation broke the 100% range in Q3 2006 and stayed above that range for about a year.  We all know what followed the 2007 peak in stock prices.

Woj’s Thoughts - These days it’s becoming increasingly tough to find stock market indicators that are not either approaching all-time highs or levels that have only been reached just prior to the onset of a bear market. As shown by the previous two market peaks, clearly this measure can go higher still. Nevertheless, this metric supports the view that the current bull market is much closer to the end than the beginning.

2) A Future of Low Returns? by Timothy Taylor @ Conversable Economist

Here's a figure showing U.S. experience in the long run. The bars on the far right show how annual returns on equity have outstripped those for bonds and for bills from 1900-2012. The middle bars show a similar pattern, a bit less extreme, for the last half-century from 1963-2012. The bars on the far right show the 21st century experience from 2000-2012. Stocks have offered almost no return at all; neither have bills. Bonds have done fairly well, given the steady fall in interest rates, but as interest rates have headed toward zero, the gains from bonds seem sure to diminish, too.

Dimson, Marsh, and Staunton have some grim news for those waiting for a bounceback to 20th century levels of returns: "[M]any investors seem to be in denial, hoping markets will soon revert to “normal.” Target returns are too high, and many asset managers still state that their long-run performance objective is to beat inflation by 6%, 7%, or even 8%. Such aims are unrealistic in today’s low-return world. ... The high equity returns of the second half of the 20th century were not normal; nor were the high bond returns of the last 30 years; and nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional."

Woj’s Thoughts - Most people are probably aware that equity returns have been dismal, so far, during the 21st century. What I find striking is how small the gap between equities and bonds has been over the past fifty years. Sure 2.3% in real terms is significant, especially over a long-time horizon, but given the severely different levels of risk shouldn’t this figure be higher? For those interested in many other great charts and more in-depth discussion, check out the Credit Suisse Global Investment Returns Yearbook 2013.

Will the Bank of Japan End Up Owning the Entire Stock Market?

Japan Does the Full Ponzi by Cullen Roche @ Pragmatic Capitalism

I saw this headline over at Calculated Risk regarding the new “monetary policy” in Japan:

And from the Japan Times: Japan’s economic minister wants Nikkei to surge 17% to 13,000 by MarchEconomic and fiscal policy minister Akira Amari said Saturday the government will step up economic recovery efforts so that the benchmark Nikkei index jumps an additional 17 percent to 13,000 points by the end of March.“It will be important to show our mettle and see the Nikkei reach the 13,000 mark by the end of the fiscal year (March 31),” Amari said in a speech.The Nikkei 225 stock average, which last week climbed to its highest level since September 2008, finished at 11,153.16 on Friday.“We want to continue taking (new) steps to help stock prices rise” further, Amari stressed …

…

Yes, the Bank of Japan might create some real wealth (for some market participants) in the near-term and might thereby make Japan appear better off than they really are, but there’s absolutely no underlying fundamental change in the corporations that make up this index that should lead one to believe that these price changes are justified.  And when the Ponzi scheme is exposed the market collapses thereby destroying wealth for all the current participants leaving us right back where we started.

This is ponzi based monetary policy.  It’s based on a false understanding of market dynamics, a false understanding of real wealth, and it’s very likely to cause disequilibrium in the long-term.

Woj’s Thoughts - While these comments made investors giddy, as expected, I can’t help but feeling that the continued onslaught of “open mouth” operations from Japanese officials is masking their deficient understanding of modern monetary economics. If wealth effects from higher stock prices are largely irrelevant in the U.S., what are the odds the effect will be greater in Japan where equities play a much smaller role in household portfolios?


As Niels Jensen makes clear in his most recent investor letter, the Nikkei’s recent surge combined with a plunging Yen suggests the pressures in both markets are arising primarily from foreign investors.

Prior to PM Abe taking office I was skeptical of fiscal and monetary policies actually being enacted that would materially raise either inflation or real GDP growth (effectively NGDP). Since then a minor fiscal stimulus package was announced along with a higher inflation target and commitment to future QE. Looking beyond the initial market optimism, none of these measures will actually generate the economic results to match the widespread wishful thinking. Fourth quarter NGDP was just recently announced at zero percent and real GDP fell for the third consecutive quarter. Unless further drastic policy actions are taken, I suspect future quarters will more closely resemble the current quarter than the hoped for 4% NGDP growth.

(Note: Cullen describes Japan’s theoretical new policy as a Ponzi scheme, but I think that terminology may be incorrect in this situation. Since the Bank of Japan (BoJ) can create an unlimited supply of reserves, it does not require any new lending to continually maintain any price for the Nikkei it chooses. The scariest outcome is not that the scheme would collapse, but that the BoJ would end up controlling all currently public corporations.

To be clear, I doubt that outcome would happen in practice. The more likely endgame is that the policy becomes politically unacceptable and then the BoJ retracting its price target leads to a spectacular (ponzi-esque) crash.)

Bubbling Up...12/31/12

1) Yield Spread Between Junk Bonds and Stocks by Cullen Roche @ Pragmatic Capitalism

Here’s David [Schawel]’s comment:

“The chart below shows the spread between the yield on junk bonds and the yield received from holding stocks.  The spread recently turned negative for the first time ever, showing just how much the yields on high-risk bonds have come down as central banks keep benchmark borrowing rates depressed and investors search further out on the risk spectrum for yield.”

Woj’s Thoughts - This chart, more than almost any other, may highlight the potential harm induced by the Federal Reserve’s attempts to push private investors further out on the risk spectrum. Unless junk bond companies have truly become significantly less risky, when the next round of increasing defaults begins, investors will find that current yields fail to even remotely compensate for future losses. Stocks may currently be slightly overvalued from a historical perspective, but certainly not compared with junk bonds.

2) Too Much Faith, Not Too Little by Mungowitz @ Kids Prefer Cheese

I have long believed that the problem market economies have with statists is misunderstood.

Pro-market folks tend to think that statists just don't understand markets.  And to some extent that's true.  But the real problem is that statists have too much faith in markets.

Wait...too MUCH?  How can that be? (More after the jump...)

3) Trickle-Down Monetary Policy by The Arthurian @ The New Arthurian Economics

The Fed buys the IOU from my lender. The lender gets cash. And I get to make the same payments I made before, except now I pay somebody else. That really doesn't do much for me. It doesn't do much for the economy, either.

Purchasing assets removes those assets from the economy, replacing them with money. But the liabilities remain as they were: draining income, depressing demand, hindering economic growth.

Woj’s Thoughts - Art explains in a very straightforward manner the basic problems with QE. If the heart of the issue is excessive debt, asset swaps do basically nothing to reduce household liabilities while removing interest income from the private sector. I think Art goes a bit too far in suggesting the Fed cancel private liabilities outright since explicit fiscal policy should be left to elected officials.

David Rosenberg's 2013 Investment Outlook

One of the best resources for investment advice and economic projections over the past several years has been David Rosenberg. Courtesy of Zero Hedge, here is part of his outlook for 2013:

The Fed has also completely altered the relationship between stocks and bonds by nurturing an environment of ever deeper negative real interest rates. Therein lies the rub. The economy and earnings are weak, and getting weaker, but the Interest rate used to discount the future earnings stream keeps getting more and more negative, and that lowers the corporate cost of capital and in turn raises the present value of expected future profits. It's that simple.

...

Beneath the veneer, there are opportunities. I accept the view that central bankers are your best friend if you are uber-bullish on risk assets, especially since the Fed has basically come right out and said that it is targeting stock prices. This limits the downside, to be sure, but as we have seen for the past five weeks, the earnings landscape will cap the upside. I also think that we have to take into consideration why the central banks are behaving the way they are, and that is the inherent 'fat tail' risks associated with deleveraging cycles that typically follow a global financial collapse. The next phase, despite all efforts to kick the can down the road, is deleveraging among sovereign governments, primarily in half the world's GDP called Europe and the U.S. Understanding political risk in this environment is critical.

...

With regard to global events, we continue to monitor the European situation closely. Euro zone finance ministers have given Greece an additional two-year lifeline and the Greek parliament just passed another round of severe austerity measures, which I think will only serve to make matters worse there from an economic standpoint, but I doubt that the creditors are going to let Greece go just yet. So this never-ending saga remains a source of ongoing uncertainty, but at the same time. Is a key reason why the Fed and the Bank of Canada will continue to keep short-term interest rates near the floor, and all that means is to build even more conviction over income equity and corporate bond themes.

...

As for something new, after a rather significant slowdown in China for much of this year that put the commodity complex in the penalty box for a period of time, we are seeing some early signs of visible improvement in the recent economic data out of China and this actually has happened even in advance of any significant monetary and fiscal stimulus. And while the Chinese stock market has been a laggard, if there is one country that does have the room to stimulate, it is China (make no mistake, however, China's economic backdrop is still quite tenuous, especially as it pertains to the corporate sector - excessive inventories, stagnant profits, rising costs and lingering excess capacity are all challenges to overcome).

Keep in mind that much of this slowing in China was a lagged response to prior policy tightening measures to curb heightened inflationary pressures - pressures that have since subsided sharply with the consumer inflation rate down to 2% (near a three-year low) from the 6.5% peak in the summer of 2011 and producer prices are deflating outright. What is providing a big assist to this sudden reversal of fortune in China is a re-acceleration in bank lending as a resumption of credit growth and bond issuance has allowed previously- announced infrastructure projects out of Beijing (railways in particular) to get incubated.

The nascent economic turnaround we are seeing in China, if sustained, is Positive news for the commodity complex and in turn resource-sensitive currencies like the Canadian dollar, which I'm happy to report has hung in extremely well this year even in the face of all the global economic and financial crosscurrents. Just consider that the low for the year for the loonie was 96 cents - you have to go back to 1976 to see the last time intra-year lows happened at such a high level.

...

To reiterate, our primary strategy theme has been and remains S.I.R.P. - Safety and Income at a Reasonable Price - because yield works in a deleveraging deflationary cycle.Not only is there substantial excess capacity in the global economy, primarily in the U.S. where the "output gap" is close to 6%, but the more crucial story is the length of time it will take to absorb the excess capacity. It could easily take five years or longer, depending of course on how far down potential GDP growth goes in the intermediate term given reduced labour mobility, lack of capital deepening and higher future tax rates. This is important because what it means is that disinflationary, even deflationary, pressures will be dominant over the next several years. Moreover, with the median age of the boomer population turning 56 this year, there is very strong demographic demand for income. Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible so a reliance on reliable dividend yield and dividend growth makes perfect sense.

...

Gold is also a hedge against financial instability and when the world is awash with over $200 trillion of household, corporate and government liabilities, deflation works against debt servicing capabilities and calls into question the integrity of the global financial system. This is why gold has so much allure today. It is a reflection of investor concern over the monetary stability, and Ben Bernanke and other central bankers only have to step on the printing presses whereas gold miners have to drill over two miles into the ground (gold production is lower today than it was a decade ago - hardly the same can be said for fiat currency). Moreover, gold makes up a mere 0.05% share of global household net worth, and therefore, small incremental allocations into bullion or gold-type investments can exert a dramatic impact. Gold cannot be printed by central banks and is a monetary metal that is no government's liability. It is malleable and its supply curve is inelastic over the intermediate term. And central banks, who were selling during the higher interest rate times of the 1980s and 1990s, are now reallocating their FX reserves towards gold, especially in Asia. With the gold mining stocks trading at near record-low valuations relative to the underlying commodity and the group is so out of favour right now, that anyone with a hint of a contrarian instinct may want to consider building some exposure - as we have begun to do.

The Fed’s recent actions imply that it will permit inflation to temporarily rise above 2% in the hopes of reducing unemployment and spurring growth at a faster pace. While that occurrence remains to be seen, there is potential for even deeper negative real yields over the coming year to boost stocks further. However, as I’ve been arguing for many months, future earnings growth will likely be much weaker than expected and may turn negative. Last year I offered my own predictions for 2012. In the next couple weeks, I hope to discuss those successes and failures, while also putting forth new predictions for 2013. In the meantime, here are few charts from Rosenberg’s outlook that caught my eye:

Greece Offers Once-a-Century Investing Opportunity

I was reading an article from one of the banks that was talking about how low Greece’s CAPE was (the article cited around 2).  I wanted to examine what happens when a CAPE was really, really low.  So, we looked at the database for all instances where CAPEs were below 5 at the end of the year.  We only found nine total out of about 1000 total market years.

US in 1920

UK in 1974

Netherlands 1981

South Korea 1984,1985,1997

Thailand 2000

Ireland 2008

and…Greece in 2011

Can you imagine investing in any of these markets in those years?  Me neither.  In every instance the newsflow was horrendous and many of these countries were in total crisis.

Now what would happen if you invested in these markets, the literal worst of the most disgusting terrible markets/economies/political situations?  Below are local country real returns (net of inflation):

On average:

1 Year:  35%

3 Year CAGR:  30%

5 Year CAGR:  20%

10 Year CAGR:  12%

Read it at World Beta
Blood in the Streets, or Greece
By Mebane Faber

Looking at the headlines makes one extremely hesitant about investing in Greece or the other European periphery nations. However, this data provides a tempting reason to take a contrarian point of view. Current economic deterioration is proving politically unstable, which makes drastic actions increasingly likely in the next few years. At such low levels of investor sentiment, the chances that actions/outcomes surprise to the upside are ever more favorable.

(Note: I’m currently long EWP, the iShares MSCI Spain Index Fund)

Related posts:
Niels Jensen - "a eurozone exit is not the Armageddon"
Is Non-Existent Austerity Priced in to Euro Stoxx?
Bring Back the Deutsche Mark!!

Points of Public Interest

Ugly day in DC after a beautiful week, but more good NCAA basketball on TV. Good luck to those whose brackets still have a chance of winning!

1. “The Current Models Have Nothing to Say”

Should we be surprised? Policy makers continue to employ models of an economy with no financial system.

2. Economics without a blind-spot on debt

The aggregate level of debt, especially private, matters in

forecasting economic growth.

3. Consumer Credit Growing at Highest Rate in Past Decade: Unhealthy and Unsustainable?

Stopping addictive habits is not easy, but extending those actions will only make the eventual adjustment more difficult and painful.

4. The Japan debt disaster and China’s (non)rebalancing

Chinese consumers continue to increase savings in lieu of domestic consumption. Japan is attempting to rebuild its trade surplus, but which countries will allow their surplus to decline or deficit to increase? Global (and domestic) imbalances not addressed remain significant risks to the global economic outlook.

5. A step in the right direction

Scientific exploration incorporating complex systems and networks continues to move our understanding of reality forward.

6. It's not structural unemployment, it's the corporate saving glut

Businesses save instead of investing in labor when consumer demand is weak. Until policy focuses on improving the consumer balance sheet (e.g. debt write-downs), unemployment will remain high.

7. Wrong vs Early – Contrarians Bet on Natural Gas

The best investors are often early and patient.

8. The Real Problem with Microfoundations

Microeconomics is not especially sound in predicting all outcomes

either.

9. Principal writedowns of the day, mortgage edition

Positive for households but will Bank of America (and others) really accept the associated losses?

10. Why Using P/E Ratios Can Be Misleading

In early 2009, at the market bottom, the P/E jumped to over 100 as profits plummeted. Using E/P corrects for this issue and shows the market is slightly overvalued currently.

 

A Free Market in Education

“Skillshare is solving a serious problem in the world right now: an education system that isn’t speaking to its students or taking advantage of the passion and skill that our fellow community members possess. Skillshare’s vision is to democratize education by empowering anyone to be a teacher.”

-Danya Cheskis-Gold

Read it at Forbes.com
Those Who Can, Skillshare
by Jesse Thomas


A friend and former classmate, Danya Cheskis-Gold, was recently interviewed about a relatively new educational venture called Skillshare. With our traditional educational system often struggling to provide an innovation-inspiring environment, Skillshare seeks to vastly expand the educational opportunities for all ages. Encouraging individuals to both teach and learn unique skills is a fascinating market-based approach to improving education within our society. Definitely check out the website...you may find a class to take for free or make some money teaching!

Update: While the President attempts to stem the tide in rising student debt, a few professors from respected universities are providing an even better solution...free-online courses. Aswath Damodaran (NYU) is offering his corporate finance and valuation courses this semester to anyone online. The links and necessary info to register can be found here: My small challenge to the "university" business model. Separately, David Evans (UVA) and Sebastian Thrun (Stanford) are teaching computer programming and how to build an online search engine in seven weeks. Information for their course can be found here: Udacity.

Europe Bests US in Stock Opportunities

Following the global recession a couple years ago, I thought discussion about different sections of the global economy decoupling from one another would have ceased. Surprisingly, as Europe seemingly begins another economic downturn (several countries are already in a recession or depression), many investors and analysts remain of the opinion that Europe's problems will be largely contained. Will Europe's economic troubles be contained in the same manner as the US housing bubble (which was decidedly not)?

A post today on Pragmatic Capitalism, by Surly Trader titled UNITED STATES VERSUS EUROPE, highlights the divergence between the Eurostoxx 50 and S&P 500. The graph below compares the performance of these two stock indexes since the March 2009 lows. As you'll notice, the indexes initially moved significantly higher together, with Europe even outperforming to a small degree. Correlation remained pretty tight throughout the first portion of the sovereign debt crisis until May of this year. Since then, the S&P 500 is down nearly 15%, but the Eurostoxx 50 has lost more than 40%. Although a significant portion of the difference may stem from European banks (which currently face much larger funding issues), numerous other companies have been dragged down with the broader index.

Anyone reading or watching financial news over the past several weeks has surely heard a vast number of individuals argue that US stocks are extremely cheap based on forward looking earnings estimates. Ignoring for a moment that these estimates are almost always too optimistic, if one believes US stocks are cheap based on those metrics, than Europe is screaming "buy." As the article notes,

"The Eurozone is facing massive political headwinds, but at a dividend yield of 5.98% and P/E of 8.35, it looks relatively attractive versus the S&P 500′s 2.23% dividend yield and 12.71 P/E."

Based on these stock indexes, it certainly seems that Europe is pricing in a far worse economic outlook than the US. Holding the belief that if Europe experiences a significant economic downturn, the US will also be dragged into recession, European stocks, broadly, appear to offer a better risk/return profile.

Recent strength in US markets seems partially related to hope that the EU crisis will be kicked further down the road and that some version of QE3 will be announced next week. I've previously stated why the latter will be ineffective, apart from a short-term boost to stocks, and believe time is running out on the former. My personal view is to remain defensive, focusing on companies with strong balance sheets and large dividend yields. Two names within the Eurostoxx 50 that seem particularly enticing (and I currently own) are Sanofi (SNY) and Total (Tot). Both stocks trade at or below book value, sport P/E's below 7 and offer dividend yields above 5%. Maintaining a 3-5 year investment horizon, I believe these companies will offer significant relative value.

Equity Analysts' Forgotten Word: Sell

Each day, various Wall Street equity analysts update stock recommendations and issue new opinions on previously uncovered securities. Depending on the mood of the market and prestige of the analyst, these recommendations can move a stock by several percent in a day. Numerous investors and money managers pay significant sums for these opinions, which subsequently aid in determining whether to buy, sell or hold specific stocks. Considering the amount of money spent on employing these analysts and the profit derived from their reports, one is persuaded to assume significant predictive value lies within Wall Street's research. Is this a fair assumption, or is Wall Street selling snake oil?

Well, according to recent data "published by Sam Stovall, the chief investment strategist of Standard & Poor’s Equity Research," the answer is almost certainly the latter. An article on MarketWatch yesterday by Robert Powell titled, Things are bad, but analysts can’t say ‘sell’, highlights Stovall's analysis. The numbers speak for themselves:

“Consider, at a place and time such as this, with the economy teetering on the verge of another recession, none of the 1,485 stocks that make up the S&P 1,500 has a consensus “Sell” rating. And just five, or 0.3%, are ranked as being a “Weak Hold.””

"There were (don’t laugh) just 167 (0.08%) “Sell” recommendations and 697 (4.2%) “Weak Hold” recommendations out of a total of the 19,868 Wall Street research reports reviewed in Stovall’s analysis."

Although Stovall's research screams of bias, he attempts to conceive of valid reasons the numbers are so skewed. One explanation offered is that “if stocks for the long run are on an upward trajectory, then everything is a hold.” At first glance this statement appears plausible enough to gloss over, but upon further examination it is extremely flawed.

When people discuss stocks having risen throughout history, they are generally referring to an index such as the S&P 500 or Dow. An important factor often overlooked in this comment is that those indexes are weighted based on market capitalization and price, respectively. This means that stocks which perform better over long periods exert far greater influence on the direction of the entire index than stocks that perform poorly. It should also be remembered that the worst stocks are frequently swapped out of these indexes for stronger ones, creating a survivor bias. Consider these stocks from 1980:

Allied Chemical, American Can, American Tobacco B, Bethlehem Steel, General Foods, Inco, International Harvester, Johns-Manville, Minnesota Mining & Manufacturing, Standard Oil, Texaco, Union Carbide, Westinghouse Electric, and Woolworth.

Those companies were all included in the Dow at the start of the 1980’s, yet many of the names are likely foreign to investors today because the stocks (and companies) no longer exist. The point that Stovall’s reasoning misses is one of basic capitalism. In the long run, most companies fail as new technologies and forms of production eliminate economic profits. The only way to avoid this outcome is through monopolies, either natural or government created. So unless analysts believe capitalism no longer exists in the US, it makes little sense to assume all stocks are at least a hold.

In our everyday lives, if a friend always gave the same advice, most of us would likely stop seeking advice from that friend. Regardless of the economic or market outlook, Wall Street recommendations consistently and uniformly provide the same guidance. Despite this knowledge, markets and investors continue to hand over money for Wall Street’s opinions. Stovall’s analysis is a helpful step towards unveiling the truth about Wall Street recommendations. Hopefully further research will expose the currently subjective process and ensure that stock recommendations are more objective in the future.

A September to Remember

Three years ago, on September 7th, 2008, the federal government nationalized Fannie Mae and Freddie Mac. The following week, Bank of America bought a Merrill Lynch, Lehman Brothers filed for bankruptcy and AIG was bailed out by the Federal Reserve. During the next couple weeks, Washington Mutual also went belly-up, Wachovia was acquired and the remaining investment banks converted into bank holding companies. In markets, credit spreads widened drastically and equity market volatility heightened substantially, including the S&P 500’s largest loss in history of over 100 points (nearly 9%).  

This year, following a weak August, credit and equity markets have gotten off to a miserable start in September. During the first two days of trading, the S&P lost nearly 4% and at the moment is down close to 3% in the futures market. Losses in Europe are even more staggering, with several major indices already losing nearly 10% this month, following grater than 15% drops last month. Sovereign and bank credit markets, especially in Europe, are also freezing up as the crisis worsens. These are ominous early signs of another September to rival its historic predecessor.

Although only three short years have passed, the global economy appears to be following a similar pattern. After trying to kick the can down the road for more than year, numerous underlying problems are unraveling around the world in concert with one another. Each successive attempt at papering over issues has a shorter shelf-life and the time for politicians to get ahead of the troubles is rapidly decreasing. A quick tour around the world’s major economies will shed light on the ensuing global crisis.

US-

Reminiscent of headlines in 2008, Friday witnessed new troubles stemming from apparently plagued mortgage-backed securities. From the FHFA website (http://www.fhfa.gov/webfiles/22599/PLSLitigation_final_090211.pdf):

Washington, DC -- The Federal Housing Finance Agency (FHFA), as conservator for Fannie Mae and Freddie Mac (the Enterprises), today filed lawsuits against 17 financial institutions, certain of their officers and various unaffiliated lead underwriters.  The suits allege violations of federal securities laws and common law in the sale of residential private-label mortgage-backed securities (PLS) to the Enterprises.  

Complaints have been filed against the following lead defendants, in alphabetical 

order:

1. Ally Financial Inc. f/k/a GMAC, LLC

2. Bank of America Corporation

3. Barclays Bank PLC

4. Citigroup, Inc.

5. Countrywide Financial Corporation

6. Credit Suisse Holdings (USA), Inc.

7. Deutsche Bank AG

8. First Horizon National Corporation

9. General Electric Company

10. Goldman Sachs & Co.

11. HSBC North America Holdings, Inc.  

12. JPMorgan Chase & Co.

13. Merrill Lynch & Co. / First Franklin Financial Corp.  

14. Morgan Stanley

15. Nomura Holding America Inc.

16. The Royal Bank of Scotland Group PLC

17. Société Générale  

These complaints were filed in federal or state court in New York or the federal court in Connecticut.  The complaints seek damages and civil penalties under the Securities Act of 1933, similar in content to the complaint FHFA filed against UBS Americas, Inc. on July 27, 2011.  In addition, each complaint seeks compensatory damages for negligent misrepresentation.  Certain complaints also allege state securities law violations or common law fraud.

Although the full repercussions cannot be known at this time, the fall out may prove very large. While the Obama Administration has been working hard to undermine an investigation by New York’s AG into similar matters, another part of the administration has seemingly subverted those goals. This lawsuit almost certainly dampens the Administration’s hope that the largest banks could avoid serious litigation in return for a small fee ($8.5 billion). Of the institutions listed above, several pose interesting related questions, yet the biggest questions are tied to Bank of America’s solvency.

Witnessing its stock fall more than 50% this year (shown below), Bank of America has continually denied claims about needing to raise capital. Despite these apparently false claims, the bank raised capital by selling warrants and preferred stock, along with a significant stake in the China Construction Bank, at steep discounts. Even with these actions, confidence remains fragile, as shares tumbled again on Friday.

Due to its purchases of Countrywide and Merrill Lynch, Bank of America was effectively sued in three separate claims noted above. Combining these claims generates total claims against in excess of $50 billion. However, these claims only represent a small portion of potential liabilities outstanding related to the sale of MBS and foreclosure fraud. Whether the bank ultimately settles these claims or attempts to fight in court, losses will almost certainly be significant and uncertainty regarding the outcome will weigh on the firm for some time.

Apart from unknown losses discussed above, the bank is also currently sitting on untold losses related to its own mortgage holdings, as well as European bank and sovereign debt. Thanks to the ongoing suspension of mark-to-market accounting, the actual market value of current assets is highly unpredictable. Regardless, markets are suggesting current assets should be marked down by billions of dollars and those numbers can only increase as markets weaken.

How long will the confidence last? With Bear Stearns, Merrill Lynch and Lehman Brothers, the final straw seemed to be when institutional investors began pulling funds in mass. Considering recent votes in the US House, another TARP seems unlikely at this juncture. If Friday’s lawsuits spur another significant sell off in the bank’s stock, institutional investors may decide to seek safety elsewhere. Were a run on Bank of America to occur, it’s hard to envision several other weak banks not being targeted as well. The Dodd

Europe -

On a timeline basis, the sovereign debt crisis in Europe feels most similar to the US housing crisis. Nearly 18 months ago, problems began showing up in EU periphery countries, notably Greece. As yields widened, the country’s solvency was questioned and after ECB intervention, a bailout was concocted. Despite a couple more bailouts, Greece’s economy continues to deteriorate under the weight of austerity and a strong Euro. Over the past few days, short-term yields have exploded upwards, with the 2 year exceeding 50% (shown below). Not only are markets pricing in 100% chance of default, but far more significant losses than the most recent proposals by the EU/ECB. Apparently recognizing Greece represents a solvency issue, not liquidity problem, the IMF and several EU nations are reconsidering any further aid. 

After Greece, Portugal and Ireland also fell victim to economic deterioration and questions regarding their own solvency. These countries have been locked out of credit markets for more than a year now. Having also received bailouts for austerity measures, economic performance has not turned around and debt levels have worsened. Resolutions involving some form of default still appear almost certain.

While most market participants expected Spain to become the next casualty of bond vigilantes, markets surprisingly leap frogged Spain, instead attacking Italy. Starting in July, 10 year yields quickly spiked from under 5% to early 6.5% (shown below). Fearful of the consequences, the ECB once again stepped in to purchase Italian and Spanish debt to stem the rising yields. After successfully pushing yields back below 5%, the markets have once again responded, sending Italian yields back above 5.5% today. 

The recent rise comes after Italy’s government attempted to roll back various austerity measures. As Kiron Sarkar notes in a post on The Big Picture (http://www.ritholtz.com/blog/2011/09/people-who-play-with-fire/):

“The Italians better reconsider their recent attempts to backslide from their commitments – they have a large debt maturity this week – some E14.6bn and E62bn by the end of September (the highest ever in a single month). In total, Italy must roll over E170bn by end December – Whoops.”  

Trying to sell that amount of debt may generate a further sell off in Italian debt, for which the ECB and EU appear unprepared.

Sovereign debt problems are on the verge of spiraling out of control, which is especially scary considering the lack of political unity in Europe. Time is running out on a grand solution and if politicians are forced into a reactive resolution, markets and economies will likely pay the price. As sovereign debt continues to be repriced lower, the resulting market losses are weighing heavily on European banks.

Stock prices of European banks have been falling precipitously over the past couple months. After a brief reprieve due to several countries banning short-selling on the securities, prices are once again falling. As I detailed in Europe Revives Failed Policies of 2008, these measures have been proven to fail and may even worsen the situation. Currently, credit spreads for interbank lending are showing significant strain and approaching levels last witnessed during the crisis of 2008 (shown below, top). Credit default swaps (CDS) on many banks are also reaching new records, potentially stemming from banks trying to hedge counter party risk (shown below, bottom).

Given the global nature of banking, credit problems in Europe may leak into US markets.  Once again, the ECB and Fed (primarily) will be forced to provide liquidity to the financial system. Similarly to the US, if one major bank faces a run, several others are likely to follow. With most of Europe already either in recession or experiencing sub-1% growth, the entire EU risks falling into another recession by year end. Risks are now increasing at a rapid pace, hence the next few weeks promise to be very interesting.

Asia -

After suffering a horrendous earthquake and tsunami, the Japanese economy fell back into recession. While trying to rebuild, global economic fear has sent cash flocking to the safe-haven Yen. Recently hitting all-time highs against the dollar (shown below), a strong Yen has caused exports to falter and hindered the economic recovery. Attempts by the BOJ to intervene in exchange markets have proved woefully unsuccessful. Further hurting the potential for recovery has been an unwillingness to increase deficit spending, which could generate internal demand and weaken the currency. 

As for China, the country has been fighting inflation by raising reserve requirements. History shows that this measure is not particularly successful in reigning in inflation. Recent moves to let the Yuan float higher are more encouraging. China also faces trouble relating to a fixed investment rate near 50%, potential housing bubble and rapidly increasing bad bank debt. Regardless of specific measures taken to thwart these issues, history suggests the most likely outcome is a “hard landing,” which could represent GDP growth below 5%.

For both of these export driven countries, weakening demand from US and Europe will pose significant problems on top of those already established. As the financial crises of 2008 displayed, global economies are very intertwined in today’s world and the troubles of one large nation will exert pressure upon the others. With equity markets in both these counties having already joined Europe in bear market territory, the immediate future is not looking promising (shown below: Hang Seng, Nikkei, Shanghai).

Over the past two years, markets have responded positively to a stimulus led economic recovery across developed nations. Weakening within credit markets has been largely written off as excessive caution. As credit markets weaken further and economic recoveries falter, it appears this time is not different. Equities have been moving quickly to catch up with credit markets on the way down, however the remaining spread still seems quite wide. Unfortunately the global financial system is practically no more transparent than several years ago, which means questions of solvency, plaguing the market, will be hard to defend against. Measures taken in 2008 to provide liquidity and capital will also be significantly harder to pass in a world concerned with sovereign debt and monetary devaluation.

US and German 10 year yields have now joined Japan in the sub-2% club (shown below), which suggests a lengthy period of minimal economic growth and inflation. As equity markets price in a similar outcome, I expect much further declines. A focus on individual companies with strong balance sheets and high dividends should offer great relative value. As for the dollar, equity weakness, global risk and ultimately an interest rate cut by the ECB will likely provide strength. There are times to seek a return on capital and times to seek the return of capital, I believe now is the latter.

Only three years ago, the global economy witnessed the worst recession since the Great Depression. Few people imagined so short a time could pass before the world was once again faced with such enormous challenges. Back then, September marked the period where issues started to really unravel. Could September once again witness the unfolding of historical events? Only time will tell, but based on the first few days, it certainly appears this will be another September to remember.