October 31 Market Commentary

I last wrote to you on September 26, 2011, after a couple of sharply down days in the U.S. equity markets. The markets declined for a few more days until October 4, then commenced to charge significantly higher, with the DJIA (Dow Jones Industrial Average) gaining roughly 17% between October 4 and October 28. The last two weeks have also seen a lot of headlines coming out of Europe, culminating in the announcement on October 27, 2011 of a comprehensive plan to address their issues, so it’s probably a good time to update you on our thinking.

We’ve said for some time that three major topics were driving the markets: concerns about the possibility of another recession in the U.S.; concerns over the possibility of a Chinese recession; and concerns over the possibility of a European sovereign debt and banking crisis. Since we last wrote at the end of September, the economic data about the U.S. and China has generally come in as expected or slightly better, with the notable exception of the October U.S. Conference Board Consumer Confidence Index which at 39.8 was at levels last seen during the depths of the 2008-2009 recession. I believe the markets now view the likelihood of a U.S. recession as receding, and are less fearful of a dramatic reduction in Chinese economic activity as well. (It’s been a while since we’ve heard mainstream media talk about a collapsing Chinese property bubble, for instance.) Commodity prices, from oil to copper, which had risen significantly in the spring and early summer, corrected sharply in August and September as investors no longer believed in endlessly increasing demand, and the flow of dollars from Quantitative Easing 2 (QE2) dried up. This drop in commodity prices has been a boon to economies across the globe, freeing up consumers’ dollars. China continues to tighten its money supply in order to fight inflation, and we are watching very closely for signs it is beginning to loosen—I think it is likely that may occur in the next six months or so. In short, the threat of a U.S. recession is receding, and we continue watching China for signs of change in the actions of its central bank.

Europe, of course, has been interesting lately, with lots of meetings, speeches, and associated drama. At the core of things are two inter-related problems: a number of European countries are losing their access to cheap credit, but not their need for it, and the European banks which are the creditors to these profligate countries don’t have enough capital to survive if the borrowers default. Market uncertainty over the ongoing viability of the European banks has drastically reduced the credit available to those banks to fund ongoing operations and rollover existing debt; most European banks are now turning to the European Central Bank (ECB) for short-term funding. Market uncertainty over the viability of Spain and Italy has prompted the ECB to start lending to those countries through the secondary debt markets to keep interest rates affordable, generally under 6% for 10-year loans.

The European Union (EU) summit which ended on Wednesday, October 26, worked very hard to solve, at least in part, these two problems. The plan they announced has three big pieces: a debt swap program for Greece to reduce its debt load; a forced capital raise by European banks; and the leveraging of European Financial Stability Fund (EFSF) assets by creating a bond insurance program and a Special Purpose Investment Vehicle (SPIV) which will try to borrow money in order to buy distressed government debt. Details on the implementation of these ideas have not been worked out yet. The debt swap for Greece is probably the most positive piece of the plan, but the numbers we’ve seen indicate that even after the swap, Greece’s debt-to-GDP ratio will still be about 110%, typically thought of as default territory. We find it significant that the source of the capital required for the expansion of the EFSF and the capital increase for the banks has not been identified. The German parliament on October 25, 2011 passed a resolution approving the increase in size of the EFSF (the headline), but also stating that Germany would not issue any more guarantees to the EFSF. Further, it encouraged the ECB to stop buying Spanish and Italian bonds once the EFSF was in a position to do so (usually buried in the last third of any article on the topic). Germany is not willing to co-sign any more loans to Greece. The ECB will not be lending money to the EFSF either.

We are concerned that the EU plan doesn’t really solve anything because the key element—where the additional capital is going to come from—has not been answered. In fact, the two sources of capital closest to the problem, Germany and the ECB, have stated they will not provide any additional assistance, preferring to try to incent others to provide capital instead. It remains to be seen how well this will work. In the meantime, the ECB continues to support short-term lending to the European banks and the bond markets of Spain and Italy; those three entities are still under a lot of stress. We remain concerned about Europe.

As the concerns about the U.S. economy and China have diminished, we have put some cash back to work, but still have a bit over 15% in cash. We anticipate putting more cash to work when it becomes apparent that the Chinese Central Bank stops constricting its money supply, and we continue to watch Europe.

For more on these topics, please join us on Monday, November 7, for our live webcast on Europe, China, and U.S. Politics—Why Do We Care? You may register online at www.muhlenkamp.com.

 The comments made by Ron Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.