Europe: Get Ready for a Surprise Endgame!
How do you find an edge?
I was inspired by a news story yesterday:
What a joke! This really highlights divergent viewpoints.
The market wants to know why they have not already fixed these obvious problems. Every new move is described as smoke and mirrors, kicking the can, or something similar.
Many stories begin by telling you how stupid or ineffective the European politicians are.
Back in my teaching days we had simulations as class exercises. These were wonderful teaching tools — much better than textbooks.
I only wish that I could collect a group of hedgies, traders, and market pundits for such an exercise. Each player would be given a role. The success in the game would be determined by how well the national objectives were met. For Germany, it would be preserving the Euro, which has led to great financial success, while exacting concessions from others on changes in labor rules, agreement with debt limits, etc.
For the ECB the rules would stipulate not going too far until various governments had made commitments.
For the Chinese, it would mean not committing funds until the Europeans had done their part. Ditto for the US. If you acted too soon, you could not get an "A" for the simulation.
For Greece, it would mean exacting debt concessions, stimulus, and whatever else you could get. Ditto for Italy.
For Spain and France, it would be a little more nuanced.
Please note that no single party gives flying Stanley Cup hockey puck (TM OldProf euphemism) about the short-term verdict of the US stock market.
The rules of the game do not optimize the global result. If you and I were dictators, we would have "solved" this long ago, although our ideas of the best solution might differ.
The result from students who engaged in simulations like this was amazing. They got it right away!
Meanwhile, the investment world consists of people who never took this class and who all mistakenly think they are smarter than the top leaders in the world. The bloggers and the commenters seem to think that being sassy and sarcastic makes them look smart. Even some good journalists fall into this trap.
The Alternative Viewpoint
Let us start with what does not work — being a Wall Street Parrot (a species I identified here) and repeating what you read in the newspaper.
Anything that is in the paper is "old news" so you need to look beyond the headlines. Sure, you can get your gig on CNBC and look smart by catering to what people think they already know. It is too bad that this is not like baseball, where they put up the career stats along with the featured pundit. Instead, they show the assets under management. This shows how well management does in bringing fans in to watch a bad team!
I have a long-term forecasting record on this which has been pretty accurate on general European developments. It is dragging out longer than even I expected, but I still see the following conclusions:
- Some sort of deposit insurance for Europe, ending the bank run worries that have dominated the stories for the last several weeks. Do you really think that European leaders have no plan for this? This will be the first news.
- More powers for the ESM — either direct lending to banks, or giving bank powers and leverage to the ESM.
- Expanding the war chest — this will happen gradually.
- Concerted action by G8 powers — quite possible, and already rumored.
- Political and fiscal integration — probably happening since most countries will benefit. I do not know about Greece, but I will note that an exit now is much less painful than it would have been a year ago. This illustrates why it is useful for leaders to buy time.
Evaluating the Downside
I have noted some pundits and commenters who make an argument like the following:
Company X has 20% of its sales in Europe. Europe is in a recession. This is really bad for Company X so it is obvious to sell those shares.
This is one of the biggest investor blunders — something that I call "light switch thinking." It is employed by non-economists who do not try to identify and model quantitative relationships. I invite readers to think about this.
Suppose that the European recession is a GDP decrease of 2%. What should be the cut in the sales and/or earnings of Company X? Would it matter if the company sold toilet paper? Autos? Business software? What is the worst case?
With all of this in mind, how much should we adjust the fair value of Company X? Is down 20% a good number?
The Right Approach
I like the approach of Steven Einhorn (perhaps because his list is what I have been highlighting for months). Thanks to Doug Kass and Barry Ritholtz for highlighting this useful checklist of what you should be watching in Europe.
Most people are watching for some big, comprehensive plan. They will not see a solution until they have missed the whole move. If you follow the items on this list, you can track progress in real time.
There are many stocks that have been excessively punished through this thinking, but you might see the best leverage from some software names like Oracle (ORCL) and cyclical stocks like Caterpillar (CAT). Stocks like Apple Computer (AAPL) have also been dragged down because of the excessively simplistic Karate Kid view of the markets — risk on, risk off.
If you want to do better than advice from a kid movie, my suggestions are a good start!