Tuesday, May 11, 2010

Living in the Land of Oz

All those who said Greece did not matter (I guess it has something to do with its economy being only the size of Massachusetts) can finally face the truth that it matters by roughly $1 Trillion. I guess $1 Trillion is not what it used to be, especially when central banks can print money without limit to be administered by generous, bailout-minded custodians of taxpayer money. They must save their only son (the banking system) from the cruel realities of life on the street. Who’s looking out for the rest of us? I think we can only help ourselves.

From reading and listening to many market experts today, last week’s sell-off was supposedly an overreaction anyway. The 1,000 point drop was a “glitch” (actually it is a “yet to be discovered glitch”). The market simply corrected last week to set up the next leg higher. Greece really didn’t matter after all.

Actually, there is a grain of truth to thinking that Greece doesn’t matter. French and German bank exposure to the debt of weak Euro-zone economies is all that really matters. Pure and simple, this is a bank bailout by the European Union, with self-imposed rules being broken to maintain the status-quo. The IMF, funded largely by the U.S. taxpayer, is providing 33% of the money involved ($330 billion!). In an unprecedented move, the European Central Bank has announced it began buying an unspecified amount of debt of European countries. It will provide this money, as ECB President Jean-Claude Trichet remarked, “to re-establish a more normal functioning of the market in order to be sure that we have an appropriate monetary-policy transmission.”

“More normal functioning” depends entirely on your point of view. It is becoming the norm to bail out irresponsible and negligent behavior. The money provided by the ECB didn’t exist yesterday. The ECB isn’t a money making, high return on capital enterprise. They simply own a printing press. There is a certain gullibility required for people to believe in this magic. If it was Procter & Gamble, Clorox, Cisco, Microsoft, or Berkshire Hathaway making this type of investment, we might entertain it as a shrewd, well-reasoned move by a disciplined, value-creating business. But that is not the case. In fact, left to the market to decide, it is a very bad investment. Just last week, two-year Greek bonds were yielding 15%. Only someone with a printing press would make that bet.

I know the EU, the ECB, the Federal Reserve, and the U.S. Treasury are worried. They fear that a moment like last Thursdays “glitch” was actually real. After stumbling for weeks with words of confidence, the EU finally orchestrated a “Sunday Save”, taking a page from the U.S. crisis playbook. Greek riots and truth-seeking markets seemed enough to push the EU to extreme measures. Weekend elections in Germany indicate real political divisions over the European bailout. So, the time to act is now, before markets and democracies impose real discipline. Monday, we went from “Euro-phobic” to “Euro-phoric” (clever…my words) due to the bailout’s absolute size. Who doesn’t love free money? I understand the need for liquidity in a credit crunch, but what we are dealing with here is real, lending-based insolvency in the banking system.

Sometimes it feels like we live in the Land of Oz, with some lunatic calling the shots behind a curtain. Democracy and capitalism, however, reveal the truth, even if they take us on a long, winding, yellow-brick road. Indeed, that road might someday be made of gold. If we eventually find comfort in what Keynes called the “barbarous relic”, it would be an attempt to prevent us from acting likewise. If central bankers and legislators want to maintain order without returning to some type of money based on metal, they need to act in line with free market principles and remove the specter of continual bailouts.

The curtain has been pulled back. The Wizard has been revealed. The hot air balloon is on its way. Everyone must think for themselves, and be courageous and willing to take responsibility for their actions. That is what we do every day as fiduciaries. This is our livelihood and we invest our own capital alongside our clients. The companies we invest in must create value and we look to protect capital from the risks inherent in markets.

There is no magic (or bailout) in that.

Peter J. Falker, CFA

May 11, 2010

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