Cole Sear: I see dead people.
Malcolm Crowe: In your dreams? [Cole shakes his head no]
Malcolm Crowe: While you're awake? [Cole nods]
Malcolm Crowe: Dead people like, in graves? In coffins?
Cole Sear: Walking around like regular people. They don't see each other. They only see what they want to see. They don't know they're dead.
Malcolm Crowe: How often do you see them?
Cole Sear: All the time. They're everywhere.
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The Sixth Sense, 1999
The members of the Eurozone are dead people. They only see what they want to see. The Eurozone as currently configured is on life support. Greece, Portugal, Spain will likely have to leave the Euro. When they leave is unknowable – politicians seem concerned with keeping the current members from returning to issuing their own currencies. But at the same time, they are imposing incredibly harsh conditions on Greece. They are pushing them into an untenable position financially, and worse, they are humiliating them publicly. At some point soon, the Greek people are going to tell the Germans to go pound sand and deal with the consequences, as "being rescued" is clearly worse than simply defaulting.
While imposing these impossible conditions on Greece, German leader Merkel at the same time insists that she doesn't want Greece to default and leave the Euro. However, the German finance minister is now apparently pushing for Greece to default. He doesn't think Greece will pay back the new loan, and so doesn't want to waste the money. See this article in the Financial Times for more information, or my article from 10/28/11 titled "This Isn't My Problem" on why the Germans won't bail out Greece. While most people view default as a disaster, I actually think it's the better of the two bad options facing Greece and Europe as a whole. For Europe, restructuring Greece's debt through a "voluntary haircut" would be the worst option. It would call into doubt the viability of the whole credit default swap (CDS) market. And that is the beginning of the end.
On December 8th, 2011 I wrote in this article that the downward spiral had begun, and the trigger was going to be the "voluntary" losses taken on Greek debt. Art Cashin of UBS, who I think is the best writer on financial markets, revisited the issue of making this default "voluntary" in his note yesterday. Since he clearly stated the issues, I have copied it below. From Art Cashin, Cashin's Comments, UBS 2/16/12:
Is There More At Risk Than Greece In A Greek Default - Recently, there has been a buzz building on trading desks and trading floors that there may be a lot more at stake in a potential Greek default than the media has been talking about.
As of now, most of the public discussion has centered on potential contagion among the banks as most of the Greek sovereign debt is held by the European banking community.
Traders, however, fear that the real risk is in the area of credit default swaps (CDS). They are insurance policies, individually written, that basically say - if Greece defaults, we'll pay you what they should have.
Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved.
As things unraveled in 2008 that lack of records exacerbated the crisis. Bank A could examine the balance sheet of Bank B and see how their assets looked. But were they guarantors of some unseen credit default swaps? If they were, they could be a great risk and not as solid as they might appear. That fear helped freeze the markets. Bank A would not lend to Bank C fearing some unseen CDS exposure. Look at what happened to AIG.
Okay! If you're still awake, let's get back to Greece.
No one knows how much CDS exposure there is on Greek debt but it is assumed to be a lot. Banks and others looked at the very high and attractive yields on Greek bonds and began salivating. But, what about that risk - better buy some insurance.
So, the regulators and finance ministers worry about the great unknown. They know how many Greek bonds are outstanding and who is involved in them. That is not true of CDS contracts.
Recall that, months ago, negotiators on the Greek debt bumped into part of the CDS problem. If the holders agreed to take 50 cents on the dollar, would that trigger their CDS on that bond (paying them the conceded 50 cents and making them whole).
At that time, many contended that if the bondholder "accepted" the offer of 50 cents on the dollar, that made the event voluntary and it would not "trigger" the CDS payout. That caused lots of folks to ask for a ruling from the ISDA (the ruling group on CDS contracts). If you "accepted" an offer with a gun to your head, was it really voluntary?
The finance ministers stopped that conversation immediately as if one of the children had suddenly walked into the room. Fearing a potential panic if a ruling was issued, the ministers quickly swept the CDS question under the rug.
Now traders fear the issue will come back again with a vengeance. The ministers do not want to see a lot of CDS contracts triggered since they don't know who owns them or, more importantly, who wrote them. That could become a domino-like contagion ala 2008.
But, traders fear a worse outcome might occur if the CDS contracts do not kick in. What good is insurance that doesn't pay off. That could lead to the assumption that all CDS insurance was useless. That would stratify debt around the globe. Great credits could get all the money they wanted, but less than great credit would be shut out because it could not be insured. That could make the future one in which "the haves" will have whatever they want and all others nothing. Welcome back to the Middle Ages.
Beware of people who don't know they're dead.
Our view on the markets remains the same: there are some good values out there, but the overall market has come very far, very fast (hopefully you came along for the ride), so we're extremely cautious on stocks near term. Our short Euro call in the fall worked, and I don't see a lot of risk in being short Euro here. In this article I wrote on 11/22/11, I said "The markets for now are intently focused on Europe to the exclusion of almost anything else. The crisis can only end in 3 ways, 2 of which are bad, the other of which is bad for the Euro. First is default via Greek-style "haircuts" (translation: default), which are now being openly discussed for other countries. Second is the ECB prints Euro and monetizes the debt of all the weaker countries (aka, the good option) – Germany vehemently opposes this option (see this article from the WSJ). It prefers option 1, and then rescuing its own banks with its own money. Third is the European Monetary Union breaks up, the weak countries get their own currencies, and they repay their debts in the new, debased currencies. If you can short Euro, I don't see much downside in that trade. If anyone has a fourth option, one that "fixes" the problem, please pass it along…" Three months later, not a lot has changed. Protect your capital and wait for the opportunity to put it work lower.
This week's trading rules (with thanks to Phil Cuthbertson):
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Anxiety is good if it focuses the mind.
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Constantly ask where your conviction could be wrong.
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Ask how much you are prepared to lose before you start a position.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1358, 1354/1355, then 1349, followed by 1342/1344.
Resistance: we're right at it at 1360, then 1365.
Positions: None.
