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The Bottom Line #2

The Bottom Line #2

Francois Rabelais: “Debts and lies are generally mixed together”

Thomas Jefferson: “I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.”

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” – Ernest Hemingway, “The Sun Also Rises”.

Benjamin Franklin: “Pay what you owe, and you’ll know what’s your own.”

Anyone who is reading this is probably aware that there has been a decent correction in the equity markets recently, taking the TSX down about 1,000 points off its recent highs, as we write this. The question is, is this just another healthy correction in an ongoing, healthy bull market, or a sign of greater pain ahead? In Canada, the technical indicators certainly don’t look too good: Dennis Mark, National Bank’s Technical Analyst, has said that the recent movement in the TSX points to a potential low-12,000s target. He also highlights markets on three other continents that appear to be breaking down and testing or challenging support, and he also points out that the Dow Transports are also starting to experience, as he puts it, some “technical difficulties”. So what’s causing this global exit from equities? Let’s step back and look at what’s been happening the last few weeks.

Could it be because of Greece? While the media is full of reports that suggest the Eurozone will pull together and bail out Greece without too many uncomfortable conditions, we’re struggling to figure out how this could possibly end well. In a week that saw Greece’s Prime Minister characterized as “Goldman Sachs’ Employee of the Year”, it’s become apparent that Greece’s citizens are increasingly angry and frustrated by the idea of being forced to adopt further “austerity measures”, while creditor nations are getting increasingly reluctant to keep footing the bill. By one estimate, each Finnish citizen has already subsidized Greece to the tune of 6,000 Euros a piece, and they haven’t even seen a free souvlaki in return!

If you think Greece will simply be “solved” like Ireland or Portugal was solved, or if you think that, to turn a phrase now famous for its inaccuracy from Fed Chairman Ben Bernanke, the pain will be “contained”, have a look at what a few well-known people are saying from around the world:

Here’s what Jean-Claude Trichet, the current head of the European Central Bank had to say yesterday:

European Central Bank President Jean-Claude Trichet said risk signals for financial stability in the euro area are flashing “red” as the debt crisis threatens to infect banks.”On a personal basis I would say 'yes, it is red',” Trichet said late yesterday in Frankfurt after a meeting of the European Systemic Risk Board, referring to the group’s planned “dashboard” to monitor risks. “The message of the board is that” the link between debt problems and banks “is the most serious threat to financial stability in the European Union.”

Here at home, the Governor of the Bank of Canada, Mark Carney, said this:

“Although the Canadian financial system is currently on a sound footing, the bank judges that, largely because of external factors, risks to its stability remain elevated and have edged higher since December…”.

Three guesses what “external factors” he’s referencing.

Let’s leave off the quotes with one from the Chairman himself, Ben Shalom Bernanke:

(Bloomberg) — Federal Reserve Chairman Ben S. Bernanke left the door open to a fresh shot of monetary stimulus should the economic rebound he’s predicting fail to materialize……. One of those risks is a debt default by Greece, which could “roil financial markets globally,” including bonds and stocks, and potentially have a “quite significant” impact in the U.S.

And what’s the average Greek citizen doing in the midst of all this? The Financial Times reports:

“Greek citizens are emptying savings accounts and buying gold as they brace themselves for the possibility of a sovereign default and a run on the banks.”

Suffice it to say that you can count us among the skeptics when it comes to “containment” of the Greek crisis. It seems Aflac (the large US insurer) would also fall into the skeptics camp too, considering that they announced today a need to raise as much as $1 billion as they record losses related to European bank debt! Let’s hope there’s no European equivalent of AIG lurking in the shadows….

So what’s happening closer to home?

Well, stateside they just reported yet another horrible employment number, at 429,000 in initial claims reported, yet another in a long string of employment numbers coming in below the market expectations. And as bad as they seem, the reality is likely far worse. To understand why, you need to delve a little deeper into the arcana coming out of the Bureau of Labor Statistics (BLS). Looking at the most recent employment data from May, the BLS reported that non-farm employment “changed little (+54,000) in May….??? Sounds OK, right? Well, to get the unmassaged number, you would have to subtract a certain number of jobs that are only added in based on a BLS estimate of the number of businesses created and shut down over the period called the “Net Birth/Death model???. So how many of the 54,000 jobs were created by the BLS’s guesswork? 206,000. That’s no misprint. 206,000 of the 54,000 jobs supposedly added to the non-farm payrolls came from the BLS guesswork, meaning the unmassaged positive number turns into a big negative number! Lest you think that the May numbers were a one-time anomaly, the April numbers were massaged up by over 175,000 jobs too.

And remember that this dismal employment picture is against a backdrop of massive monetary stimulus in the form of Quantitative Easing (QE2 in its most-recent iteration).

Speaking of QE, as most of you are already aware, we’ve got QE2 coming to an end at the end of this month. No one really knows what the markets will look like once it drops off. The mechanism by which the Americans chose to stimulate was a massive bond purchase program, so will Treasury yields start to move higher, and if so, what impact will that have on all the other worrisome components of the economy, like housing? Remember that low interest rates have been one of the only saving graces when it comes to the beaten-up housing sector, and even with historically low mortgage rates, housing prices have still been falling rather precariously (and the numbers would probably be even worse if you took into account the “shadow??? inventory caused by “foreclosuregate???, as we discussed in our last piece). Standard & Poors confirmed that as of May 31st, much of the US housing market has entered “double-dip??? territory, going so far as to characterize the ugliness like so:

“Home prices continue on their downward spiral with no relief in sight”

Imagine just how ugly it could get if mortgage rates start to edge up?

Since no President since Roosevelt (who was actually winning his war!) has been re-elected with an unemployment rate over 7.2%, you can bet your bottom-rapidly-declining-in-value-vs-gold-and-silver-dollar that his administration will do whatever it takes to try to stimulate the economy and employment between now and 2012. So does this mean that the recent selloff in equities is a buying opportunity? If the technicals we described at the top of our piece weren’t enough to deter you, have a look at “The Sotheby’s Indicator”:

Reprinted from Damian Cleusix of Global Tactical Asset Allocation

And if that chart doesn’t do it, then here’s the first line from Jeremy Grantham’s most recent missive:

“Lighten up on risk taking now and don’t wait for October 1st as previously recommended.”

Grantham continues by mentioning he’s probably early on his call, as he has been for other great calls that he has made over the years. As our longstanding clients, who bought US Treasuries with us starting in 2006 know well, early can be frustrating, but it sure beats being late!

So to recap: technicals look ugly, the economic numbers are bad and apparently getting worse, Greece is on the verge of a default by any other name (and for those of you who don’t think Greece could or would default, remember, Russia did it not too long ago, and perhaps the US never has, but ask any Frenchman whether the US defaulted when they went off the gold standard under Nixon and he’d probably say “mais oui!”). Greece can’t print their way out of a default like our friends south of the border can and almost certainly will. We’re starting to agree more and more with Peter Schiff’s recent musings about the dollar, and are beginning to feel more comfort with our personal stash of Cottonelle than with US dollar holdings!

Perhaps it’s worth finally having the debate about the “elephant in the room”, namely, when will the world’s governments stop allowing private firms to keep all of their profits, while “socializing” (meaning transferring to you and me!) all or most of their losses? This concept readily extends to weak nations as well, as we continue to see profligate spending both by the countries themselves and the individual citizens, with no apparent regard for the consequences. And who can blame them? So far there haven’t been that many consequences to fear! Nations that fudged their books were included in the Eurozone and are now getting money from the wealthier nations; banks that made horrible lending and investment decisions received hundreds of billions of taxpayer dollars; homeowners who never should have been able to borrow a penny, let alone several hundred thousand dollars, are simply walking away, or, worse yet, living in a house that they stopped paying for a few years ago! Ben Franklin may yet have the last word on the subject: “When the people find they can vote themselves money, that will herald the end of the republic.” Guess what? The people in Greece figured that out several years ago, as did the Americans.

This is what is meant by the expression “moral hazard”. If you never experience any unsettling consequences for bad behaviour, what would motivate people, organizations, or governments for that matter, to change their tune? We started our piece off with some quotes about debt. The debates around the world that are going on today are centred on what to do about the enormous pile of debt that has been generated by profligate spending, by tax avoidance, by the culture of entitlement, and by ballooning government involvement in the lives of their citizenry. Until these trends reverse, we’ll be having these debates for some time to come.

So what investments look promising given all the risks we’ve outlined today? Simply put, things that governments can’t print more of! Another way of saying the same thing is to invest in things that hurt when you drop them on your foot. And that’s the Bottom Line.

What countries and companies do we favour? For that you’re going to have to give us a call and get to know us a bit better. We look forward to it. As always, we appreciate your comments and feedback.

Paul Azeff and Kory Bobrow are Investment Advisors and Market Strategists in the Montreal office of Euro Pacific Canada and can be reached at 514 940-5093 or via email at or

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