Tuesday, November 15, 2011

Europe's Crisis & US Equities

Two asset managers appeared on CNBC this morning- Mario Gabelli and Larry Fink.

Of course, these days every manager is asked about Europe. I didn't pay enormous attention to Gabelli's comments, but recall him pushing industrial sector equities, which probably means that's where his book is.

Fink, however, was more interesting for several reasons. First, his firm, BlackRock, runs much more money than Gabelli. And Fink tends to be more thoughtful and expansive in his comments.

Listening to Fink, I was struck by two aspects of his remarks.

First, like many pundits and observers, he continues to see the prospect of countries leaving the Euro to return to their own currencies strictly in economic terms. This morning, Fink sort of threw up his hands and contended that it would be unmanageable for a country to have Euro-denominated liabilities while leaving the currency. But that's not really true. The country would simply have to manage its positions with the Euro like any other foreign currency. It's liabilities in Euro terms would require FX transactions to settle payments, just like dollar-denominated obligations.

Second, Fink began to describe the US economic condition as not getting worse, but a terrible surrounding environment. Then he generally recommended dividend-paying equities, as if to suggest that it would be unwise to expect price-based total returns going forward for the next several years.

When someone like Larry Fink, who controls the allocation of billions of dollars of investments, makes remarks like the ones he did this morning, I think you have to read between the lines. Fink knows that blunt remarks from the likes of him will move markets. That's not the type of book-talking he can afford to do. It might even make him, and BlackRock, liable for damages resulting from such gloomy public remarks which would negatively affect returns in the portfolios which the firm manages.

In that vein, Fink asserted that the current situation is not at all like that of 2008-09.

Yet, I can't help thinking that it actually is, in several respects.

Back in 2007, there was already a lot of discussion about commercial bank-sourced SIVs. Remember when those off-balance sheet holders of mortgage-backed instruments began to run into problems? Then in late 2007, several large US financial firms began to scour the globe for additional equity investments as they wrote off large losses on mortgage-related assets. By the spring of 2008, Bear Stearns was pushed into bankruptcy as counterparties withdrew funds and short term lending lines dried up.

My own proprietary equity allocation signal moved from long to short by the summer of 2008. In retrospect, the signs of a building problem with US equity valuations could have been said to have been building for nearly a year before the collapse of equity prices in the fall of 2008.

In the current situation, we've seen the European debt crisis begin in earnest in the spring of 2010. Things haven't really gotten better since then. Granted, the Greek and Italian governments have changed, but the realities of outstanding debts haven't.

Meanwhile, some fancy footwork avoided an outright default on Greek debt which would have triggered credit default swaps to pay off. But now, as Fink acknowledged, Europe is entering a recession. His comments about the US economy and equity strategies are tepid, at best.

Will we look back, from a year or so from now, and wonder how anyone could have missed the building signs of problems with global equity values which began to be apparent in the spring of 2010?

Perhaps in that sense, the current developing global financial strains do resemble the period of 2007-2009. A series of unresolved, connected and deepening financial problems that can't be magically resolved by climbing equity values.

It's one thing for equity prices to climb 'a wall of worry' about environmental variables which are missed or misread. But it's an entirely different matter for equities to rise amidst a large scale environmental variable such as global deleveraging in the wake of the 2007-09 financial crisis and its impact on Europe's large economies and nations. That's more like climbing in the face of real problems, not simply worries about whether problems exist.

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