Ramblings of a Portfolio Manager 2-8-2010

Bulls Bears & PIGS

The old saying on Wall Street goes bulls and bears will always make money but pigs will get slaughtered. The “pigs” in this little proverb refers the living, sty-resident type and is meant to represent greedy investors, who never succeed by being “hoggish.” The soothe-sayers of old who came up with the adage certainly could not have envisioned that one day the modern day PIGS, Portugal, Ireland, Greece and Spain, would make it a truism. After a dismal market month in January, February’s strong start was abruptly halted by the twin specters of continued debt trouble in Greece and, by extension, Spain.

To put things in perspective, Greece is a country of 11 million people and represents approximately 2% of the combined GDP of the EU. New York City, with a GDP 3x larger, could kick its butt in a rumble. Spain, on the other hand, has a GDP slightly larger than NYC, approaching that of California, with a population of 45 million, slightly less than California and New York City combined. A Sovereign default by Spain would certainly cause a big ripple across the world financial markets and the fear of the Greek contagion spreading to the other PIGS is what rocked world markets last week. By comparison, the tiny Emirate of Dubai, which caused a minor tempest in the markets last fall, is about 13% the size of Greece in GDP.

The possibility of a default by Greece cannot be dismissed. Greece’s total debt stands at over 120% of GDP as compared to California’s indebtedness at 7% and unlike the UAE, EU charter prevents member countries from coming to neighboring states’ financial aid. Any rescue of Greece would have to come from the EU as a whole, possibly in the form of a bond offering, the proceeds of which would be shared with Greece. So far, EU ministers have rejected the prospect of a bailout, as has China, now the World’s lender of last resort. But as we pointed out, Greece is very small and so that begs the question how would Greece bring down Spain? According to the Bank for International Settlements, the majority of Greek Sovereign and private debt is held by French, Swiss and German banks. So a Greek default wouldn’t necessarily harm financial institutions in Spain, however much of the same macroeconomic woes that afflict Greece are also hitting Spain, who’s debt load as a percentage of GDP is a also high, at 66%, and who’s budget deficit is comparable at 9.7% versus 13% in Greece. The sentiment is that if it could happen to one Mediterranean state, it could happen to others (including Portugal) and that fear is hanging over the Spanish currency and thus its bond market, causing the Government to cancel a planned note offering last week.

So is this the buying opportunity that retail investors have been waiting for since the March 6th bottom? Perhaps a lesson from history is in order. The Arab oil embargo of the mid 70’s led to the Latin American debt crisis of ’75-’82, when many countries could not pay the high debt incurred from years of fruitless infrastructure projects. While that crisis played itself out, the US equity markets experienced the “lost decade” of little or no progression. To be sure, much of that lost decade can be attributed to problems at home, also caused by the oil shock, but the LatAm crisis certainly played out on the equities of large US multinational banks and fears of Sovereign default weighed on the US equity markets at the end of the decade. With the resolution of the crisis in 1982, however, the US equity markets staged a stunning decade-long rally although some of that rally could be attributed to the election of Ronald Regan as US President and his subsequent implementation of supply side economics. A more recent and closer analogy is the “Asian Contagion” of 1997, which began with the collapse of the Thai Baht and the subsequent inability of that country to meet its debt obligations. The contagion spread across other South East Asian countries, many of which had Debt/GDP ratios over 100%, as their currencies and stock markets became significantly devalued by global fear. The crisis was eventually resolved by the IMF, which created a series of rescue packages (bailouts) to enable the affected countries to avoid default, tying the aid to promises of drastic economic reforms at the recipient countries. During that contagion the US equity market at first took a dive in mid-1998 but soon recovered and the S&P 500 ended the year up nearly 30%.

In our opinion PIGS issue will eventually be resolved by the coordinated efforts of the EU with some IMF and foreign assistance but that while it works its way through the markets will remain volatile. We are reminded that for half of its time as a Sovereign entity (200 years) Greece has been in default on its debt. So what we are witnessing here has been seen before. Ultimately, we believe that this will present an excellent opportunity to get back into the equity markets and look for the resolution as the catalyst.