November, Tuesday 08, 2011

 Earnings Smoke & Mirrors, Silvio is out, Iran heating up

DOW + 101= 12170
SPX + 14 = 1275
NAS + 32 = 2727
10 YR YLD +.07 = 2.06%
OIL +.73 = 96.25
GOLD – 10.50 = 1786.10
SILV -.08 = 35.00
PLAT + 1.00 = 1663.00

Yesterday I reported that third quarter earnings have been extremely strong – coming in at record levels. With 90% of the S&P 500 companies reporting, the earnings and profits on a quarterly and one-year basis will almost certainly top the previous records set in the second quarter of 2007. If you add up the earnings per share for all S&P 500 companies over the last 4 quarters, you get a total of $94.80 compared to the previous peak of $91.47.

If this market was based upon fundamentals like earnings, you might reasonably expect a big rally. Well, we have seen a rally, which we expected. What we haven’t seen is broad participation – in large part because there is a wall of worry coming out of Europe. Also, possibly because the earnings were achieved, in part, on cost cutting – and there are limits to profits based on cost cutting – so the outlook remains a bit shaky.

And also, as an astute listener pointed out:

“With all the lobbied for accounting options available to corporate America, their 
earnings need to be run through a forensic accounting validation testing process

to ensure their real content.” Take away the smoke and mirror accounting and what are you left with? I don’t know. Nobody knows – and that is an ongoing problem for the market.

We have talked extensively about the highly creative alchemy from the banks – turning debts into profits. Last week we learned about the chicanery at MF Global. Today we learn that Japanese camera maker Olympus hid losses on securities investments dating back two decades. Is accounting fraud the new normal? No, but creative accounting and mark-to-make believe has skewed reality to such a degree that trust is foolhardy.

And then there is Europe – the ticking time bomb, the roadside IED just waiting for some fool to trip the wire. Today, Silvio Berlusconi agreed to resign as Italy’s Prime Minister. Berlusconi had apparently couldn’t cobble together enough support for a budget, and he faced a loss of confidence in international markets Silvio was prime minister for 17 years – and he will likely be best remembered for bunga-bunga parties.  The equity markets rallied when the news was announced – I can’t say I know why. If the market had dropped on the news – that would have been a viable option as well. Do you really think the situation in Italy is going to be resolved with a new prime minister? Probably not; Italian debt is just too high to be repaid – at least without substantial pain for Italians.

Meanwhile, Italian bonds are pushing what is considered a red line with yields approaching 7 percent – the official explanation is that this is due to political uncertainty. Maybe, maybe not. I will offer a different reason. Maybe part of the problem is a basic supply and demand situation. Who wants to buy Italian bonds? They are risky. Yes, but you can cover your risk with Credit Default Swaps…, right? Not exactly. The Grand Greek Solution shows us that not only can sovereign bonds fail but also that Credit Default Swaps won’t necessarily cover the losses. Remember the Greek solution calls for investors to take 50% losses, but does not allow for CDS default. This is like wrecking your car and the insurance company says they won’t pay off because you still get a few pennies for the scrap metal wreck.

So, if you’re an institutional bond investor – you won’t take the risk because you can’t mitigate the risk. Demand for Italian bonds dries up, prices drop and yields jump. The spread between Italian and German bonds -- a reflection of the extra risk of holding Italian bonds compared to German bonds -- is approaching 5 percent. Is 7% yield on Italian bonds the tipping point? It is the perceived tipping point.

Now, in addition to a slowing economy, Italy faces ever-higher debt service costs. Current interest rates, if maintained, would cancel out the budget savings planned as part of a painful austerity program. Even when Berlusconi goes, there is no guarantee that reforms to cut Italy's debt and boost growth will be quickly implemented and relief on markets may not last long. What will Berlusconi’s replacement do that Silvio couldn’t do? I mean other than the bunga-bunga parties. Will an opposition party save Italy? Think about it; Berlusconi has been Pm for 17 years; the opposition bloc has been out of power for more than 10 years – this while Berlusconi was partying with teenage prostitutes. If the Italians thought the opposition bloc could do a better job than Silvio, they had plenty of opportunity to put them in power – they didn’t have to wait.

In theory, the ECB could short circuit the rising yields/insolvency feedback loop by promising to buy Italian and Spanish bonds, thereby giving those countries breathing space to enact their fiscal consolidation plans. The ECB might not even need to spend money; a credible commitment could convince the bond market that resistance is futile, driving down yields on its own.At least that is the theory.

But the ECB’s resolve would be continually tested. What would happen if the ECB backed Italian debt but the country showed no sign of realigning its finances? Would investors blink first in a test of wills? And if there is a test of wills, the Germans are going to become exasperated; they’ll pick up their bat and ball and go home in a huff.

Italy and Spain don’t just face a "panic premium" akin to bank run; they face very real solvency questions. The ECB's intervention wouldn’t address these underlying problems (except insofar as interest payments contribute to the solvency challenge.

And if the ECB were to back Italian debt only to discover that, lo and behold, the peninsula is insolvent, the consequences would be disastrous. That said, there are no good solutions to the euro-crisis—the Grand Plan announced last week, the "big bazooka" EFSF plan is floundering and structurally unsound; the Chinese show no sign of riding to the rescue; euro-periphery resistance to austerity is growing.

The European debt problem is unraveling by twists and threads. We can look at third quarter earnings and the recent rally on Wall Street, and the opportunistic investor can jump in for the ride. The prudent investor has to consider the possibility there will not be a satisfactory solution coming out of Europe.

The International Atomic Energy Agency issued a critical report Tuesday saying that it has "serious concerns" about Iran's nuclear program and has obtained "credible" information that the Islamic republic may be developing nuclear weapons. Israeli Defense Minister Ehud Barak warned that his nation would consider every option in countering Iran's bomb-making capabilities. President Obama's administration is expected to lobby the international community to slap new economic sanctions against Iran.

From Zerohedge:

With the European drama seemingly on the backburner for a few days (although with so many promises of resignations, it is now Wednesday in Greece and who is PM? Why G-Pap, despite resolute guarantees he would have stepped down by Monday... at the latest... But aaaaaany minute now, he is resigning, promise) it may be finally time to switch attention over the US, and the fact that absent lots and lots of fiscal stimulus, Q4 GDP is rolling over, as virtually everyone has predicted. Amusingly, none other than Tim Geithner provides the perfect segue, having said earlier that "the supercommittee holds "the key" to rebuild confidence." This brings us to the supercommittee itself. And for that we go to Politico: "Congressional Democrats and Republicans are trillions of dollars apart on a deficit reduction deal as the supercommittee nears its Nov. 23 deadline." So, with confidence like that, who needs any doubt. It continues: "The most recent Republican offer, according to Democratic and Republican sources, includes roughly $770 billion in spending cuts and between $550 billion and $600 billion in new revenue from a variety of sources, including selling public lands, increasing the price tag on postage stamps and new energy leases. Republicans also say they’d be willing to limit deductions and certain tax breaks – sure to anger their conservative base – in order to reach nearly $300 billion in new tax revenues. In exchange, Republicans want to change the rate of inflation for Social Security, cut Medicaid and increase Medicare premiums for the wealthy." Needless to say this is going to go nowhere in a hurry. And all of this is happening as the second interim debt ceiling target is about to be breached after two more Treausry auction weeks. But none of this matters: the robots trading this market, saw the word confidence and sent us to highs. After all buy first, ask questions later is what the motto of the NYSE Borse is, or should be going forward. Probably in German - more fitting.

Fin Fest

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