Last week I expressed my exhaustion after a volatile summer where many of the big picture things I've been worried about for the past 2 years have started to bubble to the surface.  I discussed how I had become frustrated with both the media and many investors as they continue to ignore the long-term ramifications of this summer's events.  The focus continues to be more on the next hit of pain killers from the Fed rather than when antibiotics will finally be administered so we can begin healing our troubled economy.  The fact that our politicians and policy makers would rather place blame than address the real problems continues to frustrate me. 

I didn't say I was throwing in the towel on pointing these things out, but I did point out that I had purposely not mentioned some of the more frightening news of the week because I figured nobody wanted to hear it.

Part of my frustration is that our country (and the rest of the world) MUST address their debt issues.  For 30 years the world grew on the backs of ever increasing debt.  This was unsustainable and in the whole scheme of things a giant Ponzi Scheme.  One country would borrow from another who would sell debt to another country who would turn around and buy debt from somebody else.  This could only go on for so long and the 2008 financial crisis was the beginning of the end of the Ponzi Scheme.

Rather than letting the businesses and investors that made mistakes by buying into the Ponzi Scheme, policy makers around the world decided that the taxpayers should bear the burden of the mistakes.  This saved the world from an immediate economic collapse, but it just pushed back the inevitable restructuring.  You cannot magically make debts disappear.  Somebody has to pay for it, which means every major country around the world must figure out a way to live without all of that debt.

The way I look at it is that the debt issues must be addressed -- either by choice or by force.  It would be much easier (although still painful) if our leaders chose to address the debt problems rather than waiting for the market to force them to deal with it.

I was actually optimistic when S&P downgraded the US because I thought that it would be a wake-up call for our leaders to address the reasons America was downgraded.  Instead they blamed S&P, launched a Congressional investigation into S&P's research, and forced their CEO to resign.

I was humbled at the outpouring of support from our readers on Friday.  I was also convicted by one person that said I had a "responsibility to speak the Truth whether or not people believe it or take it to heart."

So after a weekend spent with friends playing games, donating some golf balls to the poor homeowners that chose to live next to (or in some cases across the street from) the golf course, playing in our church band, watching movies with our kids, and hiking in the mountains I'm ready to get back to breaking down the issues the market is facing.

It's a good thing I had such a fun, relaxing weekend, because there are a lot of news items to digest this morning.

Europe is Imploding (Again)

We've joked on the radio that the reason the stock market has had so many strong Mondays the past few months is because on Friday everyone is worried that Europe is going to collapse over the weekend and when it doesn't happen, the market takes off on Monday.

It's a good thing the U.S. market was closed for Labor Day yesterday.  European markets were down 5% on Monday.  It's hard to keep track of what bailouts they are talking about when the headlines say "Germany pulls out of bailout discussions" or "Finland derailing Greek bailout".  It seems that Greece is not living up to its end of the bailout Europe agreed to in July, which is putting any future payouts from that plan in jeopardy.  There are also discussions about future bailouts and how they would be structured. 

Germany is once again voicing its concern about participating in future bailouts unless the bondholders share in the losses.  As I have often said, "problems do not magically disappear."  Europe is broke and one broke country lending money to another broke country will not solve the problems.

The risks of default are skyrocketing in Europe and in most cases are above where they were at in 2008.  The easiest way to see that is by looking at the price of Credit Default Swaps (CDS) (think of this as insurance against default -- as the risk of default go up, the value of the insurance policy goes up.)

The "peripheral" countries (Greece, Ireland, Spain, Portugal, etc) may be the problem, but because all of the European countries are participating in the bailouts they are at risk of defaulting themselves.

Speaking of CDS, somebody has to issue the insurance.  The issuer is the one on the hook (and is losing money as the price climbs) should the debt go into default.  Back in June we discussed how the Wall Street firms are repeating the same mistakes and have increased their exposure to Europe during the past 12 months, mainly by issuing CDS on European debt.  

The bond market is also a way to monitor the risks of default.  Even though the European Central Bank is still accepting Greece bonds as collateral as well as being the primary purchaser of Spanish, Greek, and Portuguese debt at auction the past few months, the bond market participants are basically saying there is close to zero chance Greece will be able to meet its obligations.

Check out the 1 year Greek yields:

If you want to loan them money for 2 years you only are getting 54% yields at the current market prices.  Yields across Europe have jumped substantially during the past month.

Is the Euro Finished?

Adding to the losses in Europe yesterday was the comment by one bank CEO that the liquidity situation in Europe is worse than 2008.  Grease (not Greece) was poured on the fire when UBS issued a report titled "Euro break-up - the consequences".  The report is sort of a tough read, but it starts off with a pretty bold statement -- "The Euro should not exist."  They say that in the current form the Euro creates more costs than benefits for some of its members.  You think?

This report gets into my core concerns with every economy around the world -- do you restructure by choice or by force?  If done by force, UBS highlights some of the possibilities by mentioning what has happened during past monetary break-ups:

Either there was a more authoritarian government response to contain or repress the social disorder (a scenario that tended to require a change from democratic to authoritarian or military government), or alternatively, the social disorder worked with existing fault lines in society to divide the country, spilling over into civil war. 

Reading through this report it makes sense why everyone is so worried about a possible Euro break-up.  I've mentioned to a few people that the possibility of a major war breaking out in Europe is an increasing possibility.  Most wars are caused by economic turmoil and the feeling that one party is entitled to something that the other already has.  With all of this discussion of increasing collateral and participation amongst banks in future bailouts the strong countries will continue demanding more from the weaker countries.

If I've ever done a Morningstar portfolio comparison for you the past 3 years (ask your SEM relationship manager Tim McCain or Jim Stover about this if you weren't aware of this service) you know that I always circle two things -- 1.) Exposure to Europe and 2.) Worst 3 months, and 12 months.  The two are directly related.  The more exposure a portfolio has to Europe (in my opinion) the more likely that portfolio is to experience the types of losses it had in 2008.

The Currency War Heats Up

Europe actually rallied today as the Swiss National Bank issued a strong statement today and immediately began actions to lower the value of the Swiss Franc.  This increased the value of the Euro against the Franc and helped stabilize European markets.

The reason behind the rally makes sense over the short-term.  Banks and investors across the world have been selling their Euros and buying Swiss Francs.  This should help stem the tide of some of those outflows.

Over the long-term this type of action could cause problems across Europe.  I documented last Fall the reasons every country prefers a weaker currency -- namely it makes their products cheaper overseas, which can increase exports.  The problem occurs when the country (like the U.S.) has such a large trade imbalance a weaker currency hurts the consumers in their country because it becomes more expensive to purchase goods produced overseas.

Purposely devaluing your currency is seen as aggressive and a protectionist policy, especially when there is already so much economic uncertainty.  In the past month we've seen Japan and Switzerland purposely devalue their currency.  The U.S. has been unofficially doing this via Quantitative Easing, which is making China upset because it is not only lowering the value of their investments, it is making their products more expensive for U.S. consumers.  China of course has been doing this for years, which is upsetting U.S. leaders.

This type of action could be minor in the big picture, but because of the current situation it is something that should be watched closely.  Whenever we see countries resorting to protectionist policies we should all be concerned.

Wall St. vs. Washington

Friday after the market closed it was officially announced what everyone was worried about all day -- the Federal Housing Finance Authority (FHFA - basically Fannie Mae and Freddie Mac) was suing 17 banks to recover losses from their investments in mortgage-backed securities.  After watching all the other Washington agencies settle their lawsuits related to the financial crisis for what amounted to one or two days' worth of profits to the Wall Street firms I am skeptical that the FHFA will actually pursue the full damages in their suits.

For now though it looks like we could be in the type of environment that the stock market hates -- Wall St. vs. Washington.  Politico's Morning Update this morning had a little blurb that the banks are considering an all out war against the FHFA, in which they will highlight the fact that Fannie and Freddie were active participants in creating the securities that they are suing the banks over.  This of course would be a direct attack on the Democratic supporters behind Fannie and Freddie and will once again bring attention to the sheer incompetence of those firms.

The most interesting thing about this lawsuit is this -- the taxpayers bailed out Fannie and Freddie.  Then the taxpayers bailed out the Wall Street banks.  Now the first bailed out entity is suing the second bailed out entity.  Why in the world did the taxpayers need to bail out the Wall Street banks is they were committing fraud?  Furthermore, if there was fraud committed, why has the Department of Justice not done anything about it?

The Enron executives are all in jail for fraud.  The WorldCom executives are in jail for fraud.  Bernie Madoff is in jail for fraud.  If Washington truly wanted to make a statement we would see executives from the Wall Street firms in jail for committing fraud. What are they so afraid of?

Labor Market the Real Problem

Friday's payroll report where no new net jobs were added (and the prior months' estimates were revised lower) highlighted the real problem with our economy.  The market had been rallying all week hoping that the Fed was about to save the market with more Quantitative Easing.  I think everyone realized that the Fed has been printing money for over 2 years now and we still have not seen any sort of recovery in the labor market. 

In fact, the Fed's policies have actually created a wider gap between the haves and have nots, which creates further potential for social unrest.  Over the weekend as we were all supposed to be celebrating Labor Day, the Teamsters President James Hoffa, Jr. upped the rhetoric and highlighted the wide chasm our country has in fully addressing the real issues we are facing. 

Mr. Hoffa was speaking just before President Obama gave his "labor day" speech in Detroit on Sunday.  Here is some of what he said:

"We got to keep an eye on the battle that we face: The war on workers. And you see it everywhere, it is the Tea Party. And you know, there is only one way to beat and win that war. The one thing about working people is we like a good fight. And you know what? They've got a war, they got a war with us and there's only going to be one winner. It's going to be the workers of Michigan, and America. We're going to win that war," Hoffa said.

"President Obama, this is your army. We are ready to march.... Everybody here's got to vote. If we go back and keep the eye on the prize, let's take these son of a bitches out and give America back to an America where we belong,"

It is well known that the entire reason GM and Chrysler needed bailed out was that they could no longer afford the contracts they had given the Unions over the years.  Union pensions are the primary reason most municipalities are struggling to pay their bills.  Without cuts to these pensions and renegotiated contracts the taxpayers will be forced to bail these municipalities out once again.  If the political will isn't there (which is probably why organized labor does not like the Tea Party) those municipalities will have no choice but to file for bankruptcy.

This type of rhetoric is not helpful and will only create more social unrest and once again pushes us further from addressing the real problems.

There was also an article that appeared over the weekend in most major newspapers that addressed some of the reasons I feel we are in a depression (failure to return to a prior level of employment and economic output).  "Unemployed face tough competition: underemployed," highlights one thing that is making it so difficult to get a job -- on top of the 14 million counted as unemployed, there are 8.8 million people that are working part-time, but want a full-time job.  Employers are much more likely to increase the hours of part-time people before hiring new workers and the average work week has not really gone up much at all the past year.

The President is supposed to give his highly touted jobs speech on Thursday.  I'm not sure what the market is expecting.  Back in March I discussed the delusion of stimulus.  The people that believe that the government is the key to getting our economy out of a recession had two years of a Democratic President and a Democratic House to test their policies.  The Grand Experiment is failing as everyone continues using the wrong model.

We Can't Change the Truth

While it would be nice to ignore all of the negative news out there and to live in a world where we only hear good news, choosing to ignore the truth could be dangerous.  I touched on that a few weeks ago when I said it was "time for a little truth".  The message was based on a song we played in our church band.  This weekend as I wrestled with the feeling that I was being ignored and that nobody really cared to hear the "truth", I was struck by the message behind another song we were playing.  While the song's message is about our eternal life, I think it can be applied to many situations.  It is certainly not always easy to speak the truth, especially when it appears that nobody wants to hear it.  However, it is our duty to always tell the truth.

So while today's article is probably destined for the "Mr. Sunshine" Hall of Fame, I have no regrets and I apologize for not bringing some of this up last week.

For those of you that are interested, here is a link to our song, "What I Didn't Say."

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