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Market Update: Snowboarding on the Stock Market

by iBanker on February 1, 2012

When Burton first introduced snowboards back in the 80’s, they were for lack of a better term, runaway death machines. They did not have metal edges and were very hard to control, especially in less than ideal conditions. Unfortunately for this author and the timeliness of my birth aside, my family’s fiscal situation constrained my election of riding apparatuses and thus resulted in one of my first experiences on a “snowboard” to be coupled with what I believe to be Jake Burtons first ever snowboard.

As I strapped into what essentially appeared to be a concoction of materials that resembled and likely functioned like that of a platypus’ beak, I looked to my skiing counterparts on the top of the hill (bunny slope or black diamond –  I don’t recall which – the devil is in the details) and said to myself, “I got this.”   Not sure who I was referring to, because I undoubtedly did not have control of anything as I almost broke my leg, unable to catch an edge whilst careening off into the woods.

After that experience, I hung up snowboarding for the better part of 10 years and stuck with hockey.  After moving to MN and needing something to do for fun that didn’t involve snowmobiling, sitting around a hole of ice or rhetorical assimilation (forcefully saying “eh”, “don’t ya know” and best of all…”heavens to Gretzky!”), I picked up snowboarding again.

The one thing I immediately noticed was the technology of modern snowboards was far more advanced than my “earlier” model. In fact, after a few painful runs I was able to control the board with relative ease and the riding experience was far superior to what I experienced that cold winter day many years back.  With the new snowboard technology, the “runaway death machine” risk had been removed for a more moderate “catch an edge and fall on your ass risk” to put it in technical terms.

The market today is very similar in my view, as recent actions by the ECB have significantly reduced the risk of a systematic failure of the European banking system and its resultant chaos.  However, numerous risks remain that will take time to solve and must not be ignored.

Thank you Mr. Draghi

The actions by the ECB in early December to provide much needed liquidity to the European banking system for up to three years had a profound impact upon the marketplace and certainly shifted investor perception. The issue before the action by the ECB was not that the troubled European sovereign yields were spiking and some sort of haircut or default was imminent – it was the fear that one or more European banks would collapse under the weight of perceived funding problems and capital carnage when the sovereign debt on their books was realistically marked to market.

We're #1!

The fear of a bank failure in Europe and the resultant systematic meltdown was what was dragging the market down in 2011. The move by the ECB took the risk of a systematic failure off the table in the near-term and gave the European banking system ample time to shore up capital levels for the painful hits they will be forced to take on their sovereign debt holdings in the future.

Recent actions by the IMF to boost liquidity, better than expected sovereign debt auction results and what looks like a real chance to restructure Greece’s debt to a more sustainable level are all making the European situation look more manageable and less like a “runaway death machine” to coin my snowboard analogy!

But even with the new infusion of liquidity, sizable risks remain in terms of actually getting the needed reforms done to make the debt situation sustainable over the longer-term.

Two Wrongs Make a Right

Why is the equity market up almost 9% year-to-date yet ten year Treasury yields continue to hover around 2%?  Prior to the announcement by the ECB this relationship was highly correlated with the fear of a systemic failure in Europe driving the “risk on-risk off” trade. An odd thing has happened since the start of the year with the ten year Treasury yield remaining static despite both improved fundamental economic data and the rapid ascent of the equity market. This situation has occurred numerous times in the past and although I do not portend to know the timing, one of the aforementioned markets will be proven wrong when the fundamentals matter more to the marketplace than the technicals.

The situation that is currently playing out is, in my view, primarily driven by euphoria surrounding Europe as opposed to hard economic realities. The rally in the equity market is perhaps more driven by a “relief” trade and a grab by investors who were underweight risk assets for far too long while the Treasury market continues to be manipulated by the Fed and still enjoys a safe-haven status (buy the rumor, sell the fact?). If the broader market history is any guide, at some juncture economic reality will take over and one or both markets will correct to more realistic and fundamentally sound trading ranges. Given the economic data we have seen of late and the gradual rotation into riskier assets, I would suggest that Treasury yields will be proven to be too low given the economic back-drop. However, a significant upward move will most likely not occur until the second half of 2013 once the Fed is done with operation Twist / keeping rates “exceptionally low” and more concrete news of viable debt restructuring comes out of Europe. [Note: this has since been extended to late 2014]. My advice to those investing in equities due the current rally: rewind the tape 365 days and see where your positions would be in March vs. September after our nations credit downgrade. CASH IS KING.

Same Song and Dance

With risk appetite increasingly steadily due to the actions in Europe, investors will continue to gravitate towards yield. Given most investors belief that the Treasury market is horrendously overvalued, I believe we will see investors (most notably total rate of return money managers) garner excess yield by taking on higher levels of credit risk as opposed to adding duration to their portfolios. Don’t believe me? Take a look at your high yielding dividend ETF…okay come back. YTD it’s doing pretty good right?…as it should. The market is on fire and the bid for risk is insatiable. But answer me this, what has fundamentally changed since the start of the market tanking circa 2H of last year? A supposed ECB agreement? Really? Really? (credit SNL). Pretty sure Greek 10-yr yields are still over 30%…the focal point of eurozone debt concerns remains the same yet we’re all of a sudden playing nice in the sandbox.

Not buying it and neither should you…

What are your thoughts of our global economy?

Written by iBanker

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