Meridian Quarterly Commentary: The European Wizard of Oz

The Meridian Quarterly Commentary | Q1 2012

This commentary was written around January 15th and distributed first to Meridian Wealth Management clients.

The January 9th, 2011 CNN/Money headline was Stock Outlook for 2011: Recovery Rally Will Continue, the chart below showed the consensus estimates:

2011 CNN/Money Forecast

 

 

 

 

 

 

 

The S & P ended where it started, at 1258, 42 points below the lowest estimates and 262 points below the high estimate.  A global index of stocks fell nearly 8%.  Even the consensus estimate was off by over 130 points – how could the smartest companies on Wall Street be so far off?

The truth is these companies almost never get it right, yet it doesn’t stop them from prognosticating.  It seems the more wrong they are the more often they get on CNBC.  Once again the forecasts for 2012 are rosy, the same chart forecasts for 2012

 

CNN/Money 2012 Forecast

 

 

 

 

 

 

 

The average forecast is for a 7% rise with a high forecast of almost 26% and a low of about -3%.  Given the history of bad forecasts I wouldn’t put to much ‘stock’ in these forecasts, especially considering the ending price for 2011 wasn’t even in the wide range forecasted.
Forecasting short-term results is a fools errand.  While current valuations can give you a good idea of what future returns are likely to be (even this is not perfect), there is no indicator that can tell what the market will do in the short-term.  In 2007, Money Magazine had the following to say about the stock market in 2008:

 

“But even though stock prices will jump around more, they’re still expected to rise in the coming year. The combination of decent if unspectacular earnings growth – about 7.7 percent – and a slight decline in the average price-to-earnings ratio next year should translate to an overall gain of about 5 percent in Standard & Poor’s 500 index for 2008.

 

We all know how 2008 turned out.

 

To be sure, I don’t know what stock prices will do in 2012, nor does it matter.  My general belief is that valuations are rich, especially given the risks we know about (add in the risks we don’t know about and there is little if any margin of safety).  While stocks may rise or fall in 2012 – they will likely have meager returns over the coming decade.  This is based on valuation models that have worked for as far back as we have data.  There are still pockets of fair valuation and we try to allocate towards those areas, but until stocks have a meaningful correction our allocations will be light.

 

Will the United States enter into a recession in 2012?  In my mind the question is meaningless as “valuations” matter more and I believe the U.S. is still mired in depression.  But the talk of recession is ever present and historically there have been two reliable indicators of whether or not we are headed for a recession, the ECRI Weekly Leading Index (WLI) and the Conference Boards monthly index of Leading Economic Indicators (LEI) – what are they saying?

Leading Indicator Divergence

 

They are saying the exact opposite of each other.  The WLI shows we are already in recession and the LEI points to accelerating growth.  Both indicators are widely followed and credible…yet neither give us any idea of what’s to come.

 

Next time someone tries to tell you they know where the market is headed in the short term, just smile and nod your head, they have no clue.

 

The real story of 2012 is going to be Europe.  Whether Europe falls apart, fixes itself or continues with the status quo – it will be the main thing affecting all markets (save for all the other things that we do not know about!).  Right now a battle is going on to save a failed European monetary system and how that battle is fought will determine the economic future of millions of people.  The crumbling of the Euro would be epic (a word that is overused, but appropriate), but could be the one thing that could save Europe in the long term.  One thing is for sure – kicking the can down the road will create even more risk and make any transition much more difficult.

Understanding Europe (If it were happening here)

Note: This is purely hypothetical

Many of you have expressed an interest in understanding what is happening in Europe.  It is much more complicated than they have too much debt.  I’ve tried to write an analogy that I hope will make Europe easier to understand.

Imagine you live in California and run major deficits (not difficult to imagine).  You have accumulated so much debt that you can never repay it.  Also imagine there is no Federal Government to allocate funds to California. Eventually, California is locked out of the credit markets – it can no longer borrow on reasonable terms.  The only way to avoid collapse is for the Central Bank to fund California (which it cannot do directly, but does so indirectly by purchasing California Bonds) or to receive transfer payments from a more healthy state, perhaps one of its trading partners – lets say Texas (I chose Texas because the politics of the two states are so different).

Texas buys everything California produces and so it makes sense for Texas to come to the rescue.  But the rescue comes with a price, Texas gets control and veto power over California’s budget and requires the people to take lower wages and to have their pensions cut, imposing a depression via austerity.  Texas also has aims to annex some California landmarks – it has its eyes on Catalina, Yellowstone and Truckee (some Texas politician grew up there).

Californians are now “subjects” of the Texans.  How long do you think Californians would put up with such a system?  Texan politicians who are not answerable to Californians and not voted in by Californians are now in control of their future.  Californians can roll over and give up – or fight.  At some point Californians would fight back – but how?  Using financial weapons.  You see, all that debt that California owes – much of it is owed to Texans and their longhorn banks.  Were that debt to become worthless, Texans would be in big trouble.

If this sounds a bit like Mutual Assured Destruction….it is.  Now there is a stalemate between the two states.  California either creates a new currency and converts their debts or Texas takes losses on their California bonds and moves on (which they are loath to do).

This is the exact situation occurring in Europe right now with California representing Greece (and really Portugal, Spain, Italy, etc.) and Texas representing Germany (and to some extent France).  There are a few minor differences, but I think you get the picture.

Tempers are running high and the stakes are enormous – but the people are not going to stand by and be forced into a devastating unending depression, eventually they will riot in the streets.  Change is coming to Europe – its just a matter of timing.  You may ask why this doesn’t happen in the US – after all, all the states share a common currency like those in the European Union, right? Yes, but we also have something that the Euro is missing – a strong central government and a tight fiscal union.  Europe either switches to this model or it falls it apart – I don’t believe they will switch as I can’t imagine a scenario where such divergent nations with such varied histories and strong nationalistic tendencies could ever exists with a central political body.

A few weeks ago my wife took me to see the hit musical “Wicked”.  If you haven’t seen it, it’s The Wizard of Oz as seen from a completely different perspective, it was very entertaining.  It reminded me that there are people who believe The Wizard of Oz was written as a monetary allegory.  If you type into google “Wizard of Oz” and “allegory” you will find a completely different take on Oz, one that is fascinating.

You likely never read much into The Wizard of Oz and thus never saw the rich imagery claimed.  It might be because Baum never intended Oz to be a monetary allegory. In fact, Bradley Hansen, a Professor of economics at the University of Mary Washington was quoted as saying “the true lesson of The Wizard of Oz may be that economists have been too willing to accept as a truth an elegant story with little empirical support, much the way the characters in Oz accepted the Wizard’s impressive tricks as real magic”.

Baum may never have intended Oz to be a political or monetary allegory, but I figured I could take a stab at turning it into one.

The European Wizard of Oz Symbolism

Right now in many European countries, the citizens feel like Dorothy, stuck in Oz (The European Union) wishing they could get back home.  They are stuck in a currency that is killing them and they want to get back to their old currency where they had some modicum of control over their future.

Unfortunately, the Wicked Witch of the West – played by Germany’s Angela Merkel is dead set against letting countries out of the Euro, instead she prefers more control over them.  It is unclear if Glinda the Good Witch (Christine Lagarde, head of the IMF) will be strong enough to control the situation.  Will Dorothy, joined by the Scarecrow (Greek leader Lucas Papademos), the Tin Man (French Leader Nicholas Sarkozy) and the Lion (Mario Draghi, head of European Central Bank) make it to Oz (the United States Federal Reserve) and find what they are looking for from the Wizard (Co-Wizards Ben Bernanke and Timothy Geithner)?  They will certainly find that the Wizards have no power either and they, the people really hold the power, if only they would exercise it.  Will Europe follow the Yellow Brick Road (the Euro) to destruction or will it break apart with each country in charge of their own destiny (and their own currency)?  Only time will tell, but the adventure promises to be just as entertaining as The Wizard of Oz, but with consequences that will reverberate throughout Munchkinland (The Earth).

Ok, so likelihood is you have no idea who most of those people are, that’s okay – they likely won’t matter much soon anyway.  My whole point is that Europe is on the verge – of what, only time will tell.

Investments

I’m still not a believer in gold and think that the hyper-inflationist and currency collapse crowd is dead wrong.  If anything the dollar could become stronger with deflation being the global headline risk.  Those predicting doom in American because of our debt issues will be found to have been foolish as we are monetarily sovereign – unlike Europe.  This doesn’t mean we don’t have structural problems to deal with, we are in a depression and there is nothing on the horizon that would change our course.  The good news is that we are not in a deep “Great” depression.  This is of little solace for the unemployed and poor, but this country will rise again, just not anytime soon (barring some major unexpected event).  I am still cautious with Risk assets and believe future returns will be low in all major asset classes.

One thing is for sure, 2012 is going to be another interesting year.

 

Scott Dauenhauer, CFP, MSFP, AIF

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