Tuesday, 19 June 2012

Greece/ Spain and the Iraq wars in 2003, 1991

Last weekend we had an example of a day where a lot of people thought: this will determine if we get a bear market for years. All people saw a big tail risk happening with a probability of 50%. That is too much for a tail risk: then it is priced in totally in the market. Everybody is aware of the pending disaster.


Well, Greece delayed drachmageddon but now Spain is seen as lost forever.





This is not the first time everybody sees the same tail risk occurring with a high probability. That was also the case for the Iraq wars in 1991 and 2003. We knew timely in advance when the war should start. In 1991 Peter Lynch, then the miracle investor of Magellan, warned that really everybody had priced in the Iraq risks and that he knew one thing for sure: the risk premium at that moment was gigantic. So you had to be brave to profit from these high risk premiums, especially what had become too cheap because of those too high risk premiums. Markets started to rise in the week before the attack and the bear market was over. History repeated itself in 2003. Before the market was sent down for the n th time in the slow motion bear market of 2000-2003. Fixed investments saw a double dip, quite unusual and the valuation were at the long last low again (after the bubble valuations of 2000). Everybody was cautious, kept cash because you never knew, maybe Saddam Hussein had a bacteriological bomb etc. You could not sell to your client you were bullishly positioned, because when it should have gone wrong, you would be reproached seriously: how could you take those risks when you knew the war would start? So you get a low in markets that will last for years.

In 2012 the situation is a bit different, but still comparable. The crisis in Greece is near the end phase, a happy end is not possible as everybody knows. The pain of Spain has become too high. Again we are in a situation where evberybody is positioned for these tail risk disasters. Lots of investors keep cash, they will see what happened after the Greek elections, what disappointment will be invented at the euro summit end of June.

Everybody knows something positive has to be done (as everybody in 1991 and 2003 knew that the US army is stronger than the one of Iraq and that Iraq has no mountains) . That has caused that investors are less negatively positioned now than in 1991, 2003. There are even high valuations for some high dividend equities that seem to be safe. There are extremes at the bond market. They have speculated ridiculously in German and US government bonds. That position is being unwind a bit last week.

Spain could be a bigger disaster than Greece. The macro of Europe deteriorates by the day (maybe the most after Greece in the Netherlands). The saving rates in some countries (including the Netherlands) are starting to become so high they will go down and the economic recovery will start in these countries.

What has changed is that the pain threshold of the central banks has been hit: the macro forecasts have to be brought down, inflation expectations are falling a lot. This is not only the case in the Eurozone but also in the US, UK and Japan. Draghi, Bernanke c.s. have signalled their pain threshold is surpassed. So we know for sure a new tsunami of liquidity will arrive soon. Angela knows something has to happen at the euro summit. Germany has flagged well enough no bazooka is possible to shoot away the problems immediately, buts some advance has to be made.

So we are seeing a hope rally. You could see it already in the buy write index (there is an ETF where they write every month a call option at the money on the S&P500. (the red line in the chart) versus the S&P500 itself. That points at some rise. No guarantee, only hope of course.

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