The ECB’s QE(stealth) has worked a treat since the printing presses were deployed 22 Dec 2011. The 3 year repo saw a 489 billion Euro allotment, equal to over 620 billion USD.

The signs that the market’s analysts would get this one wrong, they had expected a maximum allotment of circa 250m Euro were clear. The weekly allotments prior to 22 Dec were snowballing with the 14 Dec allotment totaling 291m Euro. That should have been the minimum forecast. A better estimate would have been 433m given the maturities of the 14 Dec 291m and the 21 Dec 142m.

On 29 Feb 2012, the ECB has another shot of morphine in the form of yet another 3 year repo. The size of the allotment is the multi-billion Euro question. Having got the allotment size forecast wrong first time round, the market is looking for double or triple the 489 billion Euro. They may not get it. The 1 week repos are not snowballing as quickly and at last count we can see 150m Euros. Of course between now and the end of the month things may change and the Open Market Operations of the ECB have to be monitored. This is just the latest tally as at 8 Feb.

My bullish call on equities, particularly European equities, since 14 Dec 2011, has been predicated on the ECB’s QE(stealth). The massive size of the 3 year repo on 22 Dec 2011 provided confirmation to the view and it has been a view that has worked out. This all does not imply that the European or Global economy has recovered or is in recovery. Far from it. Instead, it has been a market call based on psychology and an understanding of human emotional frailties.

My market view is therefore sensitive to the 29 Feb LTRO. The market is pricing in a large allotment, in the region of 250m to 500m Euro. Some forecasts range as far as a trillion Euro.  If the banks and the ECB disappoint, it would certainly invalidate or weaken the thesis.

One part of the thesis remains, that bank funding stress has been unequivocally relieved. This alone should have some support for risky assets in Europe.

The outlook therefore is now quite uncertain. I would remain long and cautious, monitoring the 1 week repos for signs that the banks are hoarding collateral for the 29 Feb LTRO. If the number threatens to be big, I would add risk and if the number looked to be missing its target, I would reduce risk. These are the signposts.

From a fundamental perspective, the economies of Greece, Portugal, Ireland, Italy and Spain operate at productivity levels inconsistent with factor prices prevailing in the market. Some of these rigidities stem from the use of a common currency, the Euro. You cannot leverage a fundamentally flawed business model (or economy) into viability. The strategy above therefore is akin to a game of chicken.

Equity markets have rallied since mid Dec 2011 as the ECB began its QE(stealth) and the US economy continued to recover. It appears that equity markets want to take a breather. This could last between a matter of days to a couple of weeks. The trend is up.

Investing or trading, call it what you will, is tricky business. One thing for sure is that if one is wedded blindly to fundamentals, losses lie in store. Asset prices are linked to fundamentals through psychology. Unless you intend to redeem a bond at par, buy out an entire company, wrest control of one or practice arbitrage, fundamentals are only useful insofar as it provides all the possible viewpoints available to all investors. Understanding which viewpoint will ultimately motivate the marginal buyer or seller provides insight into future price movements. One only buys (shorts) something with the expectation that someone else will buy (sell) it from (to) them at a higher (lower) price.

This can mean that some of the most profitable trades seem to be the least rational ones.

• when there is a bailout buy the lowest quality and short the highest quality.

• as the ECB prints money, implying a debasement of currency, the immediate relief reaction is a stronger Euro.

• buy European sovereign bonds as the ECB prints money. Front run the banks who are the agents of the ECB’s printing press.

• the US is recovering, buy China exporters.

• China is slowing, buy resource companies. Unable to restructure its economy towards domestic consumption, under pressure in a change of management year, China will flex its fiscal muscles the only way it knows how. Having built staircases going up, it will now build staircases going down. And railways and highways.

Do look at technicals but never in isolation. Causality is far more important than correlation. It is also far more difficult to envisage and validate.

Pre-empt the news and events. Don’t trade in anticipation, at least not in size. Build plausible scenarios based on common sense and understanding the motivations of all participants in the game. Then set milestones that confirm or confound the thesis.

For example, in Dec 2011, with the thesis that the ECB was printing money, trade long. Set signposts to validate and stay long as long as these signposts are met. In the meantime look for a reason the market might reverse. Set signposts again. If signposts are not met and the market turns, its likely a buying opportunity. If bear signposts are met, reduce exposure and possibly turn short.

Constantly build scenarios, set milestones and signposts, trade as planned and use the milestones and signposts to validate or invalidate the thesis. If in a trend, build the reversal scenarios and look for the signs that validate.

And even then you’ll get it wrong. But your mistakes and losses will at least be unavoidable ones. It is wasteful to make avoidable mistakes.

And to the value investors who chant the value mantra as their portfolio NAVs keep falling, I agree totally that the value is getting better but here’s the thing, where is your purchasing power?

By the way, even as risky asset markets rise and are likely to continue to rise, in my view, the real economy is in real serious trouble and there will come that point in time, again, when reality bites. On fundamentals alone, one would either be short risky assets or simply out of the way of the coming train wreck. The psychology tells us to play this game of chicken with all the other players in the great game.

Good luck at the tables…

Brace

So S&P has downgraded a gaggle of European countries’ sovereign debt ratings. What a surprise. Ratings agencies are not always the last to know, but they are always and everywhere a tad slow.

Fundamentally, Europe is in big trouble. A good number of the countries are cash flow insolvent. Their banks are insolvent. These countries are now expected to operate austerity measures in order to regain their solvency, a task diametrically opposed to their task of regaining cash flow solvency. Tax revenue is correlated with economic activity and austerity is a drag on growth and hence tax revenue.

Basically the situation is as follows. A chap is being told by his bank to cut his debt. ‘But I need credit lines to run my business’, he says. ‘But you’re cash flow insolvent’, says the bank. ‘But I can’t do that at the rates of interest you’re charging me’, he says. ‘But we can only lower interest rates if you reduce your debt’, says the bank. ‘But I can only reduce it if you lower your interest rates’, he says. And round and round it goes.

The conversation the bank should be having with the customer is as follows. ‘How do you propose to repay us given that you are cash flow insolvent?’ The borrower gives some lame excuse. The bank then lays upon the borrower a plan of reorganization that involves selling some assets, cutting costs, laying off some staff, potentially hiring more relevant ones… Ideally, the borrower comes up with their own plan as a counterbid to the creditors’ plan involving pay cuts, asset sales, rationalizations, process improvements etc etc.

Fundamentally, it is futile to reorganize the debt of a business that doesn’t make sense. You cannot lever something into viability.

Europe needs to be more competitive. But if the Italians, Greeks and Spaniards were more competitive, then the Germans might be less so. It is not a point the debtor nations want to make to the creditor nations.

The approach taken by the French and German governments towards the debt crisis in peripheral Europe is to prescribe austerity as a means to solvency as a condition for financing at reasonable rates. So far the efforts have been lacking in detail and have thus not commanded the confidence of the bond markets.

Austerity is but one solution to restoring cash flow and balance sheet solvency. In the short run, austerity exacerbates the cash flow problem.

In the short term therefore, a non-economic lender of last resort is required. The ECB’s LTRO is designed specifically to this end but requires the (not necessarily guaranteed) participation of the commercial banks. (They do appear to be falling in line.)

Austerity absent the LTRO is not viable. Tax revenues would fall, so would profits, and eventually the insolvency of the peripheral economies would be crystallized.

Austerity requires time. It is hoped that the ECB has purchased sufficient time. Whether the market believes that it has or not will determine the path of bond prices going forward.

The debt and debt service reduction is but an intermediate goal to reduce borrowing costs in the future and thus improve debt reduction. With a common currency, localized domestic prices need to be more flexible, which would be evidenced by less stable prices, i.e. more volatile inflation. This is a consequence the ECB may struggle to reconcile with its price stability mandate.

Price stability could only result from a convergence, not necessarily an improvement, in respective national productivity, in each factor market. This seems to imply not merely a harmonization of fiscal policy but also of tax and welfare systems, a first extension from harmonization of macro policy to harmonization of micro policy, for example in labour and employment law and policy. The true scope of integration necessary to maintain the Euro, while implementing a viable plan of reorganization begins to dawn.

This is what Merkel and Sarkozy are on about. It is, however, a long term goal, and as we all know, in the long run we’re all dead anyway.

The trouble is that there are no short term solutions except pharmaceutical morphine, which the ECB has already shot in the arm. And that kind of medicine has ugly side effects such as inflation and risk of loss of confidence leading to all sorts of nasty things like hyperinflation and acutely high interest rates. Also it is a case of doubling down, requiring insolvent banks to purchase the very assets that caused their insolvency in the first place in the hope of holding up their value so as to stave off insolvency. Its all very precarious.

On Dec 21, 2011, the ECB printed 489 billion EUR. On Feb 28, 2012, one expects it to print even more. That’s a lot of morphine.

In the meantime, the surgeons scrubbing down don’t look too sure of themselves.

The ECB is printing money. It may not yet be directly purchasing sovereign bonds but it is acting as prime broker to the following hedge funds: commercial banks in Italy, Spain, France, Germany, etc etc.

On Dec 14, 2011 it became clear what the ECB’s intentions were. Faced with political constraints and bureaucracy regarding its mandate, a desperately practical ECB decided on a course of action to operate debt monetization on a significant scale circumventing the German government’s envisaged objections. For the full analysis of the ECB’s cunning plan, refer to The ECB is Ready For QE.

To reiterate, the 3 year repo achieves the following:

• Recapitalizes the banks.
• Puts a cap on sovereign yields.
• Supports the coming bond auctions.
• Disengages the cross border holdings of sovereign bonds within the Eurozone.
• Liquefies the money and capital markets.

Is this a good thing? Well, it will create a rally in European equities and bonds. It will cause low quality banks to outperform high quality banks. It will devalue the Euro, which is good for exports, and Europe is a massive link in global trade chains. But it debases the Euro big time. This means that gold and other real assets will rise in Euro terms.

Initially, given the average intelligence of the recreational FX investor, the Euro will rise, so watch out for the volatility.