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VOL. 126 | NO. 237 | Tuesday, December 6, 2011

David Waddell

A November to Remember


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Lots of Ways to Lose Market activity in November was astounding, driven by the cacophonous debate over Europe’s imminent death or salvation. Of the 21 trading days in November, 10 were positive and 11 were negative. The trading range in the S&P 500, from high tick to low tick, equaled 10 percent. The average daily trading range was 2 percent. By the end of the month, the S&P 500 had gone nowhere.

This is an intensely treacherous environment for money managers. Less than a quarter of all active money managers have prevailed against their benchmarks. The HFRI Hedge Fund Index, representing traders most capable of exploiting volatility, has declined 10 percent to date through November. Likewise, many revered investors have lagged significantly as high correlations nullify fundamental analysis. Stock picking prowess in this headline-driven ticker tape, simply hasn’t translated into returns. The year will end as a humbling year for the professionals, with few ways to win and lots of ways to lose. Through Friday, the S&P 500 has gained .75 percent year to date. What we need is a trend!

For a trend to develop, the coin toss on Europe’s financial future must be decided. There have been encouraging developments in Europe lately in response to frightening developments. Crisis precedes action with politicians. Action may precede a positive trend for markets. Here’s a quick primer:

Deflation: The euro zone economy appears to be contracting rapidly. Inflation concerns have quickly become deflation concerns. The ECB, whose sole mandate is price stability, acknowledged that stability means fighting both inflation and deflation. The action for deflation is money printing.

Failed Auctions: Germany recently staged a bond auction that failed to attract buyers, indicating Germany is no longer immune from contagion. More alarmingly, an ECB sterilization procedure (selling good bonds to buy bad bonds) failed. The action to offset “no confidence” sovereign auctions is mandated fiscal responsibility within the EU. The action to offset sterilization constraints is money printing.

Inter-Bank Funding Stress: Banks rely on each other for overnight and short-term funding. When banks become suspect of each other, lending freezes, which endangers the real economy. In response to escalating tensions, central bankers worldwide acted forcefully last week to ensure adequate liquidity.

With liquidity measures now deployed, only solvency measures remain. Hope has risen, as EU political leaders appear to be drafting a pan European fiscal code of conduct. Compliance with the code confers euro privileges. Non-compliance confers sanctions and possible expulsions. With a fiscal constitution in place, the ECB could print money to backstop auctions without fear of engendering moral hazard. The profligate PIIGS would receive short-term funding relief in exchange for adopting criteria fulfilling austerity measures. This substitutes orderly punishment at the hands of their peers for disorderly punishment at the hands of the market. Good idea! Of course, no one has agreed to it yet. Nonetheless, a durable fiscal treaty, whose details may emerge at week’s end, would undergird a durable year-end rally.

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