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Generational Dynamics Web Log for 28-Oct-2011
28-Oct-11 News -- Markets explode on crazy Rube Goldberg eurozone deal

Web Log - October, 2011

28-Oct-11 News -- Markets explode on crazy Rube Goldberg eurozone deal

Haverford's Hank Smith lied about price/earnings ratios

The Dow Industrials by 340 points on Thursday, on the basis of a new eurozone deal, announced at 4 am on Thursday morning, that would be beyond belief if it weren't for the fact that nothing is beyond belief today.


Device to put toothpaste on a toothbrush (Rube Goldberg)
Device to put toothpaste on a toothbrush (Rube Goldberg)

This eurozone deal is the craziest Rube Goldberg thing imaginable. These European leaders got together in the middle of the night and strung together a bunch of proposals, most of which were the cause of the financial crisis in the first place.

Here are the major parts of the deal, according to Bloomberg, and according to numerous comments I heard and read on Thursday:

  1. Greece's bondholders will "voluntarily" take a "haircut" of 50%, under threat of forcing Greece into total default, in which case bondholders will lose close to 100%. The bondholders will be able to exchange their old grungy bonds for sparkling new long-term bonds worth half as much, but which are insured by the EU. Because this scheme is "voluntary," there will be no "credit event," and so credit default swap (CDS) insurance payments will not be collectible. The objective is that Greece's deficit-to-GDP ratio will be LOWERED to 120% by 2020, from its current 160%.
  2. Europe's bailout fund, the European Financial Stability Facility (EFSF), which is supposed to prevent future crises, will be increased to 1 trillion from its current 440 million (of which 250 billion is all that's left - the rest has already been spent). The increase will be accomplished through financial engineering in two ways:

    • Instead of using the money to bail out countries (Spain and Italy), the money will be used to INSURE or GUARANTEE the countries' bonds, so that ordinary investors will feel safe purchasing those bonds.
    • A separate Special Purpose Vehicle (SPV) will be created, which can receive money from countries like China and Brazil, so that the money can be used to bail out Spain and Italy. Those loans would also be INSURED by the EU.
  3. The major bondholders of Greek debt are banks, and since they'll lose a great deal of money, they'll have to be recapitalized. An unnamed mechanism will be used to lend them the money. The biggest banks requiring recapitalization are: 5 Spanish banks - 26 billion; 6 Greek banks, 30 billion; 4 French banks, 8.8 billion; 5 Italian banks, 14.7 billion; 13 German banks, 5.2 billion.

According to Christine LaGarde, head of the International Monetary Fund (IMF), "What we have today is a comprehensive plan that includes all the ingredients."

According to German Chancellor Angela Merkel, "This now brings us to stability and to a stable currency union!"

Problems with Part 1 - 50% 'haircut' on Greece's debt

Problems with Part 2 - EFSF expansion to 1 trillion

Problems with Part 3 - Bank recapitalization

The bank recapitalization is the least controversial of the proposals.

But since banks will be recapitalized with new debt, they will be even more reluctant than they already are to lend money, leading to a new credit crunch.

General problems

Haverford's Hank Smith lied about price/earnings ratios


Hank Smith, Haverford Quality Investments
Hank Smith, Haverford Quality Investments

On CNBC on Thursday morning, Hank Smith, the Chief Investment Officer of Equity for Haverford Quality Investing was asked whether stocks were cheap, and he said the following:

"Absolutely they're cheap on a P/E basis. They're selling below the historical average at about 13 times next year's earnings."

This is an absolute lie, and he knows it.

The historical average, based on trailing earnings, is 14. I have not seen any historical analysis of the P/E ratio based on forward earnings, but I have seen figures that indicate that forward earnings (based on analyst estimates) have averaged something like twice as high as the earnings turn out to be. This implies that the historical average for P/E ratios based on forward earnings is 7, which means that a P/E ratio of 13 is WAAAAAAAAAAAAY expensive.

Even if Smith himself, who undoubtedly earns a multi-million dollar salary, is too dumb to understand this, there's no doubt that his technical staff understands it, and so this is a purposeful lie.

As I've said before, analysts and journalists on CNBC and Bloomberg tv ALWAYS lie when they talk about price/earnings ratios (also called valuations), as I've discussed in "5-Oct-10 News -- Goldman Sachs's Cohen gives price/earnings fantasy" and "24-Aug-10 News -- Ariel's Bobrinskoy gives price/earnings fantasy."

So, in case I've been too subtle, let me state it clearly: Hank Smith of Haverford Quality Investing was on CNBC on Thursday morning and he purposely lied about P/E ratios.

The biggest monthly point gain in history

The Dow Industrials average increased by 340 points on Thursday, and the Dow is now on pace for the biggest monthly point gain in history, according to the pundits.

Back in 2004, someone online asked me, "How can you ever be proven wrong? You're predicting a financial crisis, and if it doesn't happen, then you just say it hasn't happened yet."

My response at that time was, "Public debt has been increasing exponentially. If it ever starts leveling off and falling, then you can tell me I'm wrong."

I was predicting that the financial crisis would occur in 2007, and that turned out to be right in the sense that the credit crunch began at that time. But the major crisis hasn't yet occurred, because governments around the world have been increasing public debt to astronomical levels.

Every action taken by America, Europe, China and other countries since 2007 has been to stave off disaster by enormously increasing public debt. I can't tell the exact date when this is all going to come crashing down, but Thursday's parabolic stock market surge may indicate that it may not be far off.

(Comments: For reader comments, questions and discussion, see the 28-Oct-11 News -- Markets explode on crazy Rube Goldberg eurozone deal thread of the Generational Dynamics forum. Comments may be posted anonymously.) (28-Oct-2011) Permanent Link
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