October 1, 2011

For equity investors, the third quarter of 2011 was the worst quarter in three years and it brought back to mind the financial market turmoil in the fall of 2008.  A flight of capital out of risk assets and into conservative assets drove the S&P 500 Index 14.3% lower during the quarter and drove yields on the ten-year U.S. Treasury note down to 1.93%, within a whisper of historic lows.  But while the U.S. market is down 10% year-to-date, it is actually one of the best performing large markets in the world so far in 2011.  Germany is down 20%, the U.K. is down 13%, China is down 16% and Brazil is down 24%.  The dollar and U.S. Treasury debt remain safe-havens for global investors in times of uncertainty.

Two events during the quarter tested investor confidence.  The first was the debate in Washington over the federal debt ceiling, our near default on our federal obligations and the associated Standard & Poors downgrade of the sovereign debt rating of the United States to AA+ from AAA.  The rhetoric of a divided Congress has reduced confidence of businesses and consumers alike and thereby acted as a brake on our economy.  Despite the unhelpful political wrangling, however, recent economic data has remained stable, and in fact been moderately better than economists’ average estimates.

The second major event to impact investor confidence was the re-emergence of the European debt crisis.  In the U.S. it is difficult for the federal government to reach a consensus on a bold plan of action.  But imagine what it’s like in Europe, where seventeen Eurozone countries are trying to reach an agreement on a plan of action whereby they will be forced to commit their citizens’ Euros to a plan that may or may not preserve the Eurozone in its current state.  And they have to do so on a timeline that concerned investors are prodding along.

When you put oil into the engine of your car, you do not actually make the engine better—you are merely preventing it from getting worse.  With sufficient oil your engine will continue to function smoothly, but without oil it will eventually overheat, seize up and be permanently damaged.  This is the situation facing Europe now.  Do politicians set aside their national agendas to come together to apply a big dose of oil (ring fence the likely Greek default, recapitalize banks) to the engine that is the European financial system, or do they let things grind on for a while longer, risking a seizure and significant damage?

So far the performance of European politicians has been uncoordinated and underwhelming.  The debt crisis is nearly two years old, but apart from vague outlines, there is as yet no credible agreed-upon plan to address it.  Absent is anything resembling the rapid and forceful policy response of the U.S. Treasury and Federal Reserve in the wake of the Lehman Brothers collapse in 2008.  Only in the last couple of weeks have European politicians seemed to recognize the urgency to do two things:  1) ring-fence the Greece problem so that it does not spread to Italy, Portugal and Spain if Greece should default and 2) develop and communicate a plan to the markets to recapitalize European banks that are large holders of the iffy sovereign debt of the aforementioned “peripheral” Eurozone countries.  Greece can be pictured as the first in a line of dominos that includes Portugal, Italy, and Spain.  European leaders ought to recognize that it is in nobody’s interest to let this first domino fall in a haphazard fashion.  Its fall must be structured and orderly if the Eurozone is to contain this crisis.

Consider the possible effects of an orderly default by Greece: In such a scenario, the external holders of Greek debt (which are mostly large European banks) will take a large “haircut” on the value of their bonds.  Because these bonds constitute capital, these banks will suffer a hit to their capital bases.  The weakest of them will likely require an infusion of public funds.  For investor confidence to stay intact after such events, there will have to be a solid plan in place.  In any case, we should expect to see a coordinated plan emerge within the next month—some say by the G20 summit to take place in Cannes on November 3-4.

Meanwhile, back here in the U.S., our stock market has taken its cue for the last couple of months from political developments in Europe. Broadly speaking, if progress toward a solution seems good, the market rises and vice versa.  In that sense the U.S. equity markets have become a bit unhinged from our domestic economic situation—which in recent weeks the data have shown to even be a bit better than expected.  In particular, the 137,000 private-sector jobs the U.S. economy added in September was well ahead of the 90,000 expected.  August private-sector job creation—previously reported to be zero—was revised upward to 47,000.  The U.S. economy appears to be holding its ground for the moment and our grinding, stop-and-go recovery continues.  The third quarter corporate earnings season is now underway, and so far, outside of the financial sector, the results appear to be quite good.  Come the end of earnings season, however, the focus will shift back to Europe, where we will need to see a big dose of oil applied if the gears are to keep turning.

I welcome your comments and feedback.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: thoms@orioncapitalmgmt.com

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global investment accounts for institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.