Granite Group Advisors

Well, the markets have slowly climbed the Wall of Worry and increased the valuation to 14.1 times 2012 earnings and 12.5 2103 earnings  due to historically low trading volumes and few buyers around the markets. The average is around 15 times earnings. The markets are not expensive, nor are they cheap.

This has been one of the lowest volatility quarters in our memory. We see volatility picking up because China is not doing well, Europe has a number of issues to resolve including their current recession, 10yr bond yields are very low, there is very little employment growth and the markets are starting to price in QE3 based on what Bernanke says on Thursday.

What does this all mean? If Bernanke positions himself for another QE3 the markets traditionally go up. If he says there is no need, then the markets will come off. If there is another QE3, natural resource based economies i.e. Canada, Australia, etc.. will do well vs. the US dollar.

We believe that the markets might get a short term bump up, but then reality will set in and market valuations will settle down.  The elections, valuations and whatever the media throws at us will impact market volatility, but the bottom line: bond and equity markets are a great predictors. They are saying slow growth.

Gas prices are currently the highest they have ever been at this time of year.  Unfortunately we are now in the peak of hurricane season and that is not good news for prices.  Currently, many of the off shore drillers and refiners in the southern coast are shutting down  due to tropical storm Isaac.  As of this morning, oil is closer to $100 a barrel and that is trouble in this economy as high gas prices eat up an enormous amount of expendable cash.  The U.S. government made mention of possibly releasing oil from the U.S. oil reserves but most pundits don’t think that will happen.  In the short term, prices will rise for a while, with a chance of subsiding as we near fall. However, if the Mid-East situation intensifies, higher oil prices for would ensue for the foreseeable future.

This week the ECB will be meeting to discuss plans to save the Euro Zone.  On the table, the ECB has proposed a cap on interest rates of debt issued by nations such as Spain.  The concept is the ECB will buy debt in a particular nation if the interest rates of that debt exceed the pre-set cap. In other words, if Spain’s 10 year bond rates go above 7%, the ECB will buy the bonds leaving Spain the ability to issue more debt.  This will allow countries like Spain to keep operating.  On the surface this might seem like a good idea because it protects bond buyers and limits interest rate carrying costs. However this is very short sighted as this is just another band aid and still does not fix the structural problem.  Unfortunately, the ECB does not have enough money to protect each country and the free market will eventually price this into the market.

Now that the Olympics are over, all eyes are back on the European debt crisis.  Mervyn King, the head of the Bank Of England, said that there is no solution in sight and we agree.  However, the US markets have grown weary of this story and are ignoring the debt burden of Europe. The market pundits believe the valuations are inexpensive.  This is generally accurate if you look at historical averages, but we believe the valuations are justified (trading at almost 14 times 2012 earnings) considering the slow growth and high debt environment. Going forward, the US equity markets will focus on the elections in the months to come. After November, the US and the rest of the world will have to get back to business and worry about the Fiscal Cliff.

As we begin this week we are planning on digesting an onslaught of economic indicators that will help drive the market for weeks to come.  The ECB’s Mario Draghi has said all the right things and has brought back some confidence to the markets that Europe as well as the Euro will be saved.  These comments helped fuel another rally in equities last week, but it should be short lived as we believe that the problems in Europe will persist for a long time.  As for here in the US we will be getting the July Jobs report on Friday which should show another month of tepid job growth.  Additionally, we are getting consumer confidence as well as other forward looking indicators that don’t look like they will be overwhelmingly positive.  As an example, the June ISM Purchasing Managers index came in at a contraction at 49.7. This should translate into a very volatile week in equities as well as bonds.

Today the Dow is expected to be severely down.  Is Spain’s 3 month short selling ban creating this?

Our answer is  a resounding “No”! The ban cannot be the sole reason with the weakening European markets.  The markets are selling off because these European countries simply cannot get their fiscal house in order. Spain’s economy is contracting. Germany is threatening  to cut off the money supply to Greece. Ten Italian cities are facing default. The Euro is collapsing. The unsustainable bad habit of spending more than you have will create dire results for Europe.

The rest of the world is losing patience waiting for a permanent and viable solution. Europe’s debacle will hinder a US recovery. This situation will affect November’s election. It is time for tough love.

Barclays is currently under investigation for allegedly manipulating Libor rates.  The investigation has already led to the resignation of the chairman and CEO of Barclays.  The manipulation of Libor rates has affected all mortgage rates that use Libor as a basis, as well as all loans made by banks.  While we don’t know the exact amount of additional  revenue earned by banks from its customers, we do know that it is likely that customers were overcharged in the multi- billion dollar range. Many other banks are involved in this scandal, and the probes are just beginning.  Our take on this story is that it will be settled by fines and lawsuits and will in the short term affect many banks earnings.  Additionally, there will be some criminal probes landing some executives in prison, as well as the loss of confidence that the public has with the fairness of the banking institutions as a whole. Like so many scandals in the past, the scandal will eventually go away without creating corrective change in the banking system.

On Friday the unemployment report came out with another dismal reading of job creation.  Only 88 thousand jobs were created which was well below the already low expectations and the markets reacted quite negatively.  Our take is that job growth will continue to be tepid due to uncertainty of future economic growth.  Additionally, the slew of new regulations, including health care and all the new financial regulations from Dodd Frank, are not completely known yet.  This is making businesses uncomfortable with expanding at a faster pace.

Last week the ECB agreed that they will be combining the financial systems of the Eurozone and changing the bailout process in an attempt to fix the debt crisis. Markets reacted quite favorably to this report and on the final trading day of the quarter the markets were up dramatically. Our perspective is that this is a temporary movement as the European zone is still in a very difficult situation. Spain and Italy are still in horrible financial shape and there is no quick fix for this. Additionally, this morning France, which is one of the most stable countries in the Eurozone, reported that they are in a deficit of roughly 33 billion Euros in government spending for 2013 that needs to be addressed in some form of austerity. The bottom line the Eurozone debt crisis is far from over.