A Fleeting Bump in Stocks?

Markets worldwide are rallying on confirmation of the news traders have been waiting for all week:

Renowned monetary policy authority Lindsay Lohan will, indeed, pose for Playboy.


You have to admit it makes about as much sense as the reason they say they are rallying: a “fix” for the euro crisis.

European leaders really mean it this time. Cross your heart, hope to die.

The highlights…

  • Holders of Greek government bonds will see the bonds’ value cut by 50%
  • The eurozone bailout fund, heretofore totaling €440 billion, will be leveraged to €1.4 trillion
  • European banks will be required to raise their “Tier 1 capital ratio” — a measure of their core capital relative to their “assets” — to 9%. The banks will need to scrounge €106 billion from somewhere to make this happen

We can confidently predict the bump in stocks today will prove at least as ephemeral as the bump in Playboy newsstand sales — for reasons we’ll get to momentarily. But without any further ado, the numbers…

  • Major U.S. stock indexes are up 2-2.5%. At 1,273 as we write, the S&P 500 is back to a level last seen before Standard & Poor’s downgraded U.S. sovereign debt on Aug. 5
  • Volatility as measured by the VIX has tumbled to 26 — likewise a level last seen in early August
  • European indexes also rallied to near three-month highs. Germany’s DAX jumped 5%, while France’s CAC 40 leaped more than 6%
  • At 75.4, the dollar index is back to a level seen right after Labor Day. The euro has crested $1.40, also a level last seen in early September
  • Crude oil rallied hard to $93.47 a barrel. (Don’t look now, but oil has moved up more than $7 since Col. Gaddafi met his unseemly end a week ago today. So much for the notion of Libya’s production coming back on the market quickly.)
  • The sell-off you might expect in precious metals hasn’t materialized. At $1,720, gold is right where it was 24 hours ago. Silver’s up to $33.86.

“The announcement in Brussels poses more questions than answers, so it’s puzzling to see stocks soaring on this announcement,” says Strategic Short Report’sDan Amoss, studiously avoiding any analogies to Ms. Lohan’s photo shoot.

“For one thing, the 50% haircut on Greek debt is closer to 30%, because it excludes debt held by the European Central Bank and the loans the EFSF (the eurozone bailout fund) has made to Greece since early 2010.

“This cut in Greece’s debt is obviously not enough to put its economy on a sustainable footing. It will not stop the riots and strikes, and it will lead to another round of funding stress sooner than expected.”

Then there’s the Humpty Dumpty nature of the announcement — which is extremely relevant to the health of U.S. banks.

“When I use a word,” said Humpty Dumpty in Lewis Carroll’s Through the Looking Glass, “it means just what I choose it to mean — neither more nor less.”

In the case of the news from Brussels, a 50% haircut on Greek government bonds is not — repeat, not — a “default.” Thus it does not trigger the credit default swaps that U.S. banks wrote on the European banks that loaded up on all those Greek bonds (and which said U.S. banks don’t have nearly enough resources to pay).

“This means,” Dan Amoss explains, “we could see some turmoil at big bank trading desks. Those parties who held both Greek debt and CDS will find that their insurance is not as valuable as they thought.

“So EU bureaucrats, in their haste to ‘stick it to speculators and short sellers,’ may actually bring about a collapse in demand for the debt of other PIIGS countries, as CDS is no longer a reliable hedge.

“If so, the need to refinance Italian debt would quickly burn through the €1.4 trillion ‘leveraged’ bailout fund.”

One more problem: The aforementioned €106 billion the European banks need to shore up their balance sheets? “Most credible sources place the capital shortfall at more than five times this amount,” says Mr. Amoss.

“Plus, it’s unclear how banks are supposed to raise this capital, since most of their stocks are trading far below book value. They can’t raise this much in the private markets, so some form of ‘Euro-TARP’ or bank nationalization still looks inevitable.

“Ultimately, the PIIGS crisis won’t be close to resolved until we see the ECB overtly or covertly monetize a lot more PIIGS debt. Such action would worsen the slow-growth, rising-inflation conditions facing the global economy.

“In hindsight,” Dan concludes, “today’s rally will likely be seen as a knee-jerk reaction to an inadequate plan to deal with PIIGS insolvency. Like the initial rally in the wake of the late July EFSF announcement, today’s rally will probably fail quickly.”

Sorry to burst your bubble. But you still have the January issue of Playboy to look forward to.

Addison Wiggin
for The Daily Reckoning

The Daily Reckoning