James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

It has been a tough few weeks for momentum investors.

One time darlings like Amazon, Netflix and Green Mountain Coffee Roasters have taken serious tumbles, dealing losses.

Meanwhile, the financial industry, the sector which arguably hasn’t produced positive returns since the 1980s, are on a bit of a tear, bolstered by the latest European rescue and some reassuring U.S. economic data.

There are several intriguing reasons to believe that momentum investing has seen its best days. Momentum investing, beloved by day traders and some hedge funds, is the strategy of riding hot stocks higher while selling laggards.

While the tactic itself is probably as old as the stock market, momentum investing attracted increasing interest in the 1970s and 1980s, culminating in a number of academic studies, which seemed to show that it added value.

Those former go-go stocks are on the retreat for a variety of reasons.

Amazon warned Tuesday that it could slide into the red in the fourth quarter due to heavy spending on medium-term development projects. Amazon shares fell more than 10 percent that day. Even after a rally on Thursday, its stock remains more than 20 percent down from October peaks.

Netflix famously misjudged its customers willingness to accept price hikes and its shares are now more than 35 percent down from its summer high.

Green Mountain Coffee has lost about a third of its value since hedge fund manager David Einhorn announced he was shorting the stock and raised concerns about its accounting practices.

There is more of a coherent theme when it comes to the banks. The KBW bank share index, which fell more than 30 percent year-to-date through Oct. 1, is up more than 20 percent since then. Fears of a round of financial contagion have eased as euro zone officials appeared to get to grips with their debt crisis, and many economists have reduced their odds of a U.S. recession.

All of that is positive for bank earnings, and, frankly, for their ability to remain as going concerns.

So, some momentum investors will have had their fingers burnt, but so what? Surely stock markets go through periodic transitions in which hot stocks go cold and vice versa.

All true, but some recent research indicates that something more fundamental may have changed. And, in fact, the conditions that made momentum investing successful may be long gone.

HEDGE FUNDS AND MARKET EFFICIENCY

Debarati Bhattacharya, Raman Kumar and Gokhan Sonaer, all of Virginia Tech, looked at 44 years of momentum returns up to 2009 and found something startling: momentum returns went missing sometime in the late 1990s.

While you could generate excess returns of more than 0.75 percent a month following momentum strategies between 1965 and 1998 — a really fantastic result — since then that alpha has disappeared. It’s no longer a winning way to beat the market.

To understand why you have to recognize that momentum investment is essentially a behavioral phenomenon, not a fundamental one. Anyone who has ever watched a herd of wildebeests react to a lion should understand why. The wildebeests flee as a group not because they’ve all seen the lion, but because the ones who did not see the predator know how to interpret the reactions of the ones who did.

That sort of instinctive reaction carries over to the greed or fear that news causes among investors. Good news brings its own upward momentum as people pile in, and the reverse is true for bad news.

A run of good or bad developments can take on a weight of its own as trend followers join the party. Pretty soon you are looking at Apple, or perhaps Bear Stearns.

The authors of the study suggest that the growth of hedge funds may be behind the death of momentum. Hedge funds have learned to exploit over and under-reactions to momentum.

Now, having become big enough and quick enough, hedge funds have in essence eaten the fields bare. They eat volatility, and have perhaps improved market efficiency to the stage where the low hanging fruit that was momentum investing is all gone.

Clearly, there were still manias, bubbles and overshoots in the past decade: just look at subprime or European government bonds. That, at least on the surface, would imply that buying what is hot and selling what is not should have some remaining potential. But that would be done as a tactic rather than as a strategy.

Free lunches sometimes exist, but they don’t persist forever. Investors, and hedge fund managers, are going to have to work a bit harder for their supper.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

A new U.S. plan to aid underwater homeowners once again tries to treat a debt-inflicted wound with a cash flow Band-Aid.

Under changes to the Home Affordable Refinance Program (HARP) the Obama administration will shortly allow current borrowers whose home loans are backed by Fannie Mae or Freddie Mac to refinance to lower rates, even if they owe more than 125 percent of what their house is worth.

HARP covers borrowers who are not behind in their payments but who would otherwise be unable to refinance into a lower mortgage interest rate.

The program might possibly help the housing market and economy, and definitely will help banks, but it will very likely do so at the expense of the poor saps who decide to stick with their impossibly underwater loans and the houses that go with them.

Seeing as how many of these borrowers could walk away from the loans without putting their other assets at risk, HARP really is an unforgivable instance of using people as a means to accomplishing other goals rather than as ends unto themselves.

Let’s put this in corporate terms and pretend that a company had bought a widget factory with a loan only to see the market for widgets crash, leaving it owing 25 percent more on the facility than it was worth. Now, in part because the lender has no recourse to the company’s other assets, the bank comes along and offers a new lower interest rate. Sounds good on its face, but a corporate board which approved such a deal would be liable to be sued, and with good reason. That board has a fiduciary duty to act in shareholders’ best interests, and if the company has a chance to walk away from a bum deal it very likely should.

People who owe that much more than their houses are worth — and 25 percent of U.S. borrowers are underwater to some extent — are usually better off defaulting on the loan, handing the keys to the bank, taking the hit to their credit rating and getting on with the rest of their lives. Even if real estate prices rise, the first four or five years’ gains might essentially only benefit Fannie Mae and Freddie Mac.

This has been the problem with so much of the approach to the debt bubble; no one wants to admit that the assets aren’t worth that much any more and make the painful decisions that admission implies. The only way to help these borrowers was to give them a large break on the value of the loan, despite the damage that would do to banks, investors and mortgage servicers.

FROM MAIN STREET TO ATHENS

That’s exactly what has happened in the euro zone, where an early unwillingness to deal with the damage that a Greek default will do to banks has been hugely destructive. Almost two years have been lost, and terms imposed on Greece which made it less and less able to ever pay back the money. Now we are looking at a 60 percent Greek debt write-down, which may not be deep enough. And still euro zone efforts concentrate more on giving weak borrowers like Italy low rates than on delivering credible long-term fiscal plans.

This is, of course, because recognizing losses is painful, and if you do it you sometimes discover you are broke, which can be inconvenient. Think of the billions in bank dividends and bonuses which would not have been paid out over the past two years if banks had been forced to come clean. Think too of the campaign contributions that never would have been made, and the lobbying money never spent.

This brings us back to HARP, which should be greeted with joy by banks. One of the aspects of the plan is that a loan that gets refinanced under the program releases the institution that services or originally sold it to Fannie Mae or Freddie Mac from their representations and warrants. Reps and warrants give Fannie and Freddie the ability to make a lender take back a loan that’s fraudulent or faulty under certain circumstances. That’s quite a gift to the banks, and as Fannie and Freddie are wards of the state potentially puts taxpayers on the hook for greater losses.

To be sure, the lower interest rate means fewer borrowers will default, and some of the cash saved will be recirculated into the economy. Many will still default, especially those owing so much more than their house will bring, and even worse they will have done themselves an injury by accepting a Band-Aid where radical surgery was needed.

Somehow that doesn’t seem quite right.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

Tough times make dependable excellence even more valuable, which is why we just might see the rise of a new “Nifty Fifty” of elite shares.

During their heydey in the 1960s and early 1970s the Nifty Fifty were a group of U.S. large cap companies which managed a spectacular period of outperformance during a generally downbeat and low growth period.

Featuring such household names as IBM , Coca-Cola , Procter & Gamble and Disney , the Nifty Fifty delivered strong and dependable earnings and dividend growth during a period where those were in short supply.

They were rewarded by a fantastic run of outperformance and a dizzying re-rating, or expansion of price/earnings multiples, which eventually drove valuations well into bubble territory.

Similar to the 60s and 70s, the world is staring at structural problems that will make a recovery from the long secular bear market unlikely for quite a while.

Back then inflation and choppy economic growth sent the stock market on a volatile, largely sideways journey for several years.

Today we face perhaps deeper problems in the wider global economy, such as debt, deflationary forces and huge fiscal deficits. Expecting strong growth to lift all boats is not going to be a winning strategy.

We could easily be looking at a long period where stocks remain in a wide trading range, as often happens after extended bear markets. So if we can’t get structural growth from the overall economy, best to find some structural growth stocks that will manufacture their own.

For a graphic on the S&P 500 and bear markets since 1929, click here.

“In a low growth, low return environment, companies with a sustainable growth or competitive advantage should significantly outperform, similar to the Nifty Fifty in the 1960/70s,” Ronan Carr, an equity strategist at Morgan Stanley, wrote in a note to clients.

Carr, who specializes in European equities, thinks that a select group of companies in the region, many with strong exposure to emerging markets, will end up fitting the bill. My guess is that it will be a global phenomenon, with a small cadre of outperformers from a range of markets.

PICKING WINNERS OR RIDING TRENDS?

The Nifty Fifty beat the overall markets by 15 percentage points annually for eight years from 1964 to 1972. It was a dual effect; the companies were able to increase earnings steadily and pleasingly predictably, beating their peers, and at the same time investors began to re-rate them, driving price/earnings multiples higher as confidence in the Nifty Fifty grew. That very predictability was a big part of the brand; almost none of the stocks had cut their dividends since World War II.

That kind of growth and predictability will be in short supply in coming years, and those companies that can produce consistency will see their brands grow and their shares go up. Not all will be dividend stocks, though the very low interest rate environment we will have to live with will put a premium on income, especially for the growing cadre of retired or semi-retired affluent investors.

Apple, which pays no dividend, is a great example of a stock that has turned itself into virtually a one company Nifty Fifty. (A “One and Done” Nifty Fifty, if you will.)

Apple displays a lot of the characteristics to look for – it harnesses emerging technologies to give it a dominant franchise and as a result, pricing power.

Others will doubtless emerge, some as emerging market success stories (and that may include Western companies selling into EM), some will benefit from new technologies, such as companies that do well out of the ocean of natural gas that has now become exploitable in the U.S.

In some ways, the better choice might not be to make big bets on finding the Nifty Fifty, but rather wait until the market identifies them and then ride their coat tails. The important fact is that in a world of lousy growth and high uncertainty, growth and the whiff of certainty will be in huge demand.

The Nifty-Fifty phenomenon was also partly psychological. As the years rolled on and the results stayed strong, investors became increasingly confident about making very long-term earnings assumptions about their favored stocks, as hedge fund legend Michael Steinhardt, a veteran of the period, pointed out in an interview on CNBC on Thursday.

No one makes those sorts of forecasts today, partly because we live in a quarter-by-quarter world. The more confident investors become in future income streams the higher the valuation they will be willing to assign them, especially given the dearth of confidence everywhere else.

Remember too, how badly the Nifty Fifty period ended for many investors. A mix of institutional and individual money drove valuations sky-high, to 80 and 90 times earnings in some cases. When the bear market and inflation of the mid-70s hit, they de-rated severely, burning many of the last-minute investors.

Still, it was a good ride while it lasted, and the kind we will be lucky to find in the coming decade.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

By Jim Saft
James Saft is a Reuters columnist. The opinions expressed are his own.

Having demonstrated how poorly austerity worked in Greece, Europe may be on the verge of giving it a try in credit markets.

Plans to rescue the euro zone and its banks might land Europe in an extended credit crunch, a very poor outcome given the continent’s continued heavy reliance on bank financing.

While details are depressingly vague as to the how, plans seem afoot to insist on widespread recapitalization in European banks as part of an overall financial crisis package. The idea, broadly, is that the euro zone will write down Greek debt sufficiently, while establishing a backstop to stop a run on other weak states’ debt and then recapitalize the banks so that they can withstand the losses inherent in the exercise.

The U.S. banking recapitalization of 2009 is widely viewed as the model here, if not in form then in outcome, as U.S. banks are now far better capitalized than their European peers.

There are, at least, two severe problems with this.

Firstly, a look at the U.S. will show that while its banks as independent entities were saved, their ability to play their role in intermediating capital was compromised, at least in part because they were not aggressive enough in writing down doubtful housing-related debts. That’s an important contributing factor in creating a frail, shaky recovery in the U.S., and could easily happen in Europe.

“Markets may also fear adverse unintended consequences; for example, proposals to strengthen bank capital ratios that banks try to meet by accelerating the shrinkage of balance sheets,” George Magnus, senior economic advisor at UBS, wrote in a note to clients.

“This would deepen the euro zone’s growth crisis and make higher capital ratio goals retreat ever further into the distance.”

Europe, like the U.S., is going through a balance sheet recession. That means everyone is trying to repay debts at the same time, suppressing growth, inflation and asset prices. Government austerity is exacerbating this, but an extended credit crunch as banks try to rebuild balance sheets will only make matters worse.

This is not to say that Europe’s banks don’t need to shrink, as does its sovereign debt. Euro zone plans to save itself seem to have moved from simply trying to restore confidence, an impossibility as a stand-alone plan, to adding capital to the mix. Without addressing the underlying indebtedness this is going to result in either failure or a very extended period of slow growth.

WRITEDOWN NEEDED

An attempt to shore up banks must come to terms with the other over-indebted borrowers in the euro zone, and not simply the sovereign ones.

Take Spanish house owners, for example, who already face huge difficulties in getting loans to finance real estate purchases. Independent economist Edward Hugh argues that Spain needs a substantial asset writedown program, something that bank recapitalization simply does not address.

One easy-to-foresee risk post a euro zone rescue is that continued weakness in housing in peripheral markets continues to stress bank capital, casting a shadow over funding markets and undermining confidence. Remember, euro zone banks have a loan to deposit ratio of about 108 percent, a good 20 percentage points higher than U.S. banks, and only about 10 percent below their own pre-crisis peaks.

A reduction in bank lending in Europe is going to be even more painful than it would be in the U.S. given the euro zone’s less deep and highly developed capital markets. Europe has no Fannie Mae or Freddie Mac, yet, to take the strain in housing finance. Middle-sized businesses are still very reliant on bank financing.

In the U.S., the Federal Reserve helped to mitigate the pain of bank recapitalization by creating conditions in financial markets where investors wanted to take on some risk, leading to a booming market in bond issuance for corporate borrowers. Thus far there is no talk of credit easing from the ECB but it would not at all be surprising if this is on the agenda in a year’s time, once the force of bank deleveraging has been felt.

This is not an argument for going easy on banks, their shareholders or their executives. If anything Europe needs to take a harder line — forcing writedowns of debts public and private and being prepared to deal with the consequences.

Those consequences would not be pretty for bank shareholders. Many banks would fail and need to be taken into temporary public administration.

The more controlled default there is as part of the euro zone’s rescue, the better the results will be in two years time.

James Saft is a Reuters columnist. The opinions expressed are his own.

China may be about to teach the world another lesson about what happens when speculative money learns that its favored markets aren’t panning out.

In the U.S. in 2007 the subprime bubble collapsed into a still-smoldering heap when borrowers and speculators realized that real estate was topping out.

In China speculative investments including so-called “private lending” don’t promise an exact repeat but have enough elements in common to make the two situations rhyme.

One possible side effect: in a worst-case scenario the yuan CNY= might actually start to fall against the dollar.

A fascinating report released this month by Hong Kong-based strategists at Bank of America Merrill Lynch led by David Cui laid out the dynamics.

“The biggest issue for investors in China is a combination of excess liquidity and lackluster real returns; a persistent negative interest rate has resulted in speculation in financial assets (including property) while returns of the underlying “hard” assets that these financial products are built upon are getting worse,” Cui wrote in a note to clients.

“As a result, any abrupt change in investor sentiment could pull down financial asset prices sharply.”

Despite high inflation, banking and monetary policy have kept the deposit rates offered to Chinese savers quite low, resulting in a negative effective real interest rate. China is awash in liquidity, at least some of it hot money that has flowed in anticipation of the yuan going up in value. But a comparison of the one-year deposit rate and consumer inflation show that savers have been suffering negative interest rates for the past 20 months, effectively paying the banks several percentage points a year for the privilege of lending them their money.

Seeking better treatment, huge amounts of money have flowed outside of the banking sector, into trust accounts and into private lending. Private lending, done by wealthy individuals, state-owned enterprises and private companies, is a huge and growing sector. Loans are made privately, at very high interest rates, to businesses, property developers and in some cases to speculators in property or on financial markets.

The share of Chinese household savings in alternative investments, which includes private lending, has risen from 2 percent of household savings in 2009 to 7 percent in 2011. Overall underground lending is now estimated by BofA ML to be about equal to one fifth of bank lending, in other words huge.

HIGH RATES, HIGH RISK

And because the official bank lending market is constrained, and also somewhat corrupt, private lenders are able to charge huge interest rates of up to 36 percent annually. An August survey by the People’s Bank of China into private lending in Wenzhou showed that 20 percent of the money went into property, helping to keep aloft the very high real estate valuations in China.

But here’s the rub: if you charge 25 to 30 percent interest, the people you are lending money to either have to make a killing or very quickly they will default. As in the latter subprime days you don’t need a crash to cause a crash, you only need prices to level out and the crash eventually ensues as people can’t afford the high rates. And while Chinese borrowers put down far more than American ones in down payments, they may prove unwilling to cede their equity to private lenders.

The process of weakening may already be beginning, as shown in the sharp falls in shares in China, particularly financial ones. A unit of China’s $400 billion sovereign wealth fund waded into the market on Monday to purchase shares in the country’s four largest banks after prices dropped to crisis levels.

There are a host of other systemic risks that could shock China’s system, according to BofA ML. Besides falling property prices, there is the possibility that money found its way into outright Ponzi schemes, or that private businesses that were eager to borrow the money run into slight difficulties and simply can’t make the payments.

Another possibility is that exports in China get hit by events in Europe or the U.S. This could cause financial market upsets in China and encourage some of the hot money betting on yuan appreciation to flee. If hot money sells up assets or calls in loans, property prices could fall, weakening banks and reinforcing the negative cycle. The end result might be a reversal of China’s policy of slow appreciation in the yuan, despite intense international pressure.

China wants to send powerful signals, such as its share buying, that it won’t stand by and allow a scenario like this to come to pass. That’s probably the central scenario, but like Las Vegas real estate five years ago, China has enough of the Wild West about it that it bears watching.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

It was perhaps inevitable — at some point Europe’s war on reality would flower, if that is the right word, into a war on drugs.

Funny too, because usually people who want to escape reality take drugs, rather than blaming drug-taking in others for reality’s nettlesome shortcomings.

Carlo Giovanardi, who is undersecretary in Silvio Berlusconi’s government in charge of family policy and drug prevention, is now blaming stock market “volatility” (by which I am guessing he means falls) on cocaine-taking among share traders on the Milan stock exchange. Giovanardi said that the government would look into the possibility of drug testing for traders, perhaps with the help of the Milan Bourse and the country’s market regulator.

Yes, that’s it. Drug-snorting (or should that be stock-shorting) traders are destabilizing financial markets. Perhaps these same traders are, addled by the white powder, buying credit protection against the possibility of an Italian default. Some of them may even be withdrawing their money from funds that make short-term loans to Italian banks. You know how crazy and unpredictable addicts are.

It’s not the fact that Italy’s debt rating has been downgraded, or that its banks are stuffed to the gills with Italian sovereign bonds. No, it’s not concerns about Italian competitiveness, and its inability to depreciate its currency. Instead, it’s just drug abuse.

You have to wonder exactly what drug Italian traders were taking during the good years, when nobody behaved as if a euro zone crisis was even possible, much less a risk to be worried about. Perhaps back then they were all snorting a hypnotic drug or an elephant tranquilizer. This too is a case for Undersecretary Giovanardi.

Besides being funny, this farce is instructive; it tells us that European officialdom still thinks it can resolve what are essentially problems of debt and political structure by denying and shifting the blame. This ought to make investors naturally jumpy and prone to flee.

DENY, BLAME AND PLAY FOR TIME

From almost the beginning of the crisis European officials have mostly followed three tactics; deny, blame and play for time. First the problem didn’t really exist, then it only was a small problem and only in Greece, a tiny country we shouldn’t really worry much about.

Allied to this denial was a desire to make the appearance of turmoil in financial markets the result not of underlying structural issues, but of malign speculators manipulating things for their own selfish aims.

And lest you think this kind of magical thinking is just an Italian thing, remember that both Greece and Spain were reported in 2010 to have set their intelligence services on the case of tracking down the people who were driving down the price of their debt. (By the way, if they have a list, please release it because these sellers were clearly prescient).

Of course scapegoating is not a southern European disease. If France loses its AAA rating, I fully expect French President Nicolas Sarkozy to blame speculators for making Norman cows run dry, or some equivalent nonsense.

If you think this stuff is working, just look at the recent run of events. Belgium, France, Italy and Spain introduced outright bans on short-selling financial stocks in early August, since when bank stocks have performed terribly. Greece already had a ban on short selling of its banks, which does not appear to have had the desired effect. Even the most stable banks reportedly can’t get interbank funding for much more than a week, which somewhat suggests that short sellers are not the problem.

A recently released preliminary study into the impact of short selling by economists at the New York Federal Reserve found that declines in stocks were neither driven nor amplified by short sellers. As for bans on short selling, the study finds that they don’t work, but do impose costs on all market participants by reducing trading liquidity.

Europe has a suite of interconnected problems. Too much debt is at the core, but a structure of monetary union without fiscal union means that, perhaps fatally, the players have an incentive to do mutually destructive things. Add to this a central bank, the ECB, which cannot use the printing press as a last resort and you have a set-up which positively invites short sellers.

The good and bad news is that this cannot go on for too much longer. German Chancellor Angela Merkel and Sarkozy’s detail-free pledge to do “all that is necessary” will soon be tested, and those doing the testing will be stone cold sober.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own

HUNTSVILLE, Ala. – Europe is demonstrating that a sovereign nation without a true central bank is just an uninsured bank, liable to be tipped over by the markets.

While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.
A lender of last resort is what stops a bank run on a solvent institution from bringing it down due to a lack of liquidity. In the case of a nation, a lender of last resort, usually the central bank, can simply print money to satisfy debts in its own currency. And though we’ve all become terribly cynical about the concept of liquidity crises in the past couple of years, not least because so many people in authority have used it as a place to hide when the real issue was solvency (Greece, Lehman Brothers), the fact is that markets take on their own momentum.
Just as no-one viewed euro zone debt as anything other than a safe haven for the currency area’s first decade, now investors are busy driving up the price of even German default insurance.
This is the terrible logic of markets when they view sovereign borrowers as credit risks; it is almost inevitable that they push, and in pushing weaken the un-backstopped borrower and ultimately bring it down. This is a process which needs a circuit breaker, and Europe has no adequate circuit breaker, unlike Britain or the U.S.
“Rather than viewing government bonds as risk-free, safe-haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks. This has very profound consequences for the stability of financial markets,” economist Elga Bartsch of Morgan Stanley wrote in a note to clients.
“For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, ie, rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector.”
Bartsch looked at all sovereign borrowers since the mid-1990′s whose spreads above Treasuries rose to at least 10 percentage points, an indicator of distress. In only 20 percent of the cases did a debt restructuring, or default, ensure. Some were rescued by the IMF but many righted themselves.
Thus Europe is at the mercy of markets, left without a central bank or outside force which can break the cycle and impose order. The ECB has purchased government bonds as a back door means of providing support, but this is awkward, will ultimately test the limits of the bank’s capital and, as being against the spirit of EU law, is deeply divisive. The EFSF fund is not well suited for playing this role either.

FOOL ME ONCE

You could object that, of course, all sovereign borrowers are ultimately credit risks. Even if one is repaid in the sovereign’s currency, that currency can be debased by inflation or the money printing press. True, but markets do not seem to impose the same penalty on inflation risk that they do on default risk.
There are two main take-aways from this. The first, of course, is that if you don’t have a proper central bank you ought to keep your debt profile slim so as not to attract too much attention to your vulnerability. This worked for Germany, whose Bundesbank was similarly forbidden by charter from printing money to buy government debt. Not borrowing too much is good advice but not terribly helpful in the current circumstances.
The second is that Europe needs a democratic way in which to agree to monetize or otherwise write down its debts. Failing that, the risk is that the domino-style run on government credit becomes self-fulfilling, as we’ve seen is the risk with ever larger sovereign borrowers like Italy being weighed by the markets and found wanting. This ultimately will break the euro, probably at about the point when Germany realizes it is picking up France’s dinner check.
This is not an argument in favour of suppressing markets by banning short selling or other measures, as is so often the impulse in Europe. Those arguments are raised by people, be they politicians or investment bank CEOs, who want to be insulated from the consequences of their own decisions. It is instead about clarity about who pays.
Europe suffers from unclear lines of accountability. There are easy fixes for that, but imposing them quickly will be difficult. That is certainly how markets are trading, and the result may be a self-fulfilling fracturing of the euro.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. – Right about now, even the most committed capitalist investor ought to be hoping for one thing: that labor soon has the upper hand.

That’s because the whole edifice: the global economy, the consumption-based developed economies and the share prices they power are crumbling because average workers simply haven’t got enough earning and buying power to play their central role.

Wages in the U.S., for example, have been stagnant for the best part of 40 years, during which time the consumption merry-go-round has only been kept spinning through a combination of artificially high asset prices and spending borrowed money.

Consumer incomes actually fell in August for the first time in almost two years, according to new data, and consumer spending only eked out a modest gain due to a sharp fall in the savings rate. Given that people are living longer and have stressed balance sheets, dis-saving is a tactic that will only work for so long.

This state of affairs has allowed corporate profits, as a share of the economy, to hit their highest point in the second quarter since records began in 1947, and on track to hit an annual high since at least 1929. Even the stock market no longer sees that as evidence of rude health, as shown by the steady, grinding decline in prices relative to earnings.

To be sure, this long-term stagnation in wages is in substantial part because of globalization. Some of what labor in the developed world lost has been converted to gains for labor in emerging markets, where income has surged over the past decade. Nonetheless, the system is predicated on consumption in the west and that consumption is crimped by stagnant incomes and high debt loads.

Up to a point this will be self-correcting. Wages in China, for example, have grown strongly, which will eventually lead to domestic consumption there and to a balancing out in the relative costs of production. Sadly, that long-term solution is not going to arrive in time to save this morning’s equity investors, which is perhaps why so many of them are deciding to become this afternoon’s debt investors.

This is the catch for equities; a vibrant economy depends on a rebalancing of negotiating power between labor and capital, but that very process is going to undermine corporate profits, and with them stock prices. The best strategy may well be to remain structurally underweight equities until that rebalancing has happened or until the stock market moves ahead to price it in.

UNSUPPORTIVE POLICY

There has, rightly, been a great focus on debt in the current malaise, with much head-scratching over how to deal with Greek sovereign debt and individual mortgage debt. That’s natural because debts come due and when defaulted upon have a nasty habit of causing a chain of defaults through the economy. Even so, the focus then has been on how to protect debt holders from the consequences of their foolishness and the foolishness of the parties they loaned money to.

“Almost all remedies proposed by global authorities to date have approached the problem from the standpoint of favoring capital as opposed to labor,” bond giant Bill Gross of Pimco wrote in a note to clients.

“If the banks could just be stabilized, if the ‘markets’ could just be elevated back in the direction of peak 401(k) levels, if interest rates could just be lower so that borrowers would inevitably take the bait, then labor — job creation — would inevitably follow. It has not.”

In the case of Greece, that is because austerity only makes it weaker and less able to bear the debt’s burden. In the case of over-indebted mortgage holders it is because most loan modifications leave the borrower with more than they can afford.

All of what we are describing is deflationary, which makes the epic rally in government bonds seem not so much a bubble as a down payment on future gains.

Investors hoping, as they will and as they should, to make profits need to get some things straight in their own minds: who, exactly, is going to buy all of these goods and services and where are they going to get the money?

It is not clear that monetary policy can address this. Its success rate so far is not great. It is far less clear that fiscal policy will even be given a chance.

It is reasonable to expect that eventually western labor will make gains, and that emerging market labor’s new buying power will slowly build and provide a buttress to global demand. That’s not happening any time soon, to judge by the run of events, which is a good reason to remain shy of equities.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.