The Investor

Sell First, Ask Questions Later

Greece was a blip compared to the havoc Italy is already bringing to our financial markets. Updated 11.10.11 @ 9:20 a.m.

By 11.10.11

Send to Kindle

On Monday, I sent the following note to a friend of mine who also pays close attention to financial markets (though he's not trading every day like I am):

Now they're going to go from worrying about Greece to worrying about Italy -- which is a much bigger problem.

If you look at the Euro [around 1.38 when I wrote the note], it seems to me that the last jump up to $1.41 before falling off a bit again was a short squeeze. I think people have been short this for quite a while believing it will fall apart, and are giving up -- meaning that it's probably a pretty good time to short the thing now that the trade is less crowded. I have no data to support my theory...just a hunch.

If there's one major flaw I have as a trader, it's not trading big enough on my own instincts. And although the market did make that silly rally on Tuesday, the enormous sell-off on Wednesday seems to me more likely to be the beginning of something rather than a buying opportunity. My guess is that Monday and Tuesday were selling opportunities -- that I didn't take.

By Wednesday afternoon, the market was down, albeit less than 2 percent, from Monday's opening and the Euro was down 2 percent, to around 1.355.

To be sure, the woulda-coulda-shoulda club of traders is a big, loud, and unprofitable one, and I can't honestly say that I thought we'd fall nearly 50 points in the S&P or 400 points in the Dow Jones Industrial Average the day after having an impressive afternoon rally. What I can honestly say is that I did make some small downside bets on Monday, but that I didn't have the courage of my own convictions -- I rarely do -- to make them bigger than I did or to add to them in any significant way on Tuesday. So while I made a few dollars trading (but lost much more in my long-term investments) on Wednesday, I made a fraction of what I "woulda, coulda, shoulda" made.

Enough about me, though.

My bigger point is this: We saw what Greece did to worldwide markets, not just stocks but also interest rates (much higher in weak countries, much lower in strong countries). Italy will be an intensive care-causing pneumonia compared to the hiccup that is Greece's debt problem.

While Greece's debt is a stunning 180 percent of GDP and Italy's is "only" 120 percent, Italy's national debt is a mountainous $2.6 trillion, roughly five times Greece's debt and simply too big to bail out -- even if otherwise a perfect theoretical candidate for the moral hazard of "too big to fail."

And thus, Wednesday's market meltdown (or what we would have considered a meltdown except that we've had so many of them recently that we're numb to ginormous moves) strikes me as likely to be the opening salvo in a "sell first and ask questions later" market.

Markets test and punish weakness. It is how George "I hate capitalism" Soros made one of his first billions -- testing the weakness of the British Pound. And you see it frequently in the stock market with headlines like "XYZ was down 15 percent today as short-sellers bet that the firm's accounting irregularities are a sign of serious problems." More often than not, despite investors thinking of those short-sellers -- people who actually do the most homework on companies -- as the villains, their real function is to expose the ugly truth -- or lose money if they're wrong.

And that's exactly what the "bond vigilantes" have done in Italy recently, with that nation's government bonds plummeting in price and rising in yield (implied interest rate you receive if you buy one). Over the last week, the yield on the benchmark Italian bond spiked up from 6.2 percent to about 7.3 percent, with half of the move happening on Wednesday. Asif to emphasize the volatility of the situation, the Italian government bond yield plunged by almost half a percent, down to 6.8 percent, in less than an hour in Italy's afternoon trading. No bet is safe these days.

The seven percent level, while not inherently special, is seen by many traders as the market's calling out "Danger, Will Robinson" (or whatever "Will Robinson" would be in Italian). As interest rates rise, it means that the Italian government must replace its maturing debt with new debt that costs it more, causing the annual budget deficit and thus the national debt to rise. In other words, if the market forces are big enough, as they are now, they can come perilously close to causing a serious problem by betting that there will be one.

There are always those politicians, regulators, and investors whose gut reaction is to ban short selling, and such bans are in place for certain stocks and bonds in certain countries in Europe and Asia. Additionally, the EU is trying to implement a broader ban on short-selling sovereign debt but that probably won't be in place for another year.

But banning short-selling is the market equivalent of shooting the messenger. Sure, it's nice not to hear the bad news for a little while longer, but perhaps having gotten the note sooner could have made the defeat a little less bloody.

Predicting the direction of stocks has never, in my roughly 25 years of trading, been more difficult. And never in my career have United States markets been so obviously the follower rather than the leader, buffeted nearly daily by news from Europe (and less frequently from China). These are days for agile, short-term traders who are willing to take more risk than the average investor is comfortable taking -- because the average investor has much more common sense than I do.

What makes the predictions so much more difficult is that absent what is going on in Europe the U.S. economy is trying, despite all that our government is doing to stop us, to power through, to earn profits, to be the entrepreneurial nation we have always been. Therefore, if Europe weren't such a basket case, I'd be quite optimistic about stocks. And therefore on the rare day when it seems that Europe might have a solution up its sleeve, the markets can react in a strongly positive way -- reinforced by the evil short-sellers having to "cover" and driving prices up even further. (That's why despite my nervousness/bearishness, my current trading strategy is to sell out-of-the-money calls on stock indices so that if there is a sharp rally I don't get squeezed out.)

But cogitating the hypothetical of "if Europe weren't such a basket case," I am reminded of one of my favorite sayings (and keep in mind that just as politics ain't beanbag, trading floors ain't PG-rated): "If my aunt had balls, she'd be my uncle."

And if all this isn't confusing enough, there is the positive factor that Italy, despite its huge debt, is not Greece: Italy is a large and substantially modern economy with plenty of exports and a budget deficit of only 3.1 percent of GDP this year, expected to actually drop to under two percent next year. (I find forecasts of 1.3 percent overly optimistic.) This compares to a Greek budget deficit estimated at 8.5 percent for 2010, expected by some to rise slightly in 2011 despite Greek government forecasts to cut it to just under 7 percent. (The 2011 U.S. budget deficit as a share of GDP will likely be almost exactly the same percentage as Greece, within a tenth of a percent or so. As for the U.S.'s 2012 deficit, most projections are in the 6.5 percent of GDP range but much depends on actions taken by our government to cut spending and raise revenue, the latter of which is far more effectively done by stimulating growth than by raising taxes.)

So while Italy's debt is huge, it is taking steps to address it and it is much less likely to result in a default, despite pressures created by markets, than Greece's dysfunctional mess is. The fact that the Italy situation does not have to end in tears simply adds to potential market volatility and the "overnight risk" of traders making any sort of directional bets.

Europe is a basket case and they're going to be so for the foreseeable future. It's not the short-sellers' fault. It is the fault of welfare-state governments for putting their nations in a fiscal situation so tenuous that those traders feel they have little risk in betting against a nation's currency or, now that there is one currency for most of western Europe, against its very solvency.

Unless the Italian government takes substantial and credible action -- which is more likely to happen than in Greece -- the bets against Italy will not stop, and could force everything from political turmoil to financial contagion to violence in the streets -- none of which must be confined to la Repubblica Italiana.

But when it comes to financial markets, don't shoot the messenger -- and don't be surprised if the U.S. starts hearing the same message sooner than many people think. In the meantime, not being convinced by Thursday morning's positive market direction, I'm looking to sell (call options) and ask questions later.

Like this Article

Print this Article

Print Article
About the Author
Ross Kaminsky is a self-employed trader and investor and is a senior fellow of the Heartland Institute. He is the host of The Ross Kaminsky Show on Denver's NewsRadio 850 KOA on Saturday mornings from 6 AM to 9 AM. You can reach Ross by e-mail at rossputin(at)rossputin(dot)com.