Euro Debt Default Still Not Reflected in Stock Prices

Europe has run out of money, yet default by Greece and other sovereigns is not fully priced-in...

DO YOU remember all that nonsense we heard a few years back about "bringing forward demand" for housing with the First Home Buyer's Grant? All it produced was a lot of activity – which shows up in GDP numbers – and a lot of debt, writes Dan Denning, editor of the Daily Reckoning Australia.

The end result was higher debt, house price inflation, and the conditions for an inevitable correction.

That kind of describes where Europe finds itself today. In fact, it kind of describes where the whole world finds itself today. Two decades of debt growth has "brought forward" GDP growth. But it turns out the growth that was purchased with debt was mostly in house prices and government bonds. Now there's a problem. There's no more growth to "bring forward" with new debt.

Assets purchased with debt are also liabilities. If those assets don't produce a return, you have a problem. The world has a problem. The market value of bank assets is probably a lot lower than the current book value. This puts banks everywhere in an awkward position.

As our old friend Dr. Marc Faber put in a US television interview, "Most banks worldwide are bankrupt. Bankrupt because if they had to mark to the market their assets there would be no capital left. And that's reflected in the new lows of bank stocks today." There is also the issue of European banks requiring as much as $3.6 trillion in short-term US Dollar funding, according to the Bank of International Settlements (see page 12).

Of course one thing we've learned over the last few years is that if financial rules cause unpleasant consequences for vested financial interests, they'll just change the rules. Banks don't have to mark assets to market value. They can continue the fiction that those assets will pay off.

Another example of changing the rules in mid-stream is the hike in gold and silver margin requirements by the CME group on Friday. CME runs the New York Mercantile Exchange. It hiked margins on Comex gold futures contracts by 21.28% and on silver futures contracts by 15.63%.

The CME action contributed to silver's 13.1% fall on the day. For the week, it was down 17.7%. Gold was down 5.9% for the week. And, in fact, gold had its worst week since 1983. These moves prompt an obvious question: are gold and silver really the safe havens we've said they are?

We can't wait to buy more at lower prices. Precious metals prices communicate information about the stability of the world's financial system. Right now, that system is unstable. Silver and Gold Prices can fall just like any other asset. But we reckon they're going to be better places to ride out the coming storm than most other asset classes.

A few more thoughts. First, CME is trying to do its job and wring out speculation and volatility in its exchange. Raising margin requirements makes it more expensive for speculators to "bet" on higher Gold Prices. You can attribute nefarious motives to higher margin requirements. But in the end, it does shake out the weaker hands.

Second, you can bet lots of investors who've been playing in the stock market with borrowed money got margin calls last week. To meet a margin call you need more cash. If you don't have the cash, you have to sell something to get it. This definitely hurt gold and silver last week.

Falling stock markets last week may have forced traders to take profits on gold and silver positions in order to raise cash. Keep in mind that at US$1689, gold is up 21.6%, year-to-date. Silver's fall to US$32.90 means it's given up nearly all its gains for the year, although it's still up 7.27%.

By comparison, stocks are down year-to-date. What all this means is that you should definitely be thinking about how you want to divide your assets and protect your wealth in the future. 

Now, stock markets are obviously discounting very low global economic growth. And investors obviously gave a big "thumbs down" to the Federal Reserve last week. But none of what happened last week in markets fully "prices in" a debt default in Europe. How likely is such an event?

The latest stories in British papers tell of a $2.8 trillion bailout plan, backed by the Germans and the French. It would work in three parts. Banks would be recapitalized. A bail-out fund would be increased in size. An orderly Greek default would be arranged. This is Europe's last roll of the interventionist dice before...whatever comes next.

G-20 finance ministers met over the weekend in Washington DC with the leaders of the International Monetary Fund (IMF) and the World Bank. They ate fine food and made a few announcements. No problems were solved.

World Bank president Robert Zoellick said, "Europe, Japan, the US must act to address their deep economic problems before they become a bigger problem for the rest of the world. Not to do so would be irresponsible." New International Monetary Fund head Christine Lagarde said, "Forty million people could be put back into poverty if we don't succeed...The current economic situation is entering a dangerous phase."

She got that right. The trouble is, there's no more money left. With what will Europe re-capitalize its banks? How is Europe going to fund its bailout plan?

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