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The Macro Strategist

David P. Goldman

+1 917 915 2985

Starve the Dog to Get Rid of the Fleas

Monday, November 07, 2011
European financials fell more about 3.2% as of 2 p.m. today on the imminent
resignation of Greek Prime Minister Papandreou and the imminent resignation of
Italian Prime Minister Berlusconi, while American financials (Dow Jones US Financial
Sector) fell about 0.8%. Long America, short Europe remains the way to go.
In theory, Italy's problems can be fixed with a half-dozen phone calls: China buys
ENI and ENEL, North American banks buy San Paolo INTESA and Unicredito, and
sovereign wealth funds shop for whatever they want. Pensions are reduced, the
retirement age is lifted, 500,000 government cars are sold at auction, and half the
country's bureaucrats are fired.
In practice, you have to starve the dog to kill the fleas. Italy's political class will
reject the available solution because any viable solution presumes the
disappearance of Italy's political class. State dependents, moreover, outnumber
productive entrepreneurs. Italy probably needs bankrupt to fix its problems.
We believe in a Republican landslide in 2012 and the Boom of 2013.
Exhibit 1: US vs. European Financials (IYF vs EUFN), February 2010 to

Let's see: US
financials are
trading exactly
where they were
in February 2010
while Europeans
are 25% lower.
Doesn't sound too
global to us

The Macro Strategist

The Market Got the US Sovereign Downgrade Wrong

Note from Exhibit 1 on page 1 that US financials fell farther and faster than European
financials after Moody's downgraded the American sovereign at the end of July. Our
field is valuation, not psychiatry, so we have no explanation as to why the market
hallucinated a prospective American state failure. Any number of market analysts
offered calculations of the inevitable increase in US Treasury borrowing costs, just
before the 10-year yield fell below 10%. We wrote on August 4, "Systemic strains
exist, first among them the likely restructuring of Italy's enormous government debt,
but there is no reason for this to become a global liquidity event. Central banks stand
ready to provide unlimited liquidity. There are good reasons to sell European banks."
And our view has not changed
European implied volatility, meanwhile, is now trading a third higher than the VIX, as
well it should.
Exhibit 2: French vs. US Equity market Implied Volatility (S&P 500 vs. CAC)

The divergence is
long overdue

Although the trend has diverged between European and American financials, the
correlation of daily returns remains extremely elevated.

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The Macro Strategist

Exhibit 3: Correlation of Daily Returns, European (EUFN) vs American (IYF)

Financial Sector

This is what does

not make sense

Source: Macrostrategy LLC

The stock market is still chasing the European rabbit down holes. That expresses the
same incapacity to process information that we observed when the sovereign
downgrade provoked a panic about US equities.
In purely economic terms, the impact on the US economy from the European crisis is
likely to be very small. US exports to Europe comprise 18% of total exports, but a
great deal of that reflects transshipment to other markets. Netherlands, for example,
bought $28 billion of American goods during the January-August period, almost as
much as Germany's $32 billion, but almost all of that reflects re-exports. Italy absorbs
for 1% of total US exports, and the rest of the southern Europeans reflect rounding
error. Even an extremely steep European recession would reduce American exports by
a few percentage points at most.
The American financial sector is starting to eke out earnings again. Stripped of the
smoke and mirrors (such as profits arising from revalued liabilities due to a higher cost
of term financing), the operating earnings of the S&P financial sector don't look too

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The Macro Strategist

Exhibit 4: S&P Financials Operating Earnings per Share

Source: S&P

Among the big banks (BAC excepted, due to special charges last quarter), the worst
American bank has an inherently higher profitability than the best continental
European bank.

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The Macro Strategist


And this is before

marking down
sovereign debt

Source: Yahoo! Finance

The key to American bank profitability is a recovery in investment, which appears to

be underway: corporate purchases of equipment and software rose at a 17% annual
rate during the third quarter, and investment by the S&P 500 rose by 16%.

We believe in the
boom of 2013

Our core scenario remains what we argued on September 8: a Republican victory in

2013 will unleash a torrent of investments out of the nearly $2 trillion cash hoard at
US corporations. As corporations invest rather than hoarding cash, the modest
recovery in bank lending of the past few months will turn into a boom. We attended a
set of private briefings from political consultants, pollsters, and Republican party
officials during the past week, as well as the most recent Romney rally in New York.
Without claiming any special expertise in predicting electoral outcomes, it is getting
harder and harder to imagine how Obama can win a second term with three-quarters
of the voters believing that the country is on the wrong track. It also seems hard to
imagine how the Republicans would fail to keep the House and win the Senate. With a
Republican president flanked by supporters in both houses, we should get a terrific
boom in 2013.

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