Is A Big Oil Shock Coming This Fall?

An unnamed “decision-maker” – presumed to be Ehud Barak, the defence minister – told the Haaretz newspaper that Israel could not afford to wait for the US to act. “We need to look at the reality right now with total clarity,” he said. “Israel is strong and Israel is responsible, and Israel will do what it has to do.”
If so, the three months before the US presidential election in November provide the obvious window for an Israeli strike. The impression given is that the world may be a few weeks away from another war. As for the possible consequences, Israel’s outgoing civil defence minister says that any conflict would take place “on a number of fronts”, lasting for 30 days and costing about 500 Israeli lives.
--Daily Telegraph, Aug. 16th, 2012


Since 9/11 and the Lehman crisis, we have been advised to be on the lookout for economic “black swans”, meaning unexpected events of large magnitude*. One particular swan has been flapping around our heads with increasing urgency these days, namely the Israeli government’s hints that it intends to attack Iran this fall.

Without getting into motives and probabilities**, let’s assume that this will happen. Let’s also assume that a Gulf War III will close the Persian Gulf for a considerable period of time. Iran can keep the Gulf closed indefinitely, since marine insurers won’t cover war risks in a war zone. Iran herself can’t export under such a scenario, but that could be a secondary consideration in the eyes of an angry people.
[**http://www.nytimes.com/2012/08/17/opinion/how-america-can-slow-israels-march-to-war-with-iran.html?pagewanted=all]
As we know, the short-term demand curve for oil is price-inelastic, because the ratio of stored oil to daily consumption is low. The world economy is designed around the presumption that the oil pumps are on all the time; there are no readily-available inexpensive substitutes in the short-to-medium term. Therefore, in the event of another oil shock, the price mechanism would have to be used to bring oil consumption down by 25% almost immediately. The price of oil will be set at the margin by those who must have it, can’t produce it, and can afford it at any price. Bad news for the emerging markets, and really bad news for Greece.

How high would the oil price have to go to cut consumption by 25% overnight? High enough to force oil-dependent countries to ration electricity and gasoline. We’ve been there twice before in 1973-74 and again in 1979-80. Remember long lines to get gas at the pump?

This would be the world’s third oil shock, and its impact might be similar to the prior ones. In the seventies, central banks sought to cushion the shocks resulting in considerable inflation, then pulled back hard in 1980-82 causing high interest rates and a global recession in 1982-83.

An oil shock, possibly combined with the fiscal cliff or an explosion in the eurozone, would produce a sharp drop in aggregate demand, necessitating QE3 or QE4. The Fed would be hard-pressed to fully compensate for the decline in confidence and consumption. Europe would be hit even harder because it would start from a weaker position and it has a central bank asleep at the switch.

I find it hard to imagine that Gulf War III would be a brief and uneventful exercise. It would almost inevitably be a big event on the scale of the prior Gulf wars, maybe even bigger. These wars tend to escalate, and given the potential involvement of the Gulf states, this one could be the biggest of all. Also, Iran may prove a more formidable opponent than Iraq.

The risk of Gulf War III simply adds another event to the black swan list: (1) eurozone explosion; (2) the fiscal cliff; and now (3) another war. Let’s hope that all three don’t happen at once. If they do, I feel sorry for the guy who wins in November.
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* Wikipedia: The black swan theory is a metaphor that describes an event that is a surprise, has a major impact, and after the fact is often inappropriately rationalized with the benefit of hindsight.
The theory was developed by Nassim Nicholas Taleb to explain:

1. The disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

The Emerging European Deflationary Consensus

There is a major ongoing debate in the eurozone about what to do about the “virtuous” countries, such as Spain and Italy, that have lost access to the bond market due to high risk spreads (as opposed to fiscal profligacy).

One side of the debate has argued that the eurozone is a currency union, not a mutual assistance society, and that these countries should regain the market’s trust on their own via greater austerity. The other side argues that it is the duty of all members to do what is necessary to “defend the euro” and that, if these countries pursue the path of virtue, the eurozone should provide temporary assistance in their time of need.

In the last few weeks, both the ECB and Germany have joined the latter (more charitable) group and have stated that the eurozone should offer help to innocent countries that have lost market access, such as Spain and Italy.

Both Draghi and Merkel (but not the Bundesbank) have agreed to the idea that if these countries apply to the Troika for assistance, both the EFSF/ESM and the ECB will purchase their bonds in an effort to drive down “excessive” risk premia. This has suggested to the capital markets that a medium-term solution is in the cards, and all may be well.

I don’t think so. The new consensus has two flaws: (1) it assumes that bond purchases at the margin can change market sentiment; and (2) that once these countries get over the current hump, they will regain the market’s trust and re-enter the bond market at reasonable spreads.

I have already discussed the unwillingness (inability?) on the part of Spain and Italy to apply to the Troika and submit to IMF conditionality and supervision. Let’s assume they can somehow get over that aversion and submit, agreeing to greater austerity in exchange for assistance (which they both must have PDQ).

What are the prospects that, having submitted to the Troika’s demands (no easy task in a democracy), and after implementing the required austerity, these countries will be in good enough shape to re-enter the bond market on their own over the medium-term? I would say zero.

This is because the Troika’s solution is austerity/deflation in lieu of devaluation, which has been precluded by monetary union.

Eighty years after Irving Fisher proposed the debt-deflation theory*, it should be unnecessary to point out that austerity and deflation cause a downward spiral in nominal economic activity, while magnifying the real value of debt.

It is possible to maintain growth while  undergoing an “internal devaluation” in an economy with highly flexible nominal wages such as Hong Kong, but the list of such economies stops at Hong Kong.

The modern economy has inflexible nominal wages. In order to force nominal wages to become flexible requires a depression. Just think about Spain or Italy: what will it take for their public and private sector unions to accept a material decline in nominal wages? This did occur in the US during the Hoover years, but it required starvation as an incentive and the occasional use of the army. Hoover was not re-elected, and FDR promptly reversed the deflation.

Western European countries cannot become competitive due to declining nominal wages because they are democracies and the electorate won’t permit it (see: Greece). The voters will revolt before they accept a cut in nominal wages. These are quasi-socialist economies with powerful national unions negotiating industry-wide contracts. These unions control the major left-wing political parties. They have never and will never agree to a national decline in wage-rates, no matter what the level of unemployment. (They are victims of the “money illusion”: they can happily accept devaluation, but not deflation.)

Consequently, deflation with sticky wages will lead to massive unemployment, declining output, declining government revenue, reduced national debt capacity and greater over-indebtedness. These countries simply cannot regain their creditworthiness without a significant level of inflation and nominal growth, neither of which is being offered by anyone.

The Draghi-Merkel caucus is only offering these countries more debt on top of  more austerity. As their debt burden grows, their economies will shrink, requiring more debt. Is there anyone in Europe who has taken Economics 101? Has any important eurozone (or IMF) official read Friedman, Krugman, Eichengreen or Bernanke? It’s astounding to me that inflation is not even part of the eurozone debate. When inflation is even mentioned, it is done so as an anathema, like the plague: “We may be starving, but at least we don’t have inflation.”

So, to return to my question: will the Troika’s medicine succeed in bringing Spain and Italy back to the bond market on their own: No. So nothing will be fixed by the new eurozone consensus.

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*Fisher’s debt-deflation theory (a bit simplified):
National over-indebtedness will lead to a loss of further credit availability through the alarm of  creditors. Then we may deduce the following chain of consequences in nine links:

1. Debt liquidation leads to distress asset sales;
2. The contraction of the money supply as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling leads to:
3. A fall in the level of prices, in other words, an increase in the purchasing-power of the currency. Assuming that this fall of prices is not interfered with by reflation, there must be:
4. A still greater fall in the net worths of business, precipitating bankruptcies
5. A like fall in profits, which leads companies  which are running at a loss to:
6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to:
7. pessimism and loss of confidence
8. Hoarding and slowing down still more the velocity of circulation thus further reducing nominal activity.

        The above eight changes cause:
          9. A decline in nominal interest rates and a rise in the real rates of interest.

Spain Must Surrender Now

Spain’s Prime Minister remains tight-lipped on whether he has decided to ask for more financial aid for his country, repeating instead Tuesday that he would wait until the European Central Bank outlines its plans and conditions for buying government bonds before making a move.
“As long as we don’t know what decision the ECB is going to make, we won’t be making one either,” Mariano Rajoy told reporters Tuesday
Two weeks ago the ECB’s president Mario Draghi said the bank would intervene to help lower a country’s borrowing costs if its government applies for rescue aid from the bailout funds set up by the 17 euro countries. But such a request would come with conditions, such as extra cuts.
Following Draghi’s announcement, Rajoy opened the door to such a deal but said the government needed the ECB to clarify its position.
“There’s no news until we know for sure what the ECB is going to do,” he said.
--Bloomberg, 14 Aug. 2012

So, Draghi made it reasonably clear in his pre-holiday press conference that the ECB would consider buying the bonds of those countries that surrender their fiscal sovereignty to the Troika (EU, ECB, IMF) in a sincere and penitent manner. Prime Minister Rajoy has been saying for months that Spain is not a third-world basket case and will not consent to external supervision. His new position is that he might apply if Draghi will tell him exactly what he has to do. Of course, Draghi’s position is that Spain must apply to the Troika, not to the ECB. The Troika allows the EU and the ECB to hide behind the IMF’s strict (American) conditionality, which treats sovereign nations like errant schoolboys, also known as neocolonialism.

Rajoy is afraid of the IMF not only because of conditionality, but also because he doesn’t want outsiders to take a real look at his banks’ loan portfolios, which resemble Texas banks in 1988. The bill will be so big that it might scare the German taxpayer.

Rajoy’s defiant stand is posturing for the domestic audience, but he has only one card he can play: suicide. The Spanish establishment (including the king) is not going to permit him to push that button. He can scare a lot of investors and drag down the euro, but in the end he must capitulate and agree to submit to foreign supervision. And then he’s got to push the enabling legislation through parliament, which will be painful. He has to do all of this next month.

Spain, which lacks debt market access, needs the ECB’s money for five reasons, all of them immediate:
1. Finance the government’s operating deficit.
2. Repay maturing but unrollable government, bank, regional and corporate bonds.
3. Keep the banks “solvent” in order to keep their ECB lines open.
4. Finance the massive deposit outflow from the banks.
5. Finance the current account deficit.

So, Rajoy will soon have to change his tune from defiance to penitence, and he will have to start selling the benefits of surrender to his people and parliament. Draghi is not going to blink on this one, unless the have-nots on his board launch a coup, which is not yet in the cards.

The next question, which Rajoy is also asking, is whether the ECB will intervene with sufficient force to allow Spain to borrow on its own. The answer to that one is easy: of course not. Everyone and his brother will sell into the ECB’s bid at any price higher than the current market bid. The only way that the ECB can rescue Spain is if it publicly targets a low yield on Spanish bonds and stands ready to enforce it with unlimited firepower, which is not happening, at least not yet.

So Spain, like the eurozone’s other wards, will become another poor relation, given just enough money to live on but not enough to escape horrible penury.
Another victory for the European Project. More Spanish waiters in London restaurants.

Draghi Declares Eurozone Risk Premia "Unacceptable"

“The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. [What does “fundamental manner” mean in a case like Greece?] The euro is irreversible.

“In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines. [In other words, using the Greece/Portugal/Ireland template which includes deep structural reforms in addition to austerity.]

“The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.” [What objective?]

---Mario Draghi, President of the ECB: Introductory statement to press conference following the ECB board meeting:, Frankfurt am Main, 2 August 2012

Those are President Draghi’s words and my interjections. The reason his remarks seem to be inscrutable is because he wanted his remarks to be inscrutable. He used a lot of words to tell us almost nothing.

Draghi says that risk premia on government bonds resulting from fears of exit/default are “unacceptable”. Unacceptable to whom? Certainly not to real-money bond investors. Is he saying that the ECB will guarantee that such risks do not exist?, or that the ECB will take steps to reduce such risks?, or that somebody else ought to be doing something about it? He doesn't say.

Draghi says that such fears must be addressed in a “fundamental manner”. That can mean anything. Notice his use of the passive voice: “are unacceptable”, “need to be addressed”. This is like saying that catastrophic earthquakes are unacceptable and need to be addressed. I think what he means to say is that “risk premia that are related to fears of the reversibility of the euro are difficult for us to fix right now, and so they need to be addressed by the governments themselves by proving that they can implement the troika’s diktats to the letter and for years to come”. In other words, “the ball isn’t in my court”.

Then he goes on to articulate his conception of a third ECB mandate: That it will perform its policy duties toward countries only if they comply with third-party dictates. The analogy would be if the Fed were to condition monetary easing on US compliance with the IMF’s fiscal recommendations. No compliance, no easing.

Once again, Draghi appears to be picking up the hand grenade and tossing it back to the PIIGS. “If you lose weight and get exercise, then I will consider prescribing blood pressure medicine, but not before. Otherwise you’ll just go on binging on donuts and coke.”

What this means, on a practical level, is that Spain must formally apply for a bailout from the Troika. If she applies, and if the ECB thinks that she intends to comply with the Troika's diktat, then the EFSF and the ECB may resume buying Spanish bonds. How much, a lot or a little? Draghi: “of a size adequate to reach (our) objective”. What objective? Price stability? The elimination of risk premia? We don’t know because he doesn’t know: half of his board wants to rescue Spain and the other half isn’t so sure (see below).

So the guidance we have is that, if the Spanish government agrees to surrender fiscal sovereignty to the Troika (which it has pledged not to do), then maybe the EFSF/ECB will buy some amount of its bonds.

If Spain signs the surrender documents, the EFSF/ECB will probably buy some of itsbonds, the risk premia will stay up, and the ECB will say they did what they could. For the ECB to erase the risk premia it will have say that it is prepared to buy all of Spain’s debt. Well, how about that idea? Here’s one answer:

European Central Bank bond purchases won’t solve Spain and Italy’s difficulties maintaining investor confidence, ECB Governing Council member Luc Coene said in an interview with De Tijd and L’Echo.
Bond yields have been rising because financial markets don’t trust Spanish and Italian authorities to take the measures necessary to repair their economies, Coene said in the interview, published today in the two Belgian newspapers. As a result, he predicted few benefits from any ECB action.
“It makes no sense for the ECB to start financing those countries,” said Coene, who also heads Belgium’s central bank. “It would only lead to the ECB taking on the whole public debt of Spain and Italy onto its balance sheet. That would in turn weaken the ECB and do nothing to resolve the underlying problems".
--Bloomberg, Aug. 10th, 2012

So there you have it: from “whatever it takes”, to “how about this?” to “oh, just forget it”. 

Europe is now in suspended animation for the August holidays; nothing is supposed to happen until they are back next month.

The Trap Shuts On Germany

German politicians and former European Central Bank officials sharply criticized the ECB over the weekend and pushed for Germany, as the largest contributor to the euro zone rescue effort, to have more control in the central bank's matters, after President Mario Draghi signaled that the central bank could soon start purchasing government bonds.
"The new situation that Germany provides a growing share of the euro rescue, but has only one vote just like any other country no longer fits," Herbert Reul, a German politician and chairman of the Christian Democratic Union and Christian Social Union group within the European Parliament, told German magazine Focus on Sunday.
After resigning from the ECB last year in opposition to its bond buying program, former executive board member Juergen Stark warned in press reports that the further bond buys by the ECB would amount to "printing money," and risk increasing inflation.
While Germany holds 27.1% of the capital of the central bank, Executive Board Member Joerg Asmussen is the only other German on the 23-member governing council after Mr. Weidmann, who has just one vote.
In an interview with Focus magazine, Foreign Minister Guido Westerwelle said the problem is that "the economic and demographic weight in some committees and situations is not represented accordingly."
To strengthen the weight of the Bundesbank, Mr. Stark suggested to Focus magazine that the ECB remake its board, which today includes 23 members, to a nine-member board set up, where big member states such as Germany would receive a permanent seat and the other states would share the remaining seats.
That would require changes to both the Maastricht Treaty and the ECB's statutes, he noted.
--WSJ, Aug. 5th, 2012

There is nothing more amusing than an angry (but unarmed) German: “You cannot do this because I forbid it!!!”

Germany’s in a real pickle. She thought that she had joined a prestigious country club, only to be hit with a trillion euro assessment to repair other club members’ broken-down houses, and with only one vote on the board of directors.
I certainly sympathize with the Germans. They are the schmucks who always get screwed. They’ve been betrayed, cheated and swindled by France for two centuries, and now they find out that it’s just beginning. An analogy would be if  the Canadian taxpayer were told that he had to bailout the U.S. in the name of “North American solidarity”.

The Germans have unwittingly checked into the Hotel California.

"Relax”, said the nightman,

"We are programmed to receive.

You can check-out any time you like,

But you can never leave.”

What will the Germans do when they realize that they are trapped and that there will be no new treaties? It seems to me that there is nothing that they can do that isn’t radical. They are powerless with respect to the ECB. They had a veto over the ESM but they chose not to exercise it; Merkel has signed the agreement, the Bundestag has passed it, and the court will approve it.

However, this contretemps is occurring at a crucial time in German history. Today, 99.9% of German voters had nothing whatever to do with what went on during the war, and they are tired of being guilty for a crime they didn’t commit. They are no more going apologize for the Nazis than I am for the atrocities committed by the Eighth Air Force.

So I see younger Germans (who now include almost the entire political and economic leadership) wanting to act like a normal country with normal interests. Germany’s unrequited love affair with France is over.

Now, how Germany sees her interests and how I see them are different. They have an inflation phobia that is purely psychological. They would benefit, along with their neighbors, from 5-6% nominal GDP growth in the eurozone. The bogeyman of the ECB becoming Italian is nothing to be afraid of. Germany would lose some of its Germanness and some of its wealth, but none of its prosperity. Economic growth is much more important than having tons of gold locked in your vaults.

But I think we know that Germany is not about to have a Damascene conversion to inflation, open-ended bailouts and a weak euro, and that she will only play ball with Europe if she feels that she is in charge. Since she is not in charge, what will the Germans do besides getting angry?

Is The ECB About To Be Hijacked?

Draghi yesterday announced the ECB is working on a plan to re-enter bond markets and took the unusual step of naming Weidmann as the only policy maker to object to the proposal. While the move would ratchet up the ECB’s response to Europe’s debt crisis, it risks isolating the German central bank, potentially undermining the effectiveness of the new measures.

“That’s why investors are disappointed,” said Alexander Krueger, chief economist at Bankhaus Lampe KG in Dusseldorf. “The ECB can’t just take random measures against the Bundesbank’s will. The country with the largest economy needs to be part of any package.”

While Draghi’s comments suggest Weidmann has lost the support of traditional allies on the council such as the Netherlands, Luxembourg and Finland, the Bundesbank president may have German public opinion behind him.

While Weidmann only has one vote on the ECB’s 23-member council, “the Bundesbank veto matters a lot in this,” said Julian Callow, chief European economist at Barclays Plc in London. “We need to know exactly how the Bundesbank is appraising things.”

“We are the largest and most important central bank in the Eurosystem and we have a greater say than many other central banks in the Eurosystem,” Weidmann said in an interview published by the Bundesbank on Aug. 1. The ECB’s independence “requires it to respect and not overstep its own mandate,” he said.
--Bloomberg, Aug. 2nd, 2012

Clearly, the ongoing ECB power struggle is of great importance to those of us who prefer not to forage for their food. But there’s ethnic humor in it as well. Here you have Germany, founding member of the EU and the eurozone, drafter of the ECB’s statutes, stickler for rules, laws and treaties, airily announcing that the treaty establishing the ECB's governance is “only a scrap of paper,” to borrow a rather unhappy phrase from German diplomatic history*.

While each central bank has one vote on the ECB’s governing council, Germany believes that it has all the votes. You could spend a lot of time poring through Maastricht, Lisbon and the other governing treaties, but you won’t find that anywhere. What Germany says is incorrect, unless there is a secret codicil that says “Please don’t argue with the Germans”.

So Germany has now revised the ECB treaties to give the Bundesbank a veto over policy because “the ECB can’t just take random measures against the Bundesbank’s will”. I fully understand Germany’s frustration, but they signed the treaties. You can’t defend your position by reference to the same treaty that you have just denounced. Germany has no legal remedy within the eurozone to prevent the governing council from outvoting her. She stands alone against the entire council, without a veto. Germany can exit the eurozone, but she can’t kidnap Mr. Draghi and make him broadcast Bundesbank propaganda from Berlin.

What’s interesting about the ECB vote from a kremlinological perspective is that apparently no one voted with Weidmann including even his compatriot Joerg Asmussen. Not Finland, Netherlands, nor France. One can only conclude that the Bundesbank is indeed isolated, and one might even think that this is just the beginning of its isolation (especially given Asmussen’s apparent vote). We used to think of a “Northern League” of Germany, France, Finland, Estonia, Belgium, Luxembourg and Holland. They have all, with the exception of the Bundesbank,  deserted and voted with the impecunious Catholics in the south. 


Now, to be fair, it looks like the Bundesbank still has a lot of influence, in the sense that what Draghi was able to get passed was a lot less than he had promised. I guess the council members are still hoping to work out a deal with the Bundesbank that allows them to rescue Spain and Italy.
Nonetheless, Germany's increasing isolation could be very good news for the perpetuation of our global debt-financed Ponzi scheme. If the needy and the generous can hijack the ECB and make it print money, the eurozone crisis can be speedily resolved (and I will get creamed on my GLD and TLT).

Aside from the economic importance of this drama in Frankfurt, the theatrics will be fun to watch if you are into this kind of thing.
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* Statement by German Chancellor von Bethmann-Hollweg to British Ambassador Sir Edward Goschen, Aug. 4th, 1914, referring to the multipower treaty guaranteeing Belgian neutrality.

Why Stocks Keep Shrugging Off Bad News

An observer of the U.S. equity market would have to conclude that it has a strong bullish bias. Despite the weak economy, a clouded earnings outlook, persistently high unemployment and the European Sword of Damocles, the market shrugs off bad news and spikes on anything that can be construed as good news, no matter how tenuous.

The Fed fumbles the ball, the Bundesbank shows Draghi who’s boss, Southern Europe teeters on the brink of something awful--no problem! All news is good news. Girls just want to have fun and the market just wants to go up.

Why is this? Is the stock market irrational? Perhaps, but it is being paid to be irrational.

What is happening can be summarized in one well-worn sentence: Don’t fight the Fed. Since 2007, the Fed has: cut the overnight rate from 5.5% to near zero; grown its balance sheet from $800B to $2.7T; grown M2 from $7.2T to $10.0T ; and driven down 10-year Treasury yields from 4.6% to 1.6%. (For comparison, the Fed has bid up the PE ratio for Treasuries from 22 to 63, not exactly “value” territory.)

The Fed has systematically banged fixed income yields down to levels not seen in 50 years. The Fed is charging you for holding bonds and paying you to hold stocks.

At present, the forward PE on the S&P 500 is 13.3, the earnings yield is 7.5%, and the Equity Risk Premium (earnings yield minus bond yield) is 6%, which is very high. If you were a fiduciary (such as a pension manager), you would be hard-pressed to defend an overweight on fixed income when it yields nothing, versus equities that offer an attractive 7.5%.

The case for equities is compelling, and the relative “economic return” almost requires you to sell bonds and buy stocks. When stocks get this cheap, and bonds get this expensive, bad news has been fully discounted. Future news will have to  be really really bad to hurt stock prices.

To be bearish (like me), one has to expect catastrophe with a pretty high probability. A catastrophe that is bad enough to drive investors out of all risk assets and into Treasuries, and to keep them there by hitting the earnings outlook or cratering the financial system. 


We went through that exact scenario in the six months from September 2008 until March 2009, when the Dow declined by around 40%. That was because of a panicked flight to safety; it had nothing to do with relative yield. No equity market, no matter how priced, can withstand the risk of imminent financial collapse.

If an investor believes that Europe will figure out a way to save the eurozone, he should be in equities, because they are already priced for very bad news. If you believe, like me, that things will get much worse before they get better, then you should be underweight risk assets. But you will be taking a big risk that the world will not end this year.

The Dow has doubled since the crisis, and there has been an overhang of really bad things all along; the market has climbed a wall of worry. You therefore have to be both very cynical and very certain to believe that Europe will really blow up. But that is where my bets are.