You Want The Truth? You CAN Handle The Truth!

I’m not sure exactly when it happened, but Europe has finally starting dealing in the truth.

Draghi can’t point out the limits of sovereign debt purchases often enough.

The EU, usually happy to let completely false rumor after false rumor to drive the markets, took the time to quash the idea of EFSF and ESM being increased in size.  Not just, once, but twice, as Merkel has said it on the 13th, and it came out after yesterday’s conference call.

They even took the time to point out that they hadn’t been able to agree on 85% agreement.  That could easily have been buried or ignored, but yet they chose to highlight it after their call yesterday.

Finally, they even went ahead detailing the relatively puny IMF/Central Banks bailout fund.  The fund was disappointingly small at €150 billion, rather than the €200 billion that had been expected.  The UK is out, but so are Portugal, Ireland, and Greece.  Those 3 not being in makes sense, but this is the first time that I can remember that the EU gave us the numbers straight.  Usually they would have announced the big number with caveats about various “stepping out countries” and “yet to be ratified” countries.  Estonia, which has no debt, is not going to participate.  Again, makes sense, but is a step away from the EU making everything sound bigger and grander than in the past.

I’m not really sure what any of this “truthfulness” means.  While the EU, IMF, and ECB have done a horrible job dealing with the crisis, they are not stupid nor are they quitters.  So why suddenly stop the spin and deliver the more harsh reality?  Has Merkozy finally decided to stop being the bull in a bullfight?  Every time the market waved a red cloth in front of them (telling them what they needed to do), they failed to deliver or the market failed to respond.  Have they decided to take a step back and work on a plan that they may have the resources to implement?

I remain completely convinced that we are far from the endgame in Europe and the ultimate solution will involve restructuring, debt forgiveness, and massive dilution at the banks.  But there is something about this focus on the truth and the willingness of the EU/ECB to embrace negative news that seems like a set-up.  Is this all part of a plan to allow the ECB to print?  Is it setting up for a renewed effort with the EFSF?  Does the IMF have something up its sleeve?

It feels like they are trying to create bearish sentiment, that they are purposely lowering expectations.  Longer term, I believe those lower expectations are warranted, but in the short-term, are they planning on catching the market short to get more bang for the euro on some new announcement?  The strongest seasonality effect we see would be from the closing on Wednesday until the market opens after Christmas.  That strong seasonality, coupled with reduced expectations, and an extraordinarily thin market, could be an ideal time to launch a new program or refurbished existing one.  China may be finally concerned enough about their own economy that they relent and lend their name (and money) to some plan.

Last week we were extremely bearish, and for the first time recommended buying puts if you insisted on being long.  We are more neutral right now in terms of direction, but are becoming convinced we may have a large move in the near term.  Logic dictates that the move is down to 1100, but the gut says 1300.  So at these levels, to remain short, we think buying some short dated calls makes sense.  We continue to like Europe more than the US as the “decoupling” has already been priced in and both the Euro and European stocks can outperform.  I can’t tell if I’m just bitter, but the fact that the mainstream analysts are falling all over themselves to be bearish now, makes me think that trade has run its course, at least for a little while.

While stocks have been debating whether anything Europe is doing will work, the Italian and Spanish bonds have been behaving well.  Totally manipulated of course, but an encouraging sign for the market, especially for those who believe the banks will buy some additional sovereign debt with ECB money.  That plan makes no long-term sense, but may be enough in the short-term to stem the tide.  Greece will have to default in the end, but now they have bought themselves some time until their next big bond maturity.  If nothing else, we have learned that the market has a “unique ability” to ignore problems if they aren’t immediate.

The worst part about BAC’s plight is that it debunks the myth that you can invest from your bathtub.  I was all set to pitch that trading strategy, but now that Warren wishes he had taken a shower and not bought BAC, it will be hard to convince anyone that the “Eureka” moment is a valid strategy.  I am hopeful that some of the pain in BAC is coming from the potential that they are negotiating a settlement with MBIA.  It would make sense for BAC to come to an agreement before year-end, especially since MS already settled.  I think this would be very positive for MBI and wouldn’t be the worst thing that BAC could do.  We like MBIA, but wouldn’t touch BAC here.

HY seems like it could continue to perform well.  HYG and JNK still seem to have gotten ahead of themselves, but the premium to NAV has reduced to a tolerable level, especially with the bond market catching a bid, and dealers having virtually no inventory.  HY17 might be an even better play, as it has underperformed, and the “decompression” trade seems incredibly crowded.  Any sign of spread compression, coupled with the continued decent US economic data, could cause a quick run on that trade, so I like HY17 better than HYG or JNK right now.