Waiting For Europe – October 2011

October 25, 2011

Dow Jones Average: 11,914
S & P 500 Index: 1,254


Waiting For Europe

Over the past few months financial markets throughout the world have been roiled by the looming debt crisis in Europe. Any statement from European monetary officials hinting at a resolution of the crisis has been enough to send the stock markets soaring, while indications of political paralysis have sent the markets spiraling downward. These violent changes in direction have become weekly, if not daily events.

The crisis in the European Union has broad implications for the world economy, because the global economy is in a fragile condition and can ill afford a contraction in any significant economic region. Countries in Southern Europe, i.e., Greece, Italy, Spain, and Portugal are economically troubled, beset by very high unemployment and a need to borrow additional money to cover budget deficits. Typically when nations are in deep financial trouble they print more of their currency to temporarily paper over the problem. The countries that decided to form the EU are not allowed to print the common currency (the Euro) at will. The entire EU, which is a confederation of seventeen member countries, has to agree to any financial rescue package that may entail printing more Euros.

The epicenter of Europe’s debt problem is in Greece, a country that has a GDP similar in size to that of Maryland. The Greek economy is small, while the amount of money it has borrowed is large. The Greeks owe hundreds of billions of dollars to institutional investors and banks throughout Europe. With its economy in a deep recession, there is no chance that Greece can repay its existing loans, yet it needs to borrow even more money to stay afloat. The larger, more prosperous countries, namely Germany and France, are reluctant to throw good money after bad. While the Greek economy is a minor part of the EU, a default on its debts could cripple the European banks, sending the whole region into a recession. A recession in Europe could have a contagious effect on fragile economies in North America and elsewhere.

Heads of state and monetary authorities in Europe are meeting constantly to craft a solution to the debt problem in Europe. Finding a solution has proven elusive so far, because there is great resistance to providing more funds to countries that have been financially irresponsible. Asking the citizens of one country to bail out the people of a different country is never politically popular.

I had an opportunity a few weeks ago to meet Warren Buffett and listen to him answer questions for an hour or so. The first question was what he thought about the European debt crisis. He said that printing money is always the easiest, most palatable way out of such predicaments. Through various mechanisms the U.S. Federal Reserve Bank printed and provided a lot of capital to the financial system, in an attempt to extricate the U.S. economy from the grip of the 2008-2009 Recession. A depression was avoided, and for many companies and individuals in the U.S. a sense of economic normalcy has returned. In Buffett’s opinion Europe has to do essentially the same thing, providing enough capital to bolster banks that may be impaired by losses on Greek loans, and to cover the additional borrowing needs of Spain, Italy, and Portugal. A financial rescue fund of between two and three trillion dollars is the size most frequently mentioned by analysts. The world is watching to see what kind of painful solution is acceptable to all seventeen countries of the EU. The risks of inaction at this time are quite dire.

Current Strategy

While the stock market has been extraordinarily volatile on a daily basis it is virtually unchanged from the level of last December. The market gains of 2009-2010 remain intact, largely reflecting the slow, steady progress in U.S. economic conditions. We are not finding that many compelling buys as most stocks are fairly priced given the recovery in the U.S., and substantially overpriced if anything should upend the recovery. While we hope that the Europeans follow Buffett’s advice, we are not sure that an adequate solution will be achieved. We simply do not know how the European situation will play out, which makes us reluctant to commit significant funds to stocks that are not truly undervalued.

We have purchased a few stocks in recent months, and all three have shown price appreciation already. The industries represented by the buys are telecom, consumer staples, and digital packet management. Two of the recent buys pay substantial dividends, while the other is a small, growth company that does not pay a dividend. We like the blend of stability, dividends, and growth offered by these investments. We are continually looking for new buys that have similar attributes.

We have not made any changes with fixed income holdings. Interest rates remain near zero, and the Federal Reserve has stated its intention to keep rates low for years to come. We are tempted to shift more money to foreign bonds that offer a better yield, but are well aware of the potential loss on currency translation. The U.S. Dollar appreciated in value relative to Australia, Canada, Sweden, and other higher yield countries in recent months, so buying foreign bonds this summer would have been ill-advised. We watch foreign currency movements all the time, and still intend to buy more foreign bonds when we find the risk/reward ratio suitable.

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