About jimhemphill

I am Chief Investment Strategist for an investment advisory firm in Radnor, Pennsylvania, just outside of Philadelphia. Our investment approach is globally-diversified, with our research focus on using relative-pricing and relative-yield information in historical context as a guide to optimal asset allocation.

How’s My Crystal Ball?

Prediction is dangerous, especially when it involves the future.”

Yogi Berra                                   

Greece appears to be moving steadily toward implementation of the brutal terms imposed by the troika (EU, ECB, and IMF) as conditions for the provision of more liquidity to Greek banks and a new ESM loan to the government. There can always be further twists and turns to the Greek tragedy, but we’ve come far enough to assess the accuracy of my prior predictions in this blog. By my count, I got one of my three predictions mostly wrong, and a second correct in principle but wrong on magnitude. Here’s my scoring:

1) Who’s on First? I thought Greece’s new Syriza leadership (Prime Minister Tsipras and Finance Minister Varoufakis) entirely misunderstood the strength of their negotiating position. When you are going hat-in-hand to someone to whom you have previously lied when borrowing money, in order to borrow more money you simply must have in order to survive, you cannot possibly expect to dictate terms. Germany’s Angela Merkel was the key player on the other side, and she was never going to make any deal that would leave her constituents paying indefinitely for Greeks to enjoy better public-sector benefits than they themselves received. Score this one correct.

2) Outside looking in. I predicted that Greek hubris and miscalculation would place them outside the Euro by midsummer. I missed this one on two grounds. First, I underestimated the utter determination of much of the Eurozone to keep Greece in, despite the endless provocations of Tsipras and company. Second, I did not anticipate the ultimate complete surrender to austerity by Tsipras. While we can’t entirely discount the possibility of Tsipras and company snatching even-worse-defeat from the jaws of defeat, I score this one wrong.

3) Buy on the cannons. My final prediction was that significant market dislocation attendant on a Grexit would provide a buying opportunity for European equities, followed by a strong rally. I’ll score this one both semi-correct and unresolved. European markets declined but did not crash, making a low on July 8, then rallied a bit more than 6%. We’ll have to wait and see where European stocks go in the coming years, compared to U.S. equities.

There is one poorly understood aspect of the Greek drama I got substantially correct. The central problem for Europe was keeping Greece within the Euro while simultaneously discouraging the growth of anti-austerity parties in other Eurozone nations. Greece’s comprehensive failure to improve its position by electing a radical-Left government has been noted in other countries, such as Spain, where anti-austerity party Podemos has been losing support.

A quick aside. One of Warren Buffett’s fundamental principles of investing is that we are much better at understanding today’s values than we are at predicting tomorrow’s outcomes. In this respect, it is worth pointing out that my commentary on Europe’s crisis is intended to provide context for understanding our investment strategy, which remains entirely driven by relative prices and relative yields, and not by predictions–mine or anyone else’s.

Greece: Game Over, or Game On?

On Sunday, Greek voters stunned Europe by voting in overwhelming numbers to reject the final offer from Greece’s creditors on the terms of a possible new rescue package. That package had in any case already been withdrawn, making the Greek plebiscite equal parts historic and incomprehensible, especially given the expressed desire of most Greeks to remain in the Eurozone, even as they cast a vote that European leaders explicitly defined as a vote to leave.

The results of the vote gave Greek Prime Minister Tsipras and Finance Minister Varoufakis what they said they needed–a powerful mandate from the Greek electorate to negotiate from a position of strength, based upon a clear national rejection of future austerity. To make things even more confusing, Varoufakis had threatened to resign if Greece voted to accept the creditor’s expired plan. So once Greeks rejected that plan, Varoufakis…resigned.

For months, European finance ministers were treated to lectures from Varoufakis, an academic economist and expert on game theory. At one point, the Greek Finance Minister commented, “If only the other side had a competent game theorist, they would already have accepted our position.” In his understanding of the “game” being played, Greece held all the cards, despite having fraudulently qualified for Euro membership, failed to fully implement two prior reform agreements, and with the Greek banking system on life support and operating on strict capital controls.

Over the next week or two, we’ll see if Varoufakis was visionary or delusional during all of those contentious months of unproductive negotiation. My own belief remains that there is no prosperous future in an ever-larger public sector, a less flexible labor market, and amid endemic corruption. Maybe I am wrong.

My read remains that, unless France can persuade Germany to agree to never-ending subsidies for Greece, the problem for Europe’s leaders will shift from how to keep Greece in the Eurozone to how to manage its exit. Will they be able to avoid a failed state within continental Europe? Let the games continue.

The Greek Tragedy: Final Act?

As it has been for more than a century, Greece is a financial mess. Last weekend, negotiations broke down between Greek Prime Minister Alex Tsipras and the “troika” of the European Union, European Central Bank, and the International Monetary Fund. (EU, ECB, IMF from this point forward.)  There will be no third bailout for Greece, at least not until the results of Sunday’s Greek referendum are in.

This past Monday, June 29, world stock markets fell sharply. The S&P 500 Stock Index was down 2.1%, erasing all year-to-date gains. This was the biggest decline since April of 2014. On Tuesday evening, Greece officially defaulted on a 1.6 billion Euro loan owed to the IMF.

We have watched the Greek situation carefully for years, and have written about it several times, most recently here. There are two dimensions to this latest chapter in the Greek tragedy.

The first is the human dimension. A Greek exit from the Euro (and probably from the EU as well) is likely to have profound and even catastrophic human costs. The Greek people, most of them hard-working and honest, will suffer greatly. Within a year or two, Greece is likely to be the world’s only formerly developed nation. We may see in Greece a level of poverty, suffering, and social breakdown not seen in Europe in peacetime since the grim decades of the 1920s and 1930s.

The second dimension is financial. How will the Greek drama impact the finances of U.S. investors? This is a very different picture. In the medium term, we expect a “Grexit” from the Eurozone to be a net positive for investors, for several reasons:

  • The risk of a systemic breakdown, like the 2008-2009 financial panic, is low. When the Greek crisis emerged in 2009, European banks had dangerous exposure to Greek loans, and a default could have triggered a collapse of Europe’s financial sector. Those big bank debts have been written down and recycled to European governments. If Greece defaults, it will cost European taxpayers billions, but we see little risk of contagion.
  • Monday’s market action was not unusual. Historically, declines of 2% or more happen several times a year. (Back in 2008-2009, they often happened several times a week.) Here in the later stages of a long, long bull market, periodic downside surprises are inevitable. What has been unusual is the very low volatility of markets since 2013. Expect a bumpier ride, but don’t worry about it.
  • Absent Greece, the investment outlook for Europe looks much more positive. With plenty of bad news already “priced in,” the unanticipated outcome is one where a Greek exit is largely an economic non-event for the rest of Europe. (Remember that Greece’s peak GDP was less than 3% of the Eurozone as a whole.)

Overall, our expectation remains largely unchanged. We expect the departure of Greece from the Eurozone to be an extended, messy process, very much a “Grexident” rather than a clean and surgical separation. But while markets may be volatile, we think any sharp downside break will represent a buying opportunity.

The Beginning and End of Big Europe?

The Second World War in Europe ended 70 years ago Friday before last. VE Day (Victory in Europe) preceded by three months VJ day when Japan surrendered, and humanity’s most destructive conflict finally ended. The end of the war was the beginning of the postwar project of European reconciliation and integration. A collection of brilliant statesmen began the planning of what ultimately became the European Union. Their purpose was to so completely integrate Europe’s major powers (Germany, France and Britain), in particular economically, that it would ultimately become impossible for them to go to war with each other.

Since 1945, the European project has faced many challenges, starting with the Soviet post-war domination of Eastern Europe, which led to the Cold War and the creation of NATO. Despite the East-West tensions and the Iron Curtain dividing Europe, European economic ties became ever-stronger, with Great Britain acting as the grumpy cousin who did not want to play nice with the rest of the family. The European Economic Community was formed in 1957, the Western powers won the Cold War and the Berlin Wall fell in 1989, the EEC became the European Community in 1992, the common currency of the Euro began to circulate in 2002, and the European Union was formed in 2007.

Around the turn of the 21st century, the project began to hit some bumpy patches in the road. First, several countries said “No” in various languages to steps toward closer integration. Much of their discomfort arose out of recognition of the fundamentally undemocratic character of the EU’s emerging super-bureaucracy. But the most significant challenge to the EU since the adoption of the common currency in 2002 has been the slow-motion disintegration of Greece.

We know now that Greece never qualified for its 2001 admission to the Eurozone, defined as those countries using the common currency for all transactions, because it did not meet the explicit “convergence criteria” defined by the EU in the Maastricht Treaty. The Greek government engaged in deliberate fraud, cooking the national books with the aid of American investment bank Goldman Sachs, in order to conceal current account deficits far beyond those permitted by the convergence standards. (Greece reported a 1.5% deficit in 2003, below the required 3% threshold, but the real deficit was over 8.5%.) Athens used the benefits of membership to borrow lots of money at preferentially low rates, which was spent largely on social benefits for Greek’s public sector workers and retirees, and also received a great deal of development aid.

In 2010, Greece’s financial manipulations were revealed. It became clear that large amounts of Greek debt, borrowed under fraudulent pretenses from European banks, would not be paid on time if at all. At the beginning of the crisis, there was a real risk of contagion. Banks are leveraged entities, and writing off billions in loans, even to tiny Greece, could have endangered the European financial system, in a manner similar to how bad mortgage loans substantially decapitalized the U.S. banking sector in 2008-2009.

That is no longer the case. A Greek exit from the Euro, either on purpose (“Grexit”) or by accident (“Grexident”) would be a disaster for Greece, but it seems likely it would be an economic non-event for the other members of the EU. So why is Europe, ably led by Germany’s Angela Merkel, going to so much trouble to try to keep Greece in the Union, if not for economic reasons?

The reasons for retaining Greece within the EU are geopolitical and ultimately spiritual. Having gone 70 years without any armed conflict between major European powers is a blessing almost beyond price. If any member of the EU leaves, even one as feckless and underdeveloped as Greece, it calls the entire European experiment into question. The fact that Greece is cozying up to brutal, expansionist Russia is an immediate reminder of past tensions and conflicts.

How long can Merkel’s desire to keep intact Europe’s experiment in peaceful coexistence continue to trump everyone’s frustration with Greece’s serial follies? (Not least that of German voters, few of whom relish the prospect of providing perpetual subsidies to Greek pensioners and civil servants.)

Not, I suspect, much longer. Either Greece will substantially roll over on its refusal to reform its dysfunctional statist economy, or they are likely to be outside looking in by midsummer.

Appomattox at 150

As an historian, I’ve been continuously surprised by the lack of attention to the series of 150th anniversaries of the events of the American Civil War, including yesterday’s sesquicentennial of Lee’s surrender at Appomattox. Perhaps this is because we no longer do real history in our colleges and universities. The past has become something we access, not for perspective or instruction, but as a source of raw material, to be shaped as needed to fit a contemporary narrative, in service to present-day political purposes. (Google ‘Michael Bellesiles’ for just one example.) The History Department at my alma mater is the center of unruly activism in pursuit of a radical anti-fossil fuel agenda. How those particular dots connect is a puzzlement to me.

I believe history matters. One of the most significant events in American history happened 150 years ago, at a farmhouse in the small Virginia town of Appomattox Courthouse, named after the nearby river itself named for a Powhatan Indian tribe. On Palm Sunday, April 9 1865, Robert E. Lee surrendered the Army of Northern Virginia to Ulysses S. Grant, General in charge of all the Union armies, including the Army of the Potomac and the Army of the James, to end our nation’s bloodiest war.

Lee, even in his late 50s and after four years of war, was a magnificent figure. At a time when the average man stood just over five and a half feet, Lee was six feet tall, but his trunk was long and his legs unusually short. With massive shoulders and huge hands, Robert E. Lee on a horse was an impressive sight. He was related by blood to five of Virginia’s seven signers of the Declaration of Independence. He owned two houses with names. He arrived at the McLean farmhouse before Grant, wearing an immaculate uniform with gilt buttons, armed with a ceremonial sword with a jeweled hilt.

Grant arrived late after a hard ride. His boots and trousers were spattered with mud. He was unarmed. With his mouse-brown hair and short beard, he looked, as one of his aides commented, “like a fly on a shoulder of beef.” But Grant was the victor. The shopkeeper-general beat the grand-nephew of two of the Founders. More, the system of which Grant was a representative was the victor. Free men prevailed over the slave masters. Capitalist productivity prevailed over agrarian virtue. Immigrants and the children of immigrants swelled the ranks of the Union armies.

The South lost a war whose essential purpose was to keep human beings in bondage. Lee’s skill and courage, and that of the under-fed, under-equipped army he led, excite our admiration to this day. Yet if the Army of Northern Virginia surely fought bravely and well, the cause for which they fought was just as surely, to borrow Grant’s words, “one of the worst for which a people ever fought.”

What is the duty we owe to the past? If nothing else, perhaps simply the memory and understanding of just how large a price we paid to expiate our nation’s original sin of slavery — over 620,000 dead in a nation of thirty millions, equivalent to an unfathomable 6.2 million deaths as a similar proportion of our current population. As Abraham Lincoln said in his Second Inaugural: “If God wills that [the war] continue until all the wealth piled by the bondsman’s two hundred and fifty years of unrequited toil shall be sunk, and until every drop of blood drawn with the lash shall be paid by another drawn with the sword, as was said three thousand years ago, so still it must be said ‘the judgments of the Lord are true and righteous altogether.’ “

Grexit at Last?

On Monday the European Central Bank’s deadline for Greece to submit a realistic reform plan expired. On Tuesday Greece submitted a plan long on assumptions and short on details, one that included higher spending on pensions and an increase in the minimum wage. What comes next?

I find myself in pretty substantial disagreement with many of the comments I’ve read about a possible Greek exit from the European Union. Here is my read on three common beliefs:

1) When push comes to shove, Germany will do whatever is necessary to keep Greece in the EU. I disagree. When push comes to shove, Germany will do what is necessary to keep from being the perpetual banker for the improvident weak sisters of the EU. Merkel believes she can avoid being the deep pockets while keeping the Eurozone substantially intact. In the short run (Greece only), I think she is right.

2) Greece leaving will set a dangerous precedent, leading other nations to abandon the Euro. Really doubtful. Greece out of the Euro will be an absolute economic basket case. Far from encouraging other EU countries to exit the common currency, observing Greece spiraling into dissolution, while hitched to the falling star of bankrupt, brutal Russia, will be an object lesson for other nations with structural deficit issues. Even the Greeks understand this. As a Greek economics professor observed last year, “Outside of the EU, Greece is Africa.”

3) The bold Socialists of Syriza will be able to negotiate a better deal. You can’t make a better bargain if you hold no bargaining chips. In reality, Greece has no negotiating room. Greece’s only card to play is leaving the Euro. But every time Greece threatens a default (which amounts to an exit), it triggers a further run on Greek banks, already close to insolvent. There are two rules about bank runs: 1) Avoid a bank run at all costs. In a panic, everyone loses.  2) If there is a run, make sure you panic first. Only then will you get your money. Greeks will panic and withdraw their money. They have to.

So here is my uncharacteristically bold prediction. Greece will fail to extract any meaningful concessions from Germany and the ECB. Their flirtation with Putin’s Russia will harden sentiment against them. Due to poor message discipline, they will trigger larger bank runs, and Greek banks will become insolvent. Whether they choose to leave the EU or are pitched out does not matter. They are gone. Outside the EU, Greece will find itself in immediate economic freefall.

Here’s a further contrarian prediction. Greece’s exit will be a relative non-event for Europe as a whole, and for its banks. Against expectations, European markets will rally within weeks, and possibly within days. (For compliance reasons, I hasten to add that this is my personal prediction, that it in no way represents a promise or a guarantee, and should not form the basis for buying or selling any investment.)

Once in a Century Opportunity

It is nice to know, in a world where social institutions crumble, families fragment and move to the far corners of the earth, and the settled verities are called ever more into question, that we can still rely on certain constants.

Today, we celebrate one of those constants, if only in the United States. And this is truly a case where American exceptionalism cannot be seriously questioned. This is a celebration in which European nations cannot plausibly participate. Only in the United States can this particular event happen.

In case my meaning is unclear, I’m talking about pi. Yes, tonight at we will all have the unique, once-in-a-century opportunity to celebrate one of the Universe’s enduring constants, that irrational quantity without which we cannot even begin to calculate the circumference of a circle or its area — never mind the volume of a cylinder!

piToday is March 14, 2015. Or as we in the United States would notate it, 3-14-15. So at 9:26:53 tonight, we will experience 3.141592653. (Pi actually continues indefinitely. Since I was a teenager, I’ve known it by heart to seven decimal places. This is nothing to brag about. My old friend Clifford can recite it to 50 decimal places, and does so at every opportunity. Which are few and far between.)

The way to celebrate is recognized as being the consumption of pie. Cherry, pumpkin, Boston creme, plain ordinary apple, any will work. My kids are planning to make an Oreo ice cream cookie pie.

It is not entirely clear whether the proper procedure is to pre-cut the pie into slices and serve it out, with each participant attacking their own slice at 53 seconds after 9:26, or whether that is when the unblemished pastry should be put to the knife.

Why can’t Europeans pitch in? Because in the rest of the world, the convention is to abbreviate dates day-month-year. So today is 14-3-15. No kind of mathematical constant to celebrate there. When will Europeans get their pie? Never. There will be no 3rd of the nonexistent fourteenth month this year, or in any other.

Let’s hoist our forks together this evening. This is a chance to unite our families around something we can all believe in, something as American as apple…pi?