Crisis 2.0: Q4 a toss-up, 2012 to bring the real deal

I have been strategically short the market since the day of the last FOMC from SPX of 1190-00.
The market did touch the expected target of 1080-00 since then and has since bounced back to 1222-00 as I write. I failed to capitalise on the target objective as our underlying stress models on credit and liquidity continued to flash a red alert.
 
The risk from here is 1250/1280 on the upside before we move back into the lower range again. There are two schools on the direction for balance of Q4:

The “perma-bull” school: these are the always-long-all-the-time crowd and people with short memories who now believe the EU Summit this week-end and the G-20 meeting in early November will be the 2011 equivalent of 2010's Jackson Hole in August. In, other words, a full risk-on event based on stabilisation for the banks/debt crisis and general “hurrah for liquidity” cheer.
 
Most of these optimists do realise this can’t continue but argue that the low interest rates and continued government support from untraditional measures will delay the confrontation with the real price of restructuring. This is the extend-and-pretend scenario which I favour with a 60 percent chance for the nearest term.
 
The other school is the Crisis 2.0 crowd, to which I more firmly subscribe to as the eventual destination for markets. The probability of this scenario after the Cannes G-20 meeting is perhaps 40%, but rises rapidly as the following weeks turn into months.
 
The reason for the eventual need for Crisis 2.0 is that we have reached a saturation point for debt, macro manipulation by central banks, public sector involvement and political interference. Crisis 2.0 is a crisis for governments because after years of failure to address the structural problems, markets and individuals will eventually lose faith in their governments’ ability to finance and even govern.
 
Seen through the eyes of corporations, the world is actually a better place now than it was in 2008/09 - they have massively improved their core key balance sheet ratios, shed unnecessary expenses and look quite lean and mean overall. Stocks are reasonably valued using forward 12-month trailing price-to-earnings ratio of 11-12. Earnings have been steady and bottom lines have improved on 'efficiency' gains. This story may now be coming to an end.
 
From here on out, companies will only be able to improve 'funding and operational expenses' so much, and now companies will be looking to gain volume and market share in a market where the key words are higher consumer savings rates and less government demand due to austerity.
 
Public sector demand, which has been the dominant factor in maintaining overall growth since the trough in 2008 is now entering a phase of consolidation and austerity. The US will see austerity to the tune of 1% of GDP in 2012 and most European countries approximately the same. This will force growth down and see desperate attempts by Spain, Italy and Portugal to live up to the promised fiscal deficit target. These efforts may show that real implementation of the austerity measures demanded by the Troika (EU, IMF and ECB) are a mere fantasy.
 
A country spinning out of control on fiscal deficits needs long periods to turn-around its structural challenges, otherwise austerity can act like a double blow to growth and productivity. There is a clear J-curve effect from tighter fiscal policy which seems to be ignored by policy makers when they apply 'solutions' to debt stricken countries.
 
For those of us who witnessed the Asian Crisis in the late 1990’s there is another lesson: The very reason Asia pegged its currencies and started to accumulate reserves after the crisis stem at least partially from the 'austerity measures' imposed by the IMF. Asian countries did not ever again want to be dependent on a saviour who made severe fiscal tightening of policies and a reduced standard of living the conditions for the ability to access to foreign capital.
 
The difference from now is of course that after this crisis, once we get there much, much farther down the road, Greece, Spain and Portugal are still stuck with the Euro and a restrictive fiscal policy – they don’t have a weakest link like the US dollar they can peg to as the Asians did. So a replay of the Asian approach is no longer an option for these weak countries and they are left with the choice of 5 to 15 years of slow growth and deflation like in Japan. This is hardly the best outlook for any political platform to build on and hardly an ideal condition for local stock markets.
 
This also means that the talk of whether we will see a move towards a real fiscal union or not needs to stop. Greece, Spain, Ireland, Portugal and to some extent Italy and soon France, do not have their own independent fiscal policy anymore. Their Parliament is merely a procedural approval mechanism on budgets dictated by the Troika - ergo a fiscal union dictated by a non-democratically  selected trio of bureaucrats. This in itself should raise some serious political questions and trust me, it will!
 
Zooming out to a more global perspective, there are two major forces which have started and will continue to revert to the mean:
 
The first is globalisation, which is the prime suspect in the global imbalances we see today. In the course of globalisation, our hunger for cheap consumer products created a situation in which Asia became the world’s production hub and high growth and low inflation was enabled via their cheaper labour and capital. The consumers were Europe and the US – and the Middle East and Russia provided the juice to keep the wheels turning with their oil.
 
The problem with a continuation of the current arc of globalisation is that eventually, all the world’s wealth will end up in Asia, the Middle East/Russia, but there will be no one left to buy the products, as the Western world since 2000 has basically been living on credit in order to maintain its high consumption. Now there is no more credit and the public sector is crowding out private initiative in both Europe and the US. This must reverse.
 
The second big change will be the gradual reintroduction of Glass-Steagall or its like and more regulation of banks. The bank system scored a lot of own goals since 2000 and the Lehman failure and the period in its wake did not exactly made it comfortable to introduce yourself as a banker, but we still need banks!
 
We need them in what some like to call the 3-6-3 version. Take deposits at 3% and then lend it out at 6% and then hit the golf course at 3 p.m. with your client (so you know who your clients are – the diametric opposite of “financial innovation” and the endless, anonymous securitization of the final phase of the credit bubble days). The traditional bank should be one big credit play - not a supermarket of nonsensical leveraged products, where the only purpose is extending more and more credit to reap higher fees.
 
Now we have talks of an FTT (financial transaction tax), a CTT (currency transaction tax, core capital demands of 9% for banks and the introduction of Basel III, which are similar to the austerity measures on the government side and will shrink both the banks’ balance sheets, lending power and overall risk appetite. Some of this is good - and the increase in core capital does make sense, but these requirements should have been introduced at the top of the market in 2000 and 2007 and not after the blow-up is in the rear view mirror.
 
We need policies that are restrictive at the top of markets, not at the lows. We need austerity when key measure are breaching certain qualified threshold (80% debt to gdp ratio, for example) not when we are at 125% and rising.
 
The point here is twofold: First, mean-reversion and compounding are the most important components of markets and economics.  Don't compound mistakes. Excess should be met with austerity.
 
Second, we are going into period with maximum intervention in the market which will force a reaction in the opposite direction: anti-globalisation and diminished marginal returns of said public sector intervention. Unfortunately, we need to start paying back some of the future growth which we started consuming all the way back in the late 1990’s.

In conclusion:
 
For Q4 I now see a 60% chance of extend-and-pretend leading to something like a 10% performance for Q4 4th – so the risk adjusted return is 6% (0.6*10). On the flipside, there is a 40% chance of a 25% drop from Crisis 2.0 coming already in this Q4, creating a risk-adjusted return of -10%. Yes, it smells like a typical economist’s call, but Q4 is a crapshoot – the real deal won’t come until 2012, when the gravity of bank deleveraging, slower world growth, austerity, desperate taxation/intervention and rising social unrest will make their mark.

It does not mean the policy makers will give up or not keep trying, but the chances of success are compounding negatively week by week.