Kass: The Sword of Damocles

Tickers in this article: TBT TLT

This commentary originally appeared on Real Money Pro on Nov. 28 at 8:27 a.m. EST.

The eurozone's economic union and banking system, a house built on pillars of sand -- that is, too much sovereign debt, reckless leverage and unmarked-to-market accounting by the banking industry -- are now in jeopardy.

Given the disparate economic, political and legal interests in the E.U., the regimes of some monarchs and prime ministers have been toppled, but the heavy policy lifting lies ahead.

The lesson learned in the American economic crisis and Great Decession of 2008-2009 and now in the eurozone crisis of 2011-???? is that debt cannot grow beyond the ability to service it.

A period of subpar economic growth is the best outcome for the eurozone. At worst, the European economies' downturn will be far deeper, bank credit will be restrained, the euro could vanish, currency and trade wars might erupt, and the European banking system could collapse -- or a combination of these factors could occur.

The only practical solution in Europe appears to be going the route of the U.S. and our Fed three years ago and embarking upon its own brand of massive European-style quantitative easing.

-- Doug Kass, "Easing Won't Be Easy in Europe"

Over the past several months, investors have lived in constant fear as the eurozone's debt crisis hangs over the world's risk markets like the sword of Damocles.

In the tale, Dionysius II of Syracuse offers to exchange places with one of his courtiers, Damocles. Cicero utilizes the title object, which Dionysius II has hung over Damocles' temporary throne, to convey a sense of the constant fear in which (the great) man lives. The theme -- or moral, if you will -- being that virtue is sufficient for living a happy life.

I have long suggested that the fragile, uneven and still not self-sustaining (incapable of independent or unassisted growth without the support of fiscal and monetary encouragement) domestic economic recovery was exposed to exogenous shocks.

And the eurozone's growing contagion and confidence loss is the sort of external shock that has the potential to jeopardize the U.S. recovery if it leads to more restrictive credit conditions.

The eurozone's debt crisis has already upset the U.S. stock market despite continued evidence that our economic recovery is improving moderately and that the muddle-through baseline case remains a reasonable expectation.

Few expected such a rapid deterioration in credit conditions that occurred in the last month: I was blindsided, as I certainly didn't see the loss of confidence (and rise in sovereign debt yields) happening with such swiftness.

Rather, my recently expressed rising market optimism emphasizes and reflects the improving body of evidence and increasing probability that the rate of growth in the domestic economic recovery was about to reaccelerate. Many of those critical of that more sanguine economic view have typically cited ECRI's statistics, which were flashing recession and at odds with my view that domestic growth was reaccelerating in a muddle through backdrop.

Though the eurozone's escalating debt crisis has squashed the markets, thus far my view of a slowly improving domestic economy not moving toward a double-dip has been materially correct. Lakshman Achuthan's well-regarded ECRI Indicator, which signaled recession 45 days ago, has actually turned up in each of the last three weeks, and numerous other high-frequency economic data points (e.g., LEI, regional PMIs, confidence surveys, existing-home sales, jobless claims, income growth, retail sales) point to a continued, though moderate, path of economic growth.

Risk markets are losing their patience. The eurozone situation is approaching a major climax. This is by far the most important story to follow in the coming days and weeks. U.S. economic data has been quite encouraging, and the economy remains muddling along. If Europe took care of business quickly, global stock markets would rally sharply. The S&P 500 could possibly make a run at the bull market highs. Unfortunately, there is a major ongoing political crisis in the region.

-- Tyler Durden, Zero Hedge

It is the rapidity of the loss of confidence and the quickness with which European sovereign bond yields have risen that have served as 2011's sword of Damocles hanging over stocks. As stated previously, few, including myself, anticipated how the rising tension in the eurozone's debt markets would trump the improvement in high-frequency economic statistics in the U.S.

The world's markets have broken down under the weight of the eurozone crisis in a punishing and incessant display of selling over the past two weeks. As a result, our stock market is now discounting recession.

I am not dismissive of the seriousness of the European debt crisis. The heightened pace of contagion and growing risk at the core of the European economies, the need for a unified and effective policy response by European leaders and central bankers have materially increased in order for the world's stock markets to stabilize. If preemptive moves are not made soon, the likely contraction in credit availability will flow from Europe to our shores, and I will be forced to change the economic and stock market outcomes and probabilities that I currently envision.

As investors, we always sit under Damocles' sword, but it is that uncertainty and growing fear that is typically a condition for fertile investment opportunities.

In conclusion, the tail (i.e., the European sovereign debt crisis) that wags the dog (i.e., the world's economies and capital markets) has taken center stage -- and, for now, that dog has grown undomesticated as it has soiled the carpet of confidence and capital (markets). It is now up to Europe to forcefully address, arrest and reverse the negative credit trends that have taken hold of our markets with forceful policy (easing and the implementation of euro bonds).

As Zero Hedge's Tyler Durden writes, the outcome looks binary -- either policy is implemented and the world's risk markets experience a sharp rally or the absence of policy to stem the European debt contagion leads to a bear market.

History shows that our world's leaders rise to the occasion in the face of crisis. It happened (and worked to correct the impending doom in our credit markets) in the U.S. in early 2009, when all seemed in chaos. My investment bet (and hope) is that shock-and-awe policy will soon replace tame-and-timid policy in Europe in the days and weeks ahead.

I don't know whether La Stampa's report on Sunday that the IMF is preparing a 600 billion euro loan for Italy is credible, but I do expect that the market's recent deterioration itself will likely pressure Europe's leaders into more forceful policy. As a possible precursor to more proactive, powerful and more timely policy, the eurozone countries appeared to be moving toward an accelerated path of fiscal integration over the weekend (that would bypass the cumbersome process of treaty changes). Reuters reported that this path demonstrates the seriousness with which politicians are taking the growing debt contagion. Hopefully, as The Wall Street Journal reports, "Some within Berlin say a new binding fiscal regime might just be enough to justify ECB action." Other measures, such as an EFSF partial guarantee of a portion of eurozone sovereign bonds, appear to be on the table as well.

Tomorrow's meeting of financial ministers might hold some additional clues as to the timing of policy responses as documents that formalize the EFSF leveraging will be completed and ready for signatures. And the Dec. 9 Leaders summit might have more information.

Despite the deep-rooted and structural problems in the eurozone, I remain tactically long stocks (at around 40% net in my hedge fund) and short bonds (a 5% weighting) based on the inevitability of a favorable policy response in Europe (see this weekend's developments above) that would ring-fence the debt contagion in the eurozone and based on my continued baseline expectation of moderate economic growth in the U.S. and some improvement in corporate profits for next year. If all this occurs, the flight to safety, which has lifted U.S. bond prices and depressed bond yields, should reverse, and a move out of bonds and into stocks (especially into the U.S. stock market, the best house in a bad neighborhood) seems possible.

As I have repeatedly chronicled, the risk premiums that exist today are at multi-decade highs. In the past, this condition has provided historically attractive market entry points. Remember, bull markets are borne out of bad news and investor apathy. (Bear markets are borne out of good news and investor enthusiasm.)

Without the threat of Europe, I would be further raising my invested position, but Europe's reality, prudence, risk control and the unwillingness (thus far) of the eurozone's leaders to engage in policy that would arrest the accelerating contagion precludes me from doing so. I am going to give policymakers over there several more weeks to introduce forceful measures to stem the crisis, as I believe the markets will demand (and ultimately force) such action. If little is done, however, I will likely be forced to downgrade my economic expectations and lower projected stock market outcomes.

For now, I am taking a wait-and-see approach.

Doug Kass writes daily for Real Money Pro, a premium service from TheStreet. For a free trial to Real Money Pro and exclusive access to Mr. Kass's daily trades and market commentary, please click here.

Tickers in this article: TBT TLT