Is Cyprus a game changer? Followed by thoughts on Gold and the S&P

The “Bailout” of Cyprus ended up badly for a number of reasons. At the core of it is the destruction of the idea of an implied guarantee on bank deposits across the Eurozone. Remember that even large depositors did not lose out to date in bailouts of the Irish, Greek or Spanish banks. Now in Cyprus, depositors of sums greater than €100,000 will lose a large portion of their money. This is not only in the 2 biggest banks of Cyprus that needed the bailout, but across the board on Cyprus depositors. How much these depositors will lose is still uncertain; 30%? 80%? probably somewhere in that range. In the meantime, strict capital controls are in place so only small amounts of the money are accessible for the immediate future. Here’s how things can go wrong…

1. The idea of squeezing large depositors was centered on the idea that many of these are foreigners anyway – largely Russian and perhaps some British. The question remains how much of these deposits were removed during negotiations when the British and Russian branches of these Cypriot banks were fully open.

2. What depositor in their right mind would risk over €100,000 in a peripheral or struggling Eurozone country right now? Deposits earn little interest if any and are thought of simply as convenient vaults to store money in … add some risk and this money will flee.

3. A Dutch finance minister involved said this would be a model going forward on bailouts, only to redact his statement under pressure and say Cyprus was a special case. Who is going to risk that Cypress is not a special case with large deposits in peripheral Europe?

4. The Basel III accords starting in January 2013 require a higher percentage of deposits in bank funding across the Eurozone which will now be harder, if not impossible to reach in many areas.

5. This is a major disaster for the Cypriot economy. The financial sector was 45% of GDP and will be gone, just like the financial sector in Iceland in 2008. Unlike Iceland, however, Cypress cannot devalue and bring back old industries such as tourism and manufacturing that had long been priced out by a strong Euro.

6. Large depositors in banks are not all Russian Oligarchs fleeing taxes. They are primarily business and trading interests. Accounts over €100,000 are used for things like payroll (sorry we cannot pay our employees at this time because of capital restrictions) and working capital (If you cannot purchase raw materials, you cannot produce finished products). This will cause a further reduction in GDP (and increase in unemployment) as Cypriot businesses close. The ones not directly affected will certainly be strained for capital going forward – who will lend them money?

This does make you wonder if it’s a Lehman moment, where the financial damage spreads further than you would think.

There are possible beneficiaries from these developments – where will the large Russian depositors go? Asian banks perhaps, such as those in Singapore? A lot of deposits from peripheral Europe including Spain and Italy will likely head to Germany or France for perceived safety while staying in Euros. I wouldn’t want to bet on European banks gaining though, as German and French banks still have large exposures to peripheral Europe.

Gold might benefit as fears of an actual breakup of the Euro will drive it higher. More likely though, the Euro won’t break up in the near term but ECB lending to peripheral Europe as a backstop will increase dramatically instead – perhaps also driving gold higher.

Speaking of Gold, I’ve been meaning to write on this and haven’t lately. There is serious consolidation going on in investor positions as big investors in funds such as the GLD are cutting out or cutting back. News stories are talking about the drop down to $1350 levels which adds to to the speculative pullback, just like the stories in 2008 of oil hitting $150 per barrel drove speculative purchases. India is traditionally one of the largest importers of gold, and the government has tripled it’s import duties to 6% because they worry about how this affects their current account deficit and inflation of the Rupee.

Meanwhile, emerging market central banks have been and still are big purchases of gold. Easy monetary policy across the major central banks, including near zero interest rates and expanding balance sheets (printing money) will continue to be a long term bullish sign for gold.

In the near term the consolidation may continue, as this is a very normal periodic occurrence in the investing world, but considering how much support gold seems to have in the $1500-$1550 range and the unlikeliness of the primary long-term easy money support ending anytime soon, I still expect it to jump to new highs when investor sentiment reverses.

Note: I am long a number of gold and silver instruments including GLD, SLV, RGLD, GG, SAND and SLW. I even gambled $1280 on a Jan 2015 call option for RGLD at $65 (so I “win” my money back plus $100 for each dollar RGLD goes above $77.80 at the time I close my position, which can stay open until mid January 2015, but I stand to lose up to $1280 if gold goes down or goes nowhere in that time).

Also note: John Mauldin has been writing on the Cyprus deal in both his free Thoughts from the Frontline and Outside the Box newsletters this past week, and much of the information I got on Cyprus comes from those.

Final word (and a couple of charts):

We’ve all heard that the S&P 500 is at new nominal highs. I’m near-term bearish and I’ll give you a couple of charts here to consider:

Below is a chart showing the range that the S&P 500 has been in from 1997 to now. This long trend of being stuck in a range is typical of a 15-20 year cyclical bear market. The big question is are we going to pull back, or finally break out to a new range:



The chart above is the last long cyclical bear market during the 1970’s. Note that the 70’s were known for high inflation, so high inflation and inflation expectations are not necessarily good for equities. In this case, the breakout occured in 1980 – but there was a pullback and retest of the prior peaks in 1982 before the big gains really started. The economic uncertainty was certainly there in 1980 with the powerful OPEC, the disastrous end to the Vietnam War, the revolution in oil-rich Iran leading to an extremely anti US regime there, and the height of the cold war continuing on. With that being said, we could certainly break out to new market highs going forward despite the current political uncertainties, but from this model I would at least expect a re-test of the peak before any real breakout occurs. This is however, the bullish model.

The Japanese model below is what scares me:


This model is a closer match for what we could expect for a number of reasons:

1. The 15-20 year cyclical bear is usually accompanied with deleveraging (debt levels reduced from 1968 to 1980 in the private sector, they have only begun declining recently here in the private sector) and declining market multiples (which were low in 1980 but are still significantly above the long term average now).

2. Japan followed the 1989 crash with consistently low interest rates and increasing levels of government spending, including large public works projects and temporary or targeted tax breaks to industries which were dying out under pressure, and periodic tax increases such as that of the VAT in 1997. This seems somewhat closer to the model we are following at present – temporary tax breaks with permanent tax increases and targeted funding to specific sectors such as renewable energy which show little promise of being our future economic drivers. This contrasts with the monetary tightening in the US from 1980 going forward, though no one could deny the increases in US government spending at that time.

I don’t think we’re going the way of Japan, as the US economy is a lot more dynamic (creative destruction, bringing up the industries of tomorrow rather than pinning up those of the past), but I do fear we’re in for a mix between the 2 outcomes, or at best a delayed stock market outbreak which better reflects the timing of credit cycles (which have been slowed by monetary measures) and cycles of market multiples.

Here’s a chart from a previous post which shows market multiples over the long term:

Stock market and PE ratioNote that the market multiples still haven’t gone below the long-term average of 15 during this cycle. I have no reason to believe that we’re in for a permanently higher range – it should perhaps be lower because average GDP growth has declined from 3% to expectations below 2%, and arguments of recent technological advance can only go so far when you consider the enormous technological advances seen througout the 1900’s. One believable argument for higher PE ranges would be that the ease of investing in equities has increased and costs decreased since the onset of the internet, thus pulling in money that would have been deposited elsewhere such as debt, but this is offset by an increased supply of equities as they become a stonger funding source for businesses. I’d still expect that trough in the P/E ratio you see in 1980 to be repeated before this market really turns to the next cyclical bull.

I’ve already written too much, so I’ll leave off here.

John Taylor


About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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