Market Update – Greece & Dominos

It’s likely to be a volatile day tomorrow and potentially for the rest of the holiday shortened week in the stock market. A few hours ago, Greece announced that its banks will not open on Monday and that when they eventually open (maybe a week from tomorrow), they may impose “capital controls”, a.k.a. limits to how much anyone is able to withdraw from their account each day. The Greek government has been negotiating with the “Troika”, the European Commission, the International Monetary Fund and the European Central Bank (ECB), trying to get them to agree to provide continued emergency support to the banking system, new loans so that the Greeks can pay back other maturing loans, and improved terms on other existing loans to make it feasible for the Greeks to eventually pay those loans back in their entirety. In return, the Troika wants Greece to agree to raise taxes, implement an IRS-like tax-collection agency, and reduce spending (including cutting pensions and raising the retirement age from 61 to 67) so that it is more in line with its tax revenue and sustainable over the long term. If they can’t come to terms, Greece will default on its debts and lose support from the rest of Europe. They’ll also potentially be forced out of the Euro and back to their own currency. If an exit from the Euro happens, Greek Euro deposits will be converted to local currency (Drachmas most likely) which will have much less value. In advance of this, the Greek people have been pulling their Euro deposits out of banks so that they can retain their value in the case of a Euro exit. Since all banks are built on leverage (they loan out $10+ for every $1 they have for example since there’s no need to keep those deposits on reserve for withdrawals because the entire population does not want/need their cash at the same time in normal circumstances), consistent, massive withdrawals essentially cause the banks to run out of money. Even rumors that this could happen can be self-fulfilling and create the classic “run on the banks”. If the banks go down, so does the engine for the economy, which in Greece, is already struggling horribly. No more loans, no more deposits, no way to electronically move money, no way to cash checks, etc.

Negotiations between Greece and its creditors have broken down, with a $1.8 billion loan due to the IMF on Tuesday. A referendum is scheduled in Greece for July 5th, where the people will vote whether they’d rather accept austerity imposed by creditors in return for further assistance, or turn away from the rest of Europe and go at it on their own, likely with their own devalued currency which would work fine purchase and sale of goods made domestically, but would cause massive inflation in prices of anything imported. In the meantime the banks will be closed and the self-fulfilling bank run fears grow. If they reopen without support from the rest of Europe, including emergency liquidity provided by the ECB, they will be forced to institute capital controls and/or begin using a local currency. There simply is not enough money in Greek banks to satisfy the demands of the Greek people.

You may be thinking, “That’s a shame, but what does it have to do with me in the United States?” The problem is not with Greece, per se. Since most Greek debt is owned at this point by the ECB, any defaults can likely be absorbed rather than cause other foreign banks to have liquidity problems. However, if you lived in Spain, Italy, or Portugal, knowing your government is in a ton of debt as well (though not nearly as bad as Greece), has growing deficits, and is relying on the ECB to facilitate low borrowing costs, wouldn’t you start to think the Greek situation could be coming to your backyard someday soon? If there’s a chance that your government might close your banks and institute capital controls, wouldn’t you think twice about leaving your money at those banks? That is precisely the line of thinking that can start a bank run in those other European countries, well in advance of any debt default or exit from the euro. Could they too end up like Greece, lose the support of the ECB and the rest of Europe, and default on their debts? If so, the owners of their debts (which is not well-contained at the ECB as Greek debt is) will lose massive amounts of money. Many of those debt owners are US banks and that means dominos can begin to fall as they did in 2008 with mortgage defaults triggered the ultimate collapse of Lehman Brothers and the resulting seize-up in the US banking/credit system.

We don’t know whether Greece is the first domino in a set of tightly placed dominos that could all collapse if it does. We don’t know that the Greek domino will even fall (though it’s certainly looking like it right now). We also don’t know how much of this is already priced into the markets. The potential for Greek/Europe negotiations to break down has been well telegraphed. What we do know is that there are large players in the financial markets (e.g. hedge funds) that make bets on events like this. Those on the right side reap the rewards. Those on the wrong side typically have to sell lots of assets to cover the cost of their incorrect trade (which is typically leveraged multiple times over). The sale of assets pushes prices down globally, even if temporary, which causes other institutions to have to sell, and has the potential to create panic selling from institutions that have nothing to do with the issue and from retail investors.

My intent is not to scare you, but to keep you informed so that you’re not scared. My intent is not to try to predict what’s going to happen, or to tell you that we should move money around and try to time these events. Markets could fall horribly over the next few days and snap back. They could fall overnight tonight (futures opened down about 2% as I was writing this), and snap back by the time they open in the morning. They could rise dramatically if either there is a positive resolution in negotiations (because then the fears that are priced into the market were incorrect), or even if Greek banks do fail and it does exit the Euro as then there would be certainty for the first time in almost a decade as to the final resolution. They could also rise if more central bank (Fed, ECB, BOJ) stimulus comes as a result (the probability of a September Fed rate hike fell from 45% on Friday to 25% tonight according to Fed Fund Futures). There’s no way to predict what the stock market will do tomorrow (other than the fact that it’s indicated down 2% already), or this week, or this year or how the rest of the world economies and individual events will intertwine and influence those markets. These are the types of events that create the volatility and downside risk that ultimately enables the long-term market returns that the stock market provides. When you invest, you’re making a deal with yourself that you’re willing to ride a roller coaster of ups and downs in order to benefit from the long-term compound returns that come from those investments. We strongly believe that the stock market is THE primary place to be for your long-term investments, regardless of what may be happening at any point in time. We also strongly believe that the stock market is NOT THE primary place for money you need over the short-term, precisely because negative events can happen at any time. Cash emergency funds, conservative short-term investments, and long-term investments in the stock market mean you don’t need to worry about the short-term because that money isn’t primarily in the parts of the market that can fall sharply due to an event, and you don’t need to worry about the long-term because, by definition, it’s not impacted by those short-term events. I provide this as a reminder so that if the stock market falls and the mainstream news sources begin to call this the next “crisis” (i.e. they see the opportunity to fuel the fear fire in return for ratings), you’re one step ahead of the game, know what’s going on, and can stay focused on those things that are in your control. I’ll provide more updates as the situation progresses.

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