European Bailout: The facts Financial Markets are ignoring

Financial market professionals and the media are placing high bets that Germany will effectively assist financing the bond program in Europe. The program as most are aware of, is designed to assist nations in desperate need of assistance – Spain and Italy – to stay afloat for another couple of months.

One should look far deeper than the surface before starting to believe that Germany will be able to participate in the program without facing some serious criticism by its own citizens and opposition parties.

There are some facts being ignored; among the most important is the fact that in order to have a REAL PLAN implemented by the ECB; what the media doesn’t talk about or focus on is the very Harsh reality behind European Central Bank Rules.

In order to use the Financial Stability Facility there has to be a UNANIMOUS agreement between all participants.  There is one country opposing the plan without showing any signs or intentions to change its position: Finland!

As long as one participant disagrees, the ECB hasn’t got the ability to explore the facilities.

Another important aspect hardly mentioned is the fact that the ECB must respect a limit on amounts they can lend to Europeans Banks, therefore drawing a limit for funds available to European Central Banks.  If that is not an  important detail to be mentioned in terms of the entire bailout Feasibility, I don’t really know what is.

Mario Dragui – an Italian formal Italian Central Bank president - is doing his ultimate best to get funds to Italian Central Bank.  He states often that the ECB must take a Aggressive Action in terms of supporting the European Union and the Euro. Easy said, difficult done.

I have mentioned in a previous article that Germans – and the Dutch + Finnish Citizens – are very unhappy about seeing their money being use to pay somebody else’s debts.  Angela Merkel may be willing to change her views, but it doesn’t imply that it will get broad support. Elections will take place next year in Germany and she may be using an alternative strategy to gain votes but the response from the public has been far from positive.

A couple of weeks ago, The Germans & The Dutch voted against granting a Banking License to the ESM ( Bailout Bank). ECB president Mario Dragui was beyond upset and literally pointing fingers to Dutch and Germans alike stating that they were old fashioned and narrow minded.

 I guess it isn’t necessary to mention that Finland has opposed the License granting, but I am just making sure everyone knows.  To add more fire to this entire situation, Olli Rehn, EU Commission Vice President , has openly stated that as Finland will oppose any plans regarding Spain and Italy.  

Mr. Mario Monti, Italian prime minister was campaigning for support from Germany, The Netherlands and Finland early in August.  The results were far from expected. He was met with skepticism and criticism instead of support. There are sound reasons for the skepticism. Italian economic results are worsening by the day and show very little sign of improvement and efforts.

Mr. Monti’s reaction was one of retaliation: He stated that if the European Union and ECB don’t come to assist Italy, they can count on a NON-EU oriented, NON- EURO and NON Fiscal discipline oriented Italian Government.

Being very sincere, I don’t think that Germans, Dutch or Finns were surprised. Actually, for them, is just Business as Usual at this point. Put it very simply they don’t seem to be to concerned at this point. It is very bad as it is and even if they would do their best to Worsen the situation, the Italians would not do much worse.

Any changes in opinion from Germans, Dutch and Finns would come as huge surprise and complete unexpected. Fact of the matter is they are tired to pay for others mistakes. Wouldn’t anybody be quite frankly? They tighten belts, put pressure into businesses and citizens to try to get their home economies at better shapes and are dealt blows from neighbor’s sharing a complete different strategy. As I mentioned before, differences in mentality and behavior between European nations are huge. These are gaps difficult to fill and they tend to become more accentuated when things go wrong.

Financial markets are hoping that Germany Finland and the Netherlands will change their mind and will support the Bond Program and any additional Fiscal Bailouts. I doubt, but as I always say, nothing is impossible.

European Economic Figures:

The figures released earlier this month showed that Italian debt has expanded reaching almost 2 EUR Trillion. Italy's total government debt outstanding rose by + 6.637 billion EUR during the month of June and the debt outstanding increased by 21.7 Billion Euros. The situation has been accelerating since April.

To put things into perspective government Debt is 125% the size of GDP. If that doesn't come as Bad News, I don't really know what is...

Industrial Output does look any better:

and last but not least

The figures are dismal and provide little comfort for those willing to SUPPORT Italy’s spending.  If we translate that into layman terms, it is fair to say that Germans, the Dutch and Finn’s must work “Very Hard” to pay Italy’s bill? Is that fair? I don’t think that they agree and it is showing.

Germans are well aware that their support elsewhere is having a direct impact on their domestic economy. Below an extract of the latest press release from the Zew Report:

-          The erosion in business confidence comes on the heels of the

seventh consecutive fall in Germany's composite PMI to its lowest level

(47.0) in over three years.

     "August PMI data highlights the weakest German private sector

performance for over three years, with a return to falling services

activity offsetting an easing in the manufacturing downturn," said

Markit Economics senior economist Tim Moore.

     "Overall, the latest survey indicates that the German economy is

sailing into greater headwinds as the third quarter progresses, with PMI

readings slipping deeper into territory normally associated with GDP

contractions," he added.

     The Bundesbank warned last week that the risks to Germany's

economic outlook have "increased notably" for the second half of 2012,

given the recent escalation of the Eurozone sovereign debt crisis.

There is deterioration on the 5 and 10 year Bond Yield Spread express clearly what the expectations are for the near future. 

Here is the Graph from the 10 year Bund:

GERMAN INDUSTRIAL OUTPUT 2004 to 2012

GERMAN Debt to GDP

How Markets interpret data stays completely detached from the current situation. Markets are discounting mechanisms. While situation in Europe has not improved - actually it has worsened if one reads economic data across Europe, the Euro has reached 8 week highs yesterday. 

Certainly for the public, it is difficult to follow this mechanic. It leaves people rather confused and  asking themselves what defines the value of investment instruments. In short, what the latest appreciation of the Euro represents is nothing but the perception of market participants that the European Central Bank will intervene and find solutions for the current situation.

The speculation is based upon the promises made by the ECB president as well as the overall perception that the Europeans HAVE TO DO something about it. Now, the HAVE TO is just a perception; by law they are not obliged to intervene. In fact, they don't have to do a single thing. 

Market valuations today express the view that member countries will support the members with problems and the situation will improve in the future. That is far from clear, however being as it may, the market has a BID tone and the Euro is appreciating against other currencies. Helping the cause is the fact that the Federal Reserve should engage again on further monetary easing, therefore depreciating the dollar and automatically appreciating the euro.

Making it far more clear, the Euro is a single instrument created to facilitated trade and somehow set standards for those willing to participate. If the regulations would really apply, many countries would have already been  sanctioned or expelled from the Euro Economic zone due to their economic results. 

The Debt as ratio to GDP, Budget deficits, low inflation and interest rates have all been breached by several member countries. So far, there have been no sanctions. Exceptions are being made and most likely the ECB will continue to do so for the foreseeable future. 

The euro was established by the provisions in the 1992 Maastricht Treaty. To participate in the currency, member states are meant to meet strict criteria, such as a budget deficit of less than three per cent of their GDP, a debt ratio of less than sixty per cent of GDP (both of which were ultimately widely flouted after introduction), low inflation, and interest rates close to the EU average. In the Maastricht Treaty, the United Kingdom and Denmark were granted exemptions per their request from moving to the stage of monetary union which would result in the introduction of the euro.

The situation has not improved; The European economy is not expanding and the countries aren't facing brighter futures. All that is at this point are promises - in my opinion difficult to be fulfilled - and hopes that things will turn around elsewhere. If that Elsewhere would be China, I think everyone should reevaluate their priorities, simply because things are far from Rosy in China. 

But, living in a world of hopes and promises, principally when we approach elections, reality has been placed second for the time being and will remain so until further notice.

The reality behind Brazil’s infrastructure WONDER plans and stimulus

Brazil was again In VOGUE last week when the government announced the new stimulus plan.  Reactions were mixed: Enthusiasm and optimism from some and skepticism and a wait and see stance from others.

The initiative is good and the plan makes sense.  Improving infra-structure is essential for the further growth and expansion on industrial sectors.  It would improve Brazil’s competitiveness and provide great relief to exporters. However, in my opinion, these plans are again promises that most likely will remain unfulfilled.

I don’t want to be labeled a pessimist. I wish I could come here and be able to talk about plans that were implemented and dutifully revised and maintained. That doesn’t happen often in Brazil. We don’t have to look deep nor have to dig for facts to see that plans – in the majority of cases – remains plans.

Unless there is the heavily participation and support from the private sector (without Excessive CORRUPTION) this time around, these plans are once again noting more than media and PR plays to boost morale and improve/ polish the country’s image. It sounds good, looks good, but in fact they are nothing more than drafts that remain on the draw board.  They are plans that will never have continuity.

One needs not to look too far behind in time to be confronted with reality and question the government’s ability to deliver. It doesn’t take a genius:  It takes only asking serious questions regarding plans that sound great and find out that they failed. Case in question: the AIRPORTS! In less than 12 months what once sounded like the solution for a below par, very chaotic infrastructure and logistic in airports has completely stalled. It has been delayed, forgotten, or ignored. The real reason doesn’t really matter; what it matters is that the M.O. hasn’t changed.

Ok, Let’s look at the some recent news and articles regarding Brazil’s Airports  to better evaluate the situation:

-        -   Lula’s administration promised to invest 5,5 billions Reais in airports in the 12 world cup hosting cities where there will be World Cup matches in 2014. Untill the end of his admnistration  roughly 300 millions Reais were allocated and around 154 milllion Reais executed.

A recent article on published by the BBC news expressed the international community concerns. Here is an extract of the article:

-       " According to a recent report published by Brazil's audit office (TCU), just 4% of the $3.1bn of funding set aside for transport has been invested to date.In 2011, 179 million passengers travelled through the 67 airports run by the government aviation body, Infraero - 108 million more than in 2003. The result has been queues, delays, poor services and overcrowding: at São Paulo's international airport, it can take up to two hours to pass through immigration.

Carlos Campos, a senior researcher at the Institute for Applied Economic Research (Ipea) in Brazil, says most of the scheduled improvements will not be ready for the World Cup."

Eight airports where improvements are planned in the terminals are still in the initial phase, he says.

"That means that the government might have to build temporary structures to meet the additional demand."

Final dream

Costs will rise as the government spends more to meet the deadline requirements, says Prof Rezende: "We will end up paying a high price for hosting the World Cup."

Official reports don’t bring any relief to the situation. It is definitely not news for travelers in Brazil, but an official report by Brazilian IPEA reveals that 17 out of the 20 main Brazilian airports are either on a “worrying” or “critical” situation: Maior parte dos aeroportos brasileiros está em situação crítica, diz Ipea. The study quotes the economic growth of the last decade and the lack of investment on the field.

The report quotes the examples of Guarulhos international airport in São Paulo, operating at 121% of its capacity or Congonhas domestic airport, also in São Paulo, operating at 141% (does anybody recall the promises made after the tragic accident of Tam’s Airbus at Congonhas airport?).

The Investment Opportunity

In February  the government awarded concessions to 3 investment concerns. They paid premium for the concessions and did so expecting to yield returns from the venture. The consortia are largely Brazilian owned by Brazilian capital, with some international participation.

At 16.2 billion reais ($9.4 billion), it was nearly 4 billion reais more than the second-highest bid, and 12.8 billion reais above the government-specified minimum. On offer was 51% of a public-private partnership with Infraero, Brazil's lumbering state-owned operator. The partnership will have to pay the sum in inflation-linked instalments over 20 years, and also give the government 10% of its turnover. From what is left, money will have to be found for investment of more than 4.5 billion reais fixing up decrepit, overcrowded terminals. A third of that sum must be spent before crowds of football fans arrive for the 2014 World Cup.

Controlling stakes in two more of Infraero's 66 airports were also on offer. Viracopos, 100km from São Paulo, needs huge investment to cope with overflow from Guarulhos, which has no room to grow. Brasília's airport is to be expanded as a hub for domestic flights. All told, the government pocketed 24.5 billion reais.

Some 30% of the country's air passengers and 57% of its air cargo pass through the three airports. The firms bidding are well aware of that and realize that if all goes with a certain degree of normality, They should be gold mines.

Passenger numbers in Brazil have doubled in a decade and hectic growth is expected to continue. Since Infraero is heavily overstaffed and travellers have few opportunities to spend money, costs can be slashed and revenues rose.  With all that said, one has to wonder why they paid such a high premium for the venture. Indeed, it leaves us normal mortals wondering what kind of plan these consortia have in mind…

Questions that remains unanswered:

-          Why companies with more expertise in the sector where unwilling to raise bids?

-          What kind of future cash flows they expected?

-          Are they planning to create new cash flows from diversified operations within airports?

And, we should not forget that if all else fails, they could still resort to the same old strategy of pleading Poverty and ask for relief when plans fail and situation turns out different than expected. It such common practice in Brazil to renegotiate terms and re-restructure contracts and terms to find a leeway to sort out problems, that firms have the luxury to be wrong and still come out ahead. Of course, someone will profit and lobbyists must do their best.  All in all, nothing new here; actually, this is Business as usual.

Corruption, Red Tape, fund misallocation and other recurrent problems

Brazilians have learn how to Swallow – like it or not –  problems including endemic corruption, red tape, insufficient funds and -- above all -- a glaring lack of leadership and know-how.
Government representatives keep on reassuring the world that all will be fine and that all is going according plans. Off Course they take the opportunity to express clearly that they might need SOME help in order to get there!. Now, that is really comforting!
 I think that only fools could believe that. It is really absurd to try to convince the world that all is under control when single visits prove the contrary. By some independent estimates, fewer than half of the major projects planned nationwide will be done on time.
If Stadiums, the central focus of the world cup, are suffering from rampant delays, costs inflation and logistics problems, what could we expect from Infrastructure and facilities? Not Much! So, contrary to what we are being told, things are not going well.

Infrastructure in Brazil

Airports, Roads, Railroads in Brazil are nothing more than SHAMEFUL!  It is a Disgrace! For those who doesn’t agree here are the figures:

ROADS:           

6% of roads in Brazil are paved.  The Other BRICS nations have the following percentages: India 63% of roads paved, Russia 67% and China 87%.

PORTS:                       

According to the Containerisation International Yearbook, average time of permanence of containers before leaving port gives a good idea of where we stand in terms of efficiency in Brazil. 

Our largest Port in SANTOS takes 17 days handle a container while the world average is 5 days. These are incomprehensible facts. An exporting nation with impressive outputs suffering from outdated logistics and absurd costs.  

Cost of Handling is ranks among the most expensive in the world, with services lagging in quality and efficiency.

ELECTRICITY:              

Brazil has some the most expensive Electricity costs in the planet. It stays only behind a few countries in developed economies: Namely Denmark, Italy and Slovakia in developed countries.  So in that ranking we rank number 4! Not bad, isn’t it?! Jokes aside, it is astonishing the overall scenario. Electricity costs in countries such as Germany and The Netherlands are 20% cheaper than Brazil’s current rates.  

AIRPORTS:      

I guess the few paragraphs above summarized the state of affairs…No need to elaborate any further!

RAILROADS:   

The average speed of cargo trains worldwide is 55km/h. In Brazil the speed is 20 km/h. Another problem is railroad’s coverage. In a country where GDP has grown consistently a fractional of revenues was reinvested in infrastructure and in the particular case of Railroads, the percentages where dismal.

I honestly would like someone to come up with sound arguments to convince us that the situation is somewhat manageable. A country that has grown exponentially the last decade, has left its infrastructure on Shambles, to put it very mild.

Some firms have resorted to intelligent solutions to remain competitive. They have built their own ports and cargo facilities.  Such infrastructure and operations are expensive; they are exceptions not the norm. The majority of firms must rely on the public services and networks and in a raw material/commodity exporting economy; they are without a shadow of doubt integral part of company’s competitiveness.

What casts shadows and doubts on the latest developments are a combination of timing and the approach.  

ROAD & RAILWAY REVIVAL

This week Brazil's president Dilma Rousseff announced a $66.0 billion stimulus plan intended to revive the country's road and railway systems and to help bolster the economy. It is the fourth time that the country has tried to revive and stimulate private investments on its Road and Railway networks.

The announcement’s timing gave the impression that the government came swinging in order to reassure the world that it can deliver on commitments.

Our Economy is facing some significant adjustments. The continuous growth is receding and the pace of expansion slowing considerably. The latest economic figures reflect the reality.
GDP showed a very shy recovery (0.20%q/q in Q1 2012 and Q4 2011) after a small contraction of 0.15%q/q in Q3 2011. GDP data for the second quarter of the year has not yet been released, but high-frequency indicators are suggesting further weakness. The latest round of companies’ earnings reinforces the trend. It would be a surprise to see a very strong shift in trend. It is possible, but unlike.

The government can always try to justify and adjust as it see fit. However, the reality comes when the private sector present results and they come far below expectation. Can we blame only Europe and China for our problems? I don’t think is fair. It would not be fair to say that when things go well that we are doing fantastic and when they don’t we blame everybody else in the planet. Now, I don’t think that it is fair to put things that way.

They had to find an alternative way to finance these projects in time for the world magnitude events that will take place in Brazil. The current model is slowing considerably and with the current world economic situation, we can’t rely on revenues from export as we once did.

THE AUCTION RULES

The government announced the rules under which it intends to auction a proposed 511 km high-speed rail link between São Paulo and Rio de Janeiro next year.  

It has tried, and failed, to find bidders three times in the recent past. Most companies with experience in high-speed rail say that that the current cost estimate for  the line—34 billion reais ($17 billion)—is far too low, and that ridership predictions—33m journeys in the first year of operation rising to 100m by 2050—are out of contest. They are far too optimistic.

The cheapest tickets will cost 200 reais one-way and assuming that the railway intends to entice the low/middle classes to travel, the fares are far too high for those earing low wages to effort.

Business travelers fly between São Paulo and Rio in large numbers, and would presumably be willing to spend the money to travel by railroad. The savings would be considerable, the question remaining is: would they be able to sacrifice the time and accept a Downgrade?  Tickets between Rio and SP are the most expensive in the world for city to city flights.  They can reach 700 dollars when booked short term; but with all that said, being a Brazilian, it seems hard to believe there are enough travelers willing to make the sacrifice and generate the desired passenger turnover.

The auction may go ahead this time, because the government has changed the rules since the previous failed attempts. Earlier this year it accepted that taxpayers, not contractors, would have to bear a good chunk of the risk of cost over-runs, low demand and sharp currency movements.  For those who aren’t very aware, current exposure hedging isn’t really a widespread practice in Brazil; only look at the current exposure of several stock listed companies and their quarter results to get a crash course on currency exposure in Brazil.

For the Railroads project, Brazil must rely on international players. Simply put, Brazil has never developed a single High Speed railway project.  It known factor in Railway projects is that they always EXCEED estimations and budgets.  It happened in Korea, in Japan, Taiwan and Europe. In many cases  costs were double the estimates. Given the challenges in Brazilian topography, one can assume that it won’t be different here. The Mountains and Valleys between Rio and São Paulo will be certainly a challenge to overcome and costs will exceed forecasts.

NEW CRITERIA

On August 23^rd, in order to attract investors, it implemented new criteria in the efforts to attract the best candidate: Those with the lowest estimates are most likely to win the concession. This change implies, at the very least, that the government has finally accepted that its own cost estimates are perhaps not the last word.

Also new, is the fact that Brazilian taxpayers will have to participate on the venture. They will have to carry some of the burden.

Most of Brazil's roads are unpaved. Some important routes—including some interstate highways—are single-lane and extremely dangerous.  They are dark and poorly signaled.

Half the population is not connected to the sewage system. There are few (ordinary) commuters or freight rail lines, and they are mostly in very poor condition. Urban mass transport is grossly deficient: São Paulo, a metropolis with almost 20million inhabitants, has a mere 71km (44 miles) of metro/ underground transport, plus a few overland urban rail lines, which at peak hours are all overcrowded.

The Government is planning to start take measures to tackle this backlog, but even if it goes full speed ahead, catching up will take years, maybe decades. It is so easy to think of a long list of more worthwhile infrastructure projects in Brazil (i.e. Sewage systems) that it is hard to understand why this one is not dismissed out of hand.

The only plausible reason one can think of is that of providing some relief to the international community reassuring them that we will be ready for the events ahead.  Is that Pride? is that Vanity?or maybe,  Despair?   Maybe it’s a combination of all elements.

 It may seem outrageous to many what I am about to say, but from Brazilian’s perspective at that stage, the need to show that we can deliver gives us hope that these projects may somehow be completed. Even if they come at high costs, they will fall in the hands of international players doing business with the intent to generate profits (not bleed funds into private bank accounts) and commited to the completion of tasks at hand. 

Plans normally ended in shelves, funds into corrupt politician’s pockets and the costs on the hands of Brazilians paying taxes. That is the sad reality in a country with vast potential and resources, but with a peculiar mentality in regards to projects and funding.  For those doubting my words, just spend few minutes reading about the list of political and financial scandals implicating businessmen, politicians and important personalities.  Most lead to no arrests, impunity and complete disregard to laws and regulations.

Politicians have a license to abuse and steal whenever it pleases. That dictates the mentality in brazil. Schemes are the norm not the exception. With all due respect, when Brazil was nominated to hold the World Cup 2014 and the RIO Olympics, several well placed people were wildly celebrating the inflow of cash that would be coming their way. (Here read Bribery: favors, licenses, votes and nominations for projects all have a price and the highest bidders get those projects).

So, with all sincerity, the only thing that could be relevant and make a difference this time around would be the participation of international firms, willing to do business with an intent to generate real profit. That would be a start.That could be a stone in the right direction. Only time will tell though.

Links below

http://www.guardian.co.uk/world/2012/may/15/brazil-bribery-scandal-politicians

SP500 Index and Bovespa: The mechanics of the indexes and a performance evaluation

I will take a step from economic theories to explore the mechanics and current situation on the SP500 Index and the Bovespa.

Before diving into the details regarding the nature of  movements and what could happen in the very near term, I will comment on some important elements that affect market behavior and drives asset prices up or down

First and foremost, what drives asset prices UPWARDS is the inflow and outflows of funds, buying and selling of the stocks that comprise the Index. There are some other instruments that do affect indirectly the value of the Index, however these transactions are a bit more complicated from the stand point of a non-professional investor, and we will explore them in the future but is important that we understand that they do also have an impact on the SP500 cash & Futures index contracts value. 

In the case of the SP500, the price of all stocks traded in the exchange impact the total value of the exchange. Some Stocks have more weight than others do, but, their movements impact the total value of the index.

The Futures contracts is one of the most liquid instruments traded in financial markets. The movements of the SP500 stands basically as a proxy for equities markets performance in the US. They way it behaves or in professional lingo the way it trades, in a way represents the expectations of professionals regarding the overall market. 

Nothing is perfect in financial markets, therefore, the valuations do not represent a picture perfect evaluation of the Index  but rather the perceptions of Investors in general - professionals investors also called institutional money or smart money as well as private investors and small traders.

We can argue and discuss what leads prices up or down, however one cannot argue the following fact: Prices of stocks, commodities or Forex instruments move up when the current holders of inventory refuse to sell their holding at current prices therefore forcing new comers to Bid Higher prices in order to be able to acquire these products. There is scarcity of "goods" or lack of supply and in order to be able to acquire such goods, buyers most agree to pay higher prices.

The opposite is true for selling when current holders are willing to sell their inventories at current prices and there is lack of interest from buyers. At that stage buyers aren't interested and expressing a lack of demand, that drives the prices down. They are trying to buy at lower rates, and with inventory available they bid lowers prices for goods. therefore together driving the prices of instruments down.

What decides the given price of a financial instrument is not what Wall Street  single institution or Investor thinks; prices move up or down not driven by analysis or common sense. They fluctuate due to the willingness of participants to buy or sell instruments at given prices. several factors affect this decision process, but the hard reality is that what makes prices move up or down is the participation or lack thereof in market transactions for a given period. 

For the private investors, normally "trained" to buy stocks, the principles of short selling is sometimes difficult to understand. To allow one to better follow the mechanics of markets, here is an explanation. I will dedicate a post to Short Selling in the near future, but for the time being, let's try to make it simple: Investors operating as Short Sellers, are investors that take a stance (believe) that the prices of a given asset ( stock, commodities or foreign currency) will decline in Value.

For stocks, the investors will sell in the open market a number of stocks that they currently Do NOT OWN.  To do so they have to borrow from a source. Most of the time, this source is a brokerage firm. Here is a picture to describe the process.

The transaction ("short sale") is initiated by an individual or organization (known as a "short seller"), who desires to "short " a stock. Once the stock is sold short, the short seller must deliver the stock to the buyer. The buyer cannot differentiate whether the seller is a short seller or a long seller of stock -- nor do they care. The buyer is only interested in receiving the stock they have paid for. The short seller has a problem though. He or she does not own the stock sold to the buyer. Hence, the short seller must borrow the stock to be able to deliver it to the buyer. How? The short seller will utilize a selling broker to arrange to borrow the stock from a stock lender to be used to satisfy the short seller's sale of stock to the buyer.

This transaction takes place in a margin account and might have other economic consequences, which I will discuss later on. Please note that in some instances, the selling broker may in fact be the stock lender while in other circumstances, the selling broker must borrow stock from a third party securities lender.

When the buyer receives the stock and pays for it, he or she is satisfied and no longer has any involvement in the transaction. The other three parties (the short seller, selling broker and stock lender) are still linked together by the stock loan.

Since the stock lender has lent out securities, it will require that the borrower (the short seller) post collateral to secure the loan. This collateral is derived from the short sale proceeds, which the short seller receives from the buyer. However, the selling broker will actually receive the cash from the buyer and will not disburse it to the seller. Instead, the selling broker will withhold those short sale proceeds, make a "memo entry" in the short seller's account and then use the short sale proceeds to post as collateral against the stock that was borrowed from the stock lender.

As the short seller has sold stock but not received cash he or she will miss out on the ability to reinvest the sale proceeds that are now in the hands of the stock lender. The stock lender appears to get a free lunch from this transaction by benefiting from the reinvestment of the sale proceeds. If you are an individual investor, then this is indeed the case. However, if you are an institutional investor , such as a hedge fund  or pension plan , then this inequality is cured by the stock lender paying a rebate to the selling broker. The rebate represents a sharing arrangement on the interest that the stock lender earns on the collateral, which it holds. For example, if the stock lender earns 3.5% on the cash it holds, it might pay the short seller 3.0%.

Furthermore, institutional short sellers may have to pay a fee instead of receiving a rebate on stocks that are hard to borrow (in other words, stocks that are in limited supply with large short seller demand). As an example, Apple Computers(AAPL_) may be a stock which is heavily shorted with a limited amount of stock that can be borrowed. So an institutional borrower of Apple might have to pay a fee of 2% instead of receiving a rebate in order to borrow Apple stock.

When all aspects of the short sale transaction and process are put together, this creates a "short position" for the short seller. 

Short Covering

At a later date, the short seller will "cover" the short position. When the short seller does this, he or she will buy the same stock in the open market and the entire process that I've described so far will unwind.

The short seller buys stock from another seller. The short seller's broker will then pay for the stock out of it's client account, by using the stock to then return the stock loan to the stock lender, freeing up the cash collateral and margin requirement in the process.

The Short Seller will generate profits when he will purchase the stock at lower prices than the prices that he originally sold his stock to open the position (transaction). If the Short Seller pays higher prices than the prices he originally sold the stock, he will incur a loss:

Example:

Sold Short 3 weeks ago Apple Computer for 610 dollars per share and bought the stocks back on the 27th of July for 580 dollars, the incurred a 30 gain on the sale ( 610 sold  short - 580 bought to cover = +30 US profit per share) per share.

If he waited longer and Bought back the stocks at the open market today, the investor would incur a loss of 10 dollars per share ( 610 sold - 620 bought = -10 dollars).

Investors wishing to sell short stocks, must hold margin accounts and have been cleared (allowed) by their broker to engage in this type of transaction.

When stocks are being sold, either by short sellers believing that they are over appreciated or investors liquidating positions, if part of an Index, they will influence the overall value of the Index. Some companies more than others, due to their importance and weight, but nonetheless they will.

Now that we have understood the process, let's take a down to earth assessment of the SP500 and equities markets at present:

At present, the SP500 has succeed to penetrate levels that it has not visited for a long period.

If we look historically, the last time that the SP500 was trading at this levels was 27th April last year. The participation in terms of volume of trades during this year has been similar to last year comparing the volumes from January till August 1st. In July the volume was lower than last year's July.

Looking back 5 years, the current levels are just above the 95% confidence level. The high level was 1397. The 1327 level is the level in which the highest majority of transactions occurred. 

As the market has breached the level from last year, all we can say is that currently, buyers are more aggressive and pushing the prices of stocks, therefore the prices of the Index. 

There are high expectations of further monetary easing that would prove positive for financial markets. Traders are Biased towards further monetary stimulus, therefore more funds available to be injected into financial markets.  with that picture in mind, we should also look at the opposite side is the scenario that could develop - below expectations performances by corporations in coming results and of course the possibility of no intervention  by Government officials and central bankers. If that would be the case, the mind set would switch by traders and selling could gain pace.

Nobody knows what will happen. Logic is a word that doesn't inhabit the minds of speculators when they are investing. The mind set changes on a daily basis. There are periods in which they are blindfolded and regardless how overvalued assets may be, there is nothing that stops their appetite for them. In other moments, fear takes over and assets drop at fast paced rates.

There are several types of investors: we have fundamental and technical investors; mechanical traders and behavioral traders (discretionary traders). There are as many systems and principles as there are investors willing to participate in financial markets.

Today's activity so far was a reflection of what is happening. There isn't much conviction on the current Rally. The Index reached 1417.92 on the futures market, with most of the activity taking place at 1411.92 were 76.227 contracts being negotiated.

There is a sentiment towards a further rally, however, we should not forget that the European Intervention will not come that easy. The Germans have their own problems and will have to dig deeper into their reserves - whatever that would mean at that stage - and will take very cautious steps to proceed.

Bellow 2 graphs: A 5 year weekly graph and a daily one year graph.

The Index has reached his highest levels since last year April. That is an accomplishment, given current circumstances. Will that continue? It is impossible to determine with certainty, however, at present, with a mix of skepticism and hope mingled together, the Index is moving steadily and progressing. It should continue.


In regards to the the Bovespa index, it has had a different performance so far. I will use the most liquid and traded instrument representing the Brazilian Equities overseas, the iShares Morgan Stanley Country Index exchange traded fund EWZ, in order to evaluate the situation.

The iShares MSCI Brazil Index Fund seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in the Brazilian market, as measured by the MSCI Brazil Index.  

Here is a 5 year weekly graph:

This year, the EWZ has failed to do follow the steps of the SP500 index. Bellow, a year to date graph from the EWZ:

The Brazilian Market has struggled and I believe the current problems that very important companies such as Vale and Petrobras have faced, influenced heavily the overall perception of investors regarding Brazilian Stocks. Therefore the index performance has been poor.

Five companies almost determine the Bovespa's performance : Vale, Petrobras, Banco Bradesco, Itau Unibanco, e Companhia de Bebidas da America, They do so  due to their weight and importance; they basically dictate the performance of the index. 

These companies have had stellar performances in the recent years. However, the situation has changed. We rely heavily into exports to Europe and China; the overall picture leaves doubts on the ability to meet previously set targets. 

In regards to the banking sector, there are signs that they will have some difficult times ahead in  the domestic market. 

Does it mean it won't appreciate? Not at all!

If buyers are aggressively acquiring stocks and bidding higher prices, the index will appreciate. It has nothing to do with only facts; it is a matter of perception and having the means to back that particular strategy.

The process must start with professionals allocating funds into these companies. That will be a starting point. The most successful investors look for opportunities envisioning the future valuation of current assets. When they accumulate positions and hold them, shortening the supply, there is a great possibility for advances. 

Recently, speculators started to acquire positions on Brazilian companies. Will that guarantee that they will outperform? No. it won't. However, they place a Bet because for some reasons, they believe that these assets are being sold at discounts. Whatever metrics they use, varies, however, there is a certain degree of belief on further appreciations.

News tend to drive asset prices in a way of the other. The question is how long the news will fuel that particular movement. Last week's stimulus, has had a positive impact on the OVERALL perception of Brazil's potential. Will that hold? Will the plan become reality? Such questions are difficult to answer and always filled with speculation.

Here is a comparison between both exchanges performances:

Daily Performance Comparison: S&P 500 Index(^SPX) vs iShares MSCI BRAZIL INDEX(EWZ) Tuesday, August 21, 2012 05:50 (ET) U.S. Market open in 3 hours and 40 minutes. S&P 500 Index(^SPX) Charts -    iShares MSCI BRAZIL INDEX(EWZ) Charts -    Last Trade 1,418.08 Last Trade 55.38 Trade Time (ET) 08/20/2012 16:00 Trade Time (ET) 08/20/2012 16:00 Change 0.05(0.00%) Change 0.01(0.02%) Previous Close 1,418.13 Previous Close 55.37 Open 1,417.85 Open 55.21 High 1,418.09 High 55.46 Low 1,412.12 Low 54.74 Volume 1,995,633 K Volume 8,949 K YTD Performance Comparison: S&P 500 Index(^SPX) vs iShares MSCI BRAZIL INDEX(EWZ) S&P 500 Index(^SPX) Charts -    iShares MSCI BRAZIL INDEX(EWZ) Charts -    YTD Change 160.55(12.77%) YTD Change 2.01(3.50%) YTD High 1,422.38 YTD High 70.74 YTD Low 1,258.86 YTD Low 48.27 Average Daily Volume 2,627,437 K Average Daily Volume 15,329 K Average Daily Change 0.00 % (absolute value) Average Daily Change 0.00 % (absolute value) 52-week Performance Comparison: S&P 500 Index(^SPX) vs iShares MSCI BRAZIL INDEX(EWZ) S&P 500 Index(^SPX) Charts -    iShares MSCI BRAZIL INDEX(EWZ) Charts -    52-week Change 294.53(26.21%) 52-week Change 6.32(10.24%) 52-week High 1,422.38 52-week High 70.74 52-week Low 1,074.77 52-week Low 48.27 Average Daily Volume 2,799,305 K Average Daily Volume 15,998 K Average Daily Change 10.70 % (absolute value) Average Daily Change 1.49 % (absolute value)

5 year Graph EWZ VS. SPX

The EWZ has provided very strong returns to investors compared to the SPX in the past. This year the situation has changed and the SPX is outperforming the EWZ. 

I believe that there are two reasons for the shift. The business cycle and models. Next to it, expectations play a role.

There are thousands of professionals and Guru's that profess to be able to determine where the markets will go and why. The only ones I think we should listen to are those that have their money where their mouth is. Simply put, those that have capital at risk and make honest assessments of situations, without bias.  

Has the situation globally improved that much to see stocks performing well recently? Not really, but does it really matter? Obviously the market perceives that things have improved and have showed that in their actions.

I believe that common sense professionals, acknowledge that there are significant fractures in the structure that one day will weigh on investments and will have an impact on financial markets. The ones I believe to see things within a great degree of insight/clarity are also humble and down to earth enough to immediately recognize that Markets in itself are not erratic; Investors that make the decisions influencing the markets are.

The problems are there and we are all aware of them. However, what a down to earth and shrewd investor or trader must do, is try to find the conditions that fulfill their investment style, and apply their technique being aware that upon starting that particular transaction, there are only 3 possible outcomes: Generate Profits or Losses, and in some isolated cases Break Even.

To Invest or speculate, one must accept risks. It is a fallacy to believe that there are safe investments. Those who wish to believe that they can make money without assuming any kind of risks have lost touch with reality. The best fail; they all incur losses and make mistakes. That is part of the process. What distinguishes the very successful from the unsuccessful, is the ability to accept that they are wrong. The ego gets on the way and the markets are to blame, not them.

Accept being wrong is a difficult thing to do principally when we all strive for success and hate to accept failures. More so in an industry where so many myths exist and the public believe that many in Wall Street have either a way to manipulate markets or a hidden secret that will never be exposed.

There are people who utilize whatever means they have to their advantage, however today, the field is leveled. Nobody professes that it is easy to make money. The ones that believe are fooling themselves. looking at things in a simplified fashion helps tremendously. There are no magic indicators that will always be right. They all have pitfalls and shortcomings. 

The fundamentals often take longer than expect to kick in... Simply due to the reluctance of those participating in markets to accept or acknowledge facts. Human Beings that drive the markets. Even the computers, High Frequency Trading machines, are programmed by humans and reflect in a way or the other someone's ideas about market behavior.

So, all we can do to try to make money or extract profits from financial markets is: try to find opportunities in which according to our risk tolerance and our portfolio size can generate profits. It is often called finding the EDGE, an advantage, however small that may be, that can lead us to profitability.

The markets are not different from going into an auction to buy antiques or goods. It is not that different in fact, contrary to what many try to make us believe. People pay irrational prices for houses, for clothing and for cars. So why shouldn't they do the same with stocks. What makes stocks special? Nothing.

Stocks, in essence are also Goods. It is analysed and evaluated by humans, professionals, trying to make a living and to generate profits.Nothing different from a real state broker or a second hand car salesman.

The financial markets are certainly far more stylish and flashy than the consumer market. There is kind of Aura fluctuating around financial professionals. In society, it is far more respectable and fancy to be a Investment Analyst or Broker than a second hand salesman. Yet, both have merits and shortcomings. Their pay rate may be very different for several reasons, however, the process of marketing goods is quite similar.

Insiders, that being stock or commodities markets insiders, fruit, clothing or cars, have a lot in common. They know things first hand that we don't know; however that doesn't mean that they are all successful.

They both strive to do the same: sell their inventory generating profits. If we think about markets from that perspective, things change quite a bit and instead of looking at wall street with a sense of intimidation or awe, we start to believe that they are nothing more than human. 

There is an Edge being a professional. The edge exists for the car sales man that can take advantage of holding for purchasing the best vehicles at car auctions enabling him to sell at a premium  as there is for the Stock Broker who would hold the able to purchase stocks at very competitive prices. That is a fact of life. 

However, both can make mistakes. Both can be wrong. They can make mistakes and even us, the little guy down the street can take advantage of the situation if we commit to it. 
  













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