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The New Cyprus Deal

Under the new bailout deal cobbled together at the beginning of this week, bank customers in Cyprus with deposits of 100,000 euros or less will not lose any money. As far as we can tell, this means that 97% of bank depositors will not be forced to contribute anything to the bailout. Under the original deal, these depositors would have lost about 7% of their money. The remaining 3% of depositors (those with accounts valued at more than 100,000 euros) will, however, be forced to make a substantial contribution. The amount of the loss has not yet been defined, but will almost certainly be at least 30% and could be more than 50%. Under the original deal, these depositors would have lost about 10% of their money.

In summary, the new bailout deal involves:

1. A 10B-euro fund provided by the European Union and the IMF, leaving 7B euros to be raised within Cyprus to pay the full cost of the current -- but undoubtedly not the last -- bailout.

2. A restructuring of the banking system that entails closing down Laiki Bank, Cyprus's second largest bank. Laiki Bank deposits above 100,000 euros will be moved to a "bad bank" and deposits below 100,000 euros will be moved to Bank of Cyprus, the country's biggest bank. Deposits at Bank of Cyprus of more than 100,000 euros will be frozen.

3. Tapping bond-holders and large deposits for the bulk of the 7B-euro local contribution to the bailout, and obtaining the balance via privatisations and tax increases. The Cyprus Government's tax revenue is far more likely to fall than rise over the coming 12 months and privatisations probably won't raise as much money as expected, so bond-holders and large depositors will probably end up taking a bigger hit than presently envisaged.

4. Capital controls to prevent money from fleeing the country and from freely shifting between deposits within the country following the re-opening of banks.

Many commentators asserted that the original Cyprus deal would have resulted in the theft of deposits. We tried to explain in our most recent two reports that this wasn't the case. Money was lost due to bad investments. Making depositors 'whole' would therefore require stealing money from somewhere and giving it to Cyprus's bank depositors. Under the new Cyprus bailout deal, depositors with 100,000 euros or less in their accounts (about 97% of all depositors) will be 'made whole'. This means that most depositors will now be beneficiaries of theft. It is true that these deposits were insured, but there was never any insurance reserve from which money could be obtained to offset deposit losses.

Part of the money used to 'make whole' the 97% of depositors with 100,000 euros or less on deposit will come from the remaining 3% of depositors. In effect, bank customers with large deposits are being forced to contribute to the bailout of bank customers with small deposits. This means that large depositors will be victims of theft under the new deal.

Another part of the local contribution to the Cyprus bank bailout will come from bank bond-holders. The bond-holders, however, are not victims of theft, because bond-holders SHOULD lose 100% before depositors lose anything. One of the 'unique' aspects of the Cyprus situation is that the banks in this tiny economy were funded almost totally by deposits, meaning that there was almost no financial buffer-zone to shield depositors from the consequences of the banks' investing mistakes. So, even if the banks' bonds were written off in total it would not have prevented the deposits from being exposed to substantial losses.

From a global financial-market perspective, the recent Cyprus ordeal isn't important. In addition, the fact that an attempt was made to impose losses on insured bank deposits in Cyprus doesn't say anything about the risk of having money in an insured bank deposit in most other countries. In the US, for example, the risk of an insured bank customer incurring a nominal loss is close to zero, because even though the FDIC is under-capitalised the insurance is ultimately backed by an institution with unlimited ability to create dollars (the Fed). Cash savings in the US and most other countries will suffer losses in real terms, but not in nominal terms.

The recent Cyprus ordeal does, however, have significance for three longer-term reasons.

First, it highlights the true nature of deposit insurance. This is a plus, although it appears that most commentators are still missing the point. For example, someone has missed the point if his/her takeaway from the Cyprus situation is that EZ-wide deposit insurance is needed. The point is that deposit insurance is effectively a promise by the government to steal money -- either directly via taxation or indirectly via inflation -- and give the stolen money to bank depositors to offset any losses incurred by the depositors due to bank failure. EZ-wide deposit insurance would therefore, in effect, entail a commitment by the German government to take money from German taxpayers to cover the losses incurred by Greek depositors as a result of a banking collapse in Greece.

Second, it indicates that there has been a shift by Europe's leadership towards assigning greater responsibility to private investors when financial institutions 'blow up'. This is also a plus.

Third, it underlines an important political motivation that first became apparent in the 'handling' of the Greek crisis. We are referring to the resolute determination of Europe's political leadership to maintain the monetary union in its current form almost regardless of the cost. Ejecting Greece from the euro-zone (EZ) back in 2010 would have conserved resources that could subsequently have been deployed to resolve problems in larger economies and would have left a stronger union in place. Perhaps an argument could be made that despite its relatively small size Greece was still big enough that forcing it to leave would be worse than having it remain, but that's certainly not the case with Cyprus. In Cyprus we have a country with a population of only 1M and an economy that in GDP terms is only about 1/500th of the EZ. And yet, Europe's political leadership was prepared to go to great lengths to keep Cyprus in the EZ. This is a minus, because keeping the weak links in the chain shortens the time to the next EZ-wide crisis.

We will be surprised if the EZ makes it to the end of this year without experiencing a vastly more serious crisis than the recent Cyprus episode. As we've stated in the past, this is not because Europe has bigger problems than the US; it's because with Europe not having a single government in cahoots with a single central bank, the same problems rise to the surface more quickly.

The Stock Market

The following weekly chart of the S&P500 Index (SPX) shows that the October-2007 peak (the all-time high) was 1576. Therefore, the SPX is now less than 1% from its all-time high in nominal dollar terms.

With the SPX having already moved so close to its all-time high it would be strange for it to reverse downward on a sustained basis without first making a new all-time high. Having come this far it will probably exceed its 2007 peak by a small amount before making a top of at least intermediate-term importance. This would be similar to what happened in 2007, when the SPX moved 1.5% above its previous all-time high (the high of March-2000) before commencing a large decline.



In the 18th March Weekly Update we wrote the following about DXJ, an ETF that tracks Japan's stock market:

"Everyone is bullish on DXJ because everyone knows that the Bank of Japan (BOJ) is going to deviate from its practice of the past twenty years and inflate the Yen to oblivion. Everyone knows that this will happen even though the BOJ has a) not yet done anything different and b) stated that it will not do anything different until at least early-2014. Everyone also knows that aggressively inflating the Yen will boost the Japanese economy, even though continued Yen depreciation would greatly increase Japan's energy-cost burden, reduce productivity due to the price distortions caused by the inflation, and lead to a sufficiently large rise in interest rates to bring about a government debt default.

Will everyone be right for the first time in history? Perhaps, but that's not a good bet.

We are becoming increasingly interested in taking a bearish DXJ position, either by purchasing August put options or by going short. However, we haven't done anything yet. Our preference would be to purchase August put options, but the options are difficult to trade due to insufficient liquidity."

DXJ is in roughly the same position now as it was when we wrote the above. And we still like the idea of taking a bearish DXJ position, although we still haven't done anything about it. We will most likely do something over the next several days.

In our opinion there are two equally-reasonable ways to take a position that would benefit from a substantial DXJ decline over the next couple of months. The first would be to take an initial position in out-of-the-money DXJ August put options immediately with the aim of adding to the position on strength over the next week or so. The second would be to 'short' the ETF after a clear downward reversal and to then place an initial 'buy stop' just above this year's high. A "clear downward reversal" could be defined as a daily close below the 35-day MA (the blue line on the following chart).

The first method has the advantage of offering the potential for a much higher percentage gain, but at the risk of incurring a percentage loss of more than 50%. With the second method the maximum reward potential would be a lot less, but it would be possible to limit the maximum potential loss to less than 10%.

Our view is that the next 1-3 month downturn will take DXJ back to its 200-day MA and could fully retrace the entire rise from the low-$30s.



Note that a bearish bet on DXJ is an indirect bullish bet on the Yen, because the upward trend in Japan's stock market is tied to the downward trend in the Yen. Also note that next week's BOJ meeting creates a high level of uncertainty. The BOJ will probably announce an expanded debt monetisation program next week, with the market reaction to this announcement being determined by how the new level of debt monetisation compares with the expectations built into current prices.

Gold and the Dollar

Gold

The US$ gold price is essentially in the same position now as it was a week ago. As illustrated by the following chart, it has rebounded from its low but remains below its channel top, its 50-day MA and its lowest lateral resistance of significance ($1625).



The euro gold price (gold/euro), however, has clearly broken above its channel top, its 50-day MA and its lowest lateral resistance of significance.



Many gold bulls fixate on US$ issues as if a decline in the US dollar's foreign exchange rate is a prerequisite for a large rally in the gold market, but as we've mentioned in the past a large gold rally requires a loss of confidence in the US$ and/OR the euro. Despite the Fed's profligacy, at this stage it looks more likely that the primary impetus for the next major advance in the gold price will be a loss of confidence in the euro.

Gold Stocks

Nearby resistance for GDX, the Gold Miners ETF, extends from $38.70 to $40.00. The most important resistance lies at $40, as this level coincides with the July-2012 bottom, the 50-day MA and a big round number. Consecutive daily closes above $40 would therefore be the first clear-cut evidence that the gold sector has turned the corner on a sustainable basis.

Clear-cut evidence of a sustained upward reversal is taking longer than normal to emerge, assuming that an intermediate-term bottom was, indeed, put in place early this month.



Currency Market Update

The euro is 'oversold' based on momentum and sentiment indicators. It is also close to intermediate-term support at 126.5-127.5, which, by the way, is the last support of significance between the current price and 120.This combination of factors says that it is reasonable to expect a rebound to begin in the near future. Note that a typical counter-trend rebound would take the euro back to the vicinity of its 50-day MA.



While a rebound by the euro to its 50-day MA wouldn't surprise us, it's not something that we would bet on at this time. One reason is that the senior equity indices are very 'overbought' and at risk of suffering sharp downward corrections over the weeks immediately ahead, even if the longer-term trend remains up. This matters because the US$ usually benefits from material stock market weakness. Another reason is that the euro-zone's banking industry is in bad shape. It was in bad shape a few months ago, too, but 'nobody' cared back then. For whatever reason, traders began to care in early-February and have cared more over the past few weeks due to political uncertainty in Italy, weak economic data from a number of European countries and the recent events in Cyprus. Like the euro, the EURO STOXX Banks Index (SX7E - see chart below) is short-term 'oversold' and near intermediate-term support. And like the euro, the Banks Index is possibly set-up for a counter-trend rebound. However, there is also a possibility that moderate concerns about European bank solvency could grow into outright panic sooner rather than later.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/