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A Brief Primer on the European Crisis

June 18, 2012

With Greek elections resulting in a fairly benign outcome that promises to hold the euro together in the near-term, the market may enjoy some amount of relief. The extent and duration of that relief will be informative. Based on broader factors, we don't expect that relief to survive very long, but we are willing to respond more constructively if our own return/risk measures become more favorable.

Our estimate of the prospective return/risk tradeoff in the stock market remains in the most negative 0.5% of historical instances. That said - and this is important - if market internals improve meaningfully over the next few weeks (measured across individual stocks, industries, sectors and security types), our estimate of the market's prospective return/risk profile would improve, despite what we view as rich valuations and a new recession. Very roughly speaking, this would require a solid rebound in market internals over a period of 2 or 3 weeks. That sort of outcome might accompany a Fed easing or other event, but our focus is on the measurable condition of market internals, not on Fed policy or other news per se. A positive shift in our measures of market action would likely be enough to ease back from our tightly hedged investment stance to a slightly constructive position. For now, we don't have the evidence to take anything but a very defensive stance, but we'll take changes in the evidence as they arrive.

It's fair to say that we don't foresee any development that would encourage us to remove a major portion of our hedges at present, and my personal expectation is that conditions are likely to deteriorate sharply rather than improve, but as always, I want shareholders to know where my attention is focused. Our measures of market action - and any meaningful improvement over the next few weeks - will be important in determining the whether we maintain a tightly defensive stance or shift to a slightly constructive one.

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