Since the last column two weeks ago, the markets have continued to do what they had been doing before the Passover holiday, namely, they have kept pushing higher. In the process, the S&P has now joined the Dow Jones Industrial Average, the Dow Jones Transportation Average, the Russell 2000 Index of small stocks and the mid-cap indexes by achieving its all-time highest closing levels.
And these gains have continued despite the latest “crisis” that was thrown the market’s way, namely, the financial meltdown and rescue of an island nation in the Mediterranean, otherwise known as Cyprus, whose banking system had evolved into a tax haven for wealthy Russians and British people and companies as well. As an example, foreign deposits in Cyprus banks soared by more than 60 percent in the last five years, topping $40 billion, which set the stage for a financial meltdown after these banks took a huge beating on investments in Greek bonds. At the same time that such traditional tax havens as Switzerland, Luxembourg and the Channel Islands have seen their foreign banks deposits decline, Cyprus saw this huge increase due to Russians routinely using Cyprus banks to launder illicit cash. As an example, it is estimated that more than $120 billion flows between Russia and Cyprus each year through what are called “round-tripping” arrangements, by which Russians deposit money in Cyprus and then re-invest it in Russia as a way of lowering their tax liability at home, as the top corporate tax rate in Cyprus is around 12 percent. Compared to the giant offshore tax havens such as the Cayman Islands, with more than $500 billion in foreign deposits and the Netherlands Antilles with more than $300 billion, Cyprus seemed like small potatoes, but the problem is that they incurred those huge losses from their holdings of high-yielding Greek government bonds as part of the international bailout of Greece.
The drama intensified when Cyprus’s parliament overwhelmingly rejected a proposed levy on savings in banks as a condition for an E.U. bailout, which was a stunning setback for the 17-nation bloc, as Greece, Portugal, Ireland, Spain and Italy have all been forced to accept unpopular austerity measures over the past three years in order to secure aid. The E.U. had said that it would withhold 10 billion euros in bailout loans unless depositors in Cyprus, including small savers, shared the cost of the rescue. Finally, a last-ditch deal was reached with international lenders last week on the Euro rescue plan, which included shutting down Cyprus’s second-largest bank, which will inflict heavy losses on large depositors. Without a deal, Cyprus’s banking system would have collapsed and the country could have become the first to crash out of the European single-currency union.
Financial catastrophe was spared as the largely state-owned Popular Bank of Cyprus, also known as Laiki, will be wound down and deposits below 100,000 euros will be shifted to the Bank of Cyprus to create a “good bank.” Deposits above 100,000 euros in both banks, which are not guaranteed under E.U. law, will be frozen and used to resolve Laiki’s debts and to re-capitalize the Bank of Cyprus, the island’s largest, through a deposit/equity conversion. The hit on uninsured Laiki depositors is expected to raise 4.2 billion euros and the bank will effectively be shuttered, with thousands of job losses. Senior bondholders in Laiki will be wiped out and those in the Bank of Cyprus would have to make a contribution. It is estimated that losses of up to 60 percent could be imposed on deposits over 100,000
euros at the Bank of Cyprus, which will primarily hit the Russian oligarchs and even ordinary Cypriots who so diligently tucked away their money during the supposed “good years.”
Meanwhile, back in the United States, the Federal Reserve pressed forward with its aggressive efforts to stimulate the economy when it said in the minutes of its latest meeting that it would take into account the risks posed by its policies, at the same time stating that much still needs to be done in order to lower the unemployment rate. The F.O.M.C. continued its policy of buying $85 billion per month in mortgage and Treasury bonds despite growing concerns among some officials about potential risks such as possible disruptions to financial markets and future inflation when it said that “these costs remain manageable but will continue to be monitored, and we will take them into appropriate account as we determine the size, pace and composition of our asset purchases.”
The combination of support from the Fed, improved earnings of 8 percent in the fourth quarter of 2012 and better economic reports allowed the markets to move ahead to those record highs. These reports included February building permits rising to their highest level since June 2008, another sign of improvement in the housing market, along with February existing home sales rising by the highest level in three years. The four-week moving average of weekly jobless claims declined to the lowest level since February 2008, February non-defense capital goods spending, a proxy for business spending, rose to its highest level since last July, the January CaseShiller Home Price Index showed its largest gain since June 2006, the final estimate of fourth-quarter 2012 G.D.P. moved higher to a gain of 0.4 percent, the final March U. of Michigan Consumer Sentiment Survey rose by more than expected and February factory orders increased by the most in five months on strong motor vehicle and aircraft sales.
This positive background resulted in the Dow ending the first quarter of 2013 with its best performance since the fourth quarter of 2011, when it was coming off an almost 20 percent decline due to the first-ever downgrade of the U.S. credit rating. The S&P and Nasdaq both put in their best showing since the first quarter of 2012 and they have now risen for four straight months. The Dow ended the quarter with an advance of 11.3 percent, the S&P was ahead by 10 percent and the Nasdaq gained 8.2 percent. And for those market historians out there, when the S&P is positive for the first three months of the year, which has happened nine times in the past 30 years, it has shown an average gain for the year of 17.6 percent. The S&P finished the first quarter with a gain of 10 percent, only the 13th time since its inception in 1928 that it has done so, and in 10 of the previous 12 times it achieved positive returns for the remainder of the year as well.
Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.
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