Politicians Sank Stocks in Q3; Can They Rescue Q4?

After watching the politicians cause havoc for investors for the last three months, can we hope at all that things will be any different in the fourth quarter?

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The quarter's finally come within inches of its close, and we know who we have to blame for the searing, volatile ride we're about to finish: our politicians.

Two days before the third quarter began, Larry Fink, the founder and CEO of asset management giant Blackrock, told CNBC that the US could no longer ignore its runaway budgetand said that, if his accountants would let him, he would have 100 percent of his firm's holdings in stocks, given the low returns on bonds. "Anything earning 3 percent or lower is the dumbest thing you can do,” said Fink. When your company manages $3.7 trillion, the amount of income you generate is, needless to say, hugely important. Fink saw little benefit in owning bonds that yielded less than inflation.

The problem for those of us not managing trillions on long-term horizons is that if you increased your exposure to stocks—and risk in general—at the beginning of July, you would have just been better off sitting on the beach and parking your cash in a deposit account. If you were really lucky, you would've gone into the VIX.

Since the start of the third quarter, the Chicago Board Options Exchange Volatility Index, or VIX, has traded 135.11 percent higher, gold is up 13.78 percent, and defensive stocks like S&P utilities gained 8.37 percent higher. If you bought the S&P 500 or Dow, you are now sitting on double-digit losses. If you were in German or French stocks, you would have lost around a quarter of your money. Even Chinese stocks lost nearly 15 percent in just three months.

Those numbers would have been even worse had investors not become hopeful for a resolution to the Greek debt crisis, sparking a rally in the process. It has been, without doubt, one of the most volatile and difficult quarters to navigate since late 2008 and early 2009.

The Western world's political leadership, if it can be called that, started its misfires straight out of the gate. Less than two weeks into the third quarter, Italian Prime Minister Silvio Berlusconi decided for largely domestic political reasons to criticize his finance minister, Giulio Tremonti. The Italian prime minister has made some gaffes in his time, but when he suggested Tremonti was “not a team player” who only “spoke to markets,” he took things to a new level: He unleashed bond vigilantes against his country and took the entire euro zone's crisis to another, more dangerous level.

As Italian (and Spanish) bond yields soared, so did volatility. By early August, the European Central Bank was forced to step in and start buying Italian bonds. Berlusconi was forced to push through a 54 billion euro austerity package, essentially shredding what little was left of his credibility.

The euro zone debt crisis had been rumbling on for years, and the United States must have been feeling a little left out. Months of Congressional argument about raising the nation's debt ceiling--between the White House on one side and a Tea Party-spooked Republican Congress on the other--nearly saw the Federal government run out of funds. After a last-minute deal was finally reached, Standard & Poor’s decided to strip America of its AAA rating.

"... will not be a straight line down..."

The Dow lost more than 600 points following the S&P’s move, prompting Treasury Secretary Tim Geithner to tell CNBC that “S&P has shown really terrible judgment, and they've handled themselves very poorly.”

The S&P messenger had been well and truly shot, but lawmakers on Capitol Hill and those who had helped run up America’s $14 trillion debt should probably take their fair share of the blame. As Stephen King from the economics team at HSBC said following the downgrade, America’s fiscal rot started long ago.

The credit ratings agencies were rightly slammed for obliviously missing the subprime mortgage disaster, but blaming S&P for the US downgradewas akin to blaming the Titanic watchman who shouted, "Iceberg dead ahead!" before the ship went down.

As the debt debate raged on, the economic data in the US continued to deteriorate, and it was difficult to be bullish on the prospects for the rest of the year. In an appearance on CNBC, Bob Janjuah, the head of cross-asset allocation strategy at Nomura, warned that markets were just beginning to price in the "new normal." He predicted the S&P 500 was heading toward 800. “It will not be a straight line down, but the secular (bearish) trend for risk assets is, to me, now clear and, with hindsight, this bear leg began in Q2 2011,” he said.

As Hurricane Irene hit the East Coast of the United States and people fled New York, a worse storm was brewing in Southern Europe. It came from a familiar source: Greece.

The problem, it was becoming clear, had not changed. Greece could not afford its debt burden, it would need to default on up to half its debt, and Germany and the richer members of the euro zone did not want to pay for a country they saw as living beyond its means.

What did change was that opinion across the EU and at the International Monetary Fund was hardening toward Athens, and as the market fretted over default, the euro zone banking system came under pressure amid fears of a fully-fledged liquidity crisis. Access to US money markets was withdrawn for all but the shortest durations, and the shorts were out in force with the French banks in their sights.

Twice in the last two months, Societe Generale CEO Frederic Oudea has appeared on CNBC to defend his bank amid rumors of huge losses on its exposure to euro zone sovereign debt. Despite his assurances, the market remains unconvinced, and the bank's stock begins the final day of the quarter 50 percent lower than where it started.

As the politicians squabbled over what to do about Greece and how to avoid a new banking crisis, the mood took a turn for the worse yet again. Carl Weinberg, chief economist at High Frequency Economics, began to fear depression was on the way. “This is our baseline forecast. It includes near-zero interest rates and bond yields, at least for safest sovereign credits. It includes flat prices, or outright deflation, and the highest unemployment rates the G7 economies have experienced since the 1930s.”

President Barack Obama unveiled a multi-billion dollar package to boost employment in mid-September, opening the debate on the effects of fiscal austerity. The problem for the president was that any boost to confidence from the announcement he hoped for was being overshadowed by crisis in the euro zone.

Tim Geithner was dispatched to Europe to knock some heads together, and as we headed into the third quarter's home stretch, there where hopes for a plan near the finish line that would rein in the troubles in Europe.

As G20 finance ministers met in Washington last week for the annual IMF meeting, reports began to filter out indicating a "shock and awe" plan that would ring-fence Greece, recapitalize the euro zone banking system, and deploy the European Financial Stability Fund to frighten the bond vigilantes away from Italy and Spain.

Despite no concrete details, stocks soared earlier this week on hopes a deal was in sight. Maybe we were all just desperate for good news.

Unfortunately, opposition to such a plan remains strong. Germany is opposed to leveraging the EFSF rescue fund, and agreement remains elusive. After watching the politicians cause havoc for investors for the last three months, you would have to be very brave indeed to bet things will be any different in the fourth quarter.