12/29/2012

Why I Continue To Stay Far, Far Away From Europe

Despite repeated government intervention, we can't seem to prevent the natural market forces from tearing apart PIIGS and the eurozone. After a temporary Spanish bank steroid injection of 100 billion euros announced on Monday, we saw a massive retreat halfway through the day, which will likely be reflected Tuesday when Asia and Europe open. The price action of the S&P 500 - SPDR S&P 500 Trust ETF (SPY) - at the close was especially discouraging.

Investors do have much to be afraid of, because it's getting to the point where even these huge stimulus events can't keep in any lasting sense of optimism. The market still favors the safe havens, and is keeping treasury bill yields stubbornly low.

The US dollar index - PowerShares DB USD Bull ETF (UUP) - continues to gain ground too (it just broke a new 52-week high at $23.01/share), which implies that money managers are carefully holding onto their greenbacks in anticipation of a prolonged state of panic in the financial markets. Another performer has been the popular safe-haven Japanese yen - CurrencyShares Japanese Yen Trust ETF (FXY) - which has rallied alongside the dollar.

The most pressing of issues has to do with the increasing likelihood of sovereign defaults in Europe. Just as it was in 2011, the financial market is pushing itself closer and closer to the edge of the cliff. Indeed, after all the LTRO operations we've seen performed by the ECB, the end result in the bond market has been the same - investors stick to what's safe and the yields on risky bonds skyrocket endlessly!

Spain has been a particularly horrid economy to watch this year. The following is a chart showing a 50% rise in the price of credit default swaps in the last three months:

And here is a chart displaying yields on their 10-year bonds, which have reached crisis levels again:

As you may know, Spain's economic statistics are very ugly. For instance, the country currently has a 24% unemployment rate (which doesn't factor in those who dropped out of the workforce!). No wonder Spain has trouble finding buyers for its debt.

To top it off, the Federal Reserve is becoming more picky about its inflation target (which has been almost perfectly held lately). This reduces the likelihood of any easing efforts that could temporarily placate the markets. The political importance of the second half of this year (due to US presidential elections) may also hurt the likelihood of more dovish monetary policy.

So, other than the ECB, it looks like we may be alone this time in trying to stop the inevitable default from happening. QE3 speculation has led to nothing so far, and surely left many commodity investors disappointed this year as their positions moved into the red. I'm one of them!

Yet another problem to add is the Greek elections, which are about a week away. This may mark the exit of Greece from the eurozone. While I think this is an extremely beneficial move in the long run, confusion and panic may rule for the short term if this occurs. There is also massive uncertainty regarding the outcome of the country's debt situation, and how the string of credit default swaps tied to the country's sovereign debt will effect banks involved.

On the bright side, the major US banks have had ample time to reduce their PIIGS derivative exposure (which is reported to be minimal). It's generally agreed that blows to market sentiment would hurt US banks much, much more than the direct effects of the PIIGS sovereign defaults.

I also want to add that Italy's economy measured by GDP is continuing to shrink according to data. We just had a June 11 economic release that reported a 1.4% decline in Italy's nominal GDP in Q2 2012 relative to last year. If there's one good thing to draw from the release, it's that we were already expecting it.

So while conventional metrics (like the deeply flawed P/E multiples and P/E growth ratios) are telling us that European stocks are a bargain right now, we have to consider that the complexity of the scenario renders many of our old models useless since they generally assume periods of predictable growth. There is massive potential for unpredictable contractions in PIIGS' consumer spending, since cash-strapped governments have every incentive to boost taxes while cutting stimulus spending.

Europe is not simply going through a rough patch here. This is a major economic contraction induced by unsustainable debts. Banks are going to take the first punch to the face if things get worse.

This means heavily debt-exposed megabanks like Barclays PLC (BCS) should be avoided as much as possible. Also, don't be fooled by the likes of Banco Santrader (STD) and its monstrous ~15% yield either - I expect the drop in share price to exceed that number by a significant margin in the future. The dividend may also evaporate, which would certainly discourage any shareholders that are brave enough to catch this falling knife. Honestly, do you really want to purchase shares of a troubled bank that was just issued a downgrade to BBB+ by Fitch? What is preventing further downgrades?

So, if I had to summarize my point in one sentence, it'd be simple. Europe's debt situation looks so hopeless that individual investors should be actively looking to reduce exposure to the European financial sector, if not the entirety of Europe. I'd also advise hedging a long-biased portfolio with some shorts on European assets. Since the eurozone is the root of the problem, major downside in global sentiment should surely be reimbursed (in part) by your hedge. One option is a naked short on the euro, which can be done with ProShares UltraShort Euro ETF (EUO) if you don't have access to forex trading. Naked shorts on the aforementioned banks, or others, is more problematic due to the spontaneity of central bank interventions.

The last point I wanted to make is an exception to the idea that all exposure should be limited. There are some multinationals like Siemens (SI) and Novartis (NVS) that have had strong performance due to their non-exposed industry and their presence outside the Eurozone. If the discrepancy in share performance between companies like this and their US counterparts is too large, I would actually see a bit of potential for value buying. I feel that prices still remain fair though, so buyers may want to hold off until we see more panic.

Other companies like Oracle (ORCL) have abnormally high exposure to Europe, so ceteris paribus, I'd favor more evenly spread companies like IBM (IBM).

It's up to each investor to measure his/her risk and reward with each play, but I am really not seeing many favorable ideas in Europe given the ever-increasing risk side. This could get much, much worse if we don't get major intervention in the near future, so I would also sell any heavily-exposed stocks/assets on rallies, like everyone else seems to be doing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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