There was excitement in the financial markets on Monday about the bailout of Spain’s banks, and then it was gone as easily as it was created. The ten year bond rose to 6.46% after initially being lower on the news. The worries quickly moved to Italy where yields rose and stocks fell in price. The activity prompts the question, is Europe really as big of a problem as the media implies? Are we all worried about an event that will never take place? The answer to those questions is almost as speculative as asking them to begin with, but the worry they create for investors is real. My saying, fear is temporary, but greed is permanent comes to mind. The fear issue is what we have to be concerned about. Fear drives the short term dramatic swings in the markets, and those have been very damaging over the last ten plus years. And for me, that is where Europe activity gains my attention.
One indicator of fear in the US markets is the VIX index. It is a measure of price volatility in the S&P 500 index, and the higher the level rises it is as an indicator of fear in the index. It is an over simplification to say that selling is prompted by fear, but accelerated selling at extreme levels tends to be fear motivated. The VIX is currently at 23.5 and elevated off the lows of 14 in March, indicating some level of selling and fear in the index currently. It would be important to note that not all the anxiety is driven by Europe. Therefore, it would fair to state that US investors are worried about Europe, but that it has not elevated to point of panic selling.
A look at the charts of Europe, Spain, Italy and other EU countries shows a downtrend off the highs from last May. The rally off the October lows has been erased over the last six weeks with IEV, iShares S&P 350 Europe Index ETF showing the downtrend clearly in play. EWP, EWI and GREK charts reflect the concerns in those countries where the downtrends have been essentially progressive off the May 2011 highs, and the valuations have been cut in half. The negative news, speculation and data in these countries has not subsided. If anything, the rhetoric is building towards default or withdrawal from the European Union by Greece and Spain. It is this speculation that drives the fear factor and the momentum is building. That is what I am concerned about. I stated when the US was going through this issue in 2009 that default is easier to deal with. The short term disasters are catastrophic, but at least you know what direction you need to proceed. Throwing good money into a hole to save something that is broken, only prolongs the problem, and in the end creates a bigger mess to clean up.
What you and I are concerned about is how to invest our money in light of what is happening in Europe. My first response is to avoid anything to do with the problem situations. I understand that you can make money from the volatility and swings in pricing of these countries and stocks. My question is why take the risk? Why expose capital to a situation that you know could take away principle by one announcement in the wrong direction? The ETFs mentioned above have seen speculative volume swings based on all the news surrounding them. The current situation is speculation at its best. Not for me, but if you are so inclined understand the risk you are accepting. Picking a number on the roulette table in Vegas may give you better odds.
The ripple effect on Monday shows where the problem areas are in the US markets. Financial stocks lost 1.85% and banks were downs 2.3% versus the broad indexes being down 1.2%. The banks have exposure to the situation in Europe. They can’t get out of the way it, and thus the US interest in getting the situation under control. The IMFs largest contributor is the US which means we are supporting the bailout in Spain. The White House has become more proactive in encouraging the EU to take the necessary steps to sustain the membership of Greece and Spain. Thus, we have to be aware of our exposure to bank and financial stocks. Basic materials and retail were two other sectors to react negatively to the news on Monday. Export business to Europe is the US number one destination. These sectors have exposure and we have to watch our allocations equally to them. The defensive sectors of Utilities, Consumer Staples and Healthcare have less exposure directly, but they are still subject to the ripple effect of aggressive selling.
The conclusion is we have to concerned about what is taking place in Europe. We need to position our portfolios to avoid the worst case scenarios in the sectors with the greatest impact. As in the 2009 correction in the US markets those with cash to invest when the worst is over, stand to benefit the most. Now is not the time to join the speculation party. Be patient, avoid the problem areas and let this play out, then make investment selections based on optimism for growth, not fear of what is on the horizon. Yes, Europe is a really a problem. The challenge is we don’t know how big of a problem it really is, and I would prefer to avoid the exposure or risk of the problem until we know.