Time To Prepare For The Next Euro Crisis And A Market Correction

Includes: BAC, CAT, GE, IRDM, SPY
by: Trade In Mexico

While the problems in Europe seem to have cooled off for awhile, many issues have remained in the background and are now suddenly coming back to the forefront. As is often the case, a seemingly small problem can often trigger even bigger issues and that could be the case with how the European Union is handling Cyprus. It is easy to not take the banking crisis in Cyprus seriously since it is such a small country. However, it does have a banking system that dwarfs the rest of the economy and that is why it is more significant than some believe.

It seems that the closing of banks in Cyprus for about two weeks and the fact that officials floated the idea that deposits might be "taxed," may have done some permanent damage to the credibility of many banks in Europe. If you live in Spain, Italy or Portugal and you just saw what has happened to depositors in Cyprus, aren't you just a little more likely to question how safe it is to keep money in the bank? Cypriots have not had access to their funds for a couple of weeks, and even as the banks re-open, there will be capital controls so that no more than 300 Euros per day can be withdrawn. Even worse is that large depositors in certain Cypriot banks will lose money.

Many banks are already under-capitalized in certain European countries, and in my view, it would be very foolish to keep money on deposit in those banks. If many Europeans flee the weakest banks in Europe, a run on the banks could occur. Confidence in the banking system is a must, and what happened in Cyprus significantly damaged the trust needed for a healthy banking system. The need to re-capitalize many banks in Europe is not the only problem that could lead to a downward spiral. There are also other major issues, which are being recognized by the International Monetary Fund. A recent article states:

"In its semi-annual check on the world's financial health, the Fund said the euro area's debt crisis was a key threat and the risks to global financial stability had risen in the last six months leaving confidence "very fragile."

The euro area's plodding progress means European banks are likely to offload $2.8 trillion in assets over two years to reduce their risk exposure, an increase of $200 billion from a prediction six months ago, the IMF estimated.

"Despite many important steps already taken by policymakers, this agenda remains critically incomplete, exposing the euro area to a downward spiral of capital flight, breakup fears and economic decline," the IMF said in its Global Financial Stability Report (GFSR) released on Wednesday.

Another recent article points out that social tensions are building as the European debt and banking crisis drags on. It states:

Standard & Poor's sees a high risk that Spain, Italy, Portugal and France will not be able to carry through necessary reforms as the unemployed become less willing to put up with austerity, S&P's Germany head Torsten Hinrichs told a newspaper.

"The high unemployment in Spain, Italy and France is socially explosive," Hinrichs was quoted as saying in Monday's Neue Osnabrcker Zeitung.

With youth unemployment running at about 60% in certain parts of Europe, it seems that social unrest could become the next crisis for European leaders to deal with. Tear gas was used against protestors recently during the Paris Auto Show upset with high unemployment and the lack of growth in France.

While a European depression seems far-fetched to some investors, the reality is that certain parts of Europe are already seeing conditions that are similar to what the United States experienced in the 1930s. This includes a banking crisis, and unemployment rates that were over 20%. Spain and Greece are experiencing that level of unemployment now and if conditions continue to deteriorate, it might not be long before "contagion" hits countries like France, which seems to have no growth plan. There are also other countries like Slovenia, which appear to be next in line for a bailout, so Cyprus won't be the end of bailout issues. Plus, Italy still has been unable to form a new government and that will not go unnoticed forever.

The rising optimism over a housing rebound in the United States is warranted, but it might not last if Europe deteriorates further. With the major market averages like the S&P 500 Index (NYSEARCA:SPY) near record highs, it sure seems like a great time to sell into this strength. Investors appear to have become complacent due to the rising stock market and seemingly endless intervention by the Federal Reserve. However, risks for investors are higher as valuations become increasingly lofty. Seasonally, it has often paid to "Sell in May and go away" and that is another reason to take some chips off the table, and have cash ready for a potential market correction.

Some might misinterpret this article and think that I am advocating a sell everything approach, but that is not the case. I continue to have money invested in select stocks for the long term, and I also look for short-term trading opportunities. However, I think staying fully invested in the market after a 15% rise in 2012 and a 9% gain in 2013 is just plain greedy. I am suggesting that investors consider how they will feel if the market drops 5% or more because too often investors appear blindsided when the market does correct. Often they end up selling at much lower prices, after a market correction.

If a market correction does come this year, investors who raise cash now and have a shopping list of stocks to buy will be very well positioned. With this in mind, I plan to buy a few stocks in a pullback that appear poised for gains in the long run. Stocks that are now overbought and extended beyond strong support levels are likely to pull back to those key levels in a correction and that would be the time to buy.

For example, Bank of America (NYSE:BAC) shares are trading at about $12.25, but the 50-day moving average is $11.82 and the 200-day moving average is just $9.70. A market correction could push the stock back to those levels in the short term. However, in the long term BofA could continue to move higher as the company settles litigation and reaches "normalized" earnings that are free of major charges. As individuals and corporations become increasingly concerned about European banks, Bank of America and other U.S.-based banks could benefit.

Many large cap stocks are trading near recent highs, have been picked over and now appear to have limited upside. However, lesser-known small-cap stocks are a great place to look for bargains that are worth buying now. There is an increasing amount of merger and acquisition activity, which is often targeting smaller companies. Plus, many smaller companies are still trading at very cheap valuations when compared to larger and highly-followed stocks. Goldman Sachs (NYSE:GS) recently said that investors should be looking at small-cap stocks for upside.

For an example of a small-cap stock that offers great value: Iridium Communications, Inc. (NASDAQ:IRDM) is a satellite phone network that is trading for just over $6 per share. Analysts estimates are at 92 cents for 2013 and $1.20 for 2014. That puts the price to earnings ratio at just about 6 times earnings, which is way below the market average. Plus, it is trading well below book value, which is $11.46 per share. Iridium could be a takeover target according to fund manager, Harry Rady of Rady Asset Management. Potential suitors for Iridium could include a tech, defense or telecom firm or possibly even a private equity company.

I would avoid stocks like General Electric (NYSE:GE), which has a significant amount of global and industrial exposure. With Europe still in a "rolling" crisis, it is hard to imagine that orders will be strong from that region. Also, with the Euro weakening, it could make GE products less competitive for European buyers, and also lead to negative currency translations. GE could also see weak demand from China and Asia in general, especially since Caterpillar (NYSE:CAT) recently reported a whopping Asia-Pacific sales drop of 26% in February.

As some analysts and investors have noted, Caterpillar and General Electric shares have been diverging from the major market indexes, and that could be another sign that stocks are poised for a healthy correction. Bottom line, I would not go into the bunker, but I would be cautious, raise some cash, and prepare a shopping list for an eventual correction and the better buying opportunities that will come with a pullback.

Data is sourced from Yahoo Finance. No guarantees or representations are made. Please consult a financial advisor before making investments.

Disclosure: I am long BAC, IRDM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.