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The financial mess that has engulfed Europe has caused a lot of bears to come out of the woodwork and individual investors are rattled by the rise in volatility. What is interesting is that up until a little over a month ago, complacency was rampant and warning signs were being ignored. Most mutual funds had made an all in bet by continuing to wind down their cash positions to the point that recent data shows mutual fund cash positions as percent of assets down to about 3%. Typically, this has been seen as a contrarian indicator as it means that there is less "fuel" in the form of cash remaining to power markets higher.

The warning signs that were coming from the credit markets where the prices of debt issued by the most financially troubled countries of Europe were being sold off had also receive little attention from investors until the crisis had arrived front and center. Add in a stock market that was overbought mixed in with overly complacent investors and we have the conditions requisite to send stock markets sharply lower.

More specifically, investors have traded their complacency for fears based on the idea that the troubles in Europe are going to create the second installment of the financial crisis. It is amazing how investor perceptions change in just over a month.

To be sure, the problems confronting Greece and the other European nations are significant. They are facing serious challenges that are going to require a great deal of sacrifice from their populations. The financial markets have made it clear that these nations will have to cut government spending, raise taxes and put fourth credible plans towards ensuring that their national debt levels will be brought under control.

At this point, concerns about whether the world will be dragged down into a “double-dip recession” seem a little misplaced. While the global economy may slow down a notch from its recovery pace so far, the idea that there will be an abrupt halt to global growth is a stretch at the current time.

The real issue that should worry the markets is whether or not this turmoil will spill into the global banking system turning the European debt crisis into a global financial crisis. One of the objectives of the European Central Bank’s trillion dollar emergency rescue package announced earlier this month was to calm the fear amongst banks so that they would continue to lend to one another.

European monetary authorities had become worried that banks were beginning to look upon one another with suspicion – not knowing who had what exposure to which country’s debt. The level of fear can be seen by looking at the LIBOR (London Interbank Offer Rate) which is the interest rate banks charge each other for short-term borrowing. The more worried they are – the higher the LIBOR goes as the chart below shows (click to enlarge):

Global Banking Crisis

Data source: StockCharts.com

A higher LIBOR can mean higher borrowing rates for borrowers since it is often used a benchmark for other interest rates. Secondly, a higher LIBOR means that if banks are fearful, they might end up reducing the amount of lending they are willing to do.

Thus, this would short circuit the global economic recovery and could lead to a marked slowdown. The real issue for investors who are worried about the sovereign debt crisis comes down to one thing: the banks – will they be able to adjust to these risks and continue to ensure that they are performing their essential duty which is to allocate capital from savers to borrowers. If the banking system – with the coordinated effort of the world’s central banks – is able to function as close to normal as it can, then the odds of a double dip recession will remain low.

The other indicator to watch will be the yield curve. The yield curve measures the difference between longer term and shorter term interest rates. As long as long term rates continue to remain above shorter term rates, lending will continue. If longer term rates drop relative to shorter term rates, the banks tend to find it less profitable to lend capital since their profit margins on loans drop. In such a scenario where the yield curve is flat (short term rates are about equal to long term rates) or in which the yield curve is inverted (short term rates are higher than longer term rates), a recession has usually ensued. Inverted yield curves have also tended to coincide with stock market tops.

At this point, the yield curve is continuing to do its part to help the economic recovery. The European crisis has sent mortgage rates to below 5% in the US – helping to provide a buffer to the economy. Lower oil prices will also help to give the US economy a helping hand.

The stock market correction at this point has been helpful to those investors who saw the risks on the horizon and who had reduced their equity exposure in advance over the last several months. With many equities off 12-25% or more in a short period of time, risks and rewards are a little better balanced than they have been in several months.

Disclosure: No stocks mentioned

Source: Investors Shaken as PIIGS Bring Out the Bears