Europe's False Dawn

| About: ProShares UltraShort (EPV)

by David Sterman

As Americans were heading back to work from the long Memorial Day weekend, Europeans were fretting about a looming banking crisis that threatened to take down major banks in Ireland and Spain. Europe went on to dodge that bullet, and its equity markets have rebounded +30% in the last five months, as measured by the Vanguard European Stock Index Fund (Nasdaq: VEURX).

That move is even more impressive than the rebound seen here in the United States. Part of the gain stems from a projected +35% rebound in 2010 profits among Europe's largest 500 companies, according to UBS. The bank anticipates an additional +10% gain in profits next year as well.

But even as Europe is no longer on the cusp of a crisis, it remains far from healthy. A host of factors will likely conspire to deliver muted economic growth at best. And there's also a reasonable chance the continent slides back into recession.

Germany's false dawn
The troubling budget deficits, unfavorable demographic trends and inflexible labor stances have been widely-chronicled impediments to any major economic rebound in Europe. Yet the German economy has remained remarkably resilient, thanks to robust exports of industrial equipment, autos and precision machinery. On a continent-wide basis, 40% of large European companies' sales go to exports outside of the European Union (EU).

A surging currency changes everything. Back in early June, when the European markets started to rebound, the euro was worth about $1.20. A euro now buys about $1.40, which means that European exporters are roughly -15% less competitive than before. Adding insult, the Chinese yuan is pegged to the dollar, so the euro is surging against that currency as well.

So what does a +15% gain in the euro really mean? For starters, it gets harder to compete with goods made elsewhere. Volkswagens made in Europe quickly become less competitive with vehicles made in the U.S. or Asia (outside of Japan) -- which explains why VW is desperate to expand manufacturing capacity in North America and build more vehicles here. That also spells fewer European jobs from VW.

Secondly, a rising currency reduces the value of export profits by a commensurate amount, so major European companies are likely to face increasingly stiff headwinds on the profit front.

Fiscal drag
The United Kingdom made recent headlines with plans to sharply curtail government spending. The country plans to run budget surpluses to start to bring down very high debt loads, which means that the government becomes a net drag on the economy as it takes in more revenue than the services and entitlements it doles out. Other countries will need to move in that direction in coming years to bring down deficits as well, most notably in the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain).

And as we've seen recently in Greece, economic contraction is the result. Yet the PIIGS have historically served as key export markets for France and Germany, Europe's stalwarts. Shrinking economies mean reduced demand for French and German goods. To make up for lost regional demand, major European companies will need to seek out new markets abroad to offset that drag. But as a high-cost region, that may be hard to pull off.

To be sure, the major European economies have proven resilient in the aftermath of the global economic crisis, and no one is suggesting that Europe is going to experience a sudden economic plunge. But current economic data and corporate profits look good in 2010 simply because they are being compared to the dismal results of 2009. Serious headwinds -- especially in the form of a surging currency -- imply that 2011's year-over-year comparisons will be far less robust. And this summer's impressive +30% rebound could well look like a false dawn.

If you own shares of European-based companies, profit-taking seems like the right move at this time. You can even look to go short against Europe by buying the ProShares UltraShort MSCI Europe (AMEX: EPV) exchange-traded fund (ETF), which moves at twice the rate in the opposite direction as the MSCI Europe Index. The bearish fund has lost half of its value since late May, but has posted a solid +5% turnaround in the past two sessions. That may be a harbinger of things to come.

Original Post

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.