Euro Crisis: Monitoring the Alarm Bells

by: Eric Parnell, CFA

The European situation is increasingly deteriorating. While the events in Greece have been part of the broader conversation for why the stock market has been selling off in recent weeks, the relatively mild degree of the decline so far suggests that we have not even begun to price in the risk associated with the potential fallout effects from a Greece meltdown. The situation in Europe has the potential to become another episode like the Lehman collapse in September 2008. It could even become much worse. With a stock market that is already more than 30% above its long-term historical fair value, continuing to watch the indicators from Europe closely each and every day is critical to protect against swift and sudden downside.

In my post on May 24 entitled "Euro Crisis: Latest Reason for Bears to Emerge in Anticipation of QE2’s End," I discussed how the market was likely using the situation in the euro-zone as a reason to sell off and book profits. If the stock market were actually pricing in the true risk associated with the European situation, it would have never rallied as much as it has over the last two years and would likely be far lower than where it is today. Instead, the crisis in Europe to this point is probably still secondary to investors repositioning ahead of the end of QE2 on June 30. If it were at the forefront, the decline would have likely been much more profound to this point. However, if events begin to unravel, the associated decline in stocks and other risk assets could become hasty and chaotic.

The threat of default is the key risk indicator to watch from Europe. If Greece, Ireland, Portugal or any other country were to default, it could quickly result in a contagion effect that could equal or exceed the calamity that existed in the aftermath of the Lehman collapse. A direct measure of default risk comes from the credit default swap market. As a result, the following are charts from Bloomberg that are worth watching on a daily basis to assess for yourself the true magnitude of the risk emanating from the euro-zone at any point in time. A link has been included with each to provide you with the ability to access the charts real time.

Greece – 5 Year CDS

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Ireland – 5 Year CDS

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Portugal – 5 Year CDS

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Spain – 5 Year CDS

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Italy – 5 Year CDS

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The primary takeaways from these charts is that we are currently on the brink. The CDS charts for Greece, Ireland and Portugal have all gone parabolic and are trading at new highs. Circumstances in Greece are particularly troublesome with CDS now pricing north of 2,000. And although Spain remains below previous high levels from late last year, the recent spike higher should be watched closely in the days ahead. While we have seen sharp rises in CDS in past months only to see the situation reach a short-term resolution, the high absolute levels associated with many of these readings suggest the problem is continuing to get more tenuous.

A default and the potential for contagion could have a swift and dramatically negative impact on the stock market, particularly given that the market is vastly overvalued relative to its long-term historical average, particularly where we are in the current secular bear market. This overvaluation makes it all the more important to watch the situation in the euro-zone very closely in the event that quick action is needed to protect a stock focused portfolio.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

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