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On October 7 I posted an article to my website, The Macro Hedge, reviewing (in order) what I felt were the most likely next steps or “solutions” to the European crisis. As you can see from the excerpt below, I would have hit the nail on the head with the first one if it were actually true (my plan was a bit more bold, having the EFSF turned into a bank and not a bond insurance fund).

Despite the rumors being false regarding the €2 trillion insurance fund/backstop/bailout/whatever you want to call it, the question becomes, what does it mean for the market, and would this proposal even solve the issue in Europe? Bloomberg.com reported:

Global stocks rallied. France and Germany are engaged in “intensive talks” on bolstering the European Financial Stability Facility, Steffen Seibert, German Chancellor Angela Merkel’s chief spokesman, said today. He declined in an interview to comment on a report in the Guardian that they reached agreement on increasing the size of the fund, saying he won’t comment on intermediate results of the negotiations.

Short-Term Bear (For Now)

I am bearish on the next few months because I do not see Germany bailing out anyone to the extent or with the speed that the market anticipates. Obviously, if these rumors had been true, I would have been proven wrong, and anyone short should have immediately covered and sat in cash. I would not go long because the insurance fund’s purpose would most likely be to allow Greece to default. In the short term the market might be ok with this and applaud the guarantee. Despite this, it is too risky to go long and pretend everything is ok. It will only be a matter of time before Portugal, Spain, or Italy needs a bailout and defaults on their debt as well. The bailout fund would not solve the crisis as it does not provide a solution for all the PIIGS regarding their anemic growth and burdensome debt levels that none of them will be able to pay back in full.

If you agree with my analysis, you can play this with futures, put spreads, or an ETF like SH to go short the S&P 500. I also use SDS and SPXU sometimes, but be wary of the fact that the longer you hold an ETN like SPXU (or it's opposite, UPRO), the more you lose to rebalancing.

If you like using put spreads, I would consider buying the Nov 120 puts on the SPY, selling the 116 or 115 puts (make the spread as wide or narrow as you'd like). November is a good month for this bet, because you have this recent run up on hope, comments from Merkel warning of disappointment in Brussels over the weekend, and riots in Greece over a new austerity vote Thursday.

Medium-Term (2012) Bear

If you read my articles regularly, you know that I am bearish on the market in both the coming months and for 2012, primarily because of Europe, but also because of China. It is my belief that austerity (forced spending cuts) will worsen countries that are already in a recession in the short term, as well as bring down previously growing economies. This trend has already started, as GDP throughout Europe has either gone more negative or has become less positive/stagnated. Germany will not bail out everyone without some assurance that the countries needing bailouts will trim fat and work toward being self-sufficient (only spending what they can afford). This will ensure that the global economy slows and 2012 earnings take a hit, as both Europe and China drag on the U.S. economy. The riots and Thursday’s vote could prove interesting.

Long-Term Bull

As I have written before, I believe that high unemployment and a drop in the standard of living within developed nations will continue for years into the foreseeable future. However, it would surprise me if governments did not print money and fuel inflation as a way to escape the debt burdens currently weighing them down. As earnings are nominal and not real, both stocks and housing will outperform over the next decade. First, though, the global slowdown will drag stocks lower.

Here are the solutions or outcomes I posted October 7 on my website:

“Solutions”

These are presented in order of likelihood. The first is only a temporary fix.

1. Turn the EFSF into a bank and guarantee as much as €2T to cover the contagion effect of a Greek default in order to prevent the collapse of the European banking system and a run on the banks.

This proposal is likely to face extreme headwinds from the stronger European countries as they are being asked to take on trillions of euro in debt and pay for the sins of the weak on the backs of future hard working generations. Finland has been demanding Greek real estate or a German guarantee before committing a couple billion to the recent increase to the EFSF proposed back in July. Slovakia followed suit behind Finland (which is stalling its approval) and the German people are getting agitated with the fact that 2 years of bailouts have done nothing to solve the problem. It is very unlikely that the fund is increased 3 fold as it doesn’t solve the problem and just kicks the can further down the road. This solution allows for a 50%+ haircut on Greek debt (default) while hopefully preventing a banking crisis. It does not solve the root of the problem which lies in the attitudes of the citizens of the PIIGS. In order to prevent further bailouts and for the PIIGS to be able to rely on their own tax revenue to pay for spending, they have to become German. The PIIGS have to stop taking 2 hour nap breaks during the day, stop retiring at 50 years old, eliminate pensions, start working until 65+, start working 50 hours per week, privatize their economies, and do so with German ingenuity and efficiency. Sorry but, this is unlikely to happen. They will riot and protest instead as they are doing in Greece. Nobody wants to earn their money after having been given unearned entitlements for decades.

2. Keep the EU intact, but create a second currency for the weaker nations.

It has been estimated that a weaker currency for Greece and Portugal (and possibly Spain and Italy) would trade at a 40% discount to the Euro. This would allow them to grow via exports out of their debt for a decade or so and then rejoin the Euro once they have Germanized their work ethics and spending habits. This would be painful for Germany and require a messy initial break up and recession, but would work in the long run. It would be painful for Germany because their surplus was attained through strong exports. Whereas the drachma would be worth much less than the Euro, the German mark would be worth much more. The Germans have benefited from a weak currency which has made their goods cheaper to foreign nations. If they have a strong Euro and try exporting to weaker countries, they won’t make as much money as their costs are in the strong currency, but their revenues are in the weak currency. Despite this negative, it is much better than all the weaker countries falling into a depression and no one buying German goods. This scenario would see the market go lower for a few years most likely, but then rebound hard as the global economy picks up steam.

3. Chaos. Greece gets fed up and leaves the EU as unemployment continues to rise and they can’t export out of their debt. They default and go back to the drachma.

This would be good for Greece and bad for Europe. Greece gets a weaker currency which helps to promote job growth and they don’t have to pay off their debts (unless of course someone invades them for walking away from their obligations). This would kill markets for a year or two especially if the stronger nations did have money ready to capitalize the banks once they are forced to mark Greek debt to market.

4. Germany leaves the Euro.

This is the least likely scenario. Germany would get killed by a strong mark and would not be able to export to anyone in the euro zone. This would send Germany into a depression and they would still have the issue of taking hundreds of billions in losses on bad debts. As you can imagine, this would lead to market chaos.

Source: Various-Term Market Outlook Of Potential European Solutions