Investors Beware: The European Crisis Is Far From Finished

 |  Includes: DIA, FXE, QQQ, SPY
by: Vince Martin

But importantly, investors are turning their attention away from Europe's tortuous sovereign debt drama and back to the U.S. economy..."With these European clouds clearing, the focus comes right back here to the U.S., and we'll be under the microscope at least through the end of November," said Brian Dolan of

"Market Shifts Focus to Fed Meeting, Jobs Report,", October 28

Two police officers are called to a home, on reports of a domestic disturbance. Neighbors have reported shouting, glass breaking, and what sounds like a fistfight. The officers enter to find a man and woman emotional, out of breath, even exhausted. Children roam freely, and a couple of unknown adults wander in and out amidst the chaos. The angry couple exchange some weary insults while the cops try to settle them down. "She's spending all my money!" the man cries. "He doesn't have any money left, because he doesn't have a job!" the woman retorts. They continue trading barbs before, finally, the older officer announces angrily, "If you don't knock this off, I'm hauling both of you off to jail!"

This quiets the angry couple. "I'm sorry, sir," the man mumbles. "We'll figure it out, keep it down." She nods in agreement. "Am I going to have to come back here again?" asks the officer. "No, sir," the woman replies. "We won't fight any more. We promise."

The officer thinks for a moment. "This argument is over, right?"

"Yes sir," the man replies. "We've got it all figured out. Just don't take us to jail." Now, when that officer leaves, doesn't he believe that, in fact, he's going to wind up back at the house in the not-too-distant future?

You might be asking: in this metaphor, who's the man? Who's the woman? Who's the cop? And just whose children are those, up so late at night? I'm not actually sure -- and that's a large part of the problem.

From this side of the Atlantic, peering across the ocean into European windows, the Continent looks like one of those oversized families in the corner house, with an old Fiat on blocks in the front yard and an overgrown lawn (perhaps because the gardener retired at 43 with a six-figure pension). We know there's a lot of people in that house, but we're not sure how the heck they're all related to each other and we can't imagine what it is they do all day. We do know we don't want them in our neighborhood, because they're driving our property values down.

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S&P 500 6 month chartClick to enlarge

Back in August I wrote two pieces (here and here) arguing for the long-term bull case for US stocks. I argued that strong corporate earnings and balance sheets had the potential to overcome a moribund domestic economy and the European financial crisis.

I still believe that thesis to be correct, in the mid- to long-term. S&P 500 earnings should wind up near $100 for 2011, giving the index a P/E around 13. Dividend yields are dominating Treasury bills, even with the recent fall in the government bond market. And the dirty secret of 9% unemployment and negative real interest rates is that large US companies can lower labor and interest expense, increasing margins, particularly on the nearly 50% of sales that are made to international customers.

In October, I wrote about the Dexia collapse, marking my most bearish tone of the year. I noted that the Dexia bailout, made in contentious sessions over a weekend, with the prospect of trillions of dollars in paper losses hanging over the negotiations, should not engender confidence in the Continent's ability to aggressively manage the situation. I argued that investors should not be calmed by agreements made with the market's figurative gun to the head of the participants. But they were, of course, and the market has shot up another 10% in the three weeks since I made that argument.

I feel the short-term bearish case, based on Europe, still holds. There is a "black swan" lurking out there; whether it's a downgrade of the highly leveraged EFSF, another bank failure, political obstructionism by a tiny EU member or a German court, or the continuation of Italian bonds as a market target, this is not over. The "voluntary" 50% haircuts on Greek bonds that somehow are not a "credit event" as defined by credit default swaps; the publicized "stress tests" that validated Dexia as a going concern three months before its implosion; the addition of leverage (from as-yet-unknown sources of funding) to the EFSF, which is now, essentially, a government-sponsored version of circa-2007 AIG (NYSE:AIG); these political decisions are absurd on their face.

There will be consequences -- among them, higher interest rates on other distressed sovereign debt (such as Portuguese and Italian bonds), as the CDS market is destroyed and default risk enters back into investors' interest rate calculations. (Some might argue that such return of risk to its rightful owners is a step in the right direction, but that is a discussion for another time.) These higher interest rates will only increase government expense and make the whole Euro struggle even more difficult.

And yet, the market has moved higher; substantially so. The S&P 500 is up 17% from the close on October 3. Investors should bear in mind that such a jump represents two years' worth of typical market gains. If you thought stocks were undervalued in early October, or at the early August lows just a few points higher, do you need to re-evaluate your thesis? This month, Intel (NASDAQ:INTC) has gone from 20.62 to 25; McDonald's (NYSE:MCD) from 86 to 93; Morgan Stanley (NYSE:MS) from 12.47 to 19.31, a 55% gain in four weeks.

There seems to be a complacency in market coverage and sentiment right now that contrarians like me find unnerving. The VIX is at a three-month low; many investors are hoping that the European situation is finally put to rest, as the CNBC quote above notes. It's not. The European house on the corner is still full of squabbling relatives, broken windows, and shoddy plumbing. Just because the house is quiet today doesn't mean anything has changed. The cops are going to have to come back.

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