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It was about as ugly as it could get.

European policy makers convened for two important meetings late last week. And with the fate of the euro on the line, they needed to come up with something big. Instead, they may have botched their last chance to save the common currency.

The first meeting came on Thursday with the European Central Bank (ECB). Along with a much anticipated interest rate cut, it was also anticipated by many that Mario Draghi would hint that the ECB stood ready to execute its own form of quantitative easing through the large scale purchases of at risk sovereign debt. The second meeting on Thursday and Friday was a summit meeting of European leaders where it was expected that policy makers would finally come together on decisive action to finally address the problems plaguing the region including movement toward fiscal union.

The results coming out of these meetings fell vastly short of expectations. First, the ECB announced only a 25 basis point rate cut to 1%. Not only was this what the market was expecting and nothing more, it also came with dissents among its voting members. Moreover, Mario Draghi suggested the ECB stood ready to help banks across the region, but stated that it would stand aside from any major sovereign debt purchases. This was underwhelming for the markets to say the least. And then the European summit only added salt to the wound. Instead of coming together on a major resolution strategy, policy makers struggled to even agree on many underlying mechanical details. By Friday, Britain walked out completely and only 23 of 27 EU member countries were in agreement on a proposal that was vague and lacking in substance on a variety of measures. And topping it all off, EU leaders announced they would not be meeting again until March 2012.

In the end, what was hoped to be a big result turned out to be a complete mess. Not only was it just more of the same dithering, but if European policy makers cannot even come to a full agreement on minor details and more modest policy responses, how can they be expected at any point in the future to finally come together with truly decisive action. Markets were already skittish heading into this week, and what these latest meeting signaled to investors is that policy makers remain either unwilling or unable to deliver any meaningful solution.

Unfortunately, the time for European policy makers to restore confidence to markets and stave off a full blown crisis is quickly running out. As we head into the New Year, a variety of sovereigns are facing substantial sovereign debt redemptions. And nowhere is this issue more pronounced than in Italy, which is scheduled to refinance nearly $300 billion in sovereign debt next year. Over the first few months of 2012 alone, Italy is scheduled to refinance well over $100 billion of this total. And with 10-year Italian government bond yields already well over 6% including several recent spells above 7%, the risk of a failed bond auction and in the coming months are unsettlingly high and rising. Of course, Italy is certainly not alone in this risk, as numerous countries across Europe are tempting the same fate. And the potential for the collapse of a systemically important financial institution in the region also remains high even despite the latest policy measures from the ECB. In other words, things could start to unravel at any time now going forward, and there’s no longer anything on the calendar for European policy makers to do anything about it.

Before discussing the market implications, I am compelled to add one final editorial to the European situation. Talk continues that the International Monetary Fund (IMF) may get involved to provide support to at risk European nations. Frankly, I strongly object to this idea. Why should the IMF, which is funded by countries from around the world including the United States more than any other nation, offer up support for Europe when the region has shown the persistent unwillingness and inability to help itself? All along, European policy makers have maintained higher relative interest rates, supported a strong currency and have resisted engaging in many of the same policy measures such as quantitative easing that the rest of the world has used to combat the crisis.

Until we see European policy makers fully utilizing all of the weaponry in their arsenal, until we see the ECB cutting interest rates toward 0%, until we see policies to meaningfully weaken the euro currency so that failing sovereigns have a better chance to boost exports in support of GDP growth, until we see quantitative easing including large scale asset purchases of sovereign debt (regardless of what mechanism they need to justify it), and until we see EU leaders able to agree on taking actual decisive action to resolve their crisis, only then should the IMF begin to consider providing support. If the Europeans are unwilling to take all of the necessary steps to fix their own problems, why should the rest of the world have to pay for it? After all, we already have enough problems of our own to deal with here in the U.S. But I digress.

So with the potential collapse of the euro currency looming as an ever-increasing risk, what are the implications for the stock market? Fortunately, the stock market took the latest European policy meetings in full stride on Friday. Instead of selling off, stocks actually rallied sharply higher to close out the week. And if history is any guide, we may could see stocks actually continue to rally next week and even into the following week leading up to Christmas. But regardless of whether it’s Monday or two weeks from now, events are setting up to turn ugly for stocks rather quickly once the move lower begins.

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Even beyond the situation in Europe, stocks have their work cut out for them if they seek to move higher in the coming days. Friday’s rally pushed stocks as measured by the S&P 500 back up toward its 200-day moving average. This has proven stiff resistance on four separate occasions already since late October, so it remains to be seen whether the fifth attempt will be a charm. Both relative strength and momentum indicators are working in favor of stocks at the moment, which is a positive sign.

Investors would be well served to use Friday’s advance and any subsequent rally into the coming week as an opportunity to lock in gains and dial down risk. I have long been an advocate of remaining hedged in the current environment, and this continues to be true to a large extent, but risks are elevating to the point where tilting exposures further away from higher beta securities and raising additional cash appears progressively more prudent. Even if stocks manage to breakout before the end of the year, the mounting situation in Europe is very soon likely to become too large to ignore. Unless we see a major policy shift such as real substantive action out of Europe or the launch of QE3 from the U.S. Federal Reserve, the risks are becoming increasingly biased to the downside for stocks.

In regards to equity allocations, I have begun locking in recent gains and exiting even more defensive positions such as PepsiCo (NYSE:PEP) and Clorox (NYSE:CLX). Stock positions that I continue to hold include firms that have minimal to zero direct business exposure to Europe including consumer staples names like J.M. Smuckers (NYSE:SJM) and utilities such as WGL Holdings (NYSE:WGL).

Overall, I continue to maintain an equity allocation that is proportional if not slightly smaller than allocations to other asset classes for diversification and risk control. At present, this includes exposures to U.S. Treasury Inflation Protected Securities (OTC:TIPS) and Agency MBS (NYSEARCA:MBB), both of which have been consistently positive and stable performers regardless of the market environment. Agency MBS is also likely to be the focus of any QE3 program from the Fed. Utilities preferred stocks (XCJ, SCU, ELA, DRU) also offer diversification as well as a track record of price stability and consistently solid results. In addition, I continue to maintain allocations to gold (NYSEARCA:GLD) as a defense both against crisis (beyond short-term liquidation pressures) as well as the potential for aggressive monetary policy actions such as QE3 going forward. Allocations to Silver (NYSEARCA:SLV) also provide a higher beta defense against this latter point. And while I would normally favor nominal U.S. Treasuries (IEF, TLT) in the current environment, they remain overdue for consolidation at current price levels and are accompanied by higher price volatility in their own right, particularly if stocks were to continue rallying in the short-term or if QE3 was undertaken by the Fed.

Lastly, I continue to maintain a watch list of securities that I may look to opportunistically purchase if a crisis driven sell off were to occur in the stock market. Leading among these is McDonald’s (NYSE:MCD), which is a stock that has frustratingly eluded me for months now. McDonald’s offers the best of both world’s by generating attractive growth through providing a largely recession resistant product. McDonald’s strong relative performance during the 2008/2009 crisis highlights this point. Thus, I would have strong interest in McDonald’s on any retreat toward its 200-day moving average in the coming months during any broader stock market sell off.

The events in Europe last week were disappointing to say the least. It will be interesting to see how long before the stock market begins sharing that view. In the meantime, barring some major policy shift, it may be worthwhile as long as the current stock rally lasts to sell into strength and use the opportunity to dial down risk. For things may become unpleasantly eventful for stocks as we move into the New Year.

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.

Source: 300 Billion Reasons To Lighten Up On Risk Next Week