Economists refer to the debt-burdened European nations collectively as PIIGS. PIIGS is an acronym:
The PIIGS are essentially unable to effectively manage debt. The consensus of the market is these nations have significant exposure to risk, causing trepidation of purchasing their issued government bonds. This market fear goads increased bond yields, so the cost for a PIIGS nation to borrow money becomes increasingly expensive. A yield greater than 7% is regarded as unsustainable. Although it is common knowledge that the US deficit has been soaring, the yields on treasuries are at relatively low levels. This is because the market regards the US as being able to pay its debts.
What's being done to stop these PIIGS?
Fundamentally, not a whole lot. The European Central Bank (ECB) and other vehicles such as the EFSF (European Financial Stability Fund) have purchased PIIGS sovereign debt. These large scale purchases drive down yields to sustainable levels. Consequently, the cost of borrowing money reduces. Cheaper credit allows for a large inflow of much needed capital, providing liquidity. This liquidity provides the governmental life support necessary for running a country within the short-term.
Why isn't that enough?
Liquidity is a short term fix and it's comparable to placing a band-aid on a gashing wound. The crux of the problem is insolvency. PIIGS have debt problems and need to implement sound policies and taxation codes to combat insolvency. I believe these policies should be austerity measures. Austerity measures are policies that curtail spending and in certain cases, cut taxes to stimulate growth. The ECB can continually purchase sovereign debt but the market will revisit risky debt issues unless more concrete programs are implemented that change the manner in which governments spend. Of course, cutting spending is arguably counter intuitive for economic growth. I believe an effective way of addressing this issue is for the ECB to aggressively purchase sovereign debt while austerity measures are simultaneously enacted, so PIIGS can still receive capital and implement policies that will prevent debt from spiraling out of control.
So what can the market take from all of this?
As long as the ECB merely buys sovereign debt, volatility should remain high. Based on the theatrics the European politicians are displaying - I don't expect this to change any time soon. Europe will continually take us down the gutter. The market will rally on notifications of the ECB debt buying, only for that rally to dissipate and take us down the gutter once again because none of the fundamentals have changed.
Strategies to play this?
Stay far, far away from European equities. I'm employing a 3-pronged approach:
(ii) Play the volatility but don't gamble the volatility. There's a difference here. Invest in a company that is fundamentally and technically sound, whose stock price has fallen because the market has fallen and not because the company is fundamentally weak. Even if selling opportunities are missed, the stock price should increase, resulting in future profits. Also, active investors are able to gauge how the magnitude of economic events affects the stock price of the company. My play is Baidu (BIDU).
(III) Take a chance on financials but limit exposure . Banks such as Bank of America (BAC) have a number of attractive traits including trading under intrinsic value, increased reserves, reduction of toxic mortgages, and lucrative business arms such as commercial lending. BAC is paving the path for a bright future, although the short term climate is very volatile.