There Is No Plan In Europe: Get Short Now

Includes: DRR, ERO, EU, EUO, FXE
by: The Independent Investor

So the market has rallied about a hundred points in the last couple weeks from around 1080 to just below 1160 at close on Friday. While normally this would be extreme, in this market it is really just another move in a pretty volatile market. The question, as is always the question with traders, is what to do next?

The main reason for this recent market rally that we have been given is that Europe is finally getting their act together and we are "climbing the wall of worry" since Germany is increasingly willing to consider recapitalizing the European banks. With the market at 1160, it's interesting to look at this recent rally and see if its likely to have legs.

I"m not saying stocks are cheap or expensive, and certainly, a case could be made that the market is cheap and that stocks on a relative basis to bonds do represent a great long-term buying opportunity. Nonetheless, when the market rallies this hard on supposed data coming from Europe, not corporate earnings or other economic news, it's not credible to say that valuation was the compelling force behind this rampant move up.

So, this European recapitalization plan is the primary force behind the rally. Let's really examine if that is a compelling enough force to sustain a rally. German Chancellor Merkel recently announced her intent to pursue bank recapitalization plans prior to the ECB's disappointing recent decision to not lower interest rates or pursue a quantitative easing program, like we have seen here in the U.S. The key, to me, is to understand why Europe keeps coming out and talking about these half measures.

While the total debt to GDP ratio of the eurozone is actually better than that of the U.S. and Japan, Europe is a continent not a country, and no foreign country will lend directly to the PIGS if their debt is not collateralized by Germany and France.

The main reason Germany is talking about bank recapitalization is they can't politically back a Euro-bond, which essentially would mean they are guaranteeing the entire debt of all the pigs. The other erason they are talking about recapitalizing the banks is because they have no plan on how to restructure or "default" the debt of Greece of any of the other PIGS. Essentially, because Europe can't solve the debt problem by restructuring the debt of the PIGS or borrowing enough money to push the short-term debt off longer term by issuing a bond Germany would guarantee, like a Euro-bond, we are getting vague comments about bank recapitalization.

However, its unlikely that anyone is going to accept that recapitalization is a way to solve the crisis though because no one knows what the exposure of the banks is to the sovereign debt of the PIGS, or what the capital levels of the banks is either. Bank recapitalization is really just the talking point that is coming out because there is no plan to do anything substantive about the two biggest problems facing Europe: too much debt and too little capacity to borrow short-term.

What's interesting about analyzing the market by looking at the European storyline is that the market rally coincided with the move up in the euro from 131.80 to 135. Oil moved up from 75 to nearly 84 on Friday morning, and the S&P 500 touched 1170 on this day. The asset class that has traded most closely with the overall market and the euro has been oil.

With oil just above its previous resistance point of 82.50 on some likely late day short covering, a likely failure by Merkel and Sarkozy to propose any major new European plan should create a nice shorting opportunity in markets as a whole, with oil and commodity tied currencies, like the aussie, perhaps being the most vulnerable.

Also, since the data coming from China has been increasingly weak, a strengthening dollar could put significant additional pressure on oil, copper, and commodity based currencies of export based economies, like the Aussie. The market may look cheap to some, but with continued eurozone woes, a jobs report that showed no significant hiring in the more substantive segments of the U.S. economy like manufacturing and services, and many asset classes near resistance points, the best opportunity here is likely on the short side.

Disclosure: I am short USO.