Euro, EFSF And How They Affect U.S. Markets

Includes: DDM, DXD, FXE, SDS, SSO
by: Gold Digger

Stock markets have been jittery and glued to any news coming out of Europe about a solution to the eurozone's myriad problems. However, we believe such stock market bounces are the result of short build-up followed by short covering, not anything more fundamental than that.

The Dow 30 index has moved up and down by almost 60 points (0.5%) and S&P 500 tacked on a movement of 5 points (again 0.5%) in less than 15 minutes at least 20 times in the last three sessions alone. It is very difficult for an index to make a move like that based solely on the movement in its components. These kind of moves originate due to heavy buying and selling in futures, as well as leveraged ETFs (DDM, DXD, SSO, SDS). The daily volume in these four leveraged ETFs in August and September has been almost 3 times their average. This movement alone shows that plain long-short hedge funds are creating and exploiting volatility, with Europe as the basis.

But it's important to understand longer term implications of the situation in Europe as opposed to 15-minute movements. We believe that up market moves are good selling opportunities, as not just European growth but global growth itself is settling down to a much slower pace. This is not really a bad thing, as sub-par growth is still growth -- but stock prices have already factored in a much more robust growth. The S&P 500 is trading at a P/E (NYSE:TTM) multiple of almost 13.5. However, earnings are expected to be coming down instead of going up substantially.

Though it implies a substantial down move in S&P 500 to the order of 10-15% in the next 12-18, months, that does not mean catastrophe for markets. Of course, that's assuming such a move will be orderly over a longer period than just 15 minutes. Also, of course, not every stock in S&P 500 will go down by the same amount. Therefore, it is even more important to make investment decisions more wisely and hedge the portfolio.

Europe is not the only problem. Global growth is normalizing as world population skirts on the limits of socialistic push by almost every government. Europe's problems are not going to be solved overnight. Even though European leaders are trying their best to spread the pain of few nations to other stronger nations. However, such moves are inherently limited in impact as they provide incentives to weaker nations to feed on the growth in stronger nations. This can go on until stronger eurozone countries themselves are not able to pull along. This thinking is clearly reflected in the warnings from rating agencies to France.

Europe is being guided by policies suggested by US Treasury Secretary Tim Geithner, who may not be able to name all the countries in the eurozone if asked without prior notice. His incompetence is clearly reflected in suggesting a "bazooka" approach to Europe, because it has been working in the US temporarily until now.

Europe's problem is the euro itself. It's a currency that supports nations as different as Texas and North Dakota in the US. Countries in the European region have very different geographic potential, demographic potential and fiscal potential. At the same time, to make the euro more grand, more and more countries were accepted into the bloc without much deliberation as to the consequences on monetary and fiscal policy.

As a result, we have a crisis that is taxing stronger eurozone economies to support weaker economies. The reason is very simple. The euro may strengthen in the short term on such measures, but the longer-term path for such a currency will be lower. Consider, for example, the continuous fall of US dollar of nearly 20% in just past 2 years as a result of ongoing irresponsible monetary and fiscal policies. And combine that with another problem for the euro -- that it is still not the currency of denomination for commodities. Therefore, a combination of reckless policy governance in Europe will undermine the currency in the longer duration.

This will increase inflationary pressure on nations with stronger economies. And inflation may become such a big problem in the bloc that even these nations will face negative growth. We already saw eurozone inflation inching up to 3% in the past month. If a rampant inflation scenario is triggered, it will become a downward death spiral for the euro, as stronger economies will become weaker and may need rescuing themselves.

In today's global trade, any country supporting its weaker neighbors just to gain trade benefits at the expense of weakening its own economy is being very short-sighted. It's high time for European leaders to put the right longer-term solutions in place. And increasing the size of the European Financial Stability Fund or leveraging it up are definitely not those solutions.

In the meantime, the market should be ready for adjustment for a sub-par global growth. We would advise investors to stay cautious and sell any market rally above 1,240 in the S&P 500, as the market may soon be revisiting the 1,050 level by the end of the year. Another good long-term trade is to short the euro (NYSEARCA:FXE) itself if we see any big expansion of the EFSF or other such foolish policies coming out of European leaders. Investors should watch the euro next week for initiating short positions based on any move above $1.395 to the euro.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FXE over the next 72 hours.