A Week Of Historic Reckoning

Includes: DIA, QQQ, SPY
by: James A. Kostohryz

Global equity markets are being utterly dominated by events in Europe - and this is as it should be.

As much as U.S. investors would like this whole "Europe thing" to go away so that they can concentrate on quarterly earnings reports and the latest indicators of U.S. economic activity, the fact of the matter is that the future of the U.S. economy and U.S. stock prices depends upon how the current crisis in Europe is resolved. Neither the U.S. nor the broader global economy (upon which the earnings of S&P 500 companies depend) can withstand a full-blown sovereign debt and financial crisis in Europe.

The U.S. economy and many key economies around the world have slowed below "stall speed" and realization of current fears regarding Europe would knock the U.S. and global economies into recession.

The Stakes: Huge
The consequences of a recession in the U.S. could be disastrous. The U.S. is already running a fiscal deficit of almost 9% of GDP. The US can simply not afford countercyclical fiscal policies or "bailouts" that would expand the deficit further without incurring grave consequences in the form of either increased default risk and/or high inflation. Furthermore, with underemployment and unemployment of around 16%, the U.S. cannot afford a recession from a social and/or political point of view.

In the event of recession, there is a very real possibility that something is going to give: Default risk, inflation, social/political instability - or perhaps all of the above.

That is why what is going on in Europe is so critical.

Violent Volatility and Market Efficiency
The huge stakes involved explains why the violent volatility of U.S. equities (SPY, DIA, QQQ) in the past two and a half months can be considered to be an entirely "efficient" response to the current configuration of global risks and events related to those risks. Many will be shocked by the assertion that such volatility could be a sign of market efficiency. Let me explain.

Assume for a moment that the outcome in Europe is ultimately a full-blown sovereign debt and financial crisis that results in defaults beyond Greece and the insolvency of several major European banks. Under such circumstances, and given the indirect impacts on the U.S. financial system and economy, it would not be unreasonable to expect the S&P 500 index to revisit its March 2009 low of 667. Compared to Friday's closing price of 1,238, that implies potential downside of 571 points. Now, assume that a given news item that hits the wires increases the incremental probability of a full-blown European crisis by 10%. This implies that an "efficient" response to such news would be a swift drop of 57 points on the S&P 500.

That is exactly that sort of market we are in. And this exactly what it is going to be like until the situation in Europe is resolved one way or another.

Current Proposals
The agenda for the European emergency summits center around three issues. Unfortunately, European leaders are far from dealing with the real issues at hand.

  1. Greek default. The terms of a Greek default and the degree of "haircut" to be taken by bondholders are being hotly debated. Unfortunately, these debates are ultimately a waste of time because they do not address the fundamental problem at the heart of Greece's economy: It's lack of competitiveness. Despite a crushing recession, Greece's current account deficit is expected to be above 8% of GDP in 2011! Greece's economy simply cannot grow in a sustainable fashion. Given the PPP of the Euro within Greece, the Greek economy has no way to grow without adding to its debt. The outflow in the Greek current account can only be counteracted via debt-increasing capital inflows to the private sector (an impossibility under current conditions) or via fiscal deficit spending. Without an exit from the Euro, Greece simply cannot grow. And if Greece cannot grow, as a practical matter, no amount of debt is repayable - no matter how large a haircut is made to Greek debt.
  2. Bank Recapitalizations. Frankly, this issue is nothing but a distraction. The need for bank recapitalizations arise from the Greek sovereign default and the fallout effects from this. The problem is that no amount of recapitalizations will be sufficient unless the rest of the PIIGS sovereign debt are backstopped. Dealing with the effect of a Greek default on bank balance sheets is a huge waste of time and capital unless the risk of other PIIGS default is taken off the table.
  3. Leveraging of EFSF. To take the risk of further PIIGS default off the table the EFSF must be massively leveraged. Current proposals on the table are woefully inadequate. First, as explained in a recent article, one proposal involves the issuance of a guarantee by the EFSF baked by a really poor imitation of Brady Bonds. That proposal will go nowhere, and may only make matters worse. Second, the Europeans are dreaming about getting private investors and sovereign wealth funds to participate in creating a more credible guarantee of PIIGS debt. This is a bad joke. What might induce private investors and/or other sovereign nations to guarantee the massive debts of structurally handicapped PIIGS when the Germans themselves will not do it is truly beyond what any reasonable person could conjecture. Just imagine the offering pitch: "Guarantee the sovereign debt of PIIGS! Come and take advantage of this great opportunity to postpone the bankruptcy of basket-case nation-states while you still can! Earn a 5% return and risk a 100% loss! And here's an added special bonus: The eternal hatred of millions of coddled Europeans that will blame you when you demand payment of your investment! Take advantage of this incredible opportunity while supplies still last!"

Unfortunately, none of the alternatives currently being debated in Europe will be able to avert descent into an eventual full-blown crisis. This may happen now or in a few months from now. Extremely aggressive measures would be needed to avert catastrophe. Unfortunately, such measures are not even being contemplated currently.

Thus, while it is possible that European leaders will come up with something on Wednesday that will sooth markets in the short term, the fact is that the relief will only be temporary.

Soon enough we will all be back to square one, anxiously awaiting the convening the next Emergency EU summit. The only difference will be that conditions at that time will be far less auspicious.

Investors should steer clear, even of attractively priced quality stocks such as Apple (AAPL), Microsoft (MSFT), Intel (INTC) and AT&T (T) until the resolution of the European crisis has become clear, or stocks are sufficiently cheap. In the likely event of a failure of European leaders to deal properly with the crisis on this opportunity, I forecast that U.S. indices such as the S&P 500 (^GSPC), Dow (^DJIA), Nasdaq (^IXIC) will ultimately fall by roughly 20% to the 950-1,020 range on the S&P 500.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am long puts on various equity and commodity ETFs.