EU Contagion: A Pair Of ETF Remedies To Hedge What Ails You

Includes: FXE, VGK
by: Daniel Sckolnik

Back in the Spring of 2010, when the EU and the IMF agreed to assist Greece with a massive $150 billion dollar bailout, investors retreated into the first of what would subsequently become numerous forays into the realm of denial, deluding themselves into thinking that the necessary steps were being taken to preserve the eurozone and the euro.

At the time, the word “contagion” would occasionally emerge from within the financial and business sections of newspapers and blogs used to indicate a situation that could occur should Greece default on its debt. The most common assumption seemed to be that the other PIIGS (Portugal, Ireland, Italy, Greece and Spain) would topple like a row of dominoes, in some linear and logical progression, should the sovereign debt crisis increase in scope.

Cut to present time. What appears to be happening is less of a neat sort of domino effect, and more of a random spreading of a nasty flu.

Last week, Italy’s 10-year yields shot past the 7% mark, a rise of about 20% over the level of the yield just one month back. Spain joined the fray, with Spanish bonds surfacing above 6%, marking a 15% rise over the same one-month period.

Both of those numbers entered into an arena that has been widely dubbed by economists as “unsustainable”, meaning that if borrowing costs for both countries remain at or above those same levels, it might prove inevitable that the proverbial “stuff” would come in contact with the equally proverbial fan.

As bad as this sounds for the continuation of the eurozone, it still falls within the previously imagined model. However, what is concurrently happening is what seems to indicate an even greater level of systemic problems.

The first thing worth noticing is that Monday, France was served notice by Moody’s Investor Service that its AAA credit rating might be in jeopardy. (This would no doubt severely impact the French, particularly their pride, as their perfect rating is currently a notch better than that of U.S. debt.)

Moody’s pointed to increased costs of borrowing by the French government as a key reason for the warning, along to the general level of uncertainty in the market.

France, you may notice, is nowhere to be found among the countries represented by the PIIGS acronym, landing instead into the expanded paradigm of "contagion".

Another huge red flag blowing in a stiff breeze is the rise in overnight deposits made into the European Central Bank by its EU members. This evidently indicates a degree of recognition by eurozone members that lending their excess capital to one another is a risk they don’t care to take. Apparently, there is a greater degree of security in keeping extra liquidity within the confines of the European Central Bank, and EU member-nations are taking advantage of that. This may become a trend, which could result in even higher levels of yields.

Another cause for concern on Wall Street is that, even with the recent changing of the guard in the governments of Spain, Greece and Italy, the ability of these countries to undertake the austerity measures deemed necessary by investors remains in question. Ultimately, it is a question that could directly impact the viability of the EU itself.

If the scenario of a failing EU is to be considered, then one question that arises might be how to protect one’s portfolio, or even, as mercenary as it might sound, take advantage of the situation.

Back on June 21st, IBD published an article entitled “Top Foreign ETF Picks for the Second Half of 2011” (see here). For the article, I submitted, along with Sabrient’s head honcho David Brown, a pair of ETFs that we recommended to short. The picks were geared towards ETFs that would perform well should the EU debt crisis escalate.

Well, it has. And they did.

The picks are worthy of reviewing, as they are remain valid for the current, and highly volatile, market environment.

The first ETF we recommended to short was VGK (Vanguard European ETF), which accurately reflects the pulse of the EU. It tracks the MSCI Europe Index, consisting of the common stocks from 16 European countries.

At the time the article was published, VGK was around 52. As of Monday's closing, it was under 42, a gain of around 18%.

The second ETF trade that we felt offered good profit potential was FXE (Rydex Currency Shares Euro Currency Trust). FXE tracks the euro, and measures the relative value of the U.S. dollar against it. It may even be the purer play of the two, as currencies are frequently more reactive than stocks. Again, we recommended the shorting of the ETF.

At the time of publication, FXE was around 143. As of Monday’s market close, FXE stood at 134.50, a gain of about 16%.

Both of these ETFs remain as good plays should the EU crisis continue to escalate, either as straight hedges or as an aggressive directional play.

You can short the ETFs themselves, or achieve some degree of leverage by purchasing straight Puts, though you would be paying a premium for the privilege.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.