How To Play The Move Of Desperation By The Central Banks

by: Erick McKitterick

The recent market run-up has posed a very interesting situation as it relates to worldwide equities. This week the markets took off when the central banks, in a coordinated effort, lowered the overnight borrowing rate. The banks of Canada, England, Japan, and the Swiss National Bank coordinated the action along with the Federal Reserve.

At first one would believe this is extremely positive news for equities around the world. On the other hand, investors who dig a bit deeper into the underlying reason may come up with a completely different thesis. Ask yourself “Why” would 5 banks around the world need to coordinate such an effort? Is it because European banks were on the verge of another “Lehman Brothers” situation? I am in complete agreement with Mr. Jim Cramer when he tweeted that “This was done because a large bank was about to fail”, which is reminiscent of the 2008 credit crisis.

In my opinion the Forbes article “Central Banks Intervention Raises Questions” makes some very valid points. The truth is the Euro and Euro nations are not much different from previous failures like Lehman, WorldCom, or Enron. In every instance of these failures, did any of these organizations actually admit to issues or problems prior to their collapse?

The difference is that the Euro has a huge advantage with support from central banks all around the world. However, printing money and monetary policies from these banks do not correct the underlying problem in the Eurozone. This is nothing more than a shell game with moving the debt from one country to another. Right now everyone keeps eying Greece, Spain, and Italy and the bond markets do not lie. A few weeks ago when Italy's 10 year bonds went north of 7%, U.S. markets were beaten down in response.

Today, Italy bonds continue to trade above the 7% level and now the equities' reaction seems to be muted. Investors earlier in the year were so worried about Greece and the contagion it could cause to the Eurozone. The Greece economy has a GDP of approximately 305 billion. In comparison the Italy GDP is north of 2 trillion mark or almost seven times that of Greece.

Sure, much of the Greek debt was taken on by the other nations within Europe, primarily by Germany. The sad part about this is, many of the Greek debt holders are still squabbling over what kind of haircut they are willing to take as part of the amnesty measures. Now if we take the Greek problem and multiply it by seven just imagine what the potential fallout would be from such an event.

Investors in my opinion should brace themselves and their portfolios for a possible big market decline. Anyone who invests heavily in foreign funds should be very cautious moving forward. ETF’s like EZU, EWG, and EWQ could be in for some very rough times in the upcoming months.

A few ways to hedge this is by playing the Euro currency. One way of doing this is by buying outright puts in the funds or equities. However, buying puts with volatility being high can be very expensive. A way to combat this is buying put spreads or selling covered calls to help offset the cost of these puts.

My trade on this is to use a put fly in the Currency Shares Euro ETF (NYSEARCA:FXE). I am trying to bid the March 2012 130 – 125 – 120 put butterfly in the FXE. I have an order in for this trade for .50 with the current bid / ask priced at .34 / .75 as of Friday’s close. This trade cost 50.00 and could profit up to 500.00 per contract if the Euro collapses between now and March. With a 10:1 payout ratio I see this as a very good risk reward play on the Euro.

Another trade, which could be done, is going after the banks in the Eurozone. In my opinion, the short selling ban has put an artificial floor under these stocks and these are set to drop in the near future. This can be done through put spreads or synthetic shorts of Zion Bankcorpation (NASDAQ:ZION) or Deutsche Bank (NYSE:DB). Please note these are very high-risk reward trades, but after last weeks massive run-up in equity prices they are due for a pullback or retracement.

One last play I would consider is playing off of any US company, which has large exposure to Europe. A prime example of this would be Hewlett Packard (NYSE:HPQ). Although I highlighted that HPQ has a very large Europe exposure in a previous article this could be even worse than first thought. Hewlett Packard sees more than 1/3rd of its revenue in the Eurozone, and as all these large companies hold back from a potential recession HPQ is sure to suffer.

The bottom line, I believe the shell game in Europe is ending and markets are yet to adjust to a decline in the productivity and government spending around the world. Hedge fund managers have continued to invest large amounts of capital overseas in several years past. As this capital comes out of the market in the form of redemptions and compression of multiples many investors could see substantial losses if not prepared.

No matter what your thesis is moving forward it will be a very interesting 2012.

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

Additional disclosure: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment professional as to the suitability of such investments for his or her specific situation.