Why The Spanish Bailout Is A Game Changer

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Includes: EWG, FXI, SPY
by: The Independent Investor

Wow, the market isn't going straight down anymore. While the S&P 500, and its tracking exchange traded fund, SPY (NYSEARCA:SPY), has rallied nearly 20% from the market's summer low of last year, and market leaders such as Apple (NASDAQ:AAPL) have rallied over 30% in the last year, the recent sell-off has been brutal.

While the S&P 500 has held up reasonably well, off around 10% from the market's April highs, many cyclical sectors, such as the financials and the industrials, have sold-off over 15%. European and Chinese stocks are also trading at levels not seen since the summer of last year.

(www.thestreet.com)

As we can see, the major U.S. indexes have outperformed Chinese equities (NYSEARCA:FXI) by nearly 30% in the last year. U.S. stocks have also outperformed most of the major European indexes, such as the DAX, and its tracking ETF (NYSEARCA:EWG).

I recently wrote that I thought the market would stabilize early last week, and likely continue to move higher. While I did not think the move was sustainable, I think the recent news that the European Central Bank is putting over $100 billion into the Spanish banking system is a game changer for equities.

While the $100 billion dollar number seems small, Spain's economy is less than 10% the size of the U.S economy, so the size of this new bailout is massive. Also, obviously a commitment of this size would not be made to Spain, a country with one of the largest economies in Europe, if similar commitments were not also planned by the ECB for the other PIGGS. Still, what's most interesting to me about this massive new bailout,that is Europe nowhere near being in a position to afford a bailout of this size.

In addition to the recent downgrades of Austrian and German banks, Italy and a number of the other PIIGS continue to see the yields trading on these country's debts at unsustainable levels. While operation long-term refinance was obviously a huge monetary initiative, that liquidity pump was targeted at short-term borrowing rates. The most obvious sign that Europe can't afford this recent bailout is that Italy, a country whose cost to finance its debt is unsustainable, is guaranteeing nearly 22% of the funds.

Still, the ECB obviously wouldn't announce an bailout of this size and scope without significant financial backing. So, where's the money coming from? I think its the IMF, and the U.S. and China are starting to aggressively become more involved in the PIIGS debt problems. This new bailout is also one of the first major liquidity pumps from the European Central Bank that has not also required the recipients of the bailout to impose new and significant austerity measures.

While Obama has been careful to not appear politically to be making backstopping the ECB and its member nations, the IMF is already a huge holder of Greek debt, and Geithner has also publicly been disclosed to be frequently meeting with key leaders European governments and at the ECB. China, also, is Europe's biggest trade partner, and the country is also significantly involved in Europe's fiscal and monetary crisis through the IMF as well.

China's recent leading economic indicators, such as import data, housing starts, and electricity usage, have been horrendous. There are also credible reports of significant default of buyers of iron ore and other bulk metals in the last month. Given that the world's second biggest economy's stimulus program in 2009 was to massively overbuild the country's cities, China is now limited in how the country can pursue domestic stimulus. Since over one-third of the Chinese economy is export-based, China has a significant incentive to continue to help provide liquidity to European governments and the ECB. China also does not want the country's currency to appreciate significantly, since the country is an export- based economy.

With major elections having just occurred in France, and major elections in the U.S., as well has a change in leadership in China, occurring within the year, U.S. and Chinese leaders seem more willing to offer increasing financial backing to the ECB and the Euro-Zone.

Today the economic data has deteriorated significantly, with poor jobs data in the U.S., and very poor economic data coming out of Asia and Europe. Still, the U.S. economy continues to grow at 2-2.5%, U.S. companies generally reported mid-single digit year-over-year earnings growth, and Chinese and European equities are now trading at one year lows.

While I have maintained for some time that equities are undervalued, the market has lacked a catalyst, and individual and institutions have been able to short equities without concerns of huge rallies. Now that equity markets in China and Europe have sold-off nearly 30%, in the last year, and leading commodities, such as oil, have dropped nearly 30% in the last two months, the market has a near-term catalyst to move higher. With leading cyclical companies such as GE (NYSE:GE), Citigroup (NYSE:C), and Boeing (NYSE:BA) all reporting strong earnings and guiding to significant second half growth, these companies also look very cheap at an average of 10-12x forward earnings, if the growth outlook doesn't further deteriorate. Yields on many leading companies such as Exxon-Mobil (NYSE:XOM) Chevron (NYSE:CVX), GE, and Boeing, are now much higher than the yield on the 10 year treasury, as well.

To conclude, while the recent bailout was announced by the ECB, it is likely that China and the U.S. have signed off on the Euro-Zone's central bank's new liquidity push. With China's economy struggling its leaders and central bankers left with few options, a liquidity push in Europe could make sense. Obama also has continued to the weak dollar policy under Bush, and U.S. efforts to assist the Euro-Zone are also likely designed to prevent the dollar from appreciating significantly. While the effects of stimulus policies and government intervention will always be controversial, with many major foreign markets trading at the one year lows, valuation will likely be more important for traders and investors.

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