I feel no panic about Europe.
This is a typical test. Every long-term investor considers the question of risk tolerance and understands that markets will fluctuate for mysterious reasons. So far, so good.
Then, when the event actually happens, it is accompanied by a cacophony of fear mongers -- all claiming that this is "the big one."
How can the average person tell the difference?
Knowing What to Ask
The first step in critical thinking about a problem is asking the right questions. How about these?
- Is there systemic risk? By this I am asking whether we have another "Lehman event" where there is a lot of unknown counter-party risk and the credit system freezing up.
- How big is the problem? Let us suppose that Greece defaults on debt. Or leaves the Eurozone. What is the worst case?
- How do political events affect the prognosis? We have election results where leaders and parties less willing to accept austerity have done well. What does this mean?
- If some countries back off from "extreme austerity," what will be the response? Will other institutions step up? Can there be a new bargain?
- If everything goes wrong -- absolutely no mitigation from the ECB, the IMF, or other participants --what will be the effect on the European economy?
- If the European economy falls into a deeper recession, what are the implications for the US economy?
- If the US economy is weaker, what does it mean for corporate earnings?
The Superficial Answers
Most of the commentary we see has three steps:
- Some problem in Europe
- Disaster for the world
This type of commentary ignores any policy reaction, and also often insults the leadership of European nations, the IMF, and the ECB.
This approach is popular and gets a lot of page views since there is an active response network making these the most popular media sites -- whether blogs, online MSM, or TV. It is an easy story, playing to preconceptions and simple analogies.
The Danger for Investors -- and What to Watch
As is always the case, fanning the flames on these stories is what drives ratings and page views. When the market dips, it seems to provide a confirmation of accuracy, even though the evidence is skimpy.
It is challenging to refute. You must write an article about what is not happening!
It is doubly challenging since some of the best sources are the big-time private research firms. Their business models are based upon fees, not page views. This means that most investors -- including readers of "A Dash" -- do not have direct access to this information.
I suggest that investors read very critically when a story suggests causal relationships that lack specificity or quantification. Be even more suspicious when the story ignores policy responses. And finally, how about some quantification concerning Europe's impact on the US economy?
My own conclusion -- familiar to regular readers -- is that the European story is an ongoing process of bargaining and compromise. US observers are far too ready to impose their own value judgments on other countries and cultures. The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress. The exact nature will change and I still expect new entrants.
The long-term impact on the US is exaggerated by these fears. The short-term impact reflects currency trading and (perhaps) the need for some European institutions to repatriate funds.
A Final Thought
For the average investor, a subscription to the prestigious BCA Research reports is not practical. If you have an advisor with access, you would at least have indirect knowledge of their most recent macro commentary, including the following as part of "Apocalypse (Not) Now":
- Euroskepticism in Europe: Overstated and understudied, mainly since the media does not do its homework.
- Firewalls sufficient to protect Spain.
- The expected fiscal drag from pending policy decisions is limited, manageable, and subject to improvement if risks increase.
These conclusions mirror my own. I will try to elaborate further on each theme, but I want to emphasize the most important point:
Policymakers have been responsive and flexible. Skeptics have consistently underestimated the willingness and resourcefulness of the relevant institutions.
The dumbest commentary is from those who use the phrase "out of bullets." This is exactly what people said about the Fed before the alphabet avalanche. Whether you liked those programs or not, they were unexpected and powerful.
The current result is that economically sensitive stocks are on sale, including those (like CAT) which have little European exposure. US financials that will benefit from European asset sales (JPM) are also moving lower for no good reason. The over-simplified "Risk-off" mentality confers an advantage on those who do stock picking.