Profiting from the Confusion over Europe

Mrs. OldProf "delicately" suggests that my work might be improved via brevity.  OK.

Here is the Executive Summary of what you need to know about today

When it comes to Europe, there is a pundit and media checklist for any proposed solution:

• Does it account for the certain Greek default?
• How many dominoes (other defaulting countries) are counted?
• What will happen to European banks?
• What is the US bank exposure?
• Will the Eurozone collapse?

The two most common measures cited are the total debt obligations of any country that could possibly be included in the problem zone and the German assets that might be applied.

Since the debt is greater than German assets, most of the smarmy smart money concludes that no solution is possible.

It is obvious that the market is priced for disaster, since even a hint of progress can stimulate a wild, short-covering rally like today.

If and when there is real progress, stocks may resume trading at normal levels, accurately reflecting long-term fundamentals, earnings, and cash flows.

The Longer Version

And now -- getting beyond the Cliff Notes - here is the full explanation.

My viewpoint on Europe is a reflection of my public policy background.  I embrace democracy.  It is not easy for Congresses and Parliaments to reach the right decision.  Sometimes it requires a lot of lecturing by experts before the non-experts in the legislature get the picture.  I have gotten a number of comments suggesting that cajoling by LaGarde or Geithner shows that the European leaders are bumbling bozos.  In fact, this is a normal process of influence.

Outside observers, who all think they "know" the right answer, bristle with impatience.  They get interview and quote opportunities where they explain that the politicians are all stupid and are acting too slowly.  Meanwhile, their recommended policies are all different!

It is more complicated than it might seem.

The result is a familiar pattern:

1. There is a genuine problem, widely discussed in the media;
2. Policymakers recognize the problem and discuss possible solutions;
3. Some media sources become aware of the discussions and articles are written;
4. Pundits blast the proposals because they are [pick one] tentative and not yet agreed and/or partial solutions;
5. The easily-manipulated CDS markets are showing greater risk;
6. And the ever popular -- kicking the can down the road.

The Eventual Solution

I do not pretend to know exactly what will happen in Europe, but I am going to suggest a probable outline.  The debt of the weakest countries will be re-negotiated.  It is possible that there will be a "credit event" triggering payoff of CDS agreements, but it might not actually happen due to ISDA rulings.

European banks will get more capital through a combination of government and private sources.

Some of the debt will be isolated via special purpose investment vehicles.  The prices will be written down to a point that private investors will be interested.

Sovereign wealth funds will invest, including China.  They will do so because it is part of their national interest, and they may well demand special concessions.

The solution will not be done completely with actual cash, but will include leveraged funds.  The final total of funds available will be sufficient to address the problem.

Investment Conclusion

My analysis does not include anything new -- it just pulls together what we already know.  The European leaders have clearly been working on each of these angles, but not fast enough to satisfy financial markets.

This creates an exceptional investment opportunity.

Conservative investors can embrace a dividend program that beats the fixed-income choices.  Warning:  Reaching for the highest yield will not work!  Think a combination of company strength and dividends.  It is possible to beat the low bond yields with reasonable risk.

Aggressive investors have an exceptional opportunity.  There are many stocks trading at amazing P/E ratios.  Regular readers know that I love Apple (AAPL) and  JP Morgan (JPM).  I will add Oracle (ORCL) to the list of stocks that I am aggressively buying right now.  There are others.

Trading Conclusion

I covered all short positions in trading accounts yesterday (a few hours too early).   The risk to the short position should be obvious.  There is so much negativity in the market that even the rumor of progress in Europe creates a short squeeze.

I am not predicting that today's "news" is a market bottom.  It does show the overall sentiment, the opportunity for investors, and the risk of trading from the short side.

Sources

Getting the best info on Europe.

Don't expect a Magic Bullet.

Why every story on Europe generates massive negative spin.

The Chinese (and other BRICs) will invest if and when it suits their interest -- and it probably will at some point.

 

 

 

Comments

[David McDonald]

For you and the ideas you educate us with, brevity is a mistake!!

[Mike N]

No problem with the length of your posts Jeff. I enjoy the education and your perspectives thoroughly.
Mike

[Chris Tinker]

Jeff,
The issue for Europe now is that the market has increasingly decided to position itself for the "big payoff" trade of a Euro breakup. Long "German group" debt, short "non-German" debt on the basis that even without default, a currency split would allow a major FX gain. Should that occur, then the devalued country equity markets become a buy (close out the short futures contracts)and the "German group" exporters drop further until those shorts are also closed. What policy makers will do, therefore, if they convince the markets that the Euro is NOT going to break up, is cause these position trades to be unwound - either in an orderly fashion - or a disorderly one if the likes of Pimco get behind it. Bottom line, though, is that the trade is already at an extreme so absent a Euro collapse, most of the money has been made already and the risk has to be that a relatively orderly unwind is already beginning to occur.