European Debt Worries Force Investors to Play It Safe

Regardless of whether it turns out that European debt problems aren't as bad as they were earlier this year, investors refuse to take any chances.

NY Stock Exchange Traders
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NY Stock Exchange Traders

Headlines reflecting real worries of defaults or bailouts in Ireland, Spain, Portugal and elsewherethroughout the European Union have sent the Standard & Poor's 500 off about 3 percent from the most recent high. The stock turnaround came on the heels of a 17 percent two-month rally spurred by more intervention from the Federal Reserve.

While the market pullback isn't even in the realm of an official correction—generally defined as a 10 percent pullback in stock prices—fears of what eurozone debt problems could do to the global economy clearly are weighing on what otherwise could be a robust rally.

"On one level, the market's reaction is fair in the sense that we shouldn't be breaking out to new highs with the concerns out there," said Mike O'Rourke, chief investment strategist at BTIG, an institutional trading firm in New York. "But even though there's fear and trepidation, we haven't seen an all-out meltdown, which is a good sign."

One of the main reasons that the market reaction has been just a minor pullbackand not a full-blown selling frenzy is a general sentiment that the European situation remains in hand at the moment.

The European Union is in a "much stronger position to respond" than it was when Greece raised the first red flag over sovereign debt defaults in April, said David Bianco, head of US equity strategy at Bank of America Merrill Lynch.

With an 860 billion euro rescue package waiting to be tapped, he said a complete collapse is unlikely and not a threat to the US stock market.

"Ireland is close to receiving aid to tackle its banking crisis. While many skeptics dismiss the aid package as only providing liquidity, for banks liquidity is a very meaningful step towards solvency," Bianco wrote in a research note. "Liquidity buys time and time buys solvency."

As for US banks, they have reduced their exposure to European debt since the crisis broke out in April. Problems in the banking industry remain largely related to real estate losses and the foreclosure fraud scandal.

At the time, domestic banks held $147 billion of debt from Ireland, Greece, Spain and Portugal. Since then, that exposure has been trimmed to roughly $127 billion, which is just 5.3 percent of the banks' exposure to all sovereign debt, according to data from Capital Economics in Toronto.

"It is particularly encouraging that the exposure of US banks to the problems in Europe has fallen," economists Paul Ashworth and Paul Dales wrote in a research note. "That said, US banks are not out of the woods completely. They remain heavily exposed to lingering problems at home, such as renewed falls in real estate prices."

Should the four nations each default on their debt, the hit to US banks would be just 1 percent of Tier 1 capital ratio, while theoretical defaults by Germany and France would generate a 2.5 percent hit, Capital said.

The firm calls defaults from Greece, Ireland, Portugal and Spain "not too much to worry about" for US banks given the relatively low exposure, while defaults from other more stable UK nations "would be very painful" though "such an event seems extremely unlikely."

While Germany remains probably the region's most stable nation, it has helped roil the markets through a series of incendiary statements regarding the possibility of bailouts.

That has added uncertainty even as many analysts are discounting the possibility of a major crisis at the present time.

"German policy makers are making comments that are a combination of inconsistent and unhelpful," BTIG's O'Rourke said. "The fact that they have been unable to speak with clarity is creating a bigger problem just for the markets in general."

BofA Merrill Lynch is advising clients concerned with European debt and specifically the ramifications of a likely weakened euro to decrease their exposure to pharmaceuticals, hold consumer staples steady with a tilt toward emerging markets, and to overweight tech conglomerates.

At the same time, investors overall are continuing to be wary about too much exposure to developed economies, staying away from heavy US- and Europe-centric stocks and continuing to pile into emerging markets.

Global equity funds saw inflows of $3.8 billion while US equity funds lost $4.5 billion in November, according to market research firm TrimTabs, which said it is neutral on equities. Insider selling also reflects pessimism at $10.7 billion in November, the highest level in three years, dating back to the beginning of the market coming off its all-time highs.

Interestingly, sentiment surveys, though often contrarian indicators, are still showing strong bullish sentiment. The American Association of Individual Investors said 47.4 percent of respondents believe the market is going to rise in the next six months.

"As we have mentioned many times, US equities are priced for perfection," TrimTabs said in a note to clients. "Given the sovereign debt problems in Europe, the tensions on the Korean peninsula, and the potential for more fallout from the U.S. government’s insider trading investigation, we are perfectly content to be more cautious than we would be otherwise."