Why are U.S. stocks reacting so much to the Irish news, I keep getting asked. Isn't this good news that Ireland is getting covered?
My reaction is, U.S. stocks are holding up quite well, given the dollar strength. It's Europe that is the issue.
Banks are 25 percent of the market capitalization of the European stock market. It is through the banks that this crisis will be transmitted to the stronger states of Europe. It is the banks that own much of the sovereign debt. Traders want higher interest rates to loan to the euro zone, which increases the chances of a bailout because the countries cannot afford the higher yield investors are demanding to loan the money. This is exactly what happened to Ireland.
Look at the bailout. The size of the fund is 750 billion euros...that is seen as enough for Portugal, Ireland and Greece, but not if we throw in Spain...the problem is Spain is twice the GDP of Ireland, Greece and Portugal combined.
The result: the markets have concluded that unless Europe writes a blank check guaranteeing all bondholders will be made whole, there is a high likelihood of sovereign debt haircuts. Traders increasingly believe there is not enough money to cover all the debts (unless the U.S. steps in, through the IMF).
What about American stocks? This is a headwind, not a disaster; but it is a mess for European investors, and a big mess for American investors in Europe.
Why? The euro is down 8 percent against the dollar in the last month...so an American investor in Europe is down maybe 12 percent, adding in the decline in the markets. Ouch.
The good news: European markets are cheap. The bad news: low valuations alone will not stop markets from dropping. Still too early to buy...still sitting on the sidelines.
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