For US Markets, Europe's Debt Woes Just Won't Go Away

European sovereign debt is the US stock market's bad penny—it keeps turning up where it's not wanted and at the most inopportune times.

Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.
Thomas Lohnes | AFP | Getty Images
Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.

The market's last ugly encounter with the eurozone debt problems came about eight months ago, when worries over debt defaults in Greece and elsewhere turned what had been a 9 percent rally for the Standard & Poor's 500 from January until mid-April into a 17 percent drop by mid-July.

But since then the market has been roaring along, thanks in large part to a monetary cushion from the Federal Reserve and gradually improving economic signs.

Since the start of the new year, though, sovereign debt has reared its head again, and strongly bullish predictions for stocks have lost a bit of their shine.

"We've seen other events take the European debt crisis off the front page. But this problem has continued to exist and what we've done is kicked the can down the road," said Brian LaRose, technical analyst at United-ICAP in New York. "Unless these sovereign nations really start addressing the underlying problems, this is going to continue."

Portugal has been the latest player in the debt drama, with investors demanding high yields for the nation's debt because of default fears. The worst-case scenario all along as been that problems in similarly small economies including Italy, Iceland and Greece will spread to larger countries like Spain and eventually hit the otherwise-stable Germany.

While confidence remains fairly high that the International Monetary Fund as well as global central banks will backstop debts before defaults can occur, trepidation again has risen that if the issues at hand are not resolved the problems will spiral out of the control of the world's monetary authorities.

"A major developed country has not defaulted on its debt in six decades, but that may be about to change," David Rosenberg, economist and strategist at Gluskin Sheff in Toronto, wrote in his daily analysis. "And the fact nobody around trading the market has ever experienced something like this makes it that much more unnerving."

The S&P 500 started the year off on a path to fulfill the forecasts of strategists who see the broad-based index heading to 1,400 and beyond.

But trading the past several sessions has been less-than-stellar, and volatility, at least as measured by the CBOE Volatility Index , is on the rise.

While that's hardly measure of a significant pullback, the re-emergence of sovereign debt as a discussion point, after investors had become fairly certain the damage would be contained, is not welcome.

"The Europeans of course have a tremendous vested interest both politically and financially in holding this thing together," said Milton Ezrati, senior economist and market strategist at Lord Abbett in Jersey City, N.J. The threat of default "may not be a very high probability—only 5 to 10 percent in our estimate—but the destructive power is tremendous."

Should the crisis take hold, Ezrati sees the damage as similar to the US financial crisis that began domestically but rapidly spread across the globe.

"There would be a tremendous lack of liquidity. Credit would be refused to be extended to other banks," he said. "That would happen in reverse. Instead of trouble starting in the United States and going west to east, it would start in the East and spread to the West."

To be sure the probability of that happening is debatable, with the IMF standing by with billions in bailout funds and the Federal Reserve continuing to play an active role in providing liquidity not only in the US but also abroad.

Still, the tenuous nature of eurozone financeis indisputable and gathering increasing attention, an aspect cited even by the most bullish analysts as a likely cause for volatility ahead.

"The deterioration of public finances in the majority of the advanced economies is unprecedented in peacetime," Citigroup chief economist Willem Buiter wrote in an 84-page analyst of the global debt problems that concludes no debt in the world, including that of the US, is safe from default.

"Although the focus of most of the markets and commentators has been on the EU, and especially the countries in the EA (euro-area) periphery," he continued, "both Japan and US public finances are unsustainable, in our view, and in the absence of credible and substantial fiscal tightening both would eventually face painful discipline through the markets for foreign exchange and sovereign debt and derivatives."

Anything that would have a significant impact on forex and derivatives would reverberate through the equity markets as well.

At United-ICAP, LaRose is counseling investors to "ring the register" and take gains from the market's 90 percent surge off the March 2009 lows.

"What we're facing is the prospect of failure," he said. "We have had a nice run but the Fed cannot prop up this market much longer. We feel like we're rapidly approaching the end of the bear market correction and we will make a dramatic move to the downside. I think we could see it sooner rather than later."