Are Investors Taking Debt Crisis in Europe Too Lightly?

Despite a long-term picture in Europe that appears to be as unsettled as ever, investors will take any bit of good news and run with it.

Getty Images

That's been the message from a succession of trading days in which even the whisper of resolution to the European sovereign debtproblem—a conference call among policy makers, another bailout installment for Greece—sees the market go higher.

Even downbeat economic numbers, like the batch the government released Thursday, weren't enough to derail hopes that Europe won't implode and take the global economy down for the ride.

"Somehow we're back to a risk-on trade again," says David Twibell, president of Custom Portfolio Group in Englewood, Col. "The problem in Europe is, 1) very serious, and 2) there is no easy solution. If there was we would have already solved the problem. The market is being a bit pollyannaish right now."

An announcement that the European Central Bank and its global cohorts are embarking on a program aimed at providing dollars for liquidity-challenged banks served as all the catalyst the market needed to surge.

Those who trade on hope that the plan will fix the debt crisis do so at their own peril, Twibell says.

"If the market is going to be remotely rational, the upside is going to be fairly limited," he says. "We still don't know how the US economy shakes out. The situation in Europe is going to be an overhang. I don' see a lot of upside, and the downside could be substantial if we see a disorderly default in Europe."

Though the problems with European debt and the effect it will have on banks run well beyond liquidity and into actual solvency, the narrative that took hold was that central bankers were taking a proactive step to prevent another catastrophe on the scale of the fall of Lehman Brothers.

The move came on the third anniversary of Lehman's implosionand conjured up memories of the financial crisis that nearly brought down the entire global economy.

"What is the good news? That the big powers in Europe are still adamantly opposed to any kind of debt resolution?" said Walter Zimmerman, senior vice president at United-ICAP in Jersey City, N.J. "Those who don't have a vested interest in European banks look at that and say it's just delusional to think that Greece is going to get out of this without any type of debt restructuring."

The answer to the market's movement, then, could be as much technical as it is based on hopes for European stability.

By most accounts the market is considerably oversold, with the Standard & Poor's 500 trading at 13.5 times earnings, below its historical average near 16.

Moreover, stocks in an overall downtrend will stage aggressive rallies, as they have done at least four times over the past 30 or so years when in bear market cycles, which mark a 20 percent fall from the recent high, according to David Rosenberg, senior economist and strategist at Gluskin Sheff in Toronto. The S&P 500 just missed the bear designation during its summer swoon off the early-May highs.

"In all cases, the first rally following the initial leg down reversed half of the initial selloff," Rosenberg writes in his daily note. "That is exactly what is happening right now. Tread cautiously if you are tempted to jump in. In other words, even with the bounce off the early August lows, this cyclical bear market is following a very similar path."

Hedge fund manager Dennis Gartman adds in his daily Gartman Letter, that the market is "hovering in a consolidation pattern that we think ominous in nature."

Such conditions can make for a good trader's market.

But for those with a longer horizon, trading on incrementally and likely temporary good news out of Europe is dangerous.

"Everything still has that whole contagion effect," says Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh. "The traders love this stuff, they love the volatility."

The danger from Europe even has some traders using reverse psychology, thinking that if there are so many people believing something awful is going to happen that negates the possibility of it actually coming to pass. Leon Cooperman, head of Omega Advisors, espoused that philosophy at Wednesday's Delivering Alpha conference, run by CNBC and Institutional Investor, and others believe it as well.

"The market is incredibly oversold. There's so much pessimism out there," says Keith Springer, president of Springer Investment Advisory in Sacramento, Calif. "Things are bad. However, I think the fourth quarter is going to be better than expected, mostly because nobody expects it to be good."

Baum says he's advising his clients to stay put until the market gyrations subside.

"It's all cycles," he says. "Economies are cycles, markets are cycles, and we haven't had a good stock market since 1998. It's coming. It's only a matter of time before we get a sustainable type of market getting that 8, 9, 10 percent a year."