Author: Charles Sizemore
Covestor models: Sizemore Investment Letter and Tactical ETF, Strategic Growth Allocation
After a rough 2011, this year is off to a great start. Year to date as of end of day 2/14, the S&P 500 is up 7.4% percent, making this the best start to a year in over a decade. While sentiment among individual investors remains a mixture of fear and scepticism, risk appetites among institutional investors are returning with a vengeance. Perhaps most encouragingly, the market has stopped reacting to bad news coming out of Europe. The event that kept investors on the edge of their seats for most of 2011—the possibility of a disorderly Greek default—now appears all but inevitable, yet the market has stopped reacting.
This is excellent news. In its circular (George Soros would say “reflexive”) way, the market does not merely react to events. It often actually causes them. If the market fears contagion, contagion becomes a self-fulfilling prophecy. This is what worried investors about Greece. A Greek default could have led to a banking crisis in the countries that lent heavily to Greece (most notably France), and a full-blown banking crisis would have meant a repeat of the 2008 meltdown. When investors fear that Spain or Italy would be the next dominoes to fall, they respond by selling off the bonds. This forces yields to rise to the point of actually causing the default that spooked investors to begin with.
So, what stopped this vicious cycle from becoming a reality? What stabilized the market? The answer is the European Central Bank. By offering virtually unlimited credit to the major European banks, the ECB ensured that any defaults would be orderly. There would not be a “Lehman Brothers” moment when the system ceased to function.
None of this suggests that Europe’s problems are fixed, of course. In fact, the volatility of last year has virtually guaranteed that Europe will have a recession in 2012, if the continent is not in technical recession already. A recession makes debts harder to repay, which leads to more government belt-tightening. Germany’s insistence on the new fiscal stability treaty has for all intents and purposes outlawed Keynesian economics in the European Union. This is great news for the long-term growth and stability of the region, of course. But it means that the short term will continue to be miserable.
Europe could still come apart at the seams. Citizens tired of endless austerity and dismayed by seeing their pensions and social safety nets cut may force their governments into a showdown with the EU that could spiral into a full-blown crisis or even the ejection of a member state. Nothing can be ruled out.
Still, at the moment it appears that Europe will muddle through. And so long as this remains true, we expect risky assets such as equities to do well.
