News Column

Investors Envisioning Unnerving Chapters in the European Debt Saga

February 22, 2012

Gail MarksJarvis


After flirting with 13,000 on the Dow on Tuesday, investors got cold feet once again and bolted.

The stock market milestone was hit early Tuesday, as investors found comfort in a $172 billion European deal to bail Greece out of its massive debt problems. But by the market close investors were envisioning more unnerving chapters in the European debt saga, re-examining stock prices and worrying about the threat of a possible Iranian-imposed oil shock.

Rather than continuing its ascent above 13,000, the Dow Jones industrial average settled at 12,965, 16 points above last week's close.

Despite climbing almost 22 percent since early October and almost doubling since plunging to 6,547 in 2009, the Dow hasn't restored the money it took from investors when the U.S. financial crisis started undermining stocks on Oct. 9, 2007. Then, the Dow stood at 14,164. As the Dow approached 13,000 lately, financial advisers expressed hope that a sustained rally would finally coax individuals back into the stock market.

That failed to materialize Tuesday, despite expectations last week that a bailout deal for Greece would calm fear and continue the rally that started late last year. Greece takes on greater significance than one small country alone. The concern has been that if Greece fails to pay its debts on its Treasury bonds, other heavily indebted European countries such as Portugal and Spain could also leave bond investors in the lurch and set off a panic in the banking system like the 2008 Lehman Brothers collapse.

Banks hold a lot of bonds issued by the financially weak countries, plus insurance policies known as credit default swaps that get triggered if a country doesn't pay its debts. So if countries fail to make bond payments, banks would suffer losses and, perhaps, hoard cash rather than lending to people and businesses that need money.

Although many European observers think that the threat of a banking crisis has been relieved by the bailout of Greece announced Tuesday and a recent European Central Bank lending program to banks, the more that investors saw of the bailout plan Tuesday, the less sure they became of a permanent solution. Even with less worry about a Lehman-style financial crisis, some European countries are in recession and sinking. Greece and Spain each have unemployment rates around 20 percent, and if Greece fulfills the austerity requirements of the bailout package, the country is expected to plunge deeper into recession.

The question for the markets is: If European leaders tie bailouts to austerity requirements that push countries deeper into a recession, then how will they grow enough to fund the debt payments scheduled in the future?

The German publication Der Spiegel, for example, carried an opinion piece claiming the bailout is simply intended to create an illusion that Greece isn't bankrupt, while helping its bondholders rather than allowing Greece to get back on its feet. Without a more permanent solution, investors could find themselves in months ahead worried again about Greece and other indebted European countries, although bond investors have shown significant confidence in Spain and Italy lately. That confidence shows up in bond yields, which have dropped below 5.5 percent after being more than 7 percent a few months ago.

JPMorgan's economic team wrote Tuesday, "While there still exists a clear and present threat, the Eurogroup collection of EMU finance ministers have finally settled on the second aid package for Greece."

If the agreement does what's expected, investors holding Greek debt will agree to give up 53.5 percent of what they are owed on their bonds, and Greece by the year 2020 will have a ratio of debt to gross domestic product of 120 percent, versus about 160 percent without the deal.

With that deal, JPMorgan economists say, "The risks threatening the global recovery continue to wane."

That's one reason why Ed Clissold, a global strategist with Ned Davis Research, thinks stocks will continue to rally. He thinks stocks are in the early stages of a bull market that began after the Standard & Poor's 500 dropped about 17 percent amid worries about European debt and the U.S. debt-ceiling debate last summer and early fall.

"Stocks aren't a great value, but they aren't bad," he said.

Based on the past 12 months' earnings, the price of the S&P 500 is about 16.2 times earnings, or about the average median price for the market during the last 48 years.

Although some analysts have worried because profit expectations for stocks are declining, Clissold said stock prices can go up even if earnings stay within the more subdued range analysts expect. Even small-cap stocks, which are pricier than large stocks, are not so pricey that they cannot rise as the U.S. economy shows signs of strengthening, he said.

Stocks are being propelled, said Clissold, by the massive flow of money into the system from central banks, including the U.S., Europe and Japan. The money is being pumped into the system to avert any type of financial crisis and to stem recessionary threats. That money must go somewhere, and investors are inclined to put it into stocks because yields on U.S. bonds are so low, Clissold said.

Meanwhile, Clissold noted "an oil shock could be a game changer." And that's what investors are on alert for now, as Iran has said it is cutting off sales to France and Britain while the U.S. and European Union impose sanctions related to Iran's nuclear buildup.

Crude oil rose to a nine-month high of almost $106 a barrel Tuesday. That's still far below the $147 that stunted economic growth in 2008, but some analysts are worried that if Iran disrupts oil shipments through the Strait of Hormuz, prices could spike again. Meanwhile, if investors worry about oil supplies, those concerns, at least initially, could lift Exxon Mobil and Chevron stock prices and give a lift to the Dow.

Source: (c) 2012 the Chicago Tribune. Distributed by MCT Information Services

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