European Debt Crisis: Why It Could Clobber Your Portfolio


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After a steady six-month surge, the stock markets are reversing course. The S&P 500 is off roughly 5% since early April, and signs are emerging that there may be plenty more downside on the way. 

The problems for Greece -- and Europe -- keep mounting. The continent's major economies have sharply slowed or slipped into recession . And the financial agreements struck just months ago may already be coming undone. Few are fully prepared to handle the events that may play out in coming weeks and months.

If you are a long-term investor, then you need to simply ride out this possible coming storm. If you are more of a short-term investor that likes to zig in and zag out of stocks, then it may be time to zag. Chances are some of your favorite stocks may be a lot cheaper later this summer, so you may want to trim your sails now and build cash.

The train is speeding up
Greece's financial woes have been playing out for several years, giving the appearance of a slow-motion freight train slowly sliding off the rails. That train wreck may soon speed up. 

Greek voters chose to stay on the path of austerity (for now) which Germany and other stronger countries had been insisting upon. The country's runaway budget deficits must be reversed through a huge pullback in government spending. For its part, Germany's leadership role in the financing agreements has worn out its citizenry, as many feel that further loans would just be "throwing good money after bad." Meanwhile, German business leaders know how important it is to retain the benefits that the unified euro has brought to that economy . No one's very happy about the current state of things. 

Indeed, it's a stalemate, and unless we see one party blink, a set of dominoes will start to topple, affecting your investments in myriad ways.

Here's how this may play out, in three successive steps, and how it might affect your investments:

1. It's not just Greece
Even as Greek voters elected a government that stands by its past agreements with the rest of the European Union countries, signs that other countries may also need a bailout keep emerging  -- Italy, Spain, Cyprus…

But any long-term gain for Europe comes with a huge amount of short-term pain for global investors. The first and most immediate effect would be a major banking scare as investors look to assess the extent to which key lenders will be weakened. For U.S. investors, plunging European markets could apply a similar pressure on our market

2. Freaked-out banks bring European economy to a halt. 
Banking crises often portend a sharp slowdown in economic activity. That's what happened in the United States in 2008 and early 2009 when banks spooked by the economic collapse put the clamps on virtually all types of lending. European economies need to brace for a similar possible fallout. 

As it stands, only the German economy is growing right now -- all other key European economies are shrinking and it could get worse before it gets better. That could have a direct effect on U.S. businesses that have operations in Europe. By some estimates, up to one-third of sales at companies in the S&P 500 are derived in Europe. 

3. Europe's economic woes send the U.S. and global economy spiraling. 
It's not just Europe. Asia and Latin America count on the continent as a key export market. If there's less demand in Europe for exports from countries such as China and Brazil, then that means less money coming into those countries. That could sap those countries' thirsts for the key capital goods that the United States exports to them. 

That's a big deal for Caterpillar ( CAT ) , GM ( GM ) , Microsoft ( MSFT ) and many others. In light of all of this, a mere 5% drop in the S&P 500 from the 52-week high could be viewed as an under-reaction to these gathering clouds. It is certainly far from what the worst-case scenario could be.

The good news to come
After this potentially scary scenario plays out, there will be a huge number of positives to focus on. 

First, U.S. stocks are fairly inexpensive by historical measures, and any coming sell-off will make them even more attractively priced. It's crucial to focus on the fact that corporate profits remain quite strong. Quarterly results that have been announced in the past few weeks show how resilient many companies are in the face of global headwinds.

Second, although the U.S. economy may be in need of a breather over the next few quarters, the setup is in place for a period of solid growth as we head into the middle of the decade. There is historical precedent. In the middle of the 1990s, companies had completed a wave of massive spending cuts and began to start adding jobs again. That fed into a virtuous cycle as rising employment fed more growth in many industries, A few years later, the U.S. economy was booming. 

We may not see a boom this time around, but there's every reason to anticipate decent economic growth into the middle of the decade as payrolls expand and housing firms up.

Action to Take --> Investors have reflexively shunned stocks whenever they experience a periodic sharp drop. And the events in Greece imply we may be getting another pullback soon. However, stepping into the market when things get scary is the best move you can make, even though it feels counter-intuitive. 

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of MSFT in one or more if its "real money" portfolios.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

This article appears in: Investing
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