Will Europe Sink U.S. Stocks?

A story of opposites is a fitting description between European and U.S. markets.

Sitting on one side of the Atlantic is the S&P 500 Index (SNP: ^ GSPC), which traded only 10% below its 2007 all-time high just a few months ago. U.S. companies also reported record earnings.

On the other side of the pond is Spain's stock market (NYSEArca: EWP) which now trades more than 50% below its 2007 high. But Spain is not the only weak link in the chain. France's CAC 40 also trades 50% below its all-time high and even Germany's DAX is off by more than 20%.

Even the broader MSCI EAFE Index (NYSEArca: EFA) is down some 40% since its 2007 high.

Market dislocations this large are unusual, so the key question is this: Will the U.S. market lift Europe or will Europe (NYSEArca: FXE) drag it down?

Monkey See, Monkey Do

This week the European Central Bank (ECB) took a page from the playbook of the U.S. Federal Reserve. The ECB lowered the deposit and main refinancing interest rate between 0.75% and zero percent. "Downside risks to the euro-area economic outlook have materialized," said Mario Draghi, ECB President. Draghi's statement can easily be categorized as understatement of the week and possibly of the year.

The ECB follows the same path as Australia, China, Japan, U.K. and U.S. Here's what's occurring: Financial maneuvering by global governments, from asset purchases to near zero percent interest rates, are being tried. And yet other tactics will be tried.

Thus far, the ECB's tactics haven't worked. Unemployment in the region reached a record of 11.1% in May and confidence has fallen to its lowest point over the past two years. The European Commission expects 0.3% shrinkage in economic activity and more downward revisions are ahead.

Reversion to the Mean

International and emerging market stocks (NYSEArca: EEM) easily outperformed U.S. stocks from 2009-10. When U.S. stocks were lagging, the rest of the world was rising. The short-lived blistering outperformance of Spanish stocks (NYSEArca: EWP) versus the S&P 500 (NYSEArca: SPY) circa 2009-10 is seen on the chart below.

Like many markets throughout the history of time, the performance discrepancies between international and U.S. stocks grew in early 2010. That was roughly around the same time Wall Street's strategists were telling their clients to load up on foreign stocks. But these distortions of international outperformance versus the U.S. were only temporary.

The February 2010 ETF Profit Strategy Newsletter (published in mid-January 2010) observed this and alerted: "Current prices provide an excellent opportunity to take, maintain or add to bearish positions." Shortly thereafter, Spanish stocks, along with the rest of the market, reverted and a severe correction occurred.

Don't Miss the Next Reversion...

European indexes have already succumbed to their reversion, while U.S. stocks are still plugging along. And while history shows these discrepancies can occur over unusually long periods, they are never indefinite.

Spain and Italy (NYSEArca: EWI) together have an economy that's 11x larger than Greece. You don't want to be fully invested when that bomb goes off. A reversion to the mean, like gravity, is not a force you want toargue with.

The ETF Profit Strategy Newsletter's goal today - as in 2010 and 2011 - is to issue the kind of warning that gets investors out of stocks before the next leg down. When stocks fall, they tend to fall hard, and an ounce of prevention is worth more than a pound of cure (the Newsletter issued a sell signal at S&P 1,386).

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

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

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