A False Sense of Security?

Europe made progress this past week, but pullbacks are still possible

Bearemy Glaser 10 September, 2012 | 12:04PM

Stocks around the world were rallying this past week and the markets seemed to be cheering progress in Europe and mostly shrugging off disappointing US jobs data.

The cheers were not totally unfounded. Europe did make a substantive step forward this week, and the jobs data--although disappointing--was hardly a disaster. But the world economy is far from out of the woods, and given how much stocks have run up, and how full valuations have become, investors must continue to exercise caution and should be prepared for a potential pullback.

Europe Ends Its Vacation

Europe made a real effort to bring its debt crisis under control this past week. After promising to act last month, we finally got the concrete details of the European Central Bank's (ECB) plans to keep short-term borrowing rates reasonable for some beleaguered eurozone members. And the details mostly lived up to expectations. Unlike previous plans that seemed to be filled with hidden landmines, the new outright monetary transaction plan looks like it can achieve its goals. The rub is that the goals of this plan are modest compared with the size of the eurozone crisis.

The ECB is planning on buying bonds with maturities between one and three years from countries that have entered into some kind of bailout agreement with the European Financial Stability Facility or the forthcoming European Stability Mechanism. The bond buying should have the impact of reopening the short-term bond markets for some of the most indebted countries. This potentially neutralises the troubling scenario where short-term rates rise so high for some peripheral countries that they would be unable to roll over their maturing debt and would be forced into a disorderly default. 

The ECB likely made its programme conditional on participation in a broader bailout in order to dampen political opposition. Although the bank is ostensibly an independent institution, it is still very much impacted by political winds. Germany in particular is worried about the euro being destabilised in an effort to bail out peripheral nations without imposing any structural reforms. Germany still isn't thrilled with this plan, but the conditionality helped it go down a bit easier.

The eurozone crisis is hardly the only worry that investors have on their minds. A general slowdown in the US economy could also derail corporate profits and investors' hopes

The flip side is that this decision could make it somewhat harder for the ECB to back up its forceful statement that the euro is irreversible. Take Greece for example. It is almost certainly not on track to meet the requirements in its bailout agreement. If those requirements don't get tweaked, and the country is found to be out of compliance, will the ECB decline to purchase Greek bonds as it says it will? If bailout funds are withdrawn, the only chance of the country staying in the euro would be a massive intervention from the ECB. This scenario would force the central bank to either change the rules of this programme or back off from its talk on the euro. Neither of these options will be attractive. It is very much an open question which way it would go.

The programme may reduce some of the tail risk of a breakup of the eurozone and provide useful space for economies working within the bailout mechanism to recalibrate, but it certainly doesn't eliminate the risk altogether.

US Jobs Picture Still Not Pretty

The eurozone crisis is hardly the only worry that investors have on their minds. A general slowdown in the US economy could also derail corporate profits and investors' hopes.

The US jobs report this past week wasn't inspiring, but it was hardly a disaster. The economy is still adding jobs, even if it's at a lower level than economists had hoped for, and the enormous layoffs that marked the peak of the crisis are now a distant memory. But unemployment remains very high, workers are dropping out of the workforce, and the ranks of the long-term unemployed remain large. A robust employment recovery always seems to be frustratingly out of reach. 

Add in some disappointing manufacturing data from the ISM this week, and the US economy appears to be treading water. GDP is still moving in the right direction, but at a glacial pace. And although the US economy is not nearly as vulnerable as it once was, that doesn't mean it is isolated from problems brewing elsewhere. It is not too hard to imagine how shockwaves from Europe or a sharp slowdown in China and other emerging markets could knock the US from its somewhat tenuous position.

Valuations Look Full

The recent market rally has pushed up valuation levels on many stocks around the world. The FTSE 100 has rallied by nearly 10% since the beginning of June. This means there isn't much of a margin of safety left in the marketplace. If something unexpected happens or things don't go exactly according to plan, there is plenty of room for stocks to fall. 

This doesn't mean investors should start moving exclusively into cash to protect themselves. It does, however, point to the incredible importance of asset selection. Buying pricey stocks today is not likely to end well. Thankfully, there are still some stocks out there with decent margins of safety and strong balance sheets. Finding companies with good competitive advantages, that are trading at a discount to their intrinsic value, and with the financial strength to endure some economic weakness might not be the most exciting strategy, but it is one that should help investors grapple with the unusual uncertainty in the marketplace right now.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Bearemy Glaser

Bearemy Glaser  is the worry-prone alter-ego of Morningstar markets editor Jeremy Glaser. Each week, Bearemy shares what's topping his list of concerns.

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