Will Europe sink stocks and boost gold?

Wall Street expressed relieved that Europe’s central bank agreed to release 10 billion euros ($13 billion) of emergency rescue funds for Cyprus.  In exchange, Cyprus agreed to shrink its banking industry, cut its budget, implement economic reforms and privatize some state assets.  Although the measures are expected to result in heavy losses for Cyprus’ bondholders and large depositors, Wall Street was just glad to dodge another bullet.

 

Optimism over the lack of panic in Cyprus pushed the S&P 500 (SPX) to a record closing high.  The new high in the SPX was preceded two days earlier by a new high in the NYSE Advance-Decline (A-D) line, a sure sign that higher prices were ahead.  Internal momentum on the NYSE is also still rising, which helps dictate the path of least resistance for stocks in the near term.

 

The big question on investors’ minds is how much longer the U.S. stock market can continue to avoid Europe’s increasing troubles?  It has been 130 days since the market has seen a pull back of at least 5-10%.  Many investors wonder if we’ll ever see such a pullback again as long as the Federal Reserve has the proverbial “pedal to the metal” with its loose money program.  The answer to this question is more than likely “yes” considering that the market has always had such corrections in previous quantitative easing (QE) periods. 

 

Witness the declines in the stock markets of several major European nations as well the continued weakness in the euro currency.  European bourses were considerably weaker for the week, led by a fresh new quarterly low in the euro ETF (FXE).  Spain’s IBEX 35 stock index was down by as much as 6%, testing its quarterly low while the Italy ETF (EWI) dropped 5% in a 2-day period..  The country that got the euro zone avalanche started back in 2010 – Greece – saw its stock market decline to yet another new low today via the Greek ETF (GREK) shown below. 

 

 

As Sharps Pixley pointed out, “Although the Finance Ministers highlighted that Cyprus is a special situation, the European banking crises and contagious effects are very real.”  Italy meanwhile still doesn’t have a government.  Each of the stock markets and country ETFs mentioned above present a picture of a weakened continent vulnerable to even the slightest bad news. 

 

Speaking of financial contagions, Randall Forsyth, writing in this week’s Barron’s, pointed out the history of overseas financial crises and how they all have a history of eventually making their way to the U.S.  Sixteen years ago the Thai baht became the first major currency to fall in the Asian currency crisis.  That crisis eventually spread beyond the region and made its presence felt in the U.S. and around the world.  The collapse of Long Term Capital Management hedge fund in 1998 and near meltdown of the global financial system was a result of that contagion. 

 

“In 2008,” wrote Forsyth, “Iceland was the improbable site of a credit bubble and bust.  Money flooded into the island nation’s burgeoning banks in pursuit of high returns.  Eventually, the amount at issue grew to about 10 times the size of Iceland’s economy.  But the bubble’s collapse led to defaults to foreign creditors, notably those in the U.K. and the Netherlands, and a massive devaluation of Iceland’s currency, the krona.”

 

Then there was the crisis with Greek government bonds in 2010 which required a massive bailout.  The crisis in Greece spread to banks in Ireland, Spain, and Portugal, with spillover effects on U.S. equities. 

 

The fear among investors is that Cyprus’ move to essentially penalize large bank depositors will feed a larger fear that this will become the norm in troubled European nations.  Rana Foroohar pointed out in the latest issue of Time that the current Cypriot government was voted in because it promised to protect bank deposits.  “Even if small depositors end up safe,” she wrote, “even if Cyprus doesn’t become the economic equivalent of the assassination of Austrian Archduke Ferdinand, which started World War I – the damage to trust has been done.”  As Mohamed El-Erian, CEO of PIMCO, pointed out, “The population is quickly losing confidence in the political order.”

 

All of which is to say that the fatal concoction of European bank troubles and a weakening euro currency along with depositor/investor mistrust of banks could easily result in another financial contagion in the coming months.  And this is just the sort of thing the gold market could use to reverse its fortune.