Be Wary of Europe

 | Jan 17, 2013 | 10:30 AM EST  | Comments
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A danger foreseen is half avoided. --Proverb

The Volatility Index (VIX) hit a 52-week low earlier this week. Although it is far from a perfect metric, the VIX is a useful gauge of complacency in the market, and investors have had good reasons to be complacent over the last few weeks. Indices are up more than 3% across the board since the start of the year. The market has been buoyed as the fiscal-cliff rhetoric has faded into a background after a resolution was reached earlier this month. The market is now focused on the upcoming debt-limit talks and the sequester.

However, the market is ignoring worsening conditions in Europe at its own peril. The Continent is in the eye of the storm, and rougher weather lies ahead. Much like each of the last three years, events in Europe will hit the domestic market sometime in the first half of the year and cause equities to pull back 5% to 15% in the next six to nine months.

Below are some of the signs of deterioration in Europe. I have also included what I am doing to position my portfolio ahead of a market selloff triggered by Europe.

  • Germany, the last strong economic engine in Europe, is starting to falter. The country announced Wednesday that GDP contracted a preliminary 0.5% in the fourth quarter, which was greater than expected and marked a deterioration from +0.2% in the third quarter. German growth fell to 0.7% in 2012 from 3% in 2011. It also cut its own GDP forecast for 2013 to 0.5% from 1%. Expect little to no growth in 2013; a slight decline is not out of the question if conditions continue to worsen.
  • Despite much better interest rates since the European Central Bank decided to go all in to support sovereign debt, the condition of Spain is not improving. Spain's debt-to-GDP level for 2012 came in at 9% vs. a target of 6%. Unemployment continues to hover around 25% with few positive catalysts on the horizon.
  • As bad as things are in Spain, they are much worse in Greece. Unemployment is at 27% and bread prices are soaring. Matthew Lynn had a great piece in MarketWatch on Wednesday about accelerating food inflation and how it could lead to revolutions in some emerging markets in 2013. It is his black swan for the new year. Greece is on this list, and if this event were to occur, it would probably lead to the long-awaited and feared "Grexit."
  • Finally, auto production is falling off the cliff. After falling more than 8% in 2012, another 5% decline is expected in 2013 as the market heads toward annual production of just 11 million vehicles from 16 million vehicles in 2007. The industry is unlikely to get much help from Russia this year, either, as sales are projected to grow less than 1% after more than 10% growth in 2012. Falling auto production will continue to put a major damper in European industrial production and job growth going forward, much like it did here in 2008-2009.

Actions investors should consider are:

  • Take the advice of Euro Group President Jean-Claude Juncker, who recently said that the euro is overvalued. I am short the CurrencyShares Euro Trust (FXE).
  • Avoid companies that get a large portion of earnings from Europe. Sales are likely to be very challenging and if the euro declines, that will negatively affect earnings. I would be particularly wary of entities like McDonald's (MCD), which are likely to be hurt by the same food inflation that Chipotle Mexican Grill (CMG) warned about Wednesday for its poor guidance.
  • With volatility so low, buy some protection on your long positions by picking up some out of the money puts on the cheap.

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