Beware of Complacency on Europe

 | Dec 22, 2011 | 5:00 PM EST
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One of the most difficult aspects of anticipating market action in any asset class is first anticipating investor sentiment, especially because what people say is often in opposition to what they do.

It's very common, for example, for consumer confidence to decrease even as consumption is increasing, and for stocks to rise as economic indicators deteriorate.

Sociologists have offered many reasons for such seemingly illogical actions, and investors need to be cognizant of them when interpreting the market impact of all kinds of data.

When investors begin to exhibit truly irrational behavior, something well in excess of the nuance issues, we take notice. Recent examples are the "new economy" rationale of the pre-2000 Nasdaq bubble and the "never falls in price" rationale of the pre-2007 real estate bubble. The first example represents the idea of "it's different this time," while the second represents the idea of "it's the same this time".

In both instances, the rationale was wrong, but the overwhelming majority of investors recognized it as wrong only after the markets had collapsed. The common theme for both instances was that rising markets are self-validating, an attitude that says, "If you build it, they will come."

Perhaps more appropriately, this attitude is an extension of Norman Vincent Peale's The Power of Positive Thinking or Napoleon Hill's Think and Grow Rich, or any number of other self-help and motivational books. The problem with this kind of thinking is that it can easily slip into the realm of religion, unbounded by the physical or fiscal limitations on markets.

When that happens, the markets begin to reflect participants' truly irrational actions. This is akin to the child jumping up and down on a tree limb and becoming convinced that the longer he does so without the branch breaking, the more likely it is that the branch will not break. He is of course wrong and will be shocked when he discovers it.

Two days ago, the European Central Bank announced plans for its three-year long-term refinancing operation, or LTRO. Global equity and bond markets surged on the news and have continued higher since.

Interestingly, though, sovereign bond yields in Europe were little changed on the announcement and are actually heading higher again already. The only logical interpretation is that Europe is in even worse shape today than it was before the ECB made its announcement.

The sole purpose of the announcement was to bring sovereign yields down to levels that would not mandate the insolvency of countries as maturing debt needed to be refinanced. It has failed to achieve that goal already, yet the new meme with investors is that the crisis has passed, not that it has become more serious.

There is again a belief brewing that the ECB and other fiscal and monetary authorities will do whatever they must to prevent sovereign defaults, contagion and the myriad of issues that the markets were focused on just a few days ago.

The reality, however, is that the sovereign debt markets of Europe may be indicating that the issues facing the Union are now of a magnitude beyond the power of fiscal and monetary policy tools of any kind, and that the E.U. is now more assuredly on a terminal trajectory than it was before the ECB's LTRO announcement.

Within the next few months we will know the answer to these questions, as the maturing sovereign debt throughout Europe must be refinanced, with funding coming from private investors.

There is a silver lining in all of this, though: the resilience of the markets and their ability to absorb financial shocks and rebound quickly.

After Russia's sovereign default in 1998, it only took three years for global investor appetite for its debt to recover. If Europe does experience a series of sovereign defaults, bank failures and associated events, as is increasingly probable, contrary to what rising stock and bond prices in Europe have been indicating over the past few days, I expect that Europe too will recover very quickly.

However, as the maturing debt provides us with a time line for probable crisis, it is prudent for investors to consider the ramifications, rather than just note that European equities are rising.



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