The Exchange

Replaying the Euro Doom Scenario, Fleecing Ordinary Investors

The Exchange

By Terry Connelly, dean emeritus of the Ageno School of Business at Golden Gate University

At least three times since 2009, the U.S. stock market has been pushed into a fairly abrupt downward "correction" of 10 percent or more primarily due to concerns about potential collapse of the euro currency or one of its Southern tier economies due to struggles to repay or reign in their sovereign debt.

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It's been barely a couple of weeks since the European Central bank specified a plan to backstop the debt obligations of these countries in case of market runs, and the U.S. Federal Reserve Bank followed with a commitment of low interest rates and a third round of  "Quantitative Easing" — this time in the from of unlimited purchases of mortgage bonds. Yet the equity markets in both Europe and the U.S. have temporarily thrown off the Central Bankers' security blanket. They again spooked themselves into a broad-based dumping stocks at the sight of violence-tinged street demonstrations in both Spain and Greece as both nations' governments move to implement further austerity measures required by their Northern European creditors.

Americans Just Don't "Get" Europe

Now, street demonstrations are really nothing new in Spanish or Greek politics. They happened with some regularity even before the sovereign debt crisis and the "external" imposition of enforced austerity. But American investors have very poor working knowledge of how the European economic and political systems work, and how "negotiations" within the euro systems actually take place. The street is part of the political game's playing field in the Southern tier countries, and always has been.

Same with the Bundesbank in Germany and the multiple and overlapping jurisdictions of the many agencies of the European Commission in Brussels. Simply put, market participants in the U.S. are relatively unsophisticated in terms of interpreting how Europe works, and tend to view events there through the prism of how American institutions function.

We would be shocked to see every fiscal policy dispute in Congress (or even in California) leading to midnight scenes of thousands of riot police protecting the U.S. Capitol or the governor's office in Sacramento. Our stock markets would surely plunge the morning after that! We would shaken to see Charles Plosser of the Philadelphia Reserve Bank not only dissent from Ben Bernanke's latest bond buying actions but also file a lawsuit to enjoin it! Our financial markets would swoon the morning after anything like that happened. U.S. investors would panic if California threatened to secede from the union because it disagreed with the Obama Administration's plans to cut the Federal deficit. Yet Spanish investors have generally taken similar threats from one of Spain's province in stride.

The Naysayers Are Wrong

During the past three corrections provoked by euro Sturm und Drang, various market pundits pronounced that the end was nigh for the euro; that it would go to parity with the U.S. dollar and never recover; that Greece, Spain and/or Italy would leave the euro and precipitate a currency collapse, or that Germany would tire of its lender of last resort role and itself leave the euro, with grave consequences for the world economy. None of those predictions ever came true. Nor are they likely to just now. It still takes a bit less than $1.30 to buy one euro — with all the riots, lawsuit threats and secession talk, the euro has not even lost two cents in relative value.

And yet, the same doomsayers are back again talking down the U.S. stock market. While one is reminded that a stopped clock is right twice a day (not to be confused with an actual arrival of a "tail risk" event), there is more to these repeat "sky is falling" scenarios than that. There is a purpose to this pitch!

Playing the Euro Doom and Gloom Market

As in the prior instances of euro-induced market corrections since the financial crisis of 2007-09, the hedge fund industry has again largely failed to participate in the significant equity market rallies of prior months. Taking a decidedly bearish view, they actually were under-performing the market up to the point of the recent euro events. But if the markets can again be persuaded, if only for awhile, that the eurozone issues were grave signals of Armageddon, then the unfortunate hedgies can turn their "short" positions against U.S. equities to profit, and then get back in themselves at distressed prices and enjoy the upside when euro-geddon again doesn't happen.

Their game works by taking advantage of misunderstanding of how Europe operates in the loose structure of its confederation, as compared with the well-oiled machinery of the more truly "United" States and its federal institutions. It simply takes longer and seems harder for 17 national governments (most lacking simple majorities), plus three or four eurozone agencies, to agree on anything. But they are used to doing business this way and in all cases to date have succeeded in dodging the fatal bullet. That doesn't mean all the euro issues, are not real, or as yet resolved. There is much more to do, as leaders like Merkel of Germany have repeatedly affirmed — but "end" is not "near."

Underperforming hedge funds behind the performance curve can also take advantage of the fact that the ordinary investor does not typically "short" stocks for profit, and is accordingly less aware that many savvy professional "short" funds profit handsomely when the market "corrects." Investors thus must unlearn the simplistic notion that commentators who talk down the market are inherently more credible than those who talk it up — the doomsayers are just as likely to be "talking their own book" as the more optimistic "long" promoters.

The realities of the euro bond markets, however, also offer the hedge funds opportunity to put a squeeze on sovereign debt values by relatively small amounts bet on the value of "credit default swaps," which serve as an option-like proxy for current estimation of default risk — real or imagined. A few dollars used to bid up default swap spreads can go a long way to induce panic, first in the euro-bond markets for sovereign and bank debt, next in the Eurozone equity markets, and then in the U.S. equity markets.

We have seen this movie three times in the past three years. This year's latest sequel has added a new plot twist in yet another "stopped clock" tale, but this time focused on the U.S. Predictions are rampant that this quarter's S&P 500 corporate earning will prove negative for the first time since the genuine crisis year of 2009. True, there have been some significant (Caterpillar and FedEx) negative pre-announcements, just as there were for the first two quarters when a similar outcome was widely predicted. But corporate earnings actually grew in both Q1 and Q2. If the same happens again for the third quarter, the "out and in" hedge funds will do just fine if their timing is right, and "weak hands" investors will again lose out, As they generally do in a market "correction" based on facts misperceived.

Blame the Hedge Funds

There are of course many good reasons for equity markets to move up or down, and even to "correct" at times. But the European situation, as stands now, is not really one that should provoke another sharp correction that serves mainly to bail out hedge funds.

Ordinary U.S. investors should spend more time self-educating about the differences between the U.S. and European political systems. The street actions of Athens and Madrid are not those of Damascus and Cairo — don't conflate them just because they have come to back on the evening news. And they should also treat both market promoters and doomsayers with the same degree of skepticism.

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

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