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The Worst
Area for Stocks in the Next 12 Months
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Published: October 29, 2010
As Americans were
heading back to work from the long Memorial Day weekend,
Europeans were fretting about a looming banking crisis that
threatened to take down major banks in Ireland and Spain. Europe
went on to dodge that bullet, and its equity markets have
rebounded +30% in the last five months, as measured by the
Vanguard European Stock Index Fund (Nasdaq: VEURX).
That move is even more impressive than the rebound seen here in
the United States. Part of the gain stems from a projected +35%
rebound in 2010 profits among Europe's largest 500 companies,
according to UBS. The bank anticipates an additional +10% gain
in profits next year as well.
But even as Europe is no longer on the cusp of a crisis, it
remains far from healthy. A host of factors will likely conspire
to deliver muted economic growth at best. And there's also a
reasonable chance the continent slides back into recession.
Germany's false dawn
The troubling budget deficits, unfavorable demographic trends
and inflexible labor stances have been widely-chronicled
impediments to any major economic rebound in Europe. Yet the
German economy has remained remarkably resilient, thanks to
robust exports of industrial equipment, autos and precision
machinery. On a continent-wide basis, 40% of large European
companies' sales go to exports outside of the European Union
(EU).
A surging currency changes
everything. Back in early June, when the European markets
started to rebound, the euro was worth about $1.20. A euro now
buys about $1.40, which means that European exporters are
roughly -15% less competitive than before. Adding insult, the
Chinese yuan is pegged to the dollar, so the euro is surging
against that currency as well.
So what does a +15% gain in the euro really mean? For starters,
it gets harder to compete with goods made elsewhere. Volkswagens
made in Europe quickly become less competitive with vehicles
made in the U.S. or Asia (outside of Japan) -- which explains
why VW is desperate to expand manufacturing capacity in North
America and build more vehicles here. That also spells fewer
European jobs from VW.
Secondly, a rising currency reduces the value of export profits
by a commensurate amount, so major European companies are likely
to face increasingly stiff headwinds on the profit front.
Fiscal drag
The United Kingdom made recent headlines with plans to sharply
curtail government spending. The country plans to run budget
surpluses to start to bring down very high debt loads, which
means that the government becomes a net drag on the economy as
it takes in more revenue than the services and entitlements it
doles out. Other countries will need to move in that direction
in coming years to bring down deficits as well, most notably in
the
PIIGS countries (Portugal, Italy, Ireland, Greece and
Spain).
And as we've seen recently in Greece, economic contraction is
the result. Yet the PIIGS have historically served as key export
markets for France and Germany, Europe's stalwarts. Shrinking
economies mean reduced demand for French and German goods. To
make up for lost regional demand, major European companies will
need to seek out new markets abroad to offset that drag. But as
a high-cost region, that may be hard to pull off.
To be sure, the major European economies have proven resilient
in the aftermath of the global economic crisis, and no one is
suggesting that Europe is going to experience a sudden economic
plunge. But current economic data and corporate profits look
good in 2010 simply because they are being compared to the
dismal results of 2009. Serious headwinds -- especially in the
form of a surging currency -- imply that 2011's year-over-year
comparisons will be far less robust. And this summer's
impressive +30% rebound could well look like a false dawn.
Action to Take --> If you
own shares of European-based companies, profit-taking seems like
the right move at this time. You can even look to go short
against Europe by buying the ProShares UltraShort MSCI Europe
(AMEX: EPV)
exchange-traded fund (ETF), which moves at twice the rate in
the opposite direction as the MSCI Europe Index. The bearish
fund has lost half of its value since late May, but has posted a
solid +5%
turnaround in the past two sessions. That may be a harbinger
of things to come.
-- David Sterman
Staff Writer
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