Why Stocks Aren't Cheap

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LONDON -- Stocks are cheap, right? The FTSE 100  (INDEX: ^FTSE) has dropped 6% in May, putting lots of blue-chip stocks in bargain territory. Indeed, the index itself now trades on a P/E of 10 and yields close to 4%. It's time to fill your boots.

Well, yes and no. Stock markets are driven by fear and greed, and there is much to be said for taking a contrarian stance, buying when others are selling and vice versa. I've written here before how I see the euro crisis as an opportunity to implement that strategy as markets react to the rise and fall in sentiment towards the eurozone.

Generally, the EU authorities have reacted with some form of policy response -- political statements, a quasi-treaty, the long-term refinancing operation, and so on -- whenever bond markets have become nervous. The markets have duly responded, with stocks mimicking the performance of peripheral eurozone bonds. It's been a golden opportunity to build stakes in companies by buying on predictable dips, as well as a chance to indulge in a little trading.


Wary
But I'm wary that this dip may be different. I think the latest drop in confidence is not so much the market's cyclical over-reaction to eurozone mood music, but rather it's starting to price in the risk of a meltdown in the single currency: so-called "eurogeddon".

I thought it was good news when pundits started to talk openly of Greece's exit from the euro. If politicians build a sufficient firewall around the rest of the eurozone, then I still think that country's exit would be a manageable affair that doesn't affect markets in the long term. There's only so much damage an economy the size of Colombia's can do, even if French banks recklessly lent it far too much because of the implicit guarantee that Berlin would ultimately bail them out.

But the Greek elections have shown that Europe's voters have become rebellious. When the Irish people voted against the Lisbon Treaty in 2008, they were sent away to reconsider, and they duly came back in a second referendum with the right answer. But the Greeks don't currently look so malleable. The pain of austerity forced on Greece through its membership in a currency union for which it never qualified has stripped away the veneer of European solidarity.

Fix
The economic fix preferred by Europe's elite is a fiscal union -- pretty much a European government and what many suspect was the original agenda of the architects of the euro. Bizarrely, even our own prime minister has promoted the idea. One only wonders what his predecessors would think, but centuries of history suggest that attempts to impose Europe-wide government are painful and end in failure.

Is there really appetite in Europe for more government from Berlin, Brussels, or Strasbourg? Possibly, if it's sweetened with massive transfers of German wealth, but that looks equally unlikely.

If the population of a larger economy such as Spain, with its 24% unemployment rate, took the Greek rebellion as a model, then the prospect of "eurogeddon" -- the breakup of the euro by one or more larger countries leaving -- would become more real.

Fallout
If that happened, the fallout could be global. Earlier in the year, the World Bank predicted that a euro crisis in which markets denied financing to several European economies would knock 4% off global GDP growth, creating a global recession. It warned that the downturn could last longer than the 2008 and 2009 crisis, as governments have reduced financial firepower with which to respond.

I think the stock market is implicitly recognizing that the risks of this event have increased. Those juicy low price-to-earnings ratios are discounting the risk that future earnings could be slashed across the board.

A full-blown euro crisis would impact, in descending order of severity:

  • The European financial sector.
  • The eurozone.
  • The rest of Europe, including the U.K.
  • The global economy.

Positioning
That analysis underlies the positioning of my portfolio.

I'm happy to keep quite a bit of cash at present and am circumspect about going into the market. I'm biased toward defensive sectors that were resilient in the last crisis, such as infrastructure, pharmaceuticals, tobacco and alcohol, and consumer staples. I'm wary of financial stocks -- particularly banks -- and prefer companies with exposure to Asia-Pacific and emerging markets, rather than Europe.

Greed may be good, but there are times when it's wise to be fearful.

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