Investors May Be Too Complacent About European Bank Stress Tests

Earlier this year, European bank stocks were slammed on fears that Greece and other highly ndebted neighbors might not be able to pay their debts, leading to large losses that could destabilize the financial system and undermine growth in the region.

The European sovereign debt crisis eventually sent jitters through markets worldwide, including those in the U.S.

In an effort to restore confidence, the European Union on May 12 announced plans to "stress test" its banking system to assess its ability to "withstand renewed economic weakness and bankruptcies in the household, corporate and sovereign sectors."

Although the move was seen as a positive step, especially in light of the success of an earlier but similar effort in the U.S., bank investors were wary about the issues that might come to light. Over the course of the next four weeks, the European bank sector underperformed the benchmark STOXX Europe 600 index by 7%.

Since then, however, European bank shares have recovered all of the ground they lost -- and more -- relative to the broad market. This suggests that whatever concerns investors had previously have all but disappeared. With the European Union set to announce the test results on Friday, how should we interpret this?

On the one hand, with things more-or-less back to where they were when the initiative was announced, it could be taken as a sign that whatever facts come to light are already "priced in" -- a nonevent. In contrast, the "newsless" rebound we've seen in European bank stocks in recent months may well mean that investors have grown complacent about the headwinds facing the sector, many of which will prove daunting over the longer term.

In short, it seems a good bet that Friday's stress test news will either be neutral or negative for European bank stocks, indicating that the risk is to the downside (in relative terms, at least). Given what occurred the last time this sector came undone, U.S. investors would be well advised to pay close attention to events on the other side of the pond.