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Europe Stock Selloff

CPA, Principal & Co-Founder of Zeal LLC
September 16, 2011

Europe has become something of a four-letter word among American investors and speculators lately. Weak European stock action has been mesmerizing stock-index-futures traders here in the States. They dump US stock-index futures in sympathy whenever Europe is selling off. This in turn spawns bearish sentiment and weak opens in the US markets. Europe is the epicenter of US stock fears these days.

Early every morning in the US, futures traders carefully digest overnight world events to help them make trading decisions. Did any market-moving news emerge? How are the Asian and European markets faring? Since the major European stock exchanges are still open during the critical couple pre-market hours in the States when that day's sentiment is being shaped, they can have an outsized impact.

In normal times American traders don't pay too much attention to Europe. We tend to think the massive American stock markets set the tone for the entire world's trading, which is true most of the time. But when the US stock markets have recently suffered a selloff, the psychological gravity of overnight global action swells greatly. Stock selloffs ignite fear, and worried traders eagerly look for excuses to sell.

And boy, does Europe sure provide them! Since the world's stock markets plunged sharply in early August, it is not uncommon to see huge down days in the major European stock indexes before the US markets open. I am talking 3%, 4%, even 5%+ daily losses! When you think of how scary down days of this magnitude are here in the States, it is easy to understand why they rile up nervous futures traders.

The ironic thing is these Europe fears and problems are nothing new. The big-spending, heavy-borrowing European governments have had debt problems for many years. Even the threat of defaults is well-traveled old news. You may remember that nearly-identicalEurope fears actually sparked a euro currency panic in spring 2010! Europe's struggles are always there, but only command the American limelight during major US stock selloffs.

And we have certainly suffered one in the past couple months. Every morning I eagerly watch the couple hours of futures action before the US stock markets open, and Europe's overwhelming influence recently is indisputable. US stock-index futures nearly perfectly mirror what is going on in Europe in real-time. And since Europe's major stock exchanges remain open for the first couple hours of US stock trading, this strong correlation persists until the European closes.

While minute-to-minute trading action can be important, it is easy to lose the forest for the trees. And being a typical provincial American who hasn't spent years closely following the European stock indexes, I lacked perspective. Successful trading demands buying low and selling high, so perspective is absolutely crucial to discern these fleeting opportunities. I needed to understand the relationship between US and European stock markets over longer periods of time.

Measuring the US side of this relationship is easy, as the flagship US stock index is the mighty S&P 500 (SPX). This market-capitalization-weighted broad-market index tracks the 500 biggest and best American companies, and is the benchmark of choice for the US stock markets as a whole. Unfortunately Europe doesn't have one benchmark stock index, but several. While some newer pan-European stock indexes exist, world traders still prefer to watch a handful of classic national stock indexes.

Germany, France, and the United Kingdom dominate Europe's economy, weighing in at 20%, 16%, and 14% of European GDP respectively. These powerhouses contain 16%, 13%, and 12% of Europe's population as well. Collectively commanding half of European economic activity and over 4/10ths of its people, it is not surprising that traders consider these countries' national stock indexes representative of European stock markets as a whole.

Germany's flagship stock index is the Deutscher Aktien IndeX (DAX, pronounced "dacks"), which imaginatively translates to "German stock index". It represents the 30 largest German companies in terms of market capitalization and trading volume. France's flagship is the Cotation Assistée en Continu quarante (CAC, "cack"), which means "continuous assisted quotation". It tracks the 40 "most-significant" French companies out of the 100 highest market caps on the Paris stock exchange. These indexes are known as the DAX and CAC 40.

The UK's flagship stock index is the FTSE 100 ("footsie"), an acronym from its two parent companies the Financial Times and London Stock Exchange. It tracks the 100 largest UK companies, which collectively represent over 5/6ths of this country's total market capitalization. Like the American S&P 500, this FTSE 100, as well as the DAX and CAC 40, are all market-capitalization weighted.

To gain a better idea of the probable sustainability of the US and European stock markets' recent affinity, I wanted to see how they compared in recent years. As each index has its own individual scale, and it is their percentage changes that are of interest, I re-indexed each national stock index to common bases. This makes them perfectly comparable with each other. And since the S&P 500's market capitalization is several times larger than the three elite European indexes combined, I indexed all off key SPX dates.

The first span crucial for gaining perspective on the recent Europe stock selloff is the cyclical bear between late 2007 and early 2009 that climaxed in an ultra-rare stock panic. Since the overwhelmingly-dominant SPX topped on October 9th, 2007, each national stock index is individually re-indexed to 100 as of its close that day. From there, a value of 90 represents a 10% decline, 80 is 20%, and so on.

Though the European stock markets topped earlier in the summer of 2007, they were still near their highs when the SPX started selling off in October. All of these indexes weathered very similar cyclical-bear markets, flowing and ebbing as a group. They also all plummeted in late 2008's once-in-a-century stock panic, hitting initial panic lows that autumn before slumping to secondary lows in early 2009.

Though the UK was the best performer and France the worst, all these individual indexes' tracks are essentially interchangeable. The absolute bear losses in each index were also quite similar, with the FTSE's 47.8%, CAC's 59.2%, and DAX's 54.8% closely matching the SPX's 56.8%. Note that big divergences between these national stock indexes were fleeting during the last cyclical stock bear. They tended to track in lockstep unison, meandering lower as a highly-correlated herd.

The second span for perspective is the subsequent cyclical bull that powered higher between early 2009 and this year. Each stock index is individually re-indexed to 100 on March 9th, 2009, the day the SPX bottomed. Initially all 4 indexes tracked pretty closely in this bull, until its mid-2010 correction. There France and the UK were hit much harder than the US and Germany, and they were never able to catch back up.

France was again the worst performer of this cyclical bull, while the US and Germany ran neck and neck as its best performers. At best in absolute non-indexed terms, the SPX has soared 101.6% higher while the DAX edged it out with an amazing 105.3% bull-to-date gain. The FTSE and CAC trailed behind considerably, with bull-to-date gains of only 73.4% and 65.0% respectively. Still, it's hard to complain about this magnitude of rally over just a couple years.

While this cyclical bull saw more performance divergences between these indexes than the preceding cyclical bear, they still tended to move in unison. They all rallied together and all suffered pullbacks and corrections together. While all their performances were fairly close in 2009 early in this bull, it is provocative to see the stratification gradually increase to reflect the differences in each country's underlying economic outlooks as this bull marched on.

Today after the second correction of this bull market, these differences are vast. As of this week, the SPX was still up 75.7% in its bull which is pretty darned awesome and far and away the best of this elite group. Since it didn't crater like Germany, the FTSE's 47.6% bull-to-date gain edged out the DAX's 44.6%. And poor France, ever lagging due to its sluggish socialist economy, saw dismal CAC 40 gains of only 17.0%. France was slammed so hard recently that its stocks aren't far above early 2009's secondary panic lows!

This growing stratification of national-index performances has big implications for European investors. Having just suffered such intense selloffs, vast pools of European capital are sitting on the sidelines in cash. And this cash is yielding next to nothing thanks to the world's central banks manipulating interest rates down to punitively-low levels. As the fear from this selloff passes, capital will migrate back into stocks. And the US stock markets now look much healthier and stronger than the European ones.

While Washington has a terrible spending and debt problem too, there are no fears that the United States will fracture apart or that the US Treasury can't meet its obligations. So there is a good chance that some sizable fraction of European stock investors will tire of all their local scares and start moving capital into US stocks. Investors chase performance. And not only has the SPX had the best for much of this bull, it is holding up far better than any of the major European stock indexes. This is very bullish for US stocks.

Armed with this longer-term perspective on how the US and European stock markets compare and interact, we can finally delve into the recent sharp correction. This last chart re-indexes each national stock index to 100 on April 29th, 2011, the latest post-panic high in the S&P 500. While these indexes followed similar trajectories in this selloff's initial slow grind lower in May and June, divergences accelerated in July.

While it was the US that was mired in an intense and acrimonious political debate about Obama's massive federal-government growth, the French stock markets were the ones that started selling off. I wasn't watching the CAC 40 in July, so I don't know what the catalyst for this initial selling in France was. But more recently, fears about French banks drove the sharp selling in this country. Traders worried about their derivatives exposure, Greek bonds exposure, downgrade risks, and abilities to raise capital.

Finally in late July, the fears of a potential US technical default if Washington couldn't reach a debt-ceiling deal started dragging the SPX lower. And the European markets followed the global leader, as usual. The UK and Germany mirrored the SPX's losses on a percentage basis nearly perfectly, but starting from a lower base France got hammered. As the SPX spiraled lower on a crappy, small, gimmicky, future-loaded debt-ceiling deal, European stock markets followed so Europe fears intensified.

The SPX and FTSE bottomed soon after in early August, just after the enormous 6.7% SPX plunge the first trading day after Standard & Poor's downgraded Washington's Treasuries for the first time ever. But if you recall from the previous chart, this bottoming was much more impressive for the SPX. It bounced at much higher bull-to-date-gain levels than the FTSE, despite them following a similar bottoming and recovery pattern since.

But meanwhile Germany and France continued cascading lower and ignoring the strengthening SPX. You've heard all the reasons in the news lately. They include fears that Germany and France are going to refuse to continue bailing out Greece, fears that European banks have too-heavy exposure in Greek sovereign debt, and fears internal political pressures will fracture the European Union and scuttle the euro. The net result is this stunning recent divergence in the elite national indexes seen above.

Although the US and UK bottomed right away in early August, Germany and France were still hitting new correction lows this week! And while the SPX and FTSE selloff-to-date losses of 17.9% and 17.8% were merely healthy bull-market-correction magnitude, the CAC and DAX have lost a mind-blowing 31.3% and 32.6%! This is well past the traditional 20% threshold used to define new bear markets.

So which trend is going to prevail going forward here? Are Germany and France going to see fear capitulation and start trending higher like the US and UK? Or are the SPX and FTSE going to get sucked down into the sentiment abyss wreaking havoc on the DAX and CAC? For a variety of reasons, I suspect this odd divergence will resolve in favor of the SPX's uptrend being the winner.

Earlier I mentioned that the SPX's market cap is several times larger than all the major European indexes' combined. It is the dominant index by far in terms of capital. In Europe specifically, the UK's FTSE is about the same size as France's CAC 40 and Germany's DAX combined. The larger an index and the more capital involved, the lower the odds it will be caught up in an anomaly. So it is far more likely that the CAC and DAX are out of line than the SPX and FTSE.

And though I don't follow the European stock markets closely, I've spent over a decade painstakingly studying the US stock markets to optimize my trading. And the SPX simply looks like it just experienced a healthy bull-market correction, bottomed over 5 weeks ago, and is recovering in a young new cyclical-bull upleg. Not only did the US stock markets hit their effective fear ceiling in that early-August plunge, that selloff's price action and velocity was far more ferocious than what is seen early in stock bears.

If the US stock markets are merely correcting, and the European stock markets usually closely follow the massive world-leading US markets, then European stocks are likely to snap back in line soon too. And sentiment supports this outlook as well. Incredibleirrational fear is gripping the German and French stock markets today, and extreme fear is never sustainable no matter where in the world it happens to flare up.

Whether Greece defaults or not has always been irrelevant. It is a tiny country, less than 2% of Europe's GDP. Whether it can pay its bondholders or not, life marches on. The 502m people living in the EU will continue working hard to provide for their families and advance their standards of living. And that is all any economy is, the sum total of all the goods and services produced and consumed. Just as we saw in the US in late 2008, even if a major bank fails people keep on keeping on. Economic activity doesn't cease. If Greece fails, if French banks fail, people still need to work and buy to live. And they will!

It is not the relatively-small economies and stock markets of Europe that drive the world's great bull and bear cycles, but the massive economy and stock markets of the US. While Europe always has government spending and debt problems (as does the US), they only capture everyone's attention and dominate psychology after a major stock-market selloff. During these times, scared traders are looking for excuses to sell. They want to rationalize their fears, and worrying about Europe is a perfect opportunity.

Europe fears dominated US financial headlines in late 2008 during the stock panic, in early 2009 during its secondary lows, in mid-2010 during this cyclical bull's first correction, and now again in mid-2011 during its second correction. As the SPX continues rallying out of its recent correction lows, the intense Europe fears will fade from prominence as they always have after past Europe scares. Europe will continue muddling along as always, and European stock markets will continue following the SPX.

At Zeal we dig deeper than the headlines, working tirelessly to understand the big picture. Real-time news reflects prevailing psychology, nothing more. Weak stock markets spawn bearish news. But this is the time to fight the crowd and buy low, as popular fear leads to countless oversold bargains. We've been buying this bottoming aggressively, loading up on elite commodities stocks that are likely to soar in the coming stock-market upleg. These fear-driven buying opportunities never last long though.

Our contrarian approach has been wildly successful. Since 2001, all 591 stock tradesrecommended in our subscription newsletters have averaged annualized realized gains of +51%! You too can profit from our vast experience, knowledge, wisdom, and ongoing research. We publish acclaimed weekly and monthly newsletters that explain what the markets are doing, why, and how to trade them with specific stock trades as opportunities arise. Subscribe today and start thriving!

The bottom line is the recent Europe stock selloff has indeed been weighing on the US stock markets. The intensity of this European selling often taints pre-market psychology in the US, driving futures losses which linger into stock trading. But realize using Europe as an excuse to sell US stocks is merely a rationalization. Europe's perpetual woes only gain prominence after a big US stock selloff.

When scared traders are looking for an excuse to sell, Europe often conveniently provides one. But it is not the relatively-small European economies and stock markets that drive world equities, but the massive US ones. It is US stock sentiment and bull-bear cycles that determine where global stock markets are heading next, not Europe. And after the US's recent bull-market correction, a new upleg is highly likely.

Adam Hamilton, CPA

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Adam Hamilton, CPA, is a principal of Zeal LLC, which he co-founded in early 2000 as a pro-free market, pro-capitalism, and pro-laissez faire contrarian investing and speculating Information Age financial-services company. Hamilton is a lifelong contrarian student of the markets who lives for studying and trading them.

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