How do you un-bake a cake?

NASDAQ daily @ 12:51 EDT

The market is finding modest support after the recent sell-off.  It opened higher, but has since retreated from the opening levels.  Even for the bull these up-days should be met with skepticism since it takes four days to confirm a rally.  If a person counts a down-day with an upside reversals as a rally attempt, today’s price action would only be day two.  With that in mind, any bull should wait for the confirmation before jumping on any potential rebound so they don’t get caught up in a suckers’ rally.

It is interesting to hear experts talk about Greece pulling out of the Euro.  I find it shocking that experts actually think this is a realistic possibility.  Everything is so intertwined it would be like trying to separate the sugar, flour, and egg from a baked cake.  It just can’t be done.  Since everyone’s bank deposits, loans, and salary is currently based on the Euro, how do you decide what money gets converted to Drachmas and what stays in Euros?  What if a Greek homeowner took a loan from a Spanish bank?  Euro or Drachma?  And even between a Greek borrower and a Greek bank?  Is the bank really going to keep the same interest rate between a Euro loan and a Drachma loan?  And for depositors, you’d be crazy to leave your money in a bank that will convert Euros to Drachmas.  Knowing that, everyone will cash out their savings and the banks will implode because they don’t have the reserves to let everyone cash out.  If you hear anyone mention Greece pulling out, that is a sign they just don’t understand what they are talking about.

The far simpler remedy is to preserve the Euro and have rest of Europe to pay Greece’s debts, or alternately let Greece go bankrupt and walk away from their debts.  And of course this might need to be repeated for most of the PIIGS, but hey, that is what money printing presses are for.  Its worked well for the US so far, so why not Europe too?  The funny thing is how opposed Germany is to money printing.  As one of the largest global exporters, a weak currency would benefit their export economy as it becomes more competitive globally.  Who would buy a Ford if you could get a BMW for the same price?

Anyway, there is a lot more to this story and it will play out over the next year.  The thing for the investor to be wary of is how this will effect sentiment and prices.  The rally over the last 6 months occurred because the markets largely discounted the Euro crisis as old and inconsequential news.  The rally in effect removed the risk premium associated with the Euro mess.  So where does that leave us right now?  With the risk premium taken out, that means a positive resolution will have little impact since it has already been accounted for.  But a Euro crash landing could hit the markets with a 50% haircut if the worst plays out.  Taking this into account, the Euro crisis effect on the markets ranges from +0% to -50%.  And for the +0% event to occur, it would require a very civil, orderly, and quick resolution to the problem.  Something that is highly unlikely to occur. Looking at those odds, it seems like the risk/reward is not in the bulls favor and they should proceed with extreme caution.

But don’t get me wrong, I’m not predicting doom and gloom for the global banking system or economy.  There is little reason to expect the Euro will unwind the global economy and I fully expect a reasonable resolution to this crisis, but the market will fret over the risk and this will pressure equity prices over the near-term.  Success for a trader is not about making economic predictions, but anticipating how other traders will react to the renewed uncertainty.

How I expect this to play out is the new leaders in France and Greece will make lots of noise to appease the base that pushed them into office, but once they come to the nitty-gritty details of hashing our a resolution with the rest of Europe, they’ll come to a similar conclusion as their predecessors because any other outcome will be even worse.  As we’ve seen in this country, it is far easier to criticize and make promises as an outside challenger than it is to lead and take responsibility for the outcome.  It will take some time for reality to set in for these new govts, but at this point they have little other choice.  But the period between now and then will be filled with landmines for the markets just like it was last summer.

Anyway, back to the markets and how to trade these insights; most likely any strength should be used as an opportunity to get out or initiate shorts.  Wait for the market to get overly bearish before looking to get back in.  And of course we might already be at that point if there are too many people with views like myself.  If that is the case, we could bounce any time now.  But either way, I’d rather be late than risk getting in too early.  Profit opportunities are like a city bus, if you miss one, another one will be along any minute, but losses are forever.  A similar saying, it is better to miss the bus than get run over by the bus.

Stay safe.