Does Italy change anything?

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The S&P500 crashed under 2,700 support Tuesday following a political flare-up in Italy. A populist movement is taking hold that threatens Italy’s membership in the EU and common currency and these headlines were enough to send global markets into a tailspin. Losing one of the largest economies in the EU and euro could be a fatal blow to entire union. These headlines echo Grexit and Brexit of years past. While both of those past episodes avoided the worst, it isn’t hard to imagine the economic devastation a collapsing EU would cause and is why markets are understandably jittery.

Owning stocks is risky. There is no way around it. Last week the stock market was acting well and even negative headlines surrounding rate hikes, interest rates, trade wars, and North Korean tensions couldn’t dent this teflon market. But the thing about all of those headlines is they had been in the news for months and were largely priced in. Anyone who feared those stories bailed out months ago and were replaced by confident dip buyers who demonstrated a willingness to hold these risks. After a period of turnover, we ran out of fearful sellers and recycling old headlines stopped bothering the market. When no one is left to sell a headline, it stops mattering. There are few things more bullish than a market that refuses to go down on bad news. And that is where we finished last week.

But that was then and this is now. These Italian headlines are new and unexpected. Few saw this coming and if the crowd doesn’t know about something, then by rule it cannot be priced in. That is what makes these Italian headlines a far more serious threat to stock prices than rate hikes, interest rates, trade wars, and North Korean summits. Sometimes we can ignore the news, other times we need to snap to attention and take them seriously. These new and unexpected Italian headlines most definitely deserve our full attention.

While Italy’s departure from the EU would most definitely be disruptive, this is a binary, black swan event. Either it happens or it doesn’t, and the chances of it happening are extremely remote. We saw similar episodes play out with Greece earlier in the decade. The ramifications of a Grexit were frightening, but the risks were so great that political leadership in Europe ensured it didn’t happen. And what could have been a catastrophe turned into a fantastically profitable dip buying opportunity.

No doubt most money managers remember the fear mongering surrounding the Grexit and Brexit. And most money managers also remember selling that fear and uncertainty was a big mistake. Just like the boy who cried wolf too many times lost his credibility, I expect the same to happen here. The typical reaction on Wall Street will be “not this again” and most will discount it as another EU drama that ultimately isn’t worth worrying about.

These new and unexpected events usually take at least a few days to work their way through the system and we should expect headlines to flare-up over the next few weeks. But as bad as the worst case sounds, I expect most money managers will be more confident sitting through this uncertainty than they were during the Grexit and Brexit episodes. We could see further near-term weakness, but I don’t expect this to go too far and any dip is still buyable. This will be more of a blip than a crash. There is no reason to abandon medium and long-term positions, but a short-term trader could wait for things to get a little worse before jumping in and buying the dip.

Of course the above assessment assumes Italy doesn’t destroy the EU. All bets are off if this situation escalates to the point of no return. But we are most definitely not there yet. I still think this market looks good, but I would let this situation play out for a few days before rushing in and buying the dip.

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Jani

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