Europe’s Safe Havens Are History

Like I told you last month, European unity was always an illusion. Now the crisis is entering a new and more ominous phase.

What about Greece? Whether you call it “default” or something else, the facts are the same: Greece and other nations cannot repay their debts. That money doesn’t exist anymore. It’s gone.

I expect more twists and plenty of market action in the coming weeks. What should ETF investors do? Short-term trading is extremely difficult in this environment, but here are some points to remember …

Point #1:
The Euro Currency Is
at a Crossroads

Europeans are facing an uncomfortable truth: They can’t have a common currency and independent governments! Incentivizing weaker nations to spend while sticking stronger ones with the bill is not feasible in the long run. The European Union has to either get much stronger — or disappear completely.

A resurrection of the mark and franc is a distinct possibility.

What would a stronger union look like? In practice, it means Germany and France take charge of Greece, Italy, Spain, and everyone else. In that scenario the euro could conceivably survive, though it would probably face a sharp devaluation.

The more likely outcome is for the euro zone to break apart, followed by a return to local currencies. It will be a messy process. The 1999 conversion to the euro took years of negotiation and planning. Reversing it all in a hurry will be neither clean nor simple.

For ETFs, this introduces yet another element of risk to already-weak European stock markets. In the long run we will likely see some amazing buying opportunities. But meanwhile, look for capital to seek stability elsewhere.

That brings us to …

Point #2:
No European Stock
Market Is Safe

As recently as a few months ago, it looked like parts of Europe might be able to avoid the financial contagion. Eastern European and Northern European markets seemed relatively appealing.

ETF sponsors — always quick to jump on a trend — responded with offerings like iShares MSCI Poland (EPOL) and Global X FTSE Nordic 30 ETF (GXF). These seemed like a good way to stay involved in Europe while the Mediterranean nations sorted out their problems.

Unfortunately, even nations that had stayed out of the euro (like Switzerland and the U.K.) found themselves caught up in chaos. Poland, Norway, Sweden, the Baltics — none have been immune.

We may see some of these peripheral markets begin to recover before the worst-hit areas. That’s why I still watch them all. As of now, though, I don’t see much upside anywhere in European equities.

Point #3:
Inverse and Leveraged ETFs
May Not Work Like You Think

Europe turned out to be far more integrated than even the most enthusiastic euro-boosters imagined.

Inverse ETFs that gain value when a benchmark index falls probably sound like a great way to trade Europe right now. Maybe, but I have a couple of warnings …

First, recall what I said above: Short-term trading is very difficult right now. An inverse ETF can do just as much damage to your portfolio as a long ETF if you move a day early — or a day late. Your timing has to be near-perfect.

Second, all inverse and leveraged ETFs depend on derivatives to achieve the desired market exposure. That means counterparty risk, as I explained in Three Often-Overlooked Risks of Inverse ETFs.

Under normal circumstances, I don’t worry too much about counterparty risk. In this situation — with major banks on the edge of collapse and the currency itself probably unraveling — it’s probably a good idea to think twice. You don’t want to own a fund that zigs when you expected it to zag.

Counterparty risk is especially high in exchange traded notes, or ETNs. Be particularly wary of those issued by UBS, Deutsche Bank, and other European banks. For more information see my 2009 column, Why ETNs are Riskier Than They Look.

What’s the Best Bet?

Very few traditional asset classes, European or otherwise, look bullish right now. The U.S. dollar and short-term Treasury bills are the most liquid safe havens, but don’t expect much yield.

In terms of actual growth, at this point gold has more momentum than anything else and is still a cornerstone of the defense plan for my International ETF Trader subscribers.

My concern there is that we could see a sharp correction from recent gains, so you have to be ready to move fast. If you want to take the plunge anyway, SPDR Gold Trust (GLD) and iShares Gold Trust (IAU) are the most popular gold-based ETFs.

Best wishes,

Ron