Europe: Most Traders Are Overweighting Markets

Every day US equity investors awaken and check futures trading and the latest news from Europe. What might seem like small tidbits of information have major effects on the total market cap for US stocks. It may not make sense, but it is the reality.

In this environment, it is important to ask: Whom do you trust?

The answer is more elusive than we might think.

The chief candidates are the following:

• The market
• Political leaders
• Bank executives
• Leading analysts, pundits, and bloggers
• Rumors

Maybe I missed something, but that should get us started.

Yesterday's market action showed the problem. Mark Gongloff's prolific blogging at the WSJ kept you on top of the twists and turns. The market rallied on early comments from Treasury Secretary Geithner offering a guarantee against a Lehman-like event in Europe. There was then selling because of a report that Austria had rejected expansion of the EFSF. Then we had a rebound when it was only a delay.

Get ready for months of this, as the 17 different legislatures consider the EFSF, the ECB deliberates, the IMF ponders, the G7 and G20 consider..... well, you get the idea.

If you are a long-term investor, the volatility represents Mr. Market offering you a chance for good prices -- assuming that you are not in the end of the world camp.

If you have a shorter time horizon, or have genuine worries about the financial system, you need to know whom to trust.

My Handicapping

Here are a few thoughts on each of the sources you might consider.

• Markets. Should we accept the verdict of the market on Europe --- the high credit default swap rates, etc? Is Greece definitely going to default? Here is the dilemma. Everyone pointing to the market as the ultimate source on this is a liar. If you asked them if they believed markets were efficient, they would say "no." Otherwise they would have no job. All of us get edge by finding market mistakes. So pointing to the markets on this one occasion is hypocritical, self-serving and inaccurate. It is confirmation bias in action. Furthermore, I believe (but cannot prove) that the CDS market on European sovereigns and banks is relatively thin in relationship to what some can make by shorting the banks. This is not like 2008. We do not have an AIG selling CDS instruments with no collateral, so the price can be driven up more readily. Then you email David Faber to make sure that he reports the bad news.
• Political Leaders. Should we accept the statements of political leaders? We all know that they are trying to maintain confidence. We also know that there are no guarantees. When the Geithner news came out this morning, CNBC reported from both Rick Santelli and Bob Pisani -- veteran floor observers. No one on either floor believed Geithner! Here is the dilemma. We all know that it pays to be contrarian. Maybe everyone is too skeptical. The collective memory of the Street is sketchy and simple. For proof, do you really know what Bernanke said when he talked about subprime being "contained?" If you do, you are one in a thousand. Most people just accept the Wall Street Truthiness. When it comes to this subject, no one is a contrarian. It is "smart" to dis the politicians.
• Bank Executives. In 2008 we saw a number of statements from executives that proved to be inaccurate. They could have been lying, mistaken, or inaccurate in their expectations about upcoming behavior. Most of them did not see the collapse of short-term lending and the aggressive impact of FASB 157. Is there a lesson? What I do is to listen carefully -- very carefully -- for specifics. I consider the overall exposure to dubious lending, the acknowledged level of markdowns, and the reliance on short-term fund sources. Most traders reject corporate executives because they have "learned the lesson of 2008." This is a gross oversimplification. There is a legitimate concern that this is a crisis of confidence, so we need to evaluate each statement on the merits.
• Pundits. Hooray! Here is our chance to shine. Anyone who can parse the information and avoid a knee-jerk reaction adds value.
• Rumors. Forget them! Enough said.

Conclusion

Most traders and pundits are wrong about Europe because they are over-weighting markets and under-weighting information from political leaders. This is not black and white, but it is a dark shade of gray.

I expect that there will be some European solution that will drag out, displease many, and consist of a patchwork of plans. My trader friends think in simple heuristics and binary solutions, so they will not see this coming. It is a classic wall of worry, playing out over months.

Since I mostly focus on US equities, I have a second line of defense. There is really no evidence of a US risk, other than the fact that stocks have declined.

Investment Implications

The most aggressive play would be European banks, but this does not fit my risk/reward criteria. You can get plenty of leverage on this situation with US stocks, especially financials and those perceived to have European exposure.

I hold JPM and MSFT, as two good examples.