Euro Contagion Is Like Swine Flu

People are freaked out by euro contagion even though the underlying threat is normal and expected.
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) -- How should investors reconcile the current environment?

The Argument for Continued U.S. Recovery

After the market's two-and-a-half month climb in February, March and April, it was due for a technical pullback in May. When the market is ready for a selloff it will find any reason to justify the action. This month it happened to be Greek debt contagion and the uncertainty of US financial reform. The reality of the eurozone crisis is summed up nicely by St. Louis


President James Bullard. Here are a few excerpts from his recent

speech in London :

"A new threat to global recovery is looming in the form of a sovereign debt crisis in Europe. In part as a response to the global recession, countries have now moved to larger levels of deficit spending and have accumulated higher levels of debt. The ability and willingness of some countries to repay has been called into question.

There are several reasons why this new threat to global recovery will probably fall short of becoming a worldwide recessionary shock. To begin with, this is a question of sovereign debt, and sovereign debt crises have been with us for many, many years. There is nothing intrinsic about such crises that they need to become important shocks to the broader, global macroeconomy. Countries do default or restructure their debt from time to time, and the world goes on.

Governments have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture. Because these too-big-to-fail guarantees are in place, the contagion effects are much less likely to occur. "Too big to fail" is a controversial policy, but it does have its upside in the current situation.

Let me also stress that the current agreement in Europe does buy substantial time for European governments to enact fiscal retrenchment programs. It will take time for those programs to be enacted and to gain credibility with financial markets. This is a process that will probably play out over years, not weeks. The U.S. may actually be an unwitting beneficiary of the crisis in Europe, much as it was during the Asian currency crisis of the late 1990s. This is because of the flight to safety effect that pushes yields lower in the U.S."

The remedy to the market correction will arrive when stock prices reach levels that compel investors to buy. Because the root cause of the correction is technical in nature the root solution will follow suit and investors will buy when we reach technically oversold levels. Early signals of recovery are witnessed by hedge fund activity like we saw on Monday when


(AAPL) - Get Report



(GOOG) - Get Report

, and


(BIDU) - Get Report

were driven up by the hedge funds on a down market day.

This 'slingshot' behavior among market leaders will propel the rest of market up, which will allow the media to ditch their obsessive coverage of insignificant countries like Greece and Spain as they refocus on the strength of the $14 trillion U.S. economy. As the unquestioned stock market leader, Apple's international release of the iPad on May 28 and Steve Jobs' keynote on June 7 could be the slingshot catalysts to rescue the market from its technical despair.

The Argument for European Contagion

If the root cause of this market correction truly is European debt contagion then the market will be in for a terrible finish to 2010. Any long term crisis that originates within the financial sector will end up crushing the entire market. The anti growth austerity measures combined with stock market raids on the European banks will produce a loss of confidence that results in a double dip of the global recession. The market won't quit its correction until it gets European Union reform. The necessary reforms are summed up in today's

Financial Times

article titled,

How to Cure the Euro's Ills. The important soundbites are as follows:

"Binding former enemies together in a common currency was Europe's historic political achievement. Today those ties are being tested as never before. If its leaders want the euro to survive, they must forge a new political bargain in place of the one that made its birth possible.

A new political bargain must be forged to maintain support for the monetary union. This requires a level of statecraft not yet seen from EU leaders. Their management of the crisis has been faltering; their understanding of its nature inadequate. Visceral opposition to International Monetary Fund involvement hindered decisive action on Greece.

Greece must be made safe to fail, first, by preparing the ground for orderly restructuring if the IMF programme fails, as Germany's finance minister, Wolfgang Schäuble, has proposed. Second, contagion to other sovereigns must be sealed off as much as possible.

If the eurozone cannot strike a grand bargain, countries will act in their self-interest to avoid the lethal cocktail of stagnation and belt-tightening. They will push for inflationary policies, nationally or through the common monetary policy, either way undermining the ECB's independence. If it gives way, the euro will truly be in jeopardy. To head off such a calamitous failure is the foremost responsibility of eurozone leaders.


Investors are wise to be in cash as the two scenarios duel for market supremacy. Because Europe's problems are still moving the market, we are adding a 2.5% allocation of EUO to the ETF portion of the portfolio. Owning the EUO, UUP and GLD along with 56% of the portfolio in cash is a good position to be in as we continue to watch the situation unfold. Monday's hedge fund attempt to 'slingshot' the market to recovery will be tried again. I am definitely in the camp that argues for a continued U.S. recovery which causes me to view the current market action as a wealth building, buy on the low, opportunity.

However, I will not act irrationally because the contagion fear continues to plague the market in the same way that the threat of swine flu scared the vaccine industry. People are freaked out by the label even though the underlying threat is normal and expected. Greece and Spain both have ample time and liquidity to take care of the crisis. We await the opportune moment to safely put our cash back to work in this improving U.S. economic environment.

At the time of publication, Schwarz was long AAPL, EUO, GLD and UUP.

Jason Schwarz is an option strategist for Lone Peak Asset Management in Westlake Village, Calif. He is also the founder of the popular investment newsletter available at Over the past few years, Schwarz has gained acclaim for his market calls on the price of oil, Bank of America, Apple, E*Trade, and his precision investing in S&P 500 option LEAPS. His book, The Alpha Hunter, is set to be released by McGraw Hill in December 2009.