Friday, December 2, 2011

What’s Europe Got to do with It?

My partner, Don, is a really good investor. He began saving money as a child, with his first job, a paper route. And over the years, he has actively participated in his previous companies’ 401k plans, and later, his self-administered IRA.

Today, he is a successful, self-taught, investor, focusing his investments on fundamentally strong companies in growing industries. He has never worried too much about market volatility or cycles, since he was investing for the long-term—until now.

Lately, he’s been on a tear, ranting about the incredible volatility that U.S. markets have been experiencing, as a result of the European debt crisis—and how that volatility is impacting his portfolio. He plainly states, “I don’t care about Europe, and even less about Greece, and I don’t understand why what goes on 5,700 miles away can so violently disrupt our markets!”

I hate to be the bearer of bad news, but I told him, “get used to it!”

Just as the old “buy and hold” strategy for investing has gone the way of dinosaurs, investors must realize that expecting the U.S. stock markets to continue behaving as if we are the only game in town is also an extinct proposition.

Although the Greece economy is ranked 39 in the world in terms of GDP purchasing parity, and contributes just 2% of the European Union’s GDP, investors’ biggest concern with the possibility of a Greek debt default was “contagion”—the fear that Greece’s problems would spread to the rest of the European Union.

And that’s no small concern. The PIIGS (Portugal, Ireland, Italy, Greece and Spain) have all been suffering similar debt distress. And now that Greece’s problems—at least temporarily—seem to be on the mend, the focus is now on Italy and Spain. Those two countries make up about 20% of the GDP in the European Union. Should their situations worsen, the impact will rollick U.S. markets much more than Greece’s problems!

That’s because the U.S. has considerable exposure to what is going on in Europe’s financial crisis. The U.S. is now the second largest economy (after the European Union), according to the CIA Factbook, CIA - The World Factbook, and our economy is closely tied to Europe’s:

·       Our largest trading partner, is guess who—the European Union. Folks in Europe purchase about 14%, or $1.3 trillion in goods and services, from our country’s largest 500 companies every year. Any slowdown in employment across the sea impacts consumer spending which, in turn, affects the profits of the companies in the U.S. who sell into Europe.
·       The U.S. owns approximately $18 billion of Europe’s sovereign debt, which is not a huge number, relatively speaking, but any defaults would have an effect on U.S. investors
·       U.S. ownership of private sector European securities is about $70 billion, so any ratings downgrades or bankruptcies due to credit problems will affect the prices of those securities, reducing the gains and increasing the losses to U.S. investors
·       According to Fitch Ratings, some 50% of the assets of the top 10 prime money market funds in the U.S. are invested in European bank securities, which could create enormous problems and even failures at the funds, should the European bank crisis worsen

And with growth forecasts of just 0.05% for the Eurozone next year, it’s no wonder that investors are concerned with the Europe’s financial woes.

So What’s an Investor to Do?

My advice to Don and to you is threefold:

I recommend that you limit your exposure to multinational firms with a large portion of their sales to European countries to a small portion of your portfolio at this time. The same goes for your mutual funds and exchange-traded funds.

My research tells me that the sectors that will be most affected by the crisis are retail, technology, pharmaceutical and medical supplies. You can look in your companies’ 10K to find out just how much exposure they have to Europe and to these sectors.

I am still a believer in investing for the long-term, but I also believe in protecting your portfolio, which, in today’s markets, requires a strategy that includes global considerations, a more-frequent monitoring of your holdings, and buying and selling your stocks more often.

My years of experience have shown me that you can’t fight the market. No matter how good the company is in which you invest, extrinsic factors can deeply affect its valuation. If the momentum is going against your stock, you can almost always expect it to continue for awhile, so just cut your losses and get out. You can always buy back in when the scenario improves.

And very importantly: Most investors will sleep better at night by utilizing stop-loss protection, ranging from 30% for aggressive investors to 10%-15% for more moderate and conservative folks.

Right now, the markets are having a good week, but remember, we live in a 24/7 era of news coverage, and no matter if that coverage is often lacking in facts, steeped in rumors or over-exaggerated, it still affects the actions of nervous investors.

So, rule #1—protect yourself!

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