The Greek Crisis Will Rattle U.S. Stocks

At the end of last year, I suggested that a sovereign debt crisis could be the biggest investing danger of 2010. However, even as I highlighted the incipient Greek crisis -- which is playing out with increasing momentum -- I was underestimating its potential knock-on effect on U.S. stock prices. Investors should be aware of this dynamic.

The Greek canary in the financial coalmine
The unfolding Greek crisis has sparked the market's wholesale reevaluation of the risk associated with the debt securities of over-indebted sovereigns, including the U.S. Investors were slow to grasp the significance of the Dubai World and Greek crises as early warning signs of a much wider problem affecting advanced economies. Yes, the U.S. government has unmatched flexibility in terms of funding itself, but a fiscally unsustainable path, by definition, isn't infinite. Investors are finally coming around to that notion.

Higher Treasury yields, lower stock prices
As this process unfolds, investors are starting to demand higher yields to hold the massive amounts of Treasury bonds coming to market, raising the benchmark "risk-free" rate higher. Since the risk-free rate is the first building block in the discount rate that investors use to derive stock values, higher government bond yields imply lower stock prices. Or, as super-investor Warren Buffett explains: "If the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line."

A rise in U.S. government bond yields has other indirect effects as well. As bond yields go up, bond prices go down, producing losses on banks' bond holdings (see table below), which reduce bank capital ratios.

Company

U.S. Treasury Securities, Trading Assets & Available-for-Sale (Latest Quarter)

Citigroup (NYSE: C  )

$55.5 billion

Bank of America (NYSE: BAC  )

$38.3 billion

Goldman Sachs (NYSE: GS  )

$32.4 billion

JPMorgan Chase (NYSE: JPM  )

$16.2 billion

Morgan Stanley (NYSE: MS  )

$15.4 billion

Source: Capital IQ, a division of Standard & Poor's.

High-quality tilt, overweight international stocks
In this context, investors must be particularly wary of the prices they pay to own U.S. stocks. I recommend tilting one's U.S. stock holdings toward "high-quality" U.S. companies (such as 3M (NYSE: MMM  ) or Microsoft (Nasdaq: MSFT  ) ) and overweighting international stocks (developed and emerging markets).

Between high valuations and slow growth, investors should expect disappointing returns from U.S. stocks over the next several years. Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. 3M and Microsoft are Motley Fool Inside Value picks. Motley Fool Options has recommended a diagonal call position on Microsoft. Try any of our Foolish newsletters today, free for 30 days. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (14)

Comments from our Foolish Readers

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  • Report this Comment On April 12, 2010, at 7:26 PM, plange01 wrote:

    a butterfly can rattle US stockmarkerts nothing on earth is more full of fear than wall street! nothing..boo!!!

  • Report this Comment On April 13, 2010, at 5:18 AM, gerald325i wrote:

    This article provides an incomplete macroeconomic analysis: While it is true that higher treasury yields will have a reverse impact on US stocks, the impact could be more than offset by a gain in US exports: Because of a decrease of the Euro against the Dollar, US companies, especially in the area of software, services, microchips (Intel) and heavy machinery all are winners...to include Microsoft.

    Gerald.M, MBA.

  • Report this Comment On April 13, 2010, at 10:19 AM, ConsiderThis1 wrote:

    This article sounds like trying to find facts to fit a predetermined view.

    Not all increases in interest rates will cause a impact on US Stocks. It depends on the REASON for the increase and the magnitude of the increase as a surprise.

    You can't on one hand scream that the Greek crisis will cause sovereign debt crisis and a flight to quality; and then on the other hand, scream that (the current de-facto standard in global currency, the place that CB's run to when they're fearful, the USD/UST) will see a precipitous drop in demand and hence raise in interest rate. You can't have it both ways.

    Also, a moderate raise in interest rate, if it's for the right reasons (i.e. moderate decline in USD, or inflation expectation winning vs deflation, real capital being used up for growth and causing less of a glut or overcrowding into UST in general) is actually very positive and should cause a raise in US stocks.

    Interest rate relationship with the economy is not linear; and not even absolute. For example, a 1% interest rate can have multiple "flavors": (a) voluntary decline to 1% from 2%; (b) increase to 1% from 0.5%; (c) stay at 1% from 1%; (d) forced to increase to 1% to combat some crisis, and the market believes it's (i) enough, or (ii) not enough; (e) forced to decrease to 1% to combat some crisis, and the market believes it's (i) enough, or (ii) not enough.

    There are actually nearly infinite combinations; so it's futile to try to oversimplify this.

  • Report this Comment On April 13, 2010, at 12:41 PM, grant224 wrote:

    "The Greek Crisis Will Rattle U.S. Stocks"

    Maybe it would be wise to write more than a few paragraphs to back up such a powerful, albeit vague statement.. I suppose even Fool writers have quotas to meet..

  • Report this Comment On April 13, 2010, at 1:04 PM, RaulChapin wrote:

    ConsiderThis1:

    If you were to for one second think outside the box you might understand why the writer is saying what he is saying.

    What he is saying is not that the fear from the Greek collapse will push investors into the "security" of the T bills, but that instead, he thinks that investors might finally realize that the T bills are NOT 100% secure. By thinking that Greek debt can be a sample of what could happen to US debt, investors might want to be protected from the risk of debt default.

    The second part to the scenario comes from what gerald325i says. The drop of the dollar is an indirect reduction of salaries and other inputs in the USA thus creating a benefit for exporters.

    In the long run it would have other many benefits, as reduced salaries would mean a more competitive work force and less incentive to continue exporting jobs... however as an investor, the first think you would want to do is to move your wealth to a place that is secure from the temporary fall of US Stocks, or US Tbills, or US Bonds... after the initial crash happens (if it does happen) then you come back and buy US agresively because you then bet on the second part to the scenario IE the US coming back strong.

    I am not sure I would go overweight international stocks, as they might also fall rapidly if the US stocks do. Quality companies is an early bet to the second part of the scenario (IE the growth of the better companies at the expense of the death of the lesser ones) I would also be a little affraid of going into Gold as I fear it might currently be overpriced. I have been looking at going into other inflation protectors, such as perhaps metal mines, or even real state (baby steps into this alligator pool!!)

    Anyway, thank you Alex for the article, it is by no means complete, but investors should not need hand holding, instead we can take the idea and do our own analysis and scenario planning...

  • Report this Comment On April 13, 2010, at 2:03 PM, ConsiderThis1 wrote:

    RaulChapin:

    Please take a look at:

    http://www.fool.com/investing/international/2010/04/08/there...

    " there are only four currencies in the world today that meet the criteria: the U.S. dollar, the euro, the British pound, and the Japanese yen.

    Of that select group, the dollar is by far the most preferred denomination. According to IMF data, more than 60% of the world's foreign exchange reserves are based in dollars. The next most popular reserve currency is the euro, with a little less than 30% of reserves, though it's been gaining on the dollar in recent years as skeptics around the world begin to fear the U.S. government's accumulating debt and growing deficits. Far behind that are the yen and the pound, with less than 5% of reserves."

    Now the Greek's case showed everyone that the jig's up for Euro's, because it's revealed that EURO's 30% climb in recent years may have been overdone.

    Thus, back to the equation. If you don't like EURO as much now, you can choose GBP, YEN or USD. (and their respective treasuries) That's pretty much it if you're a risk adverse investor or a CB.

    I agree with you that Gold may be overpriced; as is ample other commodities too. Plus, as a central bank or big risk adverse fund, they can't really play these anyway. Plus, from a risk-adverse perspective, stock is inherently more risky than bonds, so we're still back to square one.

    I understood what the original author is asking, but he's not answering the question "to what other less-risky store of value". Also, a crisis in Greek debt (and hence knock off similarities in other EURO coutnries) doesn't hurt USD/UST directly, because in the order of risk and debt size (relative to GDP), we're actually pretty good.

    In a sea of bad, the least bad is the best bet.

  • Report this Comment On April 13, 2010, at 5:52 PM, nuf2bdangrus wrote:

    No it won't. Nothing rattles stocks. Everybody is bullish. Everybody is "all in". Volume is light. Selling is not permitted. Stock prices are national security. The market "knows" everything. But it BELIEVES that the government has its back. And it doesn. Until it can't. We don't know when that will be. But we know this. Shorting is a fools game.

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