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.

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.