Over the last two years, we've feared that the debt woes of Greece, Ireland, and Portugal would infect the continent's larger economies -- notably France and Italy, the second- and third-largest economies in the eurozone. Unfortunately, as of this morning, the bond market provides strong evidence that at least one of these is a foregone conclusion, as Italian 10-year bond yields rose above the key 7% level on Wednesday.
The bond market as king-maker
For many equity investors -- myself included -- it's almost impossible to appreciate the overwhelming power of the bond market. One person who's not under a similar delusion is Bill Clinton. He feared the bond market's reaction to his 1993 spending plan so much that he abandoned it in favor of a balanced budget after uttering the now-infamous line: "You mean to tell me that the success of the economic program and my reelection hinges on the Federal Reserve and a bunch of [expletive] bond traders?"
A similar thing is now going on in Europe, as rising bond yields have led multiple countries to seek bailouts from the IMF and European Union in exchange for politically destabilizing austerity measures. Over the weekend, for example, Greek Prime Minister George Papandreou stated that he will resign his position as soon as a successor is named. And Italian Prime Minister Silvio Berlusconi pledged yesterday to step down after his country's Parliament approves a series of austerity measures.
The point of no return
The problem that Greece and Italy face is quite simple. Both have inordinately high levels of debt relative to their GDPs. And both continue to run large fiscal deficits, meaning that their governments spend more each year than they receive in revenue. To avoid default, in turn, Greece and Italy must have access to reasonably priced credit via the bond market or they must seek a bailout from outside of their borders -- a measure Greece has already resorted to.
And when does credit become too pricey? Well, if the recent past is any guide, the line in the sand appears to be 7%, for it was at that point when Portugal and Ireland were forced to seek financial bailouts from abroad.
So what does this mean for investors?
If your name is Ayn Rand or Alan Greenspan -- or you otherwise believe in the efficient market hypothesis that current asset prices accurately reflect all available information about future events -- then you should carry on as usual, as the possibility of an Italian default is already priced into the stock market according to this theory. Also, you may be interested in some amazing swamp land that I'm selling in Kansas -- while it isn't as magical as John Galt's hidden valley in Atlas Shrugged, you can't beat the price!
If you're a mere mortal like me, however, and you don't believe in the efficient market hypothesis, there's two ways to play this. For those of you with high risk tolerances, financials like Bank of America (NYSE: BAC), Morgan Stanley (NYSE: MS), and even regional bank Huntington Bancshares (Nasdaq: HBAN) have gotten beaten down due in part to fears about Europe, with all three stocks trading at less than book value -- B of A for less than a third! But B of A and Morgan Stanley have said that their exposure isn't big enough to justify those concerns, suggesting that investors are overreacting.
For those of you with low risk tolerances, I suggest taking advantage of the market's current pessimism by locking in high dividend yields. My two favorites in this space are Waste Management (NYSE: WM) and Philip Morris (NYSE: PM), with dividend yields of 4.3% and 4.5%, respectively. It's tough to imagine consumers abandoning either of these companies in the near future regardless of how bad things get in Europe or even here at home.
The only thing I would caution against in this regard is chasing dividend yields that appear too good to be true, as they just may be. Annaly Capital Management (NYSE: NLY) and Chimera Investment (NYSE: CIM) provide two such examples. While these real estate investment trusts pay ridiculous dividend yields of 14.6% and 17.1%, respectively, I've discussed in the past how these yields communicate a risk level that's too high for the average investor.
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