Don’t Let the Stock Market Rally Fool You: The Euro Hasn’t Been Fixed

Last week’s attempt to prop up the European common currency probably won’t work for long – and when it goes, U.S. stocks will feel the pain.

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Over the past few days, European central bankers have worked frantically to keep the common currency together. And, indeed, they’ve bought some time. As a result, the U.S. stock market has rallied, enjoying its best week since early July. At the moment, U.S. stocks are being driven chiefly by concerns about the euro and its potential effect on the soundness of banks around the world.

But don’t let this market rebound fool you: The euro is still fundamentally unsound and likely to start unraveling again. When it does, U.S. stocks could suffer a big selloff.

I described the euro’s problems and the possible outcomes last week, so I won’t repeat all that. But essentially, the euro links two groups of countries whose economies are growing at very different rates. It’s like a circus rider standing on two horses, with a foot on each saddle. Now imagine that one horse slows down, while the other one doesn’t. The rider won’t stay upright for long.

I’m not going to pretend I can time the market. But there are a few objective factors that suggest what might lie ahead. Basically, the euro can hold until the weaker countries have so much debt to refinance that the stronger countries can’t – or won’t – come up with the cash needed to help them.

(MOREIt’s Time to Admit the Euro Has Failed)

A Greek default now seems widely taken for granted. The only question is how it will happen and how destructive it will be. The far greater worry is Italy, a country that may be too big to bail out. The U.K. Telegraph figures that Italy has to roll over 62 billion euros of bonds by the end of September, while Canada’s Globe and Mail says 46 billion. Either way, it’s a lot. And of course, no country is thrilled about being asked to subsidize difficult refinancings. The least thrilled is Germany. However, the small countries are becoming increasingly resistant, too. How quickly the resistance will build is anyone’s guess, but the trend is clearly toward less solidarity.

Finally, let’s not forget that the U.S. faces its own financial disruptions later this year. The so-called debt super committee – a dozen members of Congress who are supposed to agree on at least $1.2 trillion in deficit reductions by late November – is already off to a contentious start. Will there be a repeat of the recent debt ceiling crisis in the runup to Thanksgiving? It’s certainly not out of the question.

Jumping in and out of the stock market is generally a bad idea, but that doesn’t mean you shouldn’t factor the economic calendar into your portfolio decisions. I’ve taken advantage of last week’s rally to sell a couple of things I’ve been wanting to get rid of anyway. And I’m slowly accumulating cash reserves to take advantage of opportunities in any big selloff. I think the odds are high there will be one. But if the banking crisis two-and-a-half years ago is anything to go by, the bargain prices won’t last for long.