Contrarian trades can be profitable when an asset is down and out, but after a major rally it pays to refocus on the risks. Right now, European financial stocks provide an excellent case in point.
Long one of the most beleaguered groups of stocks, European financials have become a source of high-powered returns since European Central Bank chief Mario Draghi’s late-July statement that the ECB would do “whatever it takes” to save the eurozone. How high-powered? Since the July 24 low, the iShares MSCI Europe Financials Sector Index Fund (NYSE:EUFN) has registered a gain of 31.3% — trouncing the the Select Sector SPDR-Financial ETF (NYSE:XLF) (+10.0%), the S&P 500 (+3.6%) and the MSCI EAFE Index (+11.9%).
Does this mark the beginning of a longer-term rally in this group, or is it just another head fake?
If this rally is indeed only a short-term move, it wouldn’t be the first time: Since its inception in February 2011, EUFN has registered 20%-plus gains on four separate occasions. In all cases, the rallies ended in disappointment.
The reason for this should come as no surprise: While investors periodically find reason to hope that the crisis is averted, thus far the “solutions” have largely been just short-term fixes. And in each instance, European financials have given back their gains once the bad news begins to trickle out again.
In this sense, the sector’s performance has been driven almost entirely by sentiment regarding the debt crisis rather than traditional considerations such as valuations and fundamentals.
This is exactly why investors need to be extremely wary of European financials here. While the crisis has been largely out of the headlines in recent months due to the U.S. elections and the subsequent discussions about the fiscal cliff, in reality not much has changed. Greece’s debt problem hasn’t gone away, and the country remains at high risk for a default and an eventual exit from the eurozone.
Spain, Portugal and Italy also remain in perilous shape, but the problems aren’t limited to the periphery. Last week, the Center for Economic Policy Research announced that not only is the region in a recession, but that it has been so for over a year now. Even economies that have been relatively immune from the crisis so far — such as Germany and the Scandinavian countries — are beginning to show cracks. And late Monday afternoon, after the market closed, Moody’s stripped France of its AAA rating.
In short, the underlying trend remains a vicious circle of rising public debt and slowing growth even as various policy initiatives have boosted market sentiment from time to time. Once the crisis inevitably works its way back into the headlines, financial stocks will be more at risk than any other area of the European markets.
The sector has another factor working against it: the impact of the euro. While the currency is still well off its July low, it has been sliding for two months and has been in an uneven, but persistent, downtrend for five years (see chart of the CurrencyShares Euro Trust ETF [NYSE:FXE]). The euro remains much closer to its lower support level than European financials, and a breakdown in the currency would exert a heavy toll on the region’s equity markets — and take financials along with it.
With this as the backdrop, there’s no reason to rush in and buy European financial stocks right now. The most likely scenario is that investors will be able to pick up shares in the group at a better price in the months ahead. At some point, the true long-term survivors in this sector — such as HSBC (NYSE:HCB), Banco Santander (NYSE:SAN), Barclays (NYSE:BCS) and ING (NYSE:ING) — will represent outstanding long-term buys. But as long as other shoes are left to drop in the region’s debt crisis, the risks outweigh the potential rewards.
In the meantime, investors can use EUFN as a way to track sentiment regarding the debt crisis. The ETF, currently near $18, has traded in a range from $13.50 to $19 in the past year-and-a-half. A move above $19 — aside from signaling that the note of caution set forth here is incorrect — could be a powerful indication that another up leg in the global markets is in the offing. So keep a close eye on the sector, just take care not to jump in at current levels.