Since the Olympics kicked off, markets have been on a bit of a tear.
But it’s not because investors all loved Danny Boyle’s opening ceremony. It’s all down to a central banker, once again.
You’ve heard of the “Greenspan put” and the “Bernanke put”: the way that markets can always rely on the US Federal Reserve chief to cut interest rates and prop up stocks.
Now investors are betting on the “Draghi put”.
Last Thursday, European Central Bank (ECB) chief Mario Draghi promised that he’d do ‘whatever it takes’ to save the euro. This Thursday, he gets the chance to prove it, as the ECB governing council meets to discuss what to do.
But can he live up to expectations? And what happens if he doesn’t?
Draghi Has Three Options
There are loads of things Mario Draghi could do to “save” the euro. But it all boils down to three options.
He can stall for yet more time, talking a big game, but waiting and hoping for the politicians to agree among themselves on a more permanent solution. Trouble is, after his big build up last week, this would send markets into a swoon. And the ECB has been trying to push the politicians to do more for several years now, and it hasn’t worked yet.
His second option is to put another sticking plaster over the problem. It can be a big plaster or a small one. The point is, it’s temporary. So we’re talking about another batch of LTRO (a limited form of quantitative easing), or promising to buy a set number of Italian and Spanish bonds.
That’s all fine. Markets might rally further, or they might not, depending on the size of the plaster. But it’ll wear off eventually. Because if the intervention has a specific, limited size, then the market will wait till the money is used up, then start panicking again.
His third option is to go for a solution: unlimited intervention. In other words, he prints money and uses it to put a cap on eurozone bond yields. That would cause a major rally, as it would be the full-blown European equivalent of quantitative easing.
There would be further problems down the road, but we can discuss them in more detail if it comes to that.
So what’ll he do?
Europeans Want the Euro
It boils down to politics. We’ve said it before, and we’ll say it again: whether or not the euro survives is a political question.
The majority of voters in eurozone member countries still seem to want to hang on to the euro. Psychologically, this makes sense. The tougher times get, the less people are prepared to deal with yet another potentially traumatic change.
You just need to look at Greece to see this. The Greeks backed away from full-blown rebellion against austerity when they realised it might cost them the single currency. The Irish acted similarly back in 2008 and 2009, when their crisis was at its height.
The small “peripheral” countries view the euro as a badge of respectability. It’s a sign that their small, sometimes highly dysfunctional economies have earned a seat at the table with the big boys and girls.
So the eurozone’s members all still want the euro. The real problem lies in the type of euro they want. The Germans and their allies want a “hard” euro, while the Greeks and the other peripheral countries want a “soft” euro.
You could spend weeks, months, years debating the rights and wrongs of all this. Indeed, that’s all the comment sections of the financial papers have been doing during that time.
But that’s not much use when it comes to figuring out how to make money out of this situation. And nor is second-guessing the action of the ECB, because in reality, none of us can predict with any confidence how this will turn out.
Europe is Cheap
But here’s the good news: you don’t have to. In the long run, it doesn’t matter what Mario Draghi does from an investment point of view. Europe is cheap.
Yes, there may be a fair bit of trauma ahead. One or more countries might leave the euro. Maybe the euro itself will be dismantled. But Europe is cheap.
If you buy assets when they’re expensive, you have to cross your fingers and hope for perfection. Most of the time, it doesn’t work out, because expensive markets eventually get cheap again.
But if you buy assets when they’re cheap, it gives a lot of room for bad things to happen. If markets are priced for an apocalypse, you only need to muddle through for things to look a lot brighter.
We’ve been banging on about the Shiller p/e – which looks at how cheap or expensive a market is compared to long-term average earnings – for a while now. But I recently read a fascinating paper by Joachim Klement of Wellershoff & Partners that looks at just how effective the ratio is.
To cut a long story short, Klement finds that while the Shiller p/e isn’t particularly effective over the short-term, once you get to time horizons of five years or more, it becomes very effective indeed.
In other words, if you buy a market when it’s cheap based on the Shiller p/e, there’s a good chance you’ll make a decent return on a five-year basis. And if you buy when it’s expensive, your returns won’t be so good.
His conclusion? Just now, the best bets among global markets are European countries. They ‘promise very high real returns over the coming years that should be significantly higher than historic averages.’ By comparison, the US and most emerging markets look expensive.
John Stepek
Contributing Editor, Money Morning
Publisher’s Note: This article originally appeared in MoneyWeek (UK).
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