If Europe Is Imploding, Why Are European Stocks Up?

By Sasha Cekerevac for Investment Contrarians | Aug 14, 2012

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With economic data coming out of Europe continuing to show that the financial crisis is not ending anytime soon, why are stocks in Europe moving up? There are several reasons that you should be aware, as investor sentiment can change quite quickly.

If we look at the yields for bonds in troubled nations, such as Spain, Portugal, and, of course, Greece, the market-based evidence shows us that the financial crisis is still as present as ever. No new initiatives or solutions have been formed and implemented, but the investor sentiment for the equities market has changed since the end of June, partially because of anticipation of additional stimulus by the financial authorities in Europe to try and prevent the spread of the financial crisis.

As spring moved into summer, investor sentiment turned negative, as institutions betting on a downfall of European equities increased, as seen by the number of funds that went short. Selling short occurs when investor sentiment is negative, and an investor then borrows shares and sells them first, hoping that the price will decline, at which point, they can then buy the shares back and profit from the decreased price. If the share price increases, then short sellers would incur a loss.

According to research firm Markit, the number of shares loaned out from the STOXX Europe 600 Index decreased from 3.4% in May to 2.9% at last count. This reduction in short sellers can be seen by the higher price, as investor sentiment has shifted away from being completely bearish. In the middle of the current financial crisis, millions of shares sold short were bought back by funds.

This change in investor sentiment is not, in my opinion, based on positive economic news. In fact, with the financial crisis still ongoing, this reduction in short bets is the result of investor sentiment focusing on the belief that a new wave of financial stimulus (money printing) will soon be unleashed. Regardless of what one may think of an economy, it’s foolhardy to stand in front of central banks when they unleash a torrent of fresh funds.

Chart courtesy of www.StockCharts.com.

 The STOXX Europe 600 Index is comprised of 600 firms spread over 18 nations in Europe. This index does a good job at representing the investor sentiment for equities across Europe, as it’s not just concentrated on the nations that are the most severely hit by the financial crisis.

The latest move up coincides with a comment from Mario Draghi, the President of the European Central Bank (ECB), that the Euro will be defended at all costs. With a move up of over 12% in just a few weeks, this investor sentiment shift is clearly not built on economic fundamentals, as most analysts, including myself, believe that the financial crisis will spread and engulf the continent into another recession.

One strategy that I would consider is keeping my ammunition dry and waiting for the next move by the ECB. At that point, we can better judge if their policy initiatives have a chance at reducing the possibility of a financial crisis escalating, or more likely investor sentiment shifts once again to selling European equities. We might be witnessing a classic “buy on the rumor, sell on the news” market. Once the ECB comes out with the news of their policy maneuvers, the investor sentiment will most likely shift again.

Tags: Europe, financial crisis, investor sentiment