Why US Stocks care about Europe

"On a long enough timeline, the survival rate for everyone drops to zero." – Tyler Durden, Fight Club

So the much hyped EU summit came to pass last week and what exactly happened is still up for debate. What isn't up for debate is that whatever deal it is that they agreed to is not going to do anything to alleviate the funding and solvency issues facing the weaker EU countries anytime soon.

The U.K. caused a bit of a stir (ok, quite a bit of a stir) by vetoing the proposal that Merkel championed to lock all the E.U. member nations into a very tight deficit spending range. Apparently the leaders of the other E.U. countries were shocked (shocked I say!) that the U.K didn't quite feel like throwing itself into the death spiral that the other EU countries seem so eager to enter. But the question that apparently went unasked in the Merkozy pre-summit prep was "Why would they?" Given the high levels of EU sovereign debt, adhering to the tight deficit targets effectively means that all future deficit spending will go to pay interest on existing debts. No net fiscal stimulus will be forthcoming from member governments. But given the huge role that governments play in European economies, and the inefficiencies with which they operate, this effectively means that even strong growth in the private sector will create only tepid growth overall. Hence, net tax revenues won't grow. So in order to pay down the debt, the governments will eventually have to tax private capital and income even more than they already do. The result for Europe: a recession combined with higher taxes. The survival rate for equities in Europe isn't looking so good. Tyler Durden was on to something.

So why is the U.S stock market so fixated on European government bonds and the Euro these days? For two reasons – one, the U.S. is not decoupled (remember that phrase from a few years back? Ah, the good old days…) from Europe or the rest of the world – problems in financial markets there bleed into our markets and are driving a lot of our daily market moves. Second, many U.S. companies get a large portion of their earnings from Europe, and as the Euro weakens (which we have been predicting for the past month or so) those earnings translate into fewer U.S. dollars. For example, according to the Financial Times, McDonalds (MCD) gets 40% of its sales from Europe. Hence, lower earnings and lower stocks. So, for the time being, we have to watch the unfolding drama in Europe and try to mitigate the risks to our portfolios from the fallout as best we can.

It's only after we've lost everything that we're free to do anything. Tyler Durden, Fight Club

There is a silver lining to the crisis. The welfare states that created much of the current crisis are rapidly being downsized. Italy is moving the fastest and is the most likely of the troubled countries to emerge from this crisis in strong condition. Raising the retirement age and reducing retirement benefits were good steps towards getting its fiscal house in order. Greece unfortunately continues to battle strikes and other unrest over the similar reforms that it needs to make. But eventually the Greeks will have to either wipe the entitlement slate clean, or leave the Euro and default, wiping the debt slate clean. If they lose the entitlement mentality, they will be free to build a functioning society. But not before.

Our prior market calls to short Euro and sell the rally a few weeks ago continue to look good, but we are approaching some support levels fairly rapidly. The XLF looks to be about 3% or so away from decent support around $12.10/$12.20. Focus on the big U.S. banks if you want to take a shot, and continue to avoid the European financials. Citigroup (C), JP Morgan (JPM), US Bancorp (USB), PNC Financial (PNC), Goldman Sachs (GS) and Lazard (LAZ) would make a nice little bank basket. Away from financials the recent selloff in Amazon (AMZN) makes it very interesting in here, and if you want to play commodities (gold and copper), the recent drop in Barrick Gold (ABX) from $53 to the mid $40s is mighty tempting. Las Vegas Sands (LVS) is getting to good levels here – maybe buy half and see if you can get the rest in the $37/$38 range.

S&P 500 (SPX) Support and Resistance Levels:

Support: 1200/1205, then 1193/1195 and 1180/1182.

Resistance (not that I think we're going to hit it this week): 1232/1235, then 1244/1246 and 1260/1262.

Positions: Lazard (LAZ), Amazon (AMZN), Barrick Gold (ABX), Las Vegas Sands (LVS), all long.