When the Other Shoe Drops in Europe

09/14/2010 12:00 pm EST

Focus: OPTIONS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of Short-Side Trader, says Europe’s crisis is ready to enter a new phase, and he recommends a way to play any future declines in the euro.

European vacationers are back, and they don't like what they see.

Closer scrutiny of the "stress tests" of 91 European banks shows they were faked with even less skill than the US faked its stress tests. Many banks did not fully or properly disclose exposure to high-risk sovereign debt or to other banks holding that debt.

[Meanwhile, besides] Germany, European economies are still seriously struggling and showing signs of slowing down. Those countries will get their double dip, and their governments are now implementing austerity plans that will only aggravate the economic slowdown.

[So, it’s no wonder] traders and investors are losing faith in risky sovereign debt, and Greek bonds now are selling at discounts [again.] 

Underlying all of the problems is a two-decade-long slide into stagnation due to demographics and poor government polices outside [Great] Britain. Knowledge and acceptance of this malaise underpin investors' attitudes. They know this isn't about a dynamic growth engine that is simply stalled; it is broken, except in Germany, and even there, the demographics are hitting the economy very hard.

European governments are broke (just like the US) and putting in place austerity plans that will only hurt their economies more. But they have no choice if they are going to protect their bonds and their ability to borrow—so, no more stimulus spending.

[Also,] European governments cannot print money; that is the job of the European Central Bank (ECB), and it refuses to do so. Once a German takes over the ECB [in about a year], there is absolutely no hope of using monetary policy to help the economies of the Continent. German DNA is so inflation-averse it leads to irrational policies in both good and hard times.

The best policy for all these governments is to let the euro slide to boost exports and tourism—and that's exactly what's going to happen. Along the way, a major problem (or two) will hit the markets. I'm particularly talking about the growing problem with Anglo Irish bank, which is in deep trouble and whose host government, Ireland, is broker than broke.

The bottom line is that the euro is gong to slide, get hit, slide again, and get hit again.

Once it punches down through $1.20 and stays there, it will be a freefall to a buck—and then maybe even down to the all-time low of 87 cents.

That will make the CurrencyShares Euro Trust (FXE) January (2011) 120.00 Puts (FXE 110122P00120000) one of the best positions in [your] portfolio. Now is the best time to start a position in FXE or add to one. (FXE closed above $128 Monday, and the put options traded at $1.25. Selling short, even through buying put options, is only for risk-tolerant investors who can afford to lose the value of their investment.—Editor.)

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