Profiting from Europe's Grim Outlook

10/13/2010 11:21 am EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of Short-Side Trader, says Europe’s economy is in worse shape than ours, and he recommends shorting one of its most prominent lenders.

The United States isn't the only country that is suffering from a housing crash. On the other side of the pond, they call it a property bust.  No matter what you call it, it's a financial mess.

The boom and subsequent bust in Europe and the UK may actually have done more damage than it did in the US, because the banks in the UK and Europe are more thinly capitalized.

The overall European economy is also weakening, based on conversations I've had with German, Irish, British, and French consumers and business people. It's the knowledge that more austerity is coming—meaning declining incomes, more unemployment, and the potential for strikes and other forms of disruption.

I spoke at length with a senior [Scottish] merchant banker (one of the people who lend money, short term, in order to finance trade and the shipment of goods and commodities), and his word on Europe is that business is "dead."

He sees great growth, especially in certain commodities in South America and parts of Asia, and weak growth in the United States; but according to this merchant banker, Europe is basically just "dormant."

There was a euphoria brought on by the false optimism over the Greek bailout and the faked bank stress tests, but that euphoric feeling is fading.

The political situation is also worsening as opinions are hardening about the aforementioned public-sector spending. Proposals backed by Germany to punish European Union members who violate guidelines for deficits and debts are splitting the EU into two parts--those for austerity now and those for austerity later.

A key index, the Markit Flash Eurozone Composite Output Index, fell to a seven-month low of 53.8 in September, well below expectations. This is consistent with GDP growth of about half a percent and similar to data coming out of the United States, i.e., the falloff in September was unusually sharp.

All of these problems—real estate, a slowing economy and political problems—are creating concern about the future health of European banks if countries default on bonds because other EU members will not help them out.

Our play for this situation is the Banco Santander, S.A. (NYSE: STD) Dec 12.50 Puts (STD 101218P00012500) with a Buy Under price of $1.15. (They traded Tuesday at 70 cents, while the stock closed at $12.81—Editor.)

STD faces enormous problems in its home market of Spain. Spain has the worst property market in Europe, 20% unemployment, and massive budget deficits. STD will certainly need to dilute in order to raise more capital to pay for its purchase of the retail branches of the Royal Bank of Scotland Group (NYSE: RBS) and to protect itself against future write-downs. Technically, the stock is also showing signs of weakness after a major run.

(Editor’s Note: Shorting stocks, even by buying put options, is only for the most risk-tolerant investors who can afford to lose the value of their investment.)

Subscribe to Short-Side Trader here…

Related Articles on STOCKS