What is going to happen with the financial crisis in Europe? Some on Wall Street argue Europe is finally getting its act together and the sell-off in European banks and capital markets is overdone. Others say they believe the European monetary union is going to collapse spectacularly, with the euro currency going out of existence and the region plunging into conflict.
So, here are ways to play those opposing scenarios in a portfolio.
Consider the view of Goldman Sachs Group Inc., which last week upgraded ratings on European banks to neutral from underweight, for this reason: "The new funding arrangements agreed by the ECB (European Central Bank) and other central banks should significantly help the banks offset the pressures of the economic downturn."
The coordinated action also gave commercial banks access to U.S. dollars, strategist Peter Oppenheimer wrote in a research note to Goldman clients.
JPMorgan Private Bank disagrees: "Financials . . . we're nervous about. European banks are very cheap, but even if they get recapitalized they may stay that way," said Chris Millard, investment specialist at JPMorgan Private Bank in Philadelphia. "Banks don't have the same yields you see in lower-risk stocks."
Risks in your portfolio also depend on your tolerance for volatility. For moderate-risk portfolios, Millard said he was telling clients to stock up on corporate-bond issuers, particularly in the short-term, two- to four-year maturity range, with yields of 3 percent to 6 percent.
His bank is advising clients to generally avoid Treasurys, given the run-up this past year, and stick with investment-grade or "Aa"-rated municipal bonds. A moderate-risk portfolio asset allocation, according to JPMorgan, equals 50 percent equities, 50 percent cash/fixed income. It breaks down the fixed-income portion to 9 percent cash, 15 percent in high-yield bonds, and the remainder in munis. With the current yield on the S&P 500 index exceeding that of the 10-year U.S. Treasury bond, high-quality, dividend-focused utilities, telecommunications, and consumer staples concerns are stable and provide yields of 2.5 percent to 4 percent, Millard said.
Only higher-risk portfolio investors with the stomach to buy into alternatives, such as distressed debt, should wade into Europe, and in that case, JPMorgan recommends avoiding public bank shares and instead buying banks' nonperforming loans.
"European distressed debt, we really like - some of the nonperforming loans banks are selling in Europe," Millard said. "Because of all the pressure there, and because they haven't yet recapitalized, the banks are under pressure to sell nonperforming loans. We think they're very attractive right now."
Riskier investors hold "alternative" assets such as private equity, hedge funds, and energy and gold. These act as a hedge against a massive sell-off in equities, normally through exchange-traded funds such as SPDR Gold Trust. JPMorgan is also telling clients to avoid real estate investment trusts, which have had a big run-up in price, and instead buy commercial real estate directly.
Finally, Kyle Bass, founder of Haywood Capital Management of Texas, told investors in November that Europe's future is far worse than what the United States confronts.
"We've recapped our banking system. Now we have decent loss reserves and nonperforming loans. The European banks are three times as levered as U.S. banks," Bass analyzed. "They are infinitely worse off on a balance-sheet basis, including Germany. That will sink Europe before we sink."
He told the AmeriCatalyst L.L.C. 2011 conference in Austin, Texas, that a sovereign from the developed world has not restructured its debt since World War II.
"It's not the end of the world, but people are going to lose a lot of money," Bass said.