The best way to bet against Europe in 2012

It's the most obvious trade for 2012.

The euro has to weaken. If Europeans succumb to money-printing, the single currency will fall. That's what quantitative easing (QE) did to both the dollar and to the pound. So why would it be different for the euro?

And if Europe fails to print money, that will just increase the chances of the euro breaking apart. Self-destruction is not a recipe for a stronger currency. So either way, the euro has to weaken.

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Small wonder that hedge funds increased their bets against the currency to a record level at the end of 2011, according to the Financial Times. It seems like such a sure thing.

And that's why I can't help but wonder how it could all go wrong

The most obvious trade for 2012

I'm going to be upfront here. I can't see the case for a stronger euro. Being long the euro for anything other than a short-term trade (and if you're interested in that sort of thing, sign up for our free MoneyWeek Trader email) seems foolhardy to me.

So I don't think it's wrong to bet against the euro. And the fact is, you could have made a decent amount of money being short the euro last year. The euro climbed as high as 1.48 against the dollar in May. If you'd started shorting then, you'd have been pretty happy with your result for the year. Or if you'd shorted it at virtually any point in the year against the yen, rather than the dollar, then you'd have turned a nice profit as well.

But all of this relied on getting your timing right. And that's where the difficulty lies. Most pundits say the euro was 'surprisingly' strong last year. And if you simply take its value against the dollar at the start of 2011, and compare it to the end-of-year value, it's true. It started 2011 at around $1.33, and ended at $1.29.

I suspect that all those hedge funds sticking on 'short euro' bets right now could end up being as frustrated as those who did the same thing at this time last year. It's a good illustration of why the 'obvious' trade is usually the wrong trade to make.

The trouble with the 'short Europe' trade is not that it's wrong. It's hard to make a 'long Europe' case. There may be individual buying opportunities (our own James Ferguson came up with one in the Christmas roundtable), but so much can go wrong that it seems foolhardy to pile in blindly right now.

The problem is that it's a very crowded trade. There are so many bears that it's hard to see where more can come from. As a result, anyone making big, bold bets on the total collapse of Europe is taking a big risk. When there are a lot of bears in a market, it only takes a bit of good news to make things go the bulls' way instead, whereas it takes a lot of bad news to push things even lower.

So while those who are betting against Europe are probably right in the longer run, the chances are they'll get shaken off by the wild swings along the way.

Is there a better way to play broader weakness in Europe without having to get your timing exactly right on the euro? I think so. Bet against China instead.

The mainstream is still relaxed about China

I'm not going to pretend that betting against China is a wildly contrarian move. But it's by no means a consensus forecast either. Few mainstream analysts are willing to stick their necks on the line and predict a 'hard' landing for China.

Despite the slide in commodity prices, mining stocks, and Chinese stocks in general in 2011, every other financial institution 'outlook' statement I read continues to talk about the shift in wealth to the East, 'decoupling', and the growing importance of the middle classes in developing economies.

There's nothing wrong with this theme in the long run. But the fact that they're still happy to talk about it in their glossy 2012 brochures shows that mainstream groups are ignoring the idea of an imminent economic crash in China.

Instead, consensus opinion is for a 'soft' landing. We'll see a gentle touchdown for the world's second-biggest economy, managed expertly by the command capitalists at the controls.

But these are the same guys who were saying that China wouldn't even have a soft landing a few years ago. Needless to say, most of them didn't see the credit crunch in the US coming either.

So a major slump in China would be a huge surprise for 2012. How does this relate to Europe? Europe is an important export market for China. So a European recession which seems very likely would hit demand for Chinese-made goods hard.

A weakening euro is bad news for China too. The US gets irritated with China for pegging its currency to the US dollar. As a result, the headlines focus on the US-China exchange rate.

But what often gets forgotten is the fact that the US dollar has been extremely weak in recent years. So Chinese exporters have had a double benefit. They've enjoyed stability against the US dollar. And they've seen their currency remain weak against the euro as well.

That's all changing. The US dollar is becoming stronger. If that continues, then the yuan will be pushed higher as well, assuming that the currency peg is maintained. Again, that's bad news for Chinese exporters.

What does it mean for your investments? Avoid the luxury goods sector. It's becoming a very over-hyped way to play demand from wealthy Chinese buyers. Be cautious on commodities. Get exposure to the US dollar it'll be the safe haven of last resort if China does crash. And if you're feeling adventurous, short the Australian dollar it's already fallen from its 2011 highs, but there's much more room for it to fall further if news from China disappoints investors.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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