The European sovereign debt crisis is a disaster waiting to happen. A default is inevitable. And when that happens, Europe's banking sector will see a catastrophic fall. Bengt Saelensminde explains the best way to play it.
The most important events in the markets are often underestimated and overlooked. Like the furring of an artery, sinister events occur slowly and out of sight until disaster strikes.
And yet as investors, we're paid to understand what's going on in the arteries of the market. And we certainly don't want to ignore the important events just because they unfold at such a painfully slow pace
Take the brewing European sovereign debt shenanigans. This looks like a heart attack waiting to happen. It's been many years in the making. And the fact that its been rumbling on for so long seems to have desensitised investors to its potentially dire ramifications. Euro-fatigue seems to have set in. And you may be a lot more vulnerable that you think.
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The nations of the EU have been busy trying to patch up the so-called PIIGS mess for over a year now. Not because they feel sorry for the PIIGS. Their main motivation is to protect domestic banks that have massive exposure to PIIGS debt.
Remember, sovereign nation debt was supposed to be 'risk-free' it's where banks park a lot of their capital the capital the regulators force them to hold to maintain a secure financial footing. And in Europe, many of those holdings are getting pummelled.
The politicians want and need to save the banks and the bankers. They thought that by establishing the near $1trn European Financial Stability Facility (EFSF) they'd kicked the sovereign debt crisis can far enough down the road.
But for all the money chucked at the problem, and for all the talk about 'no bailouts', 'no re-scheduling of sovereign debt', 'nobody's leaving the euro' we're no nearer a sensible resolution to the funding issues facing the periphery countries. Absolutely nothing has changed.
Except that the banking sector has taken another lurch down, that is.
Steer clear of Britain's rotten banking sector
I hope you didn't forget Valentine's day this year. Not because it may have dented your love life, but because I showed you this chart:
Source: Digital Look
I suggested that the banking sector was a sell; that shareholders would bear the brunt of banking reform and the evolving debt crisis.
And sure enough, they have.
Since mid February, the sector is down around 11%, while the FTSE is off only 2.5%.
The eurozone endgame is playing out in slow motion. And I'm convinced that that means many investors are missing what's underway.
My colleague Tim Price of PFP Wealth Management sees another savage banking crisis emerging. He points out that Greek sovereign debt is now pricing in a 50% to 60% 'haircut' for its holders. As he said yesterday in his Price Report letter:
"For Greece, the devilish problem with austerity is that it saps economic vitality. To a bankrupt economy, austerity can end up being the cure that finally kills the patient off.
Failed politics has led to failed economies and will at some point trigger a default. It would be logical to expect European bank stocks (notably those of France and Germany) to be hit hard at that point, and it would be reasonable to expect equity markets to sell off as we encounter 'Bank Crisis Part II'."
If Tim is right, you'll want to have some insurance in place.
How to trade this disaster
The EFSF was touted as the answer to the brewing crisis just over a year ago. And yet debts and the severity of the problem continue to grow.
This is not the time for ostrich-like investors to stick their heads in the sand. This is the time for action.
I'm not a massive fan of shorting stocks. It seems impolite to profit from the misery of others. But at the same time, I'm even less of a fan of losing money.
That's why I think shorting the banking index could be a great bet. A banking crisis is certain to drag down the rest of the market with it. So shorting the banks could provide you a decent hedge for your portfolio.
We can't be sure which banks will be hardest hit - and even if we did, we don't know what other banks have counter party arrangements with the 'diseased'.
What we do know is that the international banking system is a complex system of inbred relationships. The failure of a Greek bank could put pressure on the stability of an Italian one. As shares on the Italian bank get taken out, so a London bank with exposure to the Italians starts to wobble.
One by one, the dominos fall. And the big UK investment banks are right in the thick of it.
So I say short the lot of them. And you can do that by putting a down bet on the UK banking sector with a spread bet.
When I looked at the UK banking sector this morning, the index stood at 4,532. IG index was offering a price to sell the September contract at 4,530.
FTSE 350 Banks Index five year perfomance: 2006 +9.99% | 2007 -21.30% | 2008 -56.78% | 2009 +23.80% | 2010 -0.10% | 2011 -8.13%
So if over the next three months or so (the contract expires 20 September) the index falls another 10%, you'd make 453 spread betting points (4,530 x 10%). Multiply the number of points by your stake and that's what you win. So if you bet £10 a point, you'll make £4,530 tax-free.
Of course this all works in reverse too. If the index reverts back to where it was in mid-February, you could lose a similar amount. When you spread bet, you need to be prepared to lose more than your initial stake if the market goes against you.
IG Index will offer you the spread bet. You can compare the top 20 spread betting accounts using MoneyWeek's spread betting comparison table.
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Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
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