Events Trader #57: Get ready for a Euro rebound

1st June 2010

Get ready for a Euro rebound

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This is a great time to be a trader.

Over the last month, we have seen investors panic over a series of completely disconnected events the stability of the Euro, the oil spill in the Gulf of Mexico and ructions in East Asia.

As each story has unfolded over days and weeks, the markets have seesawed in panic, relief and then panic again.

And when fear overtakes the market, it is open season for traders. I think if we play the current instability correctly, it should provide us with the bulk of the profits we'll make this year. I'm talking about an opportunity that comes around once a year.

Why is that? Because the kind of fear that is upsetting markets at the moment, can disappear overnight. In fact the market could return to normality a lot sooner than you might think. Today I want to explain exactly why the fears driving the market are so irrational.

And I'll also take a closer look at BP's woes and the exciting opportunity on the back of the Prudential deal.

No Doomsday for Europe

The Euro is sinking today tumbling to a fresh four year low against the dollar. Investors are fixated with the prospect that the Euro could disintegrate as a default in Greece sends a panic wave through Portugal, Spain and Italy.

Now this could happen. But not in the next few months. The Greek bailout has bought Europe a couple of years. And in this space of time, the market can go up and down a dozen times.

Let's not forget the financial firepower of France and Germany, the two European members keenest on integration and the creation of a Super-European State.

The end result of the current crisis, could be a return to normality with the higher risk countries (Greece, UK, Italy, Spain, Ireland and Portugal) paying more interest on their public debt.

In fact, what we are seeing is the unwinding of the convergence trade that started ten years ago and led to the bonds of every single country in Europe to converge to yield a fraction more than the German bund. This was another product of the cheap liquidity and low interest rates that we enjoyed over the last decade.

This is not a systemic threat to the capitalistic system like the banking crisis. It will tip a few countries into recession by raising interest rates. But the system is not yet broke, it can chug along for a few more years. And at least in the short run, that could mean a rebound for the Euro from current levels.

If we have economic stagnation that prolongs beyond 2012 then we need to worry about default, but by then we would have been in and out of the market a number of times, making great trades along the way. I'll get back to you as soon as I think it is worth getting in a trade on the Euro or anything else that is suffering for irrational panic.

For now let's turn to the latest developments with the Prudential deal. Some interesting stuff here for us to get our teeth into.

Two ways to profit from the Prudential mega-deal

Prudential is having a rough time with its effort to buy up AIG's Asian insurance wing at the moment. It is not looking good for the deal. Lucky for us, there may be a great opportunity to pick up the pieces if it hits the wall.

Lets start with the latest developments. A couple of weeks ago on the eve of the publication of the prospectus for the massive right issue needed to finance the acquisition of AIA, the FSA decided to step in and asked for more time to evaluate the deal.

In particular the FSA is worried that the capital tied up in the local subsidiary of AIA is not freely movable within the group and could not be deployed where needed. The FSA is worried that if Prudential Thailand is hit by a loss and needs capital to cover the losses Prudential Group will not be able to use the capital it holds in Prudential Vietnam or Prudential Hong-Kong because it is tied up in the local subsidiary and cannot be moved. This in turn could trigger a serious crisis.

Against this backdrop institutional shareholders have started to revolt over the deal, saying that AIA is overvalued and threatening to scupper the deal by voting against the rights issue at the Extraordinary Shareholders Meeting that is due to take place on the 7th of June.

Institutional shareholders representing nearly 20% of the company have said that they will vote against the deal on the basis that the price for AIA is too high.

In my view these institutional shareholders are very, very unhappy because they face an unpalatable dilemma - either they stump up a massive amount of cash (which is very scarce at the moment) or they face a massive dilution during this right issue and that is the reason they are opposing the deal.

Our strategy, if the deal goes ahead, is to subscribe to the cheap stock in Prudential once the right issue is under way. Given the size of the issue, I believe that it will be a huge amount of downward pressure on the share price a great entry point for us.

But if it doesn't go through, there is another great way to profit from this deal. And it's due to a detail in the deal that many won't have picked up on. The day of the deal was announced, Prudential has hedged its dollar exposure for $35.5bn.

Now if this deal doesn't go through, there will be no need for Prudential to have such a large position in dollars. This means that in the market there will be a net buyer of £24bn Pounds sterling ($35.5bn) and that should be enough to move the pound rise against the dollar.

Remember that on the 1st of March when the Pru announced the deal the pound fell from 1.54 against the dollar to 1.5 - a monstrous move by any standard. It is not unreasonable to expect another move of the same magnitude if voters scupper the deal on June 7th.

So if the deal officially fails use a Forex account or a spread betting account to take out a long position in the Pound against the dollar - one that makes money if the pound rises from say 1.44 to 1.5 against the greenback. Of course I will send out a short note to warn you and to give you levels and targets as we approach the June 7th vote.

You should stick with the BP trade

Finally, a word on BP another victim of the irrational fear in the market. BP has been sold off sharply after the latest failed attempt to stop the leak in the Gulf of Mexico.

It is difficult to pick up the bottom with these types of stories and so far it looks like we have been too early. But I will stick to this trade. Bp will not go bust as a result of a leaking oil pipe. And deep sea exploration will not stop because the alternative are unpalatable for the US. Either they use less oil to power their economy and their cars or they pay money to import oil from hostile governments such as Venezuela or Saudi Arabia.

The critical point here is that BP is trading at 6 times earnings and 9% dividend yield. We are not into an internet stock at 100 times earnings or a takeover candidate at 25, both of which can fall heavily as the fundamentals are much lower. Here the fundamentals (10 times earnings and 5% yield) point to a much higher price around 600p.

Investors fear that the cost of the cleanup operation and criminal damages could run into the tens of billion of dollars for BP. But they forget that Exxon after the Exxon Valdez disaster in 1989 has appealed against the $5bn fine (or 1 year profit) imposed by the US government for years. Two years ago they got the $5bn slashed to $500m in the courts.

There is a huge amount of irrational fear holding down the BP price. Time to sit tight on this one. If you want to get in touch you can mail me at eventstrader@moneyweek.com.

Riccardo Marzi

Events Trader

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