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In the spring of 2010, I appeared on CNBC and Bloomberg TV and spoke about the revelations for markets concerning French bank exposure to the Greek debt crisis. I was one of the first to say that Europe's sovereign debt worries were then growing from a mere government problem to a systemic banking crisis very similar to the US one.

At the time, it was considered a fairly big deal that France's top three commercial banks owned such a large majority of Greece's public debt totaling over $80 billion. This month, as the fortunes of Italy and Spain tremble, we have learned French banks own debt of theirs totaling hundreds of billions.

This is why, of course, European officials stepped into markets Thursday with a ban on short-selling of banks and other financial institutions. Will it stem the tide of losses and erosion of capital ratios?

Probably not any better than it worked here in 2008. But the more interesting questions I’ve been pondering are, "If it was so bad, why weren't these banks in free-fall months ago and why is the euro currency still holding up so well above $1.40?"

Will the Euro Survive?

I wrote a piece reviewing some of these questions in June (linked above). Based on how well Europe's banking system had weathered the mud of its PIIGS for 18 months up to that point, I thought their crisis would have little effect on our economy.

And maybe that's what lots of other big investors and strategists thought too. Here's what I wrote in June...

"And you have to consider that from crisis, often comes a new equilibrium. When you accept that Europe has its own unique problems, just like the US and its burgeoning municipal debt crisis, it's hard to say how things will resolve.

Who predicted the near collapse of the US financial system? And who predicted its amazing recovery from the abyss? Not many.

As Moody's Investor Service warned last week, three of France's top banks could be in for a credit downgrade as they continue to use cheap US dollar funding to roll their large exposure to Greek debt.

BNP Paribas, Crédit Agricole and Société Générale may all be playing hot potato with debt of a deteriorating quality, borrowing over $75 billion on the short end to finance their longer-term holdings of Greece government paper."

Tip of the Iceberg

This was the mood of quiet toleration (heads in the sand?) before we learned how much Italian debt they owned. So the selling of these top three banks really didn't even begin until July, weeks after the Moody's warnings and awareness of "the Italian problem" heated up.

Here's a summary of their declines before the short-sale ban (priced in euros) since July 1, when two of the three were close to their 52-week highs and the third, Soc Gen, was still within 20%.

BNP Paribas (BNP:FP) -- 55 down to 33 euros (40% decline to lows)

Societe Generale (GLE:FP) -- 42.50 down to 20 euros (53% decline to lows)

Credit Agricole (ACA:FP) -- 11 down to 6 euros (45% decline to lows)

Chanos Chimes In

Notorious short-seller Jim Chanos gave an interesting quote to Bloomberg.com for its story, "Short Selling of Stocks Banned in France, Spain" by Howard Mustoe and Jesse Westbrook:

"EU policy makers don’t seem to understand the law of unintended consequences. The vast majority of short-selling financial shares is by other financial institutions, hedging their counterparty risks, not speculators. The interbank lending market froze up completely in October to December 2008 -- after the short-selling bans."

This is exactly what we learned back then. I was working for a large options market maker in Chicago and the "unintended consequences" were numerous and obvious to us, especially as market makers were at first not exempt from the ban, eliminating their ability to hedge and provide liquidity to markets in both options and stocks.

The Europeans got the market maker part right this time, but volatility may still rise because hedge funds who normally try to strike some balance between long and short positions will be leaving the market, the Bloomberg story goes on to explain.

A Moby Dick of Fears, Besides GDP

So, while I have been writing for two weeks about this sell-off being mostly a function of lowered growth expectations since the awful GDP revisions of July 29, I should consider that the banking crisis finally unfolding in Europe has been a big catalyst too.

Like a sea monster you can"t see under the surface, the vaguely familiar unknowns trouble institutional investors who remember 2008, even if our economy and banking system are much more sound.

We grew accustomed to Europe's debt crisis, as if it were unfolding in slow motion. Just another part of the daily headlines, it didn't bother us as much. And as with all crises of confidence, especially those involving banking, they don't really matter until they do and things implode. In other words, until the creature bumps into your boat and makes its presence very real and known.

The Big Question Now for the US Economy

If Europe's crisis does devolve into a wholesale systemic crisis that freezes their markets and economies, what impact will that have on a US economy at stall speed?

Everyone talks about the impact of fear on the American consumer, as if we can collectively talk ourselves into a recession with negative headlines that weaken and dispel confidence -- and spending. But I think the American consumer has proven amazingly resilient since our crisis. His and her expectations about jobs and credit and growth are much more reasonable and realistic, if subdued. That's good right now.

I am more worried about the impact of fear on these two groups of spenders: institutional investors, primarily equity portfolio managers, and CEOs and their purchasing managers. If these people are uncertain about the future and lack confidence in growth prospects, this will become a self-fulfilling feedback loop that can cause recession.

Earlier this week, I wrote "QE3 and the Probability of Recession" in which I shared a chart of the Federal Reserve's last growth forecast from June. And while I look forward to their update since they got it wrong -- and got the bad news to prove it on July 29 -- I am even more eager to see and hear the projections and concerns of money managers and heads of industry.

Since the S&P derives 45% of its earnings from abroad, and Europe's contribution is easily one-third of that, a fallen EU is a big blow to the US economy. Viewing the current 15% correction in equities (I'm using the drop in the S&P 500 from roughly 1,350 to 1,150 to get 15%) as an extremely quick discounting of the increased "probability of recession," I still expect the market to trade sideways for the next few weeks until we get more information.

Pricing in Blah

Here are some numbers to keep in mind until we start to get lower growth forecasts and downward earnings estimate revisions after Labor Day:

Estimates as of August 1 were for the S&P 500 to earn about $98 per share in 2011. Let's say that realistically the best we could expect now is $95 EPS. At an index level of 1,200, that's a "working" P/E of 12.6.

If you bump EPS down to $85, at 1,200 the S&P still looks cheap at 14 times. The catch is that if earnings and GDP are still declining, then money managers and CEOs will continue to price in lower expectations. Right now we wait for more data.

In "How Long Will the Correction Last?" from August 5, I wrote the following about where we stand...

"I think the highest-probability scenario is a 'wait and see' by institutional investors. That means to me that the S&P will range trade between 1150 and 1250 for the next 2-3 months, in waves of pessimism and optimism, until more visibility on GDP, jobs, cap ex, manufacturing, and corporate earnings rolls in.

What are the chances that this advance 'pricing-in of the recession' heats up and we dip below S&P 1,100? I'll say about 40%, right around where I think the probability is for an actual recession.

Use my probabilities as a rough guide and trade your own view accordingly. Many strategists from major investment houses, managing trillions of dollars in aggregate, have similar projections.

The hard part is that on big sell-off days, they look like they are more scared than they really are."

Investing Without Certainty

During this tumultuous two weeks, I've done many interviews with financial media, both TV and print. When asked by AARP what I thought senior investors should be doing with their money, I became very cautious, thinking of my own parents and their retirement concerns.

But then I just stepped back and framed the question as any investor should by moving away from emotion and just thinking rationally about time horizon. Here's what I said on Monday...

"If one has ten years left in the market, it's a no-brainer to be putting money to work in stocks. There are lots of buying opportunities to take advantage of right now in stocks like Apple (AAPL), Eaton (ETN), and National Oilwell Varco (NOV).

If you have five years left for your money to work for you, there are still stocks and sectors like energy, technology, and materials that one should be accumulating at these levels. But for those who need their money in the next two years, it's a good time to just sit back and see how this unfolds into October earnings season.

Given a 40% chance we slip into recession, institutional investors -- who move the market in aggregate with the trillions of dollars they manage -- will be waiting for more bloodwork on the economy and earnings before they return to the business of investing."

Kevin Cook is a Senior Stock Strategist for Zacks.com
 
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