It’s possible that we’ll see prolonged economic and political stagnation in Europe of the type we’ve experienced in Japan since 1990 as the continent tries to decide whether the EU project will survive.

My conclusion, based on the prior two posts on this topic, is that–like Japan–Europe by itself is too small in the global terms for its problems to derail economic progress elsewhere.  Market volatility, yes; global recession, no.

In a nutshell, that’s my base case.

Nevertheless, even an investor who is not directly involved in Europe nor compelled by customer mandate to invest there faces two issues:

–the fact of continuing European selling of equities, both in Europe and abroad, as EU investors rebalance their portfolios and make themselves more liquid in response to developments there, and

–the possibility that the European financial situation is much more dire than we now suspect and/or the global banking system will transmit part of that damage to the rest of the world.

what to do?

I’m writing under the assumption that we’re not yet anywhere near either the end of the EU crisis, even though it has been dragging on for more than a year.  Nor am I willing to bet that we’re at or near the low point in stock market terms.

These are very important assumptions.   As a result of them, I want to protect myself from bad news coming out of Europe  I don’t think we’re at the equivalent of late-March 2009 for Europe.  So I don’t want to bet against the prevailing sentiment and hold already severely beaten-down beneficiaries of the dissipation of storm clouds.  But–as with everything in the stock market–I could easily be wrong.  So I’ve got to keep these assumptions in the forefront of my mind.

Three cases:

–a professional equity investor with a US-style mandate from institutional clients to remain fully invested.  Here the portfolio composition is straightforward.

One choice is to “neutralize” the EU by looking exactly like the index and trying to achieve outperformance elsewhere.

That’s the conservative choice.  My personal preference would be to underweight Europe, avoid the banks and choose stocks that are listed in the EU but which have the largest part of their operations in other parts of the world.  I’d look for growth names and avoid companies that depend on a robust worldwide economy.

–an EU-based balanced (i.e., a portfolio of stocks +bonds) investor, maybe with predominantly high net worth individual clients.  This investor will have a strongly European focus.

He is probably being required by the rules set up in his contracts to sell stocks because his bond losses have made his equity allocation too big.  He’s probably also being bombarded by negative news–and by customer inquiries about whether his strategy (no matter what it is) is too aggressive.  So he’s feeling the need to become increasingly more defensive.

He is probably selling stocks in peripheral markets, especially if they have done well; selling smaller capitalization stocks to buy larger; selling growth names to buy defensives like utilities and consumer staples. He is probably heavily tilted toward large cap names in northern European markets.  He probably has raised some cash (this may give him emotional satisfaction, but won’t affect his returns unless he’s raised a huge amount).

I think much of the selling in places like Hong Kong, and even the US, is emanating from Europe, and from the kind of professionals I’ve just described.  I think such selling will prove to have been the wrong move, but I suspect that I would be doing some of the same if I were in the position of this investor.  Ideally, I’d have the same strategy here as in my first case.

The world may also have to wait for this guy to run out of stuff to sell before markets take on a healthier tone.

–you and me.  …or rather, what I’m thinking/doing now in my own portfoli0.

The sound bite form of my central case is, as I wrote above, that Europe is the new Japan. That’s probably too pessimistic, but it’s going in the right direction.  Once the market settles down, there’ll be the opportunity to pick stocks (I do own one individual stock in Europe now through an ADR–IHG).  But there’s no rush.  In the meantime, I’m content to watch from the sidelines.

My guess is that worries about contagion through greater exposure by US banks to Europe than we now know about–or that bank hedging won’t work at all–is wildly overblown.  But I’ve never been a fan of banks in any case–and I know very little about financials, so I’m happy to continue to avoid them.

I’ve begun to take some profits on big multi-year winners and reinvest the proceeds into semi-defensive stocks.  DeNA (2432:JP) and WYNN are examples of the former; INTC and (believe it or not) LVS are instances of the latter. Part of this is pure tactics, not strategy.  Part of this is that the slow growth emphasis I’ve had for a couple of years has worked too well for too long, so I should probably reduce my heavy emphasis.

These are only changes on the margin, however.  I still think that we’re in a slow-growth world where there isn’t enough demand to satisfy all the firms in a given industry.  This means the important distinctions to make are between best of breed vs. the rest, and between niche players that serve hot spots of demand vs. everybody else.

I think continuing troubles in Europe will offset the good news coming from the US economy, at least until the situation in Italy and Greece develops further.  Therefore, the overall environment hasn’t changed much, in my opinion, other than short-term volatility is increased.  And, unless there’s a very compelling counterargument, everything in Europe is now in the minus column.  But most of it was already there, anyway.