For Clues to U.S. Stocks, Look at Greek Bonds

Government austerity policies were a target of a demonstration last month in Thessaloniki, in northern Greece.

IT’S come to this. For day-to-day guidance on the likely direction of American stocks, there’s an unlikely contrarian indicator: the battered Greek bond. 

“You’ve got to keep your eyes on Greece, if for no other reason than that everyone else is,” said Richard Bernstein, formerly the chief investment strategist at Merrill Lynch and now the proprietor of his own firm and a fund manager for Eaton Vance.

Mr. Bernstein says his main focus right now is actually American stocks, which he favors for fundamental reasons: they are relatively cheap, he says, given the earnings they are likely to produce over the next decade. But for the short term, those virtues are often being overlooked by investors, so as a guidepost for Wall Street he has been looking at an unlikely benchmark, the Greek 10-year note.

It has had little intrinsic connection to the American stock market in the past, as Mr. Bernstein is quick to acknowledge. But it has been a perversely contrarian signal of late. As the European rescue plan for Greece appeared at times to unravel last week, Greek 10-year notes hit new lows, falling to less than 30 percent of their nominal value — a 70 percent discount. As the price dropped, the American stock market often rose.

“A decade ago, you’d have thought I was crazy if I told you there was a connection” between American equities and the fixed-income market in Greece, Mr. Bernstein says. Recently, though, there does seem to have been at least a loose correlation, he says, because American banks, both directly and indirectly, are exposed to the debt of Greece and other troubled European countries.

And the ups and downs of the Greek crisis have provided the impetus for the risk-on, risk-off trading that has dominated financial markets worldwide.

Quite often these days, the tone on Wall Street has been set by the frantic efforts to stave off a financial calamity in Europe. The uncertainty has been buffeting the American economy as well, as Ben S. Bernanke, the chairman of the Federal Reserve, said last week. 

“Most notably,” Mr. Bernanke said, “concerns about European fiscal and banking issues have contributed to strains in global financial markets, which are likely to have adverse effects on confidence and growth.” He added that the Fed remained ready to intervene further, if needed.

Despite these problems, Mr. Bernstein says, investors should be focusing on the handsome profits that American companies are churning out. But he says it’s understandable that people are fixated on the immediate crisis in Greece. So he turns to the Greek bond as a back-of-the-envelope indicator. What’s his logic?

As he sees it, the sinking market price for those bonds tells him that the Greek bailout deal, if it holds together, will be extremely “bullish short term for banks,” and therefore “bullish short term for the stock market in the United States, too.” But in the slightly longer term, however, it will also be bearish for both. Why? 

A “voluntary” 50 percent haircut — or discount — for those bonds was part of the fragile settlement worked out by European leaders late last month. The current market price amounts to a much higher de facto discount of about 70 percent, so if the European settlement holds, it will be a “very good deal” for bond holders — that is, banks, he said — and bank  shares have often dominated the American stock market. 

Slightly longer term, though, the pricing discrepancy implies that the European deal does not adequately account for the reduced value of Greek debt.

“Ultimately, the markets will be skeptical about any deal like this, because the debt has not been written down sufficiently,” he says. “It’s bearish longer term because it suggests that this crisis isn’t close to being over.”

Because prospects for a short-term settlement of the crisis grew shakier in the last week, he says, the implications of the sinking Greek bond may not be translatable into anything more than extreme volatility for global markets.  He says the festering European crisis will probably make American stock markets “quite volatile” for some time, despite what he considers excellent prospects for American companies.

For fixed-income investors, meanwhile, the prospects are likewise not entirely positive, in the view of Kathy A. Jones, fixed-income strategist at Charles Schwab. The Fed “will be keeping interest rates very low for some time to come” on government bonds, she says. And in response to an economic slowdown and to the financial crisis in Europe, the European Central Bank lowered interest rates last week.

This environment, she says, “creates real dilemmas for individual investors,” who will need to decide whether to accept these rates or take on additional credit risk in an effort to get higher yields.

“Unfortunately, there are no easy solutions,” she said.

Scott Minerd, chief investment officer at Guggenheim Partners, says he believes that Treasury yields have already bottomed and are beginning to edge upward. The 10-year Treasury note is likely to breach 3 percent by the end of the quarter, he says, though he observes that the Fed appears to be “preparing the way” for further unorthodox policies aimed at keeping rates low and stimulating the economy. 

He believes that it makes sense to buy some high-yield bonds. “The market for these securities got hammered so hard in anticipation of recession” that the prices are very attractive, he says.

Like Mr. Bernstein, Mr. Minerd is bullish on American stocks. He says he believes that the economy will muddle along, “and that it will actually turn out to perform better than the market has anticipated,” driving stocks higher.

Still, high volatility is part of his outlook, too, in large part because of the crisis in Europe.

“We’ve reached a stage where we all understand that a train wreck of some sort is coming,” he says. “The question is what will the wreck actually look like, how much damage will it do, and the markets have already priced in a lot of damage.”

As far as the Greek crisis goes, he says, there appears to be worse to come, though it may not be as bad as the market anticipates.