Posted by Joseph Y. Calhoun, III

For the average investor the market action of the last few weeks must be a bit mystifying. Earnings season has generally been upbeat, the economic data has been pretty positive and the US government seems headed for gridlock with Scott Brown (R, Kennedy) taking his place in the Senate. And yet stocks are down roughly 6% since peaking in mid January. The cause of the selloff - allegedly - is the euro area debt difficulties centered in Greece and Portugal. These peripheral Euro countries were the hot topic in Davos where the terminally hip lumped them together with Spain and Italy to form the PIGS bloc.

How does a debt crisis in Greece turn into a stock market selloff in the US? Could a default by Greece and/or Portugal be the end of the Euro common currency? That doesn’t seem likely; Greece and Portugal together represent roughly 3% of EU GDP. Could a default there cause investors to abandon the debt of other periphearl markets? I suppose that is more possible but bond yields don’t reflect a lot of fear at this point. Spain auctioned 3 year notes yesterday for a yield of just 2.63%. For that matter, Portugal’s bonds don’t show a lot of fear either with two year notes yielding 2.67%. Greece’s two year notes yield 6.44% which is high only when compared with other euro area bonds. Portugal did have problems selling some bills today; they sold 300 million euro at 1.38% when they wanted to sell 500 million euro.

The bottom line here is that there does not seem to be a lack of demand for government debt as long as the interest rate offered is reasonable based on the risk. Rates less than 10% do not, at least in my book, indicate severe stress. So again, how does this cause a selloff in US - and for that matter the world - stock markets?

I think there are a few things at work here. First of all, there are certainly hedge funds out there that have been borrowing in dollars and buying bonds denominated in other currencies, including the euro. And if you are a hedge fund doing that trade you are more likely to be holding the peripheral country debt since it offers a slightly higher yield than say, Germany. Undoubtedly, some of these funds are unwinding positions, selling euro denominated bonds and repaying dollar loans. That tends to put a bid under the dollar and a rising dollar is considered bad news. Why? Well, normally I don’t think it would make much difference, but since the crisis of late 2008, a rising dollar has been seen as risk avoidance and so traders sell risk assets when the dollar rises. Does it make sense? Not really, but traders only remember the recent past.

Another factor is the psychological one that comes with the potential for sovereign defaults. The Greek budget deficit is not that different as a % of GDP than the US, so I guess there are some who will look at this and wonder if the US is just as vulnerable. Of course that doesn’t really make much sense, but who said investors were rational?

I actually don’t think this correction has anything to do with Greece or Portugal. The problems with Greece are not new and even an actual default would have little effect on the US or Euro area economy. Furthermore, I don’t think most investors are even aware of the problems afflicting the PIGS. This selloff, like every correction or bear market, is about fear. If you bought anywhere near the bottom last year, what is your larger worry right now - protecting your profits or making more? There are a lot of people who believe that the recently announced 4th quarter GDP figures are as good as it will get in this recovery and if that is true, there is little reason to own stocks as they would appear fully, if not over, priced. Those people are the ones driving this selloff. They aren’t worried about Greece; they’re worried about the US economy.

And I think at least for the next year or so, they will be wrong. This economic recovery is just starting to gain steam. And like every other deep recession the last several decades, the rebound will be at least partially symetrical with the depth of the recession. It won’t happen because of anything the Obama administration does but rather in spite of it. They’ve done plenty of damage with the bailouts and stimulus packages but I don’t think they’ll be able to do much more. There is little appetite in Congress for more spending programs. Obama’s budget is DOA. No, this rebound will be robust - at least for the short term - for the same reason that every recovery from a deep recession is robust. Capitalist economies are amazingly resilient and while ours isn’t perfect, it is still pretty damn good.

So I don’t think this is the beginning of anything other than a correction. The Greeks and Portuguese will figure out what to do about their budgets. Either they’ll get their houses in order by themselves or the other members of the EU will force a solution on them or maybe the IMF will come in and make a loan in exchange for some fiscal discipline. But I fully expect it to be resolved short of default and the fear we are experiencing right now will be forgotten.