One Sentiment Gauge in Europe Reaches Epic Proportion

The one-two punch 2014 winter storms that battered the southeastern United States left $13.5 million in damages in Georgia alone and thousands of residents displaced due to burst pipes and power outages. I am one of the displaced. Three months after the flood, I’m still living out of suitcases in a hotel while my apartment gets rebuilt.

I’m ashamed to admit before Icepocalypse, I had the least
comprehensive homeowner’s insurance. Why bother, I thought.
This is Atlanta. The only blizzard this city’s seen in the
last decade is on the dessert menu at Dairy Queen.

But now, you better believe the first thing I’m going to
do when I move back in is upgrade my policy to cover all
and any acts of man and God — fire, tornado, sharknado,
alien invasion, you name it.

It’s human nature. You can never truly prepare for the worst until you experience it first-hand. Then, and only then, do you go above and beyond to protect your health and welfare.

Nowhere is this more apparent than in the world of finance. The tendency for investors to be blindly optimistic in the run-up to disaster, and then stringently fearful after is undeniable. You can actually see it with your own eyes in the yield spread between low-grade bonds and long-term securities.

In a nutshell: A falling yield spread signals a growing appetite for risk among investors, while a rising yield spread signals an aversion to risk.

As for a real-world example, the April 2014 Elliott Wave
European Financial Forecast opens with a special, two-page
section on one of the most accurate gauges of eurozone sentiment
since the start of the financial crisis: the 10-year spread
over German Bunds.

Before we delve into our analysis, let’s set the pre-crisis scene to 2006 early 2007. Europhoria is off the charts as seen in these headlines from the time:

– “Euro Bull is Far From Over! Not only has the bear market been consigned to memory, it has been replaced by a rampaging bull market in equities. It’s Goldilocks all over again!” — April 20, 2006 National Post

– And — “Lehman Brothers strategy boffin says buy, buy, buy Europe.” — January 16, 2007 Daily Mail

So, did the yield spread mirror the blind optimism among investors?

You betcha! Here, the April 2014 European Financial
Forecast confirms: “By mid-year 2007, bond investors
lent money to treasuries in Greece, Ireland, Italy, Portugal
and Spain at more or less the same rate as they lent money
to Germany.” The first half of our chart of the 10-year spread
over German bunds captures this historic complacency:

The move in the other direction was far from swift, as ingrained optimism persisted amidst the 2007 U.S subprime implosion, and 2008 Lehman Brothers bankruptcy. The next series of charts show how investors didn’t fully “snap awake” until late 2008-9.

From there, the needle of sentiment swung firmly into risk-aversion territory:

The spread between 10-year yields in Germany versus peripheral Europe rose by a factor of 43 — from around 23 basis points in January 2008 to almost 1,000 basis points in January 2012.

Now is the time for reckoning. Historic complacency coincides with peaks, while historic fear with bottoms. So there is only question before you: Where does the 10-year spread over German Bunds stand now?

The April 2014 European Financial Forecast
zooms in on the yield spread’s performance since 2012 and
has this answer:

Only a trend of “epic proportion can explain” today’s reading; and when this phase gets underway, equities along with debt instruments “of all stripes” will follow.

Don’t wait until after the tide has already turned. Prepare for the long-term changes ahead in Europe’s leading economies with EWI’s European Financial Forecast Service.