Playing a European Renaissance

Mario Draghi, head of the European Central Bank (ECB), pledged to do whatever is necessary to save the euro and the eurozone. Promising to deliver “enough” as long as it falls within the ECB’s mandate.

Like any well oiled propaganda machine the most influential European politicians lined up behind Draghi and stoked the “all-for-one and-one-for-all” fire by vowing to do whatever is necessary to save the eurozone. The implication being that whatever the ECB cannot do… they can and will.

When some in the financial markets raised concerns that the definitive solution lacked specificity, Draghi offered specifics such as: 1) shoring up private banks, 2) buying new bond issues from debtor nations, 3) engaging in open market operations which ostensibly is trading in the secondary market, and 4) lowering interest rates.

Those comments were enough to move the needle from lack of specificity to the size of Draghi’s bazooka. And while that has yet to be determined most believe it will have to be well north or $1 trillion euros.

The second act begins this week as US Treasury Secretary Timothy Geithner is scheduled to meet with Draghi in Germany. I suspect he will offer advice on how to deploy the bazooka so as to get the best bang for the euro. He may also intimate that the US Fed is about ready to launch its own stimulus plan – QE III – and may well do it in conjunction with the ECB.

The stage has been set for powerful actions by influential people at a time when the market is clamoring for a solution. Given the backdrop, it is no surprise that global markets rallied and if the Fed were to jump on the same bandwagon this week, we could see the rally extended. There is after all, a line of reasoning that one should never fight a determined central bank.

The bears would put forward the case that such brazen political posturing is being driven by fear. Could it be that things are worse than we think?

Then there is the fatal flaw elephant in the room. If the eurozone is a fatally flawed model then no amount of political cheerleading or infusions of capital will fix it. That is a major bear trap for a market that is being priced for perfection.

The easiest way to play a bull thesis is through iShares MSCI EAFE Index Fund (TSX: XIN, Friday’s close $16.17), which is hedged back to the Canadian dollar. The rally in XIN last week recovered all that it had lost in the previous week. It could go higher if you believe that eurozone leaders have finally got the message and if the US Fed steps up to the plate.

Still I would opt to hedge my bet with any bull strategy. Buying short-term XIN calls rather than an outright purchase of the underlying security would be one possibility. If the market continues to rally it will do so over the next couple of months so the short term calls will profit. If the market stumbles your risk is limited to the cost of the call. Look at buying the XIN September 16 calls at 45 cents or better.