Is There a “Draghi Put” in the Market?

I’m surprised how quickly tensions have calmed regarding Italy’s election results last week. Whenever the market reacts differently than I expect, I always try to find out why. That way I can judge whether the market’s reaction signals a trend change or a short-sighted move by traders.

To that end, I spent the weekend researching why investors aren’t more concerned about the political situation in Italy, and why it hasn’t weighed more heavily on stock prices.

Since Mario Draghi took over as president of the European Central Bank (ECB), we have seen the central bank get pretty creative in inventing tools to combat the European sovereign debt crisis.

First it was the long-term refinancing operations (LTROs) in the fall of ’11, which ended the Lehman-style liquidity crunch that was enveloping Europe.

Then last summer it was the creation of the Outright Monetary Transactions (OMT), making the ECB the “buyer of last resort” and finally breaking the pressure on PIIGS sovereign debt. This has given the market a lot of confidence in the ECB’s ability to tackle crises.

So from my research, here is why the market isn’t as concerned about Italy as I would expect:

It assumes if there is trouble and contagion begins to creep across the continent due to Italian politics, Draghi and the ECB will simply invent some other way to stem the crisis like they did with LTROs during the European credit crunch, and last summer with the OMT.

In other words, there’s a “Draghi put” in the market right now. If a crisis reignites, he and the ECB will protect us from losses by creating some tool or policy designed to protect markets.

Is the market putting too much faith in a Draghi put?

I agree his track record is impressive. And he is largely responsible for the huge progress that has been made in Europe since last summer. But, I’m not sure the Draghi put will really protect us from losses this time if Italy’s political situation continues to decline.

Here’s why …

The Anti-Austerity and Anti-Europe

Movement is Growing in Italy

We have a problem in Italy because the Italians voted against austerity and against the measures put in place by the government to right their fiscal ship and convince the rest of Europe that Italy is serious about getting its finances in order.

But — and this is important — suppose this anti-austerity and anti-Europe feeling gains momentum, and the Italians simply elect someone who will say “basta” to Europe?

There is nothing the ECB or anyone else could do to stop it. Nor could they stop the losses bondholders will incur.

To the point, over the weekend Beppe Grillo, whose anti-Europe Five Star party placed third in the elections, proposed an online referendum on Italy staying in the euro. While the vote itself would only be symbolic, obviously it underscores the growing resentment in Italy and other PIIGS countries towards the rest of Europe.

I’m not implying Italy is going to leave the euro. I don’t think that will happen. But I just want to point out a potential flaw in the market’s “Draghi put” thesis that is currently responsible for surprisingly resilient sentiment towards Italy.

And unless Italy makes significant progress in solving its political dilemma in the coming weeks, I expect the market to “re-price” the situation, which should lead to a decline in European stocks.

One way you can play this seemingly misplaced market optimism is through ProShares UltraShort MSCI Europe (EPV). This inverse ETF seeks to rise 2 percent for each 1 percent fall in European stocks.

Best,

Tom