Play Europe with This ETF Pair Trade - Investment Ideas

Despite a rash of bailouts and pledges to do more in terms of integration, investing in Europe is still as uncertain as ever. Both of the trillion dollar PIIGS economies are now teetering on the brink with mid-term debt costing both of the countries more than 6% at this time. 

This situation is now causing damage not just in the weak peripheral nations, but in the core of the euro zone and even in markets well outside the region as well. In fact, broad global markets have slumped by nearly 10%-- as represented by the Vanguard Total World Stock Index ETF (VT) so far in the second quarter, erasing all of the solid gains that investors saw in the first three months of the year.

With this backdrop, many investors are skittish about investing in the broad European region at this time as there is just too much uncertainty for some in the marketplace. However, for those with a longer time horizon and the stomach for some short term volatility a closer look at some of the stronger nations could be warranted, especially in the case of Germany (also see German ETFs On The Rise).

Germany is arguably the best positioned nation in the entire EU. Unemployment is rather low when compared to other European nations and the weak euro helps the country’s many exporters who are seeking to compete on the global stage.

The country also has the third highest current account surplus, trailing only China and Saudi Arabia in this regard while it has a small budget deficit, coming in below 2%. Meanwhile, the country has a robust level of foreign reserves (including gold) and a solid ‘AAA’ rating from all the major agencies (see Three Great ETFs For Your IRA).

Thanks to these advantages, investors may want to consider making a play on the beaten down German ETF (EWG) at this time. The product tracks the broad German stock market and gives investors exposure to over 50 companies that are based in the country.

Furthermore, investors should note that unlike many country specific ETFs, this one doesn’t put too much in financials or energy. Instead, it offers up a modest 16% to financials, nothing in energy, and instead is tilted towards cyclical consumer stocks and basic materials firms instead (read Euro Small Cap ETFs: The Way to Play Europe?).

The popular product has been in a slump over the past three months, losing about 16.5% in the time period, and could be presenting a solid value to investors at this time, assuming they have a long time horizon. After all, the P/E on the holdings is a modest 16 while the 12-month yield comes in at a strong 3.5%.

While this exposure may be a great idea for those in it for the long term, some investors may be worried that Germany may be forced to foot much of the bill for the euro zone crisis. If Germany does give in and plunk down cash for the periphery, it could hurt the overall economy and cause EWG to sink (also see For Europe ETFs, It Is Hard To Beat Switzerland).

Given the likelihood of more German spending in order to help boost peripheral members and their banks, investors may want to consider pairing a purchase of EWG with a short selection in a slightly smaller and weaker economy, France, via the iShares MSCI France Index Fund (EWQ).

The country just across the Rhine from Germany makes for an excellent short candidate to be paired with EWG for a few reasons. First, it is a major economy that many investors have looked towards, at least in the past, in order to help pay for the mounting bailout bill. However, now the country is looking at downgrades of its own and some fear that, eventually, the country will need a bailout of its own as well.

If investors then take these issues and add them together with the structural problems facing France, it becomes clear why EWQ and France need to be avoided. Not only does Germany rank far higher than France in terms of global competitiveness, but France appears unwilling to do anything about its growing budget problems and, if anything, is making things worse (also read Three European ETFs Beyond The Euro Zone).

While investors can debate the battle of austerity vs. stimulus all they want, it seems hard to argue that France’s path of lowering retirement ages and more business taxes or regulations makes any sense. Yes, France is getting away with it now, but if the bond vigilantes eventually turn their attention to Paris, some of these moves will definitely be contributing factors.

Lastly, investors should also note that history is definitely on the side of EWG over both EWQ and the broad European market. Over any meaningful time period, EWG has crushed both EWQ and the iShares MSCI EMU Index Fund (EZU), including doubling the return of both the French and the broad EMU fund over the past decade.

This is further evident when looking at more recent time frames as well. In the chart below, look at how EWG has stacked up against EWQ and EZU over the past three years:

As you can see, EWG has handily outperformed its counterparts in the time frame. However, it is also important to note that there is a high level of correlation between the securities both in down and in up markets.

This is important and it is what makes EWQ such a strong pick for the short part of this trade. When markets are sliding, all of the European ETFs are going to be down but Germany has managed to lose less on rough days than many of its counterparts (also read Beyond Germany Three European ETFs Tracking Strong Countries).

If this holds true, just as it has over the past decade, investors could obtain a profit even if both EWG and EWQ go down, so long as the French ETF leads on the downside. Personally, I see no reason why this won’t continue to be true; Germany is in the top class of Europe and its markets seem poised to outperform France’s in the future just as they have over the past one, three, five, and ten year periods.

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Author is long EWG
 
ISHARS-GERMANY (EWG): ETF Research Reports
 
ISHARS-GERMANY (EWG): ETF Research Reports
 
ISHARS-GERMANY (EWG): ETF Research Reports
 
ISHARS-GERMANY (EWG): ETF Research Reports
 
ISHARS-GERMANY (EWG): ETF Research Reports
 
ISHARS-FRANCE (EWQ): ETF Research Reports
 
ISHARS-FRANCE (EWQ): ETF Research Reports
 
ISHARS-FRANCE (EWQ): ETF Research Reports
 
ISHARS-FRANCE (EWQ): ETF Research Reports
 
ISHARS-FRANCE (EWQ): ETF Research Reports
 
ISHARS-EMU IDX (EZU): ETF Research Reports
 
ISHARS-EMU IDX (EZU): ETF Research Reports
 
ISHARS-EMU IDX (EZU): ETF Research Reports
 
ISHARS-EMU IDX (EZU): ETF Research Reports
 
ISHARS-EMU IDX (EZU): ETF Research Reports
 
VANGD-TOT W STK (VT): ETF Research Reports
 
VANGD-TOT W STK (VT): ETF Research Reports
 
VANGD-TOT W STK (VT): ETF Research Reports
 
VANGD-TOT W STK (VT): ETF Research Reports
 
VANGD-TOT W STK (VT): ETF Research Reports
 
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