Why Europe's problems haven't roiled the markets

European union concept, digital illustration.
Emrah TURUDU

Many investors seem panicked about the problems Europe has faced over the past few years. Yet the markets don't seem to be reacting negatively to all the bad news. The simple way to understand why is to look at the differences between "stage-one" thinking and "stage-two" thinking.

Stage-one thinking involves only looking at the immediate consequences of a problem before it's addressed. Stage-two thinking, on the other hand, involves looking at the consequences farther down the road once actions have been taken to address the problem at hand.

Those who engage in stage-one thinking see crises and risks, but can't see beyond that. Their stomachs take over, they can't control their emotions, panic sets in, and even well-developed plans are abandoned. On the other hand, those who engage in stage-two thinking know that while there's no certainty, they do expect to see solutions to address the problem. And the worse the crisis gets, the more people will act with urgency and scale. That insight allows them to see beyond the crisis, enabling them to keep control over their stomachs and their emotions.

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Over the past year, Europe has been caught in the eye of a financial storm. European stocks experienced sharp losses, and bond yields on sovereign debts soared as credit ratings were slashed. Stage-one thinking leads to sales of assets as investors assume the bad news means prices are surely going lower. The result is that sales occur after prices have already fallen and are low, and expected returns are high (reflecting the high perception of risk).

Stage-two thinking allows one to see that the light at the end of the tunnel might not be a truck coming the other way. Instead, it might be actions to help resolve the crisis.

In response to the crisis, we've seen European governments from Greece to Spain slash budgets in ways that they likely wouldn't have considered if their hands hadn't been forced. In addition, the European Central Bank cut rates and lent money to banks, first with short-term loans, and then with three-year loans once the short-term loans didn't appear sufficient. That not only assured the markets that there wouldn't be a liquidity crisis in the banking system, but it allowed the banks to buy up their respective country's sovereign debt, driving down interest rates on the bonds and killing two birds with one stone.

It also provided profitable opportunities to the banks which were borrowing from the ECB at a rate of just 1 percent and lending out at much higher rates to their governments, which in turn will help to restore bank profitability. These actions appear to have had the intended effect. Not only have rates been slashed on sovereign debt, but equity markets have rallied.

Note that the ECB's actions were basically a replay of the actions taken by the Federal Reserve during our crisis. The Fed not only slashed rates to zero, but when that was not sufficient they engaged in massive bond buying programs in what became known as QE1 and QE2.

European nations continue to announce new programs to address the crisis. For example, after announcing a $40 billion austerity package in December, Italy's Prime Minister Mario Monti announced a $7.1 billion infusion in infrastructure, in addition to opening up professional guilds to competition.

While perhaps amusing, it hasn't been a surprise to me that the same people asking me in 2008 and 2009 why we continued to recommend holding U.S. stocks when international stocks were clearly safer are now asking me why we continue to recommend holding European stocks when U.S. stocks are clearly safer.

The ability to see beyond the immediate crisis is what enables investors like Warren Buffett to keep their heads when others around them are losing theirs. Listen carefully to his advice: "The most common cause of low prices is pessimism -- sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."

Having a well-developed plan, one that includes the virtual certainty that you will have to face many crises over your investment horizon, along with the ability to avoid stage-one thinking, will give you the best chance of achieving your financial goals.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.