See Chris Ciovacco’s Short Takes blog below.  It helps remind us that strong bear market rallies are very common.  There were 3 very strong rallies in the fall of 2008, but the S&P 500 fell 33.8% before we were through.

We have been conditioned this past year or so to believe that the Fed or the ECB will come to the rescue and print money sooner rather than later to kick the can down the road.  With Europe, the costs of failing to do this are too large.

However, what if politics in the healthier European countries keep that from happening until there is a crisis and the global financial markets plunge 30% or more?

I have included a second blog below that tries to address that question.  It is Tyler Durden’s post on 9/09/11 on the ZeroHedge blog.  He shares an article by Dylan Grice of SocGen.  Dylan hypothesizes that one of many plausible triggers (e.g. PIIG defaults, deterioration in Italy and Spain, failure to approve the new role and money needed to adequately capitalize the EFSF, or some other trigger) could cause runs on the securities of Eurozone governments and banks.

Particularly if this happens in Spain and/or Italy, fear that the banks are too big for already strained governments to save could breed more panic.  Germany and France would have their hands full with their own banks.  Runs could develop in core government bond markets as investors take fright.  The absence of any coherent pan-European political leadership ensures any opportunities to get ahead of the panic are missed, and so one/some European banks fail.

Tyler Durden says that he doesn’t agree with this hypothesis.  He thinks that Germany will roll over and allow the European Central Bank to print huge sums of money in order to support Eurozone banks and governments before the markets seriously panic over the solvency of the Eurozone’s core, or its banks.  Tyler believes it will buy time, but quite a lot of time.  The important point he makes is that equities are likely to become very cheap in the sort of panic that would force the ECB to print with the abandon of a Ben Bernanke.

Dylan Grice and Tyler Durden help show us two potential outcomes, neither of which is good.  However, no one knows how long we have before conditions in Europe deteriorate enough to cause the financial markets to panic.

If Greece defaults and there is no contagion causing other defaults or bail outs of the PIIGS, if the new EFSF (European Financial Stability Facility) is capitalized with enough money to calm the markets or the markets believe the ECB will step in and print the money is needed to keep Spanish and Italian bond yields down - the can could be kicked down the road longer.  Or, if the Fed surprised everyone and voted to approve a major new type of quantitative easing, this could also calm the markets short term especially if a good portion of the money printed provides liquidity to European banks – like it did with QE2.

The panic in the markets recently has been due to the fact investors are no longer confident any of the above will happen.  If their confidence is restored, the financial markets could stabilize.

The bottom line is that risk now is potentially as high as it was at the time of the Lehman Brothers default simply because politics in the stronger countries in Europe could prevent the EU from getting ahead of the panic until after there has been a large selloff in the financial markets. Having some cash allows you to take advantage of that whenever it does happen.

Strong bear market rallies make it very tough mentally to have a good portion of our portfolios in cash and bonds when we experience 15% to 20% rallies, which are a normal part of any bear market.  These rallies convince small investors that the worst is over so they jump back in only to watch the stock market plunge again.

My purpose in sharing these articles is to help you better visualize where the events in Europe might lead the financial markets so that you can make better informed decisions as to the risks you take with your portfolios and to help you understand that strong, short rallies in bear markets are normal, so don’t let them seduce you there are major policy changes which reduce the risk.  As always, this is not meant to be individual investment advice.  Everyone’s risk tolerance, goals and needs when it comes to investing are different.

Chris Ciovacco’s Short Takes blog >> Bear Market Rallies Are Common