U.S. Stocks Plunge on Europe’s Debt Woes: What Should Investors Do?

Wall Street notched another difficult day Tuesday, with the Dow Jones Industrial Average (DJIA) plunging 389 points to close at 11,781.

Traders commenting on the Dow say volatile, choppy conditions are likely to persist for a while, at least until institutional investors get a better sense of how extensive the sovereign debt and related bond concerns are in Italy. Moreover, with the aforementioned in mind, here are answers to a few questions that may be on the mind of typical investors:

Q. The market plunged another 400 points on Tuesday. One day the Dow is up 200, the next day it's down 400, what's going on?

A. We're still in the midst of the global financial crisis -- actually its second phase - which involves primarily European government debt, and institutional investors remain concerned about the long-term value of those European bonds they bought. Specifically, investors are concerned about the value of their bonds in two of Europe's debt-plagued countries -- Greece, Italy, and Spain.

Q: But I don't quite understand how concern about the value of bonds in Europe can affect stocks in the U.S. Why is that so?

A: Well, for one thing, U.S. institutions have invested in those European bonds, as well, but to your point, credit market concerns in Europe would likely slow the Eurozone economy, possibly tipping it back in to a recession. And as you know, Europe is a major trading partner of the United States, hence any slump in Europe would hurt U.S.-based multi-national corporations (MNC), and by extension, their stocks, which is one major reason why the Dow plunged Tuesday.

Q: But I thought we were done with the financial crisis, what with all the U.S. government bail-outs and all?

A: Briefly, sorry, but no. The interventions and bailouts in the United States did a very good job stabilizing key institutions and maintaining liquidity in credit markets on this this side of the Atlantic. Europe, including Greece, represents the second wave of the crisis.

Q: So what are European public officials likely to do?

A: Good question. Right now, there's no consensus, but three possible responses are being discussed. Keep in mind that there are no easy, cost-free solutions to the crisis.

The first involves muddling along, also known as kicking the can down the road. That's where Eurozone officials offer a modest increase in the European Financial Stability Facility (EFSF), currently €1 trillion or $1.38 trillion.

The fund is big enough to handle a bailout of Greece, but not big enough to handle Italy's roughly $2.8 trillion in debt, hence some type of fund increase would be needed. If the Europe's leaders choose the incremental approach, they may increase the fund by €300 billion to €500 billion, then take a wait-and-see-approach, hoping Italy's economy will recover enough in 2012 to make it easier for that country to service its debt.

The second option involves letting Greece and/or Italy, and possibly other debt-plagued countries, leave the Eurozone. This would be a major change -- some would call it radical change -- that would affect the stock, bond, and currency markets. The upside is that the tactic would allow Greece and/or Italy to let their new currencies weaken to help service their national debt.

The problem is, the value of those bonds would plummet -- and bond holders would likely be irate: they expect to be paid back in euros -- not in a new currency that may not be as valuable or as stable as the euro.

As noted, the ripple-effects would likely be major, if Greece and/or Italy break away from the Eurozone, but it's one option being discussed.

The third option involves a major, coordinated intervention, involving the fiscal governments of Europe, supported by the U.S. government, in conjunction with monetary intervention by the world's major central banks: the U.S. Federal Reserve, European Central Bank, Bank of England, Swiss National Bank, Bank of Japan, and the Bank of China.

The fiscal governments would provide the backing to enable Greece and Italy to implement austerity measures, and the central banks would maintain liquid credit markets and also support institutions' need for cash, should credit lines tighten.

The cost: at least another $1 trillion in fiscal money. Additions to central bank balance sheet could approach or exceed that level, as well.

The goal of the coordinated intervention would be to do what kicking the can down the road does not do -- address the financial crisis with enough size to end contagion, once and for all.

Q: Given the above, what should U.S. investors do if they are invested in stocks?

A: The keys, as is almost always the case in investing, are: 1) your risk tolerance, 2) investment horizon, and 3) investment goals.

As a primer, this adage applies to all: If you are about to retire, of if you see yourself retiring within one year, the bulk of your investments should not be in stocks. It's quite possible that U.S. stock markets could drop 20 percent, even 30 percent in the two quarters ahead, and not recover by the time you retire, when most adults switch their investments to lower-risk investments.

Likewise, if you expect you'll need money for a major purchase -- such as a home purchase or child's college education. It may be prudent to sell a portion of your stock holdings, given the increased risk of owning stocks over the next six months.

However, if your investment horizon is longer than 1 year, and you can tolerate the risk associated with owning stocks, the best tack would be to sit tight. Keep me in mind that any stock market decline can represent a buying opportunity -- a chance to buy stocks at a bargain price -- provided additional, major stock market declines do not occur.

To be sure, no one can guarantee against additional stock market declines after a substantial sell-off, but the view from here argues, providing the free world doesn't revert to the barter system, the companies with demonstrated business models will rebound, and perform well, once the financial crisis has been resolved.

Again, underscoring: the key is having the ability to wait-out soft market conditions. This is not a stock market for rookies or squeamish investors.

Here are few blue-chip U.S. companies and should perform well, once the financial crisis has been resolved:

Caterpillar (CAT), recent price: $91.64, P/E: 14

Deere (DE), recent price: $72.78, P/E: 12

Boeing (BA), recent price: $64.55, P/E: 13

United Technologies (UTX), recent price: $76.44, P/E: 14

Coca-Cola (KO), recent price: $67.03, P/E: 12

IBM (IBM)¸ recent price: $182.24, P/E: 15

AT&T (T), recent price: $28.91, P/E: 15

Verizon (VZ), recent price, 36.89, P/E 15

Procter & Gamble (PG), recent price: $62.72, P/E: 16

Colgate (CL), recent price, $87.45, P/E: 18.

Market Analysis: If you dollar-cost-average your purchase over several weeks (buy in stages -- 100 shares at a time if you're buying 500 shares of a company; 200 shares at a time if you're buying 1,000 shares, etc.) you'll undoubtedly reap the benefits, long-term, of these quality companies.

To be sure, no one can predict with certainty where the Dow is headed in a week, a month or quarter. But long-term, the argument forwarded here is that stocks of companies with demonstrated business models -- particularly large capitalization companies -- will perform well.

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Disclosure: Lazzaro has no positions in stocks, but does own federal, municipal, and corporate bonds.