The stock market rallies reflect naive optimism that a solution will be found to the European debt problem. The stock market declines reflect the realization that the risk to the U.S. economy from the European debt problem is very real.
The European countries need to borrow a huge amount of money in 2012. Adding together maturing debt, new borrowing and interest payments, Italy will need to find 400bn euros, France a tiny a bit less, Spain around 220bn euros and the UK approximately 260bn euros (based on data from Bloomberg and the European Commission).
Banks across the world are stuffed with sovereign debt. If more countries follow the Greek example of writing down loans, some banks will suffer horrible losses that will wipe out their entire capital base. The entire financial system seems likely to implode, and American banks will be infected as well. Simply a big jump in interest rates, causing bonds to lose value, could lead be an equally damaging result.
However, the debt crisis in not just limited to Europe. During the January - March 2012 quarter, the U.S. Treasury expects to issue $541 billion in net marketable debt. Thus, the Treasury will be competing for funds with European banks.
The likelihood of a financial crisis in Europe occurring in 2012 are becoming increasingly likely, be it a country defaulting on its debt, or major bank failures. The collateral damage is likely to spread across the pond. Most of the Fortune 500 companies have European subsidiaries, financial institutions have exposure to European debt, and lots of U.S products get shipped to Europe.
It is appropriate to be worried about the impact of European debt problems on the U.S. stock market. In my opinion, a 2012 year end close for the Dow Jones Industrial Average below 10,000 is probable. If I am correct, retirement funds will take a big hit, and the problems of underfunded pension fund will become worse.
Thus, be skeptical about the positive headlines from Europe, and beware of the negative ones. The only news that would truly indicate that Europe can solve its debt problems would be that their economy is growing. Anything else is just putting lipstick on Piigs.