Europe's troubles pose a real threat

— -- For investors, the best European vacation right now might be an escape from the havoc the continent's problems have been wreaking on U.S. financial markets.

All summer, investors have been force-fed a mountain of bad economic news from the region. Staggering levels of debt held by several European nations — especially Greece — make the odds of defaults by entire nations increasingly likely. Big European banks are faced with the possibility of owning large pieces of debt, issued by European nations, that take a huge hit to their values. And the looming economic quagmire in Europe is hardly a help at a time U.S. economic activity is sluggish, at best.

The ramifications for U.S. investors are staggering. For the first time in recent memory, Europe isn't just a playground for vacationers. Instead, unfolding events there are holding U.S. markets hostage and threatening to unseat long-held investing truisms.

Europe is filling many investors with "never-ending fear," says Bill Stone of PNC. "It's the primary driver of why the markets are so volatile. If there's something to keep investors up at night, it's the European situation."

Investors wake up to a daily dose of news of economic wrangling in Europe. Central banks around the world are working to decrease the impact of a default by a major European nation — the most impending, Greece. Governments in Germany and Finland are offering bailout funds to help Greece keep servicing its debts, but in exchange, are demanding big cutbacks in government spending by the heavily in debt nation. There's also speculation that China might be interested in investing in European nations, providing much-needed cash.

Even casual investors who are trying to cobble together portfolios to save for retirement can't help but let the European turmoil affect their thinking. One of the most commonly held beliefs among investors is that a diversified portfolio should include European stocks. But that tenet isn't looking so good now, with European stocks down 16% this year and exerting a gravitational pull on an already weak U.S. market.

Simply put, people are so worried about Europe because "they're invested in it," says Ken Winans of money management firm Winans International. "It's been a train wreck."

But for those mindful of the fact that the U.S., with the world's biggest economy, usually sets the tone globally — not the other way around — it might seem investors are becoming overly fixated on Europe. Some might wonder, does Europe really matter?

The answer, say economists and institutional investors, is a resounding yes.

Decades ago, Americans could easily ignore developments in the Old Country. But now, thanks to a global economy, problems in Europe are also our problems, due to some less-than-apparent linkages between the U.S. and European economies. Worldwide stock markets are taking cues from each other, which is applauded during prosperity, but festers fear and unknowns during downturns, says Bill Ryder of RiverFront Investment Group.

The increased linkage between U.S. and European stocks isn't just a topic for business journalists; it's shown statistically. European and U.S. stock markets have had a correlation of 0.9 in the past three years, Ryder says. That seemingly arcane statistical measure, when translated into English, means that when Europe zigs, the U.S. zigs, almost in lockstep.

Investors and traders have defined five distinct reasons why Europe's woes are a real threat to the U.S. economy and stock market:

Fear of a global bank ripple effect

U.S. banks aren't big owners of European government debt directly. It's the indirect connection that's deep and potentially troubling, says Axel Merk of Merk Funds. Many large non-government money market funds, places where U.S. investors often park cash for safekeeping, have half their money invested in commercial paper issued by European banks, he says. And those European banks are heavily invested in debt issued by most of the European nations, he says.

While much of the problem is centered around Greece, for now, the possibility of a ripple effect is what investors are fretting about, says Dan Seiver, finance professor at San Diego State University.

If Greece defaults, as many analysts expect in some form or another as early as this year, that could greatly reduce the value of Greek bonds held by many European banks. Suddenly seeing the value of their Greek holdings evaporate, the assets of many of these European banks would not be worth as much as previously thought, and the banks could have troubles of their own as they need to raise money to meet capital requirements, Seiver says.

It doesn't take much imagination to see a game of European economic dominoes unfolding. All eyes are on Italy, which is one of the European nations that investors fear is in the next worse shape after Greece and Portugal, PNC's Stone says. If Italy runs into trouble due to its debt load, and the value of its government debt takes a hit, that could quickly bleed into France, for instance, since many French banks own Italian debt. "It was just Greece, Portugal and Ireland," he says. "Now, we're talking Italy and Spain."

Anti-stimulus for global economy

The U.S. economy's growth is sluggish, but it's hard to make a case that conditions are bad enough for the economy to slip back into recession due to a U.S.-centric problem, says Barry Knapp, chief U.S. equity strategist at Barclays Capital. But as often has been the case in recent recessions, it's usually an outside event that spells serious economic problems for the U.S. Investors fear the European debt crisis is potentially an event that could be trouble for the U.S. economy.

Waning demand in Europe due to a recession would cut into a big export market for many top U.S. companies. Europe as a group has a gross domestic product roughly in line with that of the U.S., underscoring its importance as a global trading partner, PNC's Stone says.

Brings up memories of Lehman

Investors are shaped by past crises, and the market meltdown that started following the fall of Lehman Bros. in 2008 is still a fresh wound. Investors are sorely afraid the global capital structure, which allows for the free movement of goods and money worldwide between trading partners, would slow following a European default, much as the collapse of Lehman did in the U.S. Investors are worried "things go so badly in Europe … we have a Lehman-like moment," Knapp says.

The nightmare scenario would arise if there's so much selling of European debt, it overwhelms the banking system as the value of government securities falls, Knapp says. If that happened, most European banks would see their reserves lose value, causing them to be short of the capital needed to lend. That, in turn, could spark selling of any liquid securities, which could include U.S. stocks, he says.

Stokes lack of confidence in policymakers

Investors rely on central governments to manage an erosion of confidence in capital markets before they get out of hand. German officials have attempted to assure investors it would stem the crisis. But given how economic decision-making in Europe is so fragmented, investors have little faith that nations, with their different needs, positions and historical baggage, will be able to navigate the situation, PNC's Stone says.

Conjures questions of the eurozone's future

Perhaps the biggest wild card is the idea that some nations that use the euro could stop using it, retreating to their original currencies. Such an event could have profound influences on the entire banking system that are impossible to forecast.

Nations understand the contagion would be so devastating, however, the odds of it happening are practically zero, says Peter Cardillo of Rockwell Global Capital.

Yet, analysts conclude Europe's woes will be resolved. The solution might be uncomfortable for Europe and will take longer than optimists hope. Europe will ultimately reform the way that stronger nations can apply fiscal discipline to nations, such as Greece, that are living beyond their means, PNC's Stone says.

European nations understand that they must stop the crisis by whatever means needed, says Seiver, or risk dragging the global economy down. "While the house may catch fire, they're all in the same house," he says. "They have to put out the fire."