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.