European government debt problems surfaced over a year ago. Initially, Greece was the only country struggling to access the capital markets, yet the problems have continued to spread and are in no way contained. Although European countries created a stabilization fund and the ECB has bought European debt on the open market, bond prices have continued to fall. Yet, even in the face of falling government bond prices, global equities have continued to rally.

A similar situation occurred in 2007 when stocks rallied despite a crumbling mortgage market. In early 2007, the lowest rated subprime mortgage bonds began to fall in price (Figure 1). However, by October, 2007, stocks made all time highs.

Figure 1. Subprime Mortgage Bond Prices in 2007

The stock market is making new highs despite yields of European sovereign bonds showing signs of stress. Below are the charts of Irish, Italian, Portuguese, and Spanish bond yields.

In 2007, as the subprime mortgage market was in turmoil, the equity market rose to all time highs as investors ignored the risks to home prices and the economy. Now, just four years later, equity investors are again overlooking the turmoil in credit markets. Could investors be making the same mistake they made in 2007?