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If you never heard of the small island country in Eastern Europe called Cyprus prior to the last few weeks, you are not alone.  The Republic of Cyprus is a popular destination for tourists along the Mediterranean Sea.  Cyprus joined the European Union (EU) and the Eurozone in 2004 and 2008 respectively.   The majority of their economy, as measured by Gross Domestic Product (GDP) is derived from services from industries such as financial, real estate, and, of course, tourism.

Cyprus only represents 0.2% of the total European economy.  According to the World Bank, as of the end of 2011, the entire population of Cyprus stood at just over 1.1 million people.  To put this in perspective the population of the state of New Jersey is 8 times greater than the entire country of Cyprus.  Despite this small economic and demographic footprint, Cyprus has dominated the headlines for the past couple of weeks while being the scapegoat for down days in the stock market and recent market volatility.

Part of the reason for the “Cyprus Effect” may be the feared precedent that the Cyprus lawmakers are setting by raiding the accounts of local bank depositors to finance their own financial bailout.  According to Sky News, large depositors (i.e. those with greater than 100,000 Euros) stand to lose as much as 60% of their deposits if the Cyprus plan goes through as currently described.

However, according to Benoit Couere, a member of the European Central Bank’s (ECB) governing council, in a recent New York Times article entitled, “Head of Cyprus’s Biggest Bank Resigns”, the situation in Cyprus is unique from the other debt problems plaguing areas of Europe; namely in the P.I.I.G.S. countries of Greece and Spain, because Cyprus was actually in a bankruptcy situation.  As a result, the solutions being considered for Cyprus are not seen as being likely or necessary for other countries in the Eurozone.  Regardless, it does set a precedent for what other debt plagued nations in Europe may consider if they are faced with a similar financial quandary.  Perhaps, even more daunting, it creates a potential bailout blueprint for other emerging and developed market countries outside of Europe.  Some analysts have even expressed concern over the likelihood (albeit slim) of such a remedy being employed at some point in the future in the United States.

Another reason for the market reaction to the recent financial actions in Cyprus may be that the “Cyprus Effect” may be a convenient excuse for some investors to take some of the profits that they realized during the historic bull market run that has major stock market indices such as the Dow Jones Industrial Average (DJIA) and the S&P 500 each hitting all-time highs.  The events in Cyprus may also serve as anecdotal evidence to those investors whom believe that the market is due for a correction given that much of the market advance has been on the heels of government intervention without any meaningful and sustainable improvements attributable to the private sector in terms of economic growth.

While a feasible argument can be made that the market may have rallied too high, too fast thus far in 2013 given the first quarter return of greater than 10% for the S&P 500 index, it is hard to argue that improvements are not being made in the economic foundation that underlies the capital markets.  For example, the housing sector continues to be one of the bright spots in the U.S. economy.   To this end, the real estate market recovery in the U.S. appears to not only be stabilizing but now also shows signs of picking up steam.  According to the S&P/Case-Shiller Home Prices Index, which measures housing prices in the twenty largest cities in the U.S., prices are higher in all 20 cities over the course of the last year (January 2012 – January 2013) with an average price increase of over 8%.  Furthermore, improvements, while meager, continue to be made on the private sector job creations and national unemployment fronts.

Hence, we at Hennion & Walsh see more potential upside for stock market investors in 2013, yet still encourage investors to build and maintain diversified portfolios, incorporating a wide range of different asset classes and sectors where appropriate, due to the continued turbulence in Europe and uncertainty in Washington given the unknown outcome of the Fiscal Cliff – Round 2 negotiations related to spending and their impact on future increases to our nation’s Debt Ceiling.