Post-Vacation Blues and the Current Market

Post-Vacation Blues and the Current Market
Photo: Petrick2008, Creative Commons, Flickr
Since coming back from my holiday last week I’ve made a point of walking past the New York Stock Exchange on my way to work. I sat on a bench and looked at the traders as they exited the building after the close, and every now and again I eavesdropped on their conversations.

Something is wrong.

I keep telling myself that it’s all going to be OK, I keep telling myself that things are never as bad as the fear mongers proclaim, but I can’t shake off the feeling that the situation is about to take a turn for the worse…

Post-Vacation Blues and the Current Market
Photo: Walsh, Creative Commons, Flickr

Over the weekend we learned that the Fed will offer a lifeline to mortgage giants Fannie and Freddie. So much has already been said about this train wreck, but I’d like to highlight a comment that stood out for me. Jeffrey Gundlach, an analyst at TCW Group in Los Angeles, pointed out that "the credit crisis has obviously entered into a new phase – the government has one bailout left in them, and this is it." In other words, the Treasury had used one of its last bullets and will soon be fighting the monster with a BB gun.

Inevitably, the market will now start to wonder which institutions are too small to bail out, and it looks like smaller regional banks will be beaten up over the coming weeks. It wouldn’t surprise me if we saw a bank run every few weeks until the end of the year. The New York Times seems to agree with this assessment, with an article suggesting that up to 150 U.S. banks could fail or seek mergers over the next 12-18 months.

Stocks will continue to slide lower, simply because they remain overvalued. The Bespoke Investment Group blog recently pointed out that the trailing 12-month P/E ratio for the S&P 500 is currently at 20.54, and just a couple of weeks ago, it had risen to its highest levels in years. Even at 20.54, it is higher than it was when the market peaked in October.

And it looks like the greenback is about to get a thumping if Fannie and Freddie continue on the road to nationalization. John Noonan, a senior foreign exchange analyst at Thomson Reuters IFR Markets, said if the U.S. government does assume the risks attached to Fannie Mae and Freddie Mac, this move could devalue the "most sacred" U.S. Treasury bond.

"The U.S. dollar implications would be extremely negative," said Noonan. He said the other problem is that the Fannie and Freddie crisis comes only four months after the Bear Stearns debacle/rescue that was supposed to shut the book on potential systemic failure. "In other words, even if there was a bailout of either/or Fannie or Freddie the market would then turn to the next obvious candidate for default and would assume that the next one will not result in a bailout," Noonan said.

Considering that the negative correlation between the U.S. dollar and oil prices is at a record high, a weakening dollar will probably translate into skyrocketing oil prices. Now, one would imagine that the Middle East would try and avoid war and make sure that the oil keeps flowing during this $150/bbl bonanza, but tensions between Israel and Iran are escalating.

French President Nicolas Sarkozy on Sunday asked the Syrian president to help resolve the crisis over Iran’s nuclear program by persuading Tehran to cooperate with the international community. Syria and Iran have good relations, but President Bashar Assad expressed doubt that his intervention could help. This is interesting, and it’s even more interesting when considering that Syria, a traditional ally of Iran, is in the process of signing a peace accord with Israel. Syria launched indirect peace talks with Israel this year under Turkish mediation over the return of the Golan Heights captured by Israel in 1967. The consensus seems to be that a Syria/Israel peace deal would be a blow to Iran.

I’m not going to pretend to be an expert on the Middle East, but my gut feeling is that Iran will be weakened if it loses Syria as an ally. This raises an important question: Will Israel exploit Iran’s isolation and launch a preemptive attack? If you believe in the wisdom of crowds, note that Intrade, the online prediction market, sees a 33% chance of an air strike on Iran by the end of the year.

Maybe it’s time for another vacation…