Where are the Financial Markets Headed?

Global markets are faced with great uncertainty as we wind up 2007. The subprime mortgage debacle unleashed in the US now threatens the very fabric of credit on a worldwide scale. While the US has a nine month start on confronting the problem of over-valued real estate, the rest of the world is just now facing its ramifications.

Global banks, brokerage firms and insurance companies packaged mega-mortgage pools and distributed them everywhere--sovereign governments, pension plans, Govt Guaranteed Agencies, and mutual funds. The risk of over-valued mortgages threatens deposit capital. In the US the sub-prime debacle has even adversely affected money market accounts--the state of Florida having had a run on a state money market account leaving a greater percentage of defaulted or downgraded debt than investment grade debt. General Electric (GE) and Bank of America (BAC) likewise had money market problems, with GE cashing out accounts at 96 cents on the dollar.

As investors, we accept market risk--the risk that we can lose our money by a company going out of business. But today we have to accept additional risks including the risk of terrorism, the risk of war, the risk of excessive leverage, and the risk of an over-valued market.

We say over-valued because one has to ask themselves if the US economy is better off than it was last year? The answer is clearly NO! And if that is the case why is the market higher? How can the Dow be justified at these levels?

Market pundants argue the interest rate cuts effect P/E ratios such that the US market gets cheaper with each interest rate cut. True in the short term, but not the long term because weak currencies artificially create imbalances in trade, spur trade & tariff wars, and lead to low margins for everyone. With profits declining the "E" in the formula can support the "P."

This year has been an exceptional year by most any measure. First the rate of return earned YTD in the markets has been good. Secondly the volatility as measured by the VIX has swung widely causing exceptional trading opportunities. And finally, the impact of the devaluation underway in real estate prices has been a bonanza for short selling to add real return to this year's pot.

So what's up ahead? We'll we argue that this time is different. Losses are going to be realized and capital lost. The tendency to disclose losses will be one of gradualization. This will continue to cast a pall on the markets for some time to come. Moreover, just as the worst has been priced in the Congress and foreign Parliaments will "ad nauseum" seek to both benefit and legislate. For these reasons look for 2008 to be an almost never ending story.

Meanwhile, will the markets muddle through? We think not. A correction is likely coming and is needed. The only wild card is foreign investment in the US. Our view is that Mr. Paulson is hard at work putting a plan together to invite the Arabs and Chinese into buy these cheap US assets. Look for London to make a grab as well. But not until there is some certainty that a deflationary cycle is not underway. Until that is known, even these investors will sit on the sidelines. That's when Treasury persuasion will have its most poignant impact.

Disclosure: none