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What a week it's been. Last week, Fannie (FNM) and Freddie (FRE) were on the verge of going down, and taking the good faith and credit of the US with them - and this week the stock tip of the week has been "buy financials". Everyone now assumes banks are doomed and the new contrarians are those calling for a rally in financials. Do we let go of entrenched assumptions and switch sides now?

As I write this, gold is down another $11, on top of the previous day's $20 loss. One more session  and gold - the traditional safe haven in times of market stress and geo-political instability - could be back under $900.

Most diligent traders I know are experiencing whiplash, and checking their sanity to see if they are seeing things correctly: Wachovia (NASDAQ:WB), Merrill (MER) and other bank stocks who had been on death watch have actually seen double digit gains on terrible earnings in recent days. Oil and commodities, the money makers of the past 4 years, are the dogs of the week - and the winners have been the beleaguered airlines.

As always, Mr. Market teaches us that the minute we think we have things figured out, and have a sure-fire money making strategy in place, it's time to check the mirrors for fast moving objects in our blind spots.

What is the cause of this crazy trading? We all know that the SEC has held a gun to the hedge funds, curtailed naked shorting (read as a ban on shorting of financials in general, both naked and clothed) and issued subpoenas to hundreds of firms in a search for the culprits who may have been spreading rumors about the health of banks. The short sale restrictions have no doubt led to the massive short covering rally in financials we've seen the past week...but is that all? The money I witnessed pushing the Financial ETF (NYSEARCA:XLF) an impressive 8% into the close was enormous, more noteworthy as XLF had begun the day deep in the red and seemed headed for quick sprint south of $20.00

What's up? Market sentiment towards banks and financials continues bearish. The cover of Barron's not withstanding, few of the traders, analysts or fund managers I hear interviewed on Bloomberg radio believe this rally is merited. So why is so much money being lavished on the sector?

Yesterday, the legislation to curb oil price manipulation won a test vote in the Congress (see the Bloomberg story: Congress Pursues $80 Oil With Trading Limits, Disclosure Rules). This is the key, in my opinion.

Hot money is being forced out of commodities and back into equities (and the ensuing sharp drop in oil prices would seem to confirm the theory that the price of oil had run to $150 due to hedge fund trading and NOT peak oil)

Furthermore, the funds, on notice and made aware their actions are being tracked, have been told "hands off the banks", so no shorting.

What's a hedge fund manager to do? These restrictions have blown a hole in what has been the sure fire money making trade of the past six months: short financials, buy oil.

Can it last?

I believe it will last until Fannie and Freddie are able to complete their fund raising efforts. This is not a small matter; on the contrary, the crisis engulfing Fannie/Freddie is so enormous that I think most do not realize the full implications.

The U.S. Treasury is not in the position to comfortably bail out the two mortgage giants. A collapse of the GSEs would have a knock on effect on the entire U.S. banking sector, expose the FDIC fund as depleted, and lead to more I-Bank bailouts than the Treasury may be able to handle; after all, they used up roughly half their bullets on Bear Stearns alone.

Furthermore, the very prospect of a Fannie/Freddie meltdown could result in a disastrous run on the U.S. dollar, and worse, U.S. treasury debt. The AAA credit rating of the U.S. could even be at risk. The draconian measures taken by the SEC and the Fed this past week underscore the severity of the crisis, and the extreme measures to which the agencies are willing to go in order to prevent the major investors in the United States from losing confidence in the safety of their purchases (see story here.)

Whether those investors, after witnessing the close calls of the past month, are going to diversify out of the U.S .dollar anyway is another issue. The question right now is timing...

As an aside, I may have an intellectual disagreement with the Fed and SEC's recent actions and their interference in the free markets, however, in reality, as an American, I cannot blame them. At which point do you allow the unfettered markets to bring down the very system in which they operate? The same can be said for the new senate regulations outlawing certain aspects of future trading: oil over $150 barrel was threatening to strangle the U.S. economy and drive millions of citizens over the financial brink. If the traders could not be counted on to restrain themselves during an energy crisis, some would argue for the necessity of external controls. It would seem that the greater good has won out over the rights of traders to pursue the avenue of fastest and greatest profits. But again, will it last if the underlying pressures remain intact? That remains to be seen over the longer term...

So, what does this mean for our markets in the near future? I would say that the passage of the Senate trading limits is going to lead to more money leaving the commodities, specifically leaving oil. If oil breaks the $120-$118 support, it could drop to $80; I believe gold will no doubt follow oil and drop below $900. (If it does not, that would be an interesting disconnect, and could be evidence that a major central bank is diversifying funds out of the USD)

If oil does close under $120 for more than a day, I would expect to see a sizeable stock market rally across the board, but most specifically in those sectors which have been hit the hardest by the soaring price of oil. Airlines and other transport companies could continue to rally for days. Short covering in those sectors could lead to more eye popping days. Winning strategies could include going long the S&P SPDRs ETF (NYSEARCA:SPY), PowerShares QQQ Trust (QQQQ), UltraShort QQQ ProShares (NYSEARCA:QID), and the Ultra Financial ProShares (NYSEARCA:UYG), as well as the transportation ETF(NYSEARCA:IYT). (For more ETF ideas, visit here.)

What are the caveats in this rosy scenario? There are many. Nouriel Roubini, one of my favorite economists, has warned there are other major banks about to go 'belly up' such as Lehman Brothers (LEH) (see the RTT interview I posted a few days back). However, could we assume that the market's reaction to such news would be a massive selloff that would last? These days, having witnessed counter-intuitive rallies in WB and MER on terrible news, and given the restrictions on short selling, I will say guardedly that I believe the reaction would be negative and the selling plentiful. We also don't know for certain that LEH will be forced to make their internal crisis public, however the prospect is certainly worth keeping an eye on.

In addition, although the Bush administration has taken the welcome step of negotiating with Iran this past week, we cannot assume that the situation there is happily resolved either. Were Israel to reiterate their intentions of attacking Iran, or were an actual strike to take place, all bets would be off, in my opinion.

In that case, one could see a sharp and violent reversal of the trends of the past week. Oil and gold would see sharp and sizeable gains. Consider the oil ETFs such as UltraShort Oil and Gas ProShares (NYSEARCA:DUG), Ultra Oil and Gas ProShares (NYSEARCA:DIG) and the two new ones introduced last month: Oil Down (DOY) and $100 Oil (UOY).

Today, however, I expect the trend to continue. XLF over $22.50 could cause those on the sidelines to join the party, despite their doubts about the sustainability of the rally. The Fed has painted the technicals, and bullish indicators are drawing in the doubtful. Airlines, transport should continue to see gains, as well as retail. industrials and the Russell. This is just my opinion. Keep an eye on the overbought indicators, however, for a 5-10% correction. Underlying market sentiment is still quite bearish, despite the evidence of the tape

Put the logic cap on the shelf, and put on the dunce cap. This could well be fool's rally, but the fools are making money - so trade the trend, but keep your eye on the map of the middle east. When flying pigs crowd the sky, stubborn traders will argue it isn't possible, while savvy traders grab a net instead.

Source: On Oil, Gold and Flying Pigs