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Chasing Liberty


Financial markets reach critical cusp.


"Give me your tired, your poor, your huddled masses yearning to breathe free, the wretched refuse of your teeming shore."-The Statue of Liberty

America's founding principle was to accept those that others cast aside. The government has now applied this concept to financial assets.

As Bear Stearns (BSC) was tossed into last Monday's volcano, wheels on financial wagons wobbled throughout the world. Into that hopeless hysteria, the tempted and tossed found a friend in the Federal Reserve.

During the process of downside price discovery, I shared a few reasons why "we could conceivably see a melt up in the equity space." The initial feedback was uniform in offering the other side of that opinion.

Following a vicious lift that caught many investors looking the wrong way, sentiment has shifted in kind. It's human nature to examine risks when the chips are down and chase rewards when screens are green. Paradoxically, that mindset is the mirror image of successful money management.

Since the beginning of last year's decline, the two previous rallies in the financial sector measured 13% (December) and 16% (January). As that complex is now 16% above last week's low, we've arrived at a juncture that requires serious consideration.

Will we hold and embolden the bulls or fold just as they've started to get comfortable? Welcome to Stock Market 2008, the most interesting juncture in the history of finance.

The Three Phases of Leave

Market psychology involves three distinct phases. Denial, when nobody wants to believe they're wrong. Migration, when everyone realizes they were. And panic, when emotional decisions are made in fear of missing the move.

This process works on both sides of the ride and applies across multiple time horizons.

Last summer, when we were probing all-time highs on a daily basis, the powers that be denied that the potential for credit contagion existed and investors took them at their word.

During the next eight months, as serious structural imbalances manifested, the market migrated down the slippery slope.

In recent weeks, with many of the world's largest financial institutions 50% off their highs, perception caught up with reality as mainstream media championed the risks in the system.

The question I'm wrestling with is whether we've seen sufficient panic to qualify the cycle turn. Throughout my career, true fulcrums of despair have been sloppier than what we saw last week. Remember, capitulation occurs when nobody-and I mean nobody-wants to own stocks.

The wildcard in this equation is the pervasive intervention we've witnessed to date. There is no way to know what the panic phase would have looked like without the trillion-dollar Federal infusion or the Plunge Protection Team working diligently behind the scenes.

A Riot is an Ugly Thing

We can debate the merits of government intervention until we're blue in the face. We've arrived at a point, however, where these policies are like the Iraq war. You may not have agreed with the initial occupation but now that we're there, you can't suddenly pull out without profound consequences.

The government is socializing the markets and will, in my opinion, eventually nationalize Fannie Mae (FNM) and Freddie Mac (FRE). It's too late to shift course, sort of like a cruise ship in a canal trying to navigate the tips of multiple icebergs.

One of three things will ultimately manifest a function of our current course.

  • The system will repair itself as real estate rebounds and the underlying collateral starts to appreciate. This preferred path would allow the Fed to transition assets back to the balance sheets of the banks and unwind the most recent round of intervention.

  • Foreign holders of dollar denominated assets will finally balk, which is an alternative many nations would have opted for already if they could do so without disrupting their own financial fate.

  • If the economy continues to deteriorate, the Federal Reserve would effectively and eventually become insolvent. It won't go bankrupt-it will simply print more currency and further dilute the value of the dollar, which would bring us back to the second scenario.

Déjà Vu All Over Again

Our current conundrum can be traced back of the implosion of the tech bubble. If we were allowed to take our medicine rather than being injected with artificial drugs, we would already be on the road to recovery.

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