“Well the good old days may not return, the rocks might melt and the sea may burn.”
(Tom Petty)

My grandfather taught me many things, one of which was to always “think positive.” As a financial professional, I’m careful not to confuse that powerful perspective with blind bullishness.

As we edge towards the midpoint of the calendar year, the bovine have reason for optimism. Despite credit contagion, debt unwinds, structural smoke, geopolitical risks and a housing abyss, mainstay market proxies are only down mid-single digits.

I’ve learned a few things over the course of my career, three of which currently warrant particular attention. First, the reaction to news is more important than the news itself. Second, stay humble or the market will do it for you. Third, discipline must always trump conviction.

With those lessons in tow, I wanted to explore another topic, one that few people have a motivation to discuss. It’s the risk of a seismic equity readjustment, a possibility that has much higher odds than most people currently foresee.

The market is fluid and multi-linear, which is a fancy way of saying that “things can change and they often do.” Still, the ingredients for a downside disconnect exist, conditional elements that, when brewed together, could combine for a toxic ride that will come to define 2008.

The Bank Bungee

We often say “As go the piggies, so goes the poke” in Minyanville and for good reason. The BKX (bank index) has been a prescient precursor of the S&P 500 for many years. The fact that so many now expect a decoupling between the two only serves to reinforce the risk inherent in the relationship.

Quite simply, the financials must catch a sustainable bid or the S&P will get sloppy in a hurry. This, more than any other juxtaposition, remains front and center as we digest earnings from Lehman Brothers (LEH), Goldman Sachs (GS) and Morgan Stanley (MS).

China Rider

While the rapid ascent of Chinese stocks garnered a lot of attention last year, the watershed decline has gone largely unnoticed. Shanghai has been testing a critical technical juncture and that bears watching in the era of globalization.

Last week we touched on the importance of Shanghai Composite 3000. It’s where the bubble first broke out in early 2007, a 50% retracement since October—fifty percent!—and where China must hold, particularly if it’s gonna light an upside torch into the Olympics.

The Mood Ring

It’s critical to remember that the stock market crash didn’t cause the Great Depression, the Great Depression caused the stock market to crash. It was an era, not an event.

Social mood and risk appetites determine price action. I offer this in the context of the massive issuance we’ve seen in the financial sector. While they continue to ratchet terms to attract demand, buyers are becoming more selective as evidenced by the absence of Sovereign Wealth Funds in the Lehman Brothers deal.

If and when flailing firms fail to find capable buyers—and there are precious few players fitting that bill—the wheels on the wagon will wobble anew.

Hut, Hut, Hike!

We’re currently standing at the crossroads of our wishbone world, with inflation on one side and deflation on the other. Given the recent rhetoric from government officials—jawboning the dollar last week and attempting to quell rate fears yesterday—it seems like that conundrum in coming to bear.

Federal Fund Futures are now pricing in a 60% chance of an autumn rate hike aimed at combating the devil we know (inflation) while turning a deaf ear towards the devil we don’t (deflation). It’s our sense in Minyanville that this necessary evil has foreign fingerprints all over it.

Perception is reality in the financial markets. If the collective mindset shifts from “the worst is behind us” to “we’re between a rock and a hard place,” the comeuppance will be swift.

Reversal of Fortune

Conventional wisdom dictates that lower crude and a higher dollar will offer an equity panacea. Allowing some room for a Pavlov-style upside response, our take is that this is the biggest misperception in the marketplace.

Since the back of the tech bubble—and contrary to stated public policy—the lower greenback has been the rising tide that lifted all asset class boats. It stands to reason that when this dynamic reverses, equities will not be immune from the swoon.

One Foot in Front of the Other

As always, our ultimate destination pales in comparison to the path that we take to get there. Therein lies the risk and by extension, potential reward in trading the tape as we find our way.

Pundits are pointing to last week’s “higher low” versus the March abyss. That, coupled with retreating input prices, could pave the way for higher prices as fund managers chase performance into a very tenuous quarter-end.

Be that as it may—and it may well prove true—the greatest trick the devil ever pulled was convincing the world he didn’t exist. I’m here to tell you that the imbalances not only remain, they’re cumulative in both cause and effect.

Outlier, or “tail” events, such as downside dislocations are by definition a low probability affair. An outright bet that one will happen is a risky proposition but assimilating the probability that it could is proactively prudent.

What we know is this—regardless of which way the next ten percent manifests, the move will be obvious with the benefit of hindsight. The key—and the tenet that continues to be tested in this tape—is the ability to manage risk rather than chase reward.

The market is like a casino—it has the staying power—so remember that the mechanics of the swing will always trump the results of the at-bat. Capital preservation, debt reduction and financial intelligence remain staunch allies as we wade our way through these unchartered waters.

R.P.