WALL STREET AT CROSSROADS
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
March 18, 2007

The stock market was damaged on February 27, 2007, as fears of a Chinese market meltdown circulated through the global market place.  But, as time has passed, and the usual discovery process after such an event has progressed, there are other issues beyond subprime, which may lead to further trouble.

Over the last few trading sessions, the market has tried to put in a bottom. But the action has remained very tentative, and it is unknown at this point whether this bottom will actually hold.

Derivative Fears Rise
(March 14, 2007)
Under The Surface

The current selling on Wall Street is not so much about subprime home loans going bad, but about the sudden realization that bad loans are everywhere and that they are linked through derivative networks.

According to Tod Harrison, founder of Mynyanville and who writes a nifty column for Marketwatch.com, the subprime problem "only scratches the surface of the structural risks in the system," as there may be as much as "$370 trillion in outstanding derivative contracts," out there waiting to do something.

But Harrison notes that although there is that estimated figure floating about "nobody knows" how much of a derivative web there really is, thus rendering the extent of its potential as another unknown.

Harrison further adds: "derivatives aren't evil products. They're fantastic risk management tools when managed correctly. Unfortunately, given the proliferation of hedge funds and the massive amounts of leverage in the system, the odds of a "tail event" (an outlier move that isn't factored into financial models) increase in kind. "

Admitting that he's not sure if the subprime issues are that "tail event" or not, Harrison wisely notes that "it is that possibility -- the percentage probability -- that is currently being priced into the system."

His discussion gets more interesting, though, when he writes: "You see, in a finance based economy, such as the one we currently have, the dependence on financial operations has never been more acute. General Motors, General Electric, Ford, to name a few, all feed their bottom line and buffer earnings through financing operations. We like to call these "financials in drag" because most folks don't view them through the same lens as traditional banks. But let's be honest, do you think GM makes money selling cars? No. They make money selling loans. And those loans are packaged and repackaged numerous times and passed amongst financial intermediaries."

Harrison's astute analysis notes that the passing off of loans to others is a good thing in a liquidity driven, stable market. And it's rarely questioned when companies beat their bottom line earnings estimates." But, he cautions that "The other side to that trade will come to bear, however, if a pebble falls into this" intricate global machination. The perception of that risk has diminished through the years as it failed to materialize."

In effect, "The unfortunate truth is that the risk, rather than dissipating, has actually increased on a cumulative basis."

Ugly Charts

And just in case anyone missed it, the financial sector has all but crumbled with the broker and bank indexes dropping like stones.

Chart Courtesy of StockCharts.com

First, we'll look at the Amex Broker Dealer Index (XBD, above). This is where Goldman Sachs (NYSE: GS) and Merrill Lynch (NYSE: MER) reside. Two things stand out with XBD. First, the index made a new low for the current down trend. And second, the index sliced through its 200 day moving average, signaling that the long term trend might have reversed and is now primarily to the down side.

Chart Courtesy of StockCharts.com

Next, we'll look at the Philadelphia Bank Index (BKX, above). Here we see a similar picture, as this index has also broken below its 200 day moving average.\

The financial sector is traditionally one of Wall Street's leaders. When the leaders break, it's often not long before the rest of the market follows.

And that's also the message from our third chart, the NYSE advance decline line (NYAD, below), which looks to have topped out.

Chart Courtesy of StockCharts.com

Conclusion

Risk is rising, not falling. And it is not falling so much on reality, which is not particularly rosy, but on the expectation that something worse might be lurking.

And if history is any guide, this correction, or whatever else it turns out to be, is not likely to work itself out in a very short period of time.

A great deal of what happens next depends on whatever else is lurking out there in the dark dreary world of derivatives.

In other words, investors should prepare for rough times to continue over the next several weeks to months, if not longer.