When will Forclosuregate Tank Equities?

The massive mortgage mess a/k/a Foreclosuregate could be another doomsday scenario for the banks, so it’s worth exploring how it might bear on market analysis.  A decent background piece on the technicalities of it is here.  I think recalling the sovereign debt crisis is instructive, even if it does not turn out to be a close analog.

The seeds of the debt crisis emerged in the media about the same time last year, in Oct 2009.  Initially, news about insolvency in the Club Med states, especially Greece, was shrugged off.  Then came a nasty shakeout on headlines regarding Dubai’s debt.  This occurred over a US market holiday (Nov 27, 2009) and turned out to be a buying opportunity.

Equities melted up throughout December, and it wasn’t until about mid-January 2010 that the markets were not able to recover selloffs coming off negative headlines.  At this point, credit default swap (CDS) spreads had reached record wides for some states, indicating panic, though they had been elevated for some time.  Equities corrected, but less than a month later, the market stopped going down on bad news.

The Feb 16 follow through day was a strong technical buy signal, though it still seemed dubious at the time that the sovereign problems could be solved [or at least papered over for a time].  Nevertheless, equities rallied for over two more months, as one technical hurdle after another was overcome.  In April, the negative news resurfaced, and CDS spreads starting edging wider, eventually surpassing the January levels.  The risk markets began to capitulate toward the end of April and early May, but only after they became noticeably frenetic, culminating in the May 6 flash crash.

It took about six months for all of this to occur, which should provide some perspective on the current situation, which has only made it into the main stream media very recently (yes, blogs have been covering this for over a year, but that was the case with the sovereign debt situation too).  Similarly, one could argue that the banking panic of 2008, which accelerated after the Lehman bankruptcy, was the culmination of events that came to public light six months earlier with the Bear Stearns failure.

Given some time, as the worms pour out of the proverbial can, the Foreclosuregate/MERS scandal could indeed facilitate another bear leg (as could other events).  However, yesterday, October 14 was only the first shakeout on news related to it.  Given the scope of the problem and the policymaker/regulatory responses over the last few years, it’s a no-brainer that there will be an attempted bailout, back-door or otherwise.  The bond vigilantes will wait on the sidelines, and if/when they smell blood, we’ll see it first in the derivatives markets, especially as financial CDS spreads blow out (they’re just beginning to).  Cracks in the equities markets will emerge when key technical levels are broken and not recovered after negative headlines.  Therefore, a quick rebound today or Monday would signal considerable strength.

One can argue that the investing public is increasingly shell shocked and will be quicker to run, which is probably the case.  As I said, this may not be a perfect analog, but I do maintain we’re only in the very early stages of this matter.  Accordingly, I’m not expecting the THE BIG decline just yet.