Brother can you spare a dime? I need something to turn on. Although markets seemed to have bottomed about a year ago and the economy has quickly been rebounding in various (but not all) corners, many seem to be caught surprised by the unrelenting about-face of security prices and economic indicators, especially since many sectors seem to be limping along and loans are still hard to come by for individuals and small and medium sized businesses. Evidence of a low inflation, mini economic boom continues to emerge and the profit rebound in the non-financial sectors may persist well into 2011.

Neither the Greek debt fiasco nor the more recent Goldman Sachs fraud allegations have triggered substantial corrections. This is no doubt reflective of the very flush monetary conditions around the globe. However, a healthy economic recovery seems to have become widely recognized and therefore is being rapidly discounted by the market, which suggests that a flattish or consolidation phase could develop. If the ongoing economic recovery indeed evolves into a mini boom, then the rapid shift in monetary parameters such as rate expectations, assumptions on quantitative easing, and the shape of yield curves could cause dislocation in financial markets, including a sharp down draft in security prices.

However, recent economic and earnings data have reduced the probability of the downside scenario and the multi-year cyclical outlook remains positive. Nonetheless, there are plenty of possible catalysts for a near term correction. Actions by the SEC could be one of the potential catalysts, as the regulator seems intent on getting its “pound of flesh” out of the investment banks. Rising litigation and reputational risk have the potential to trip up the low grade debt of financial companies and the broader market.

More important, though, to the health of financial firms is the financial reform bill. It is still too early to judge the impact of the reform package currently working its way through Congress because many issues are undecided. The package will likely include a resolution authority for large financial institutions, an increase in capital requirements for banks, a new consumer protection authority, and heightened regulation of derivatives markets (possibly forcing much of the derivatives market onto exchanges or through clearing houses). Sweeping reforms will throw some sand in the wheels of finance and will raise the cost of capital. Thus, the financial sector is likely to shrink as a share of GDP and total corporate profits in the coming years.

Turning to the U.S. dollar, the conditions for another down-leg appear to be falling into place. Dollar strength over the past few months is mostly reflective of euro weakness due to the Greek debt crisis. The disbursement of EU/IMF financial aid for Greece could trigger a sharp short-covering rally in EUR/USD. Short-term interest rate differentials between the U.S. and Canada and Australia will likely move further against U.S.

Michael Ashley Schulman, CFA
Managing Director
Hollencrest Capital Management