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Farrell: Testing Those International Waters Again

Just when you thought it was safe to go back into the (international) waters, along comes Dubai with $60 billion in debt that it can't make good on. More accurately it's Dubai World, the city-state's investment arm. You'll need smarter heads than mine to make sense of the Dubai World debt fiasco. Dubai World got itself overextended in services (financial) and property. Sound familiar? This is almost a logical extension of the worldwide collapse of property values. Some investors also naively assumed the government of Abu Dhabi would automatically stand behind the debt of its neighbor. Why, I don't know. Abu Dhabi has most of the oil, so perhaps that's why it was assumed these monarchies would back one another. They are independent nation-states that cooperate on most everything and are part of the United Arab Emirates. The other five Emirate members are Sharjah, Ajman, Umm al-Quwain, Ras al-Kalaiman, and Fujairah. (Thank you, Google. I couldn't have named them on a bet.)

This financial setback, though, has been coming for some time, considering the international fall in property values. Palm-shaped artificial islands with staggeringly expensive beach villas can only hold so much appeal. Our markets chose not to react before the Thanksgiving break when the news started to circulate but waited till after the international markets cracked. Most of the debt is outside the US, but in our internationally connected world we are all impacted. I couldn't get halfway through the Saturday New York Times article on the matter before I went screaming from the room. "Investors worried about hidden debt bombs in other countries -- heavily indebted countries like Greece and even Britain, high-flying emerging markets, and even European and American banks" are under suspicion. The Times quoted a report from Bank of America that said "One cannot rule out. . . a case where this would escalate into a major sovereign default problem, which would then resonate across global emerging markets in the same way that Argentina did in the early 2000's or Russia in the late 1990's." The fears that there are other hidden credit risks lurking in the global financial system can't be dismissed. But nor should it be assumed we are on the brink again. A restructuring of the debt seems most likely to me, and over-reaction is rarely profitable, but smarter heads should be listened to on that matter. But then again it was smarter heads that extended $60 billion in debt.

The market rally we have had was getting a little old, and an excuse for profit-taking at the end of the year could be embraced by money managers to lock in their gains. So-called riskier assets, like commodities, might be the most vulnerable. It's tough to say there has been a bubble in commodity prices, though. Too much, in my opinion, has been made of the "carry trade" argument. With cash reserves high around the world, the thesis that so many were borrowing dollars to buy other assets has probably been exaggerated. Bank loan volumes have not risen, which would indicate that the alleged borrowing did not take place. If that is correct, then the correction the Dubai situation might precipitate (if left unaided by the other Emirates, which is not likely) could be a more normal one. Money managers have had good years and even more hedge funds got back to their high-water marks, so locking in gains makes sense. For what it is worth, the moving averages on Wednesday's close for the S&P 500 Index were: 20-day: 1085; 50-day: 1073; 80-day: 1053; 100-day: 1034; and 200-day: 942. The S&P closed Friday's abbreviated session at 1091.49. Some traders I talked with took heart from the fact the market sold off sharply on the opening and bounced off the 20-day average (1085) to close above it.

We have had a couple of 6% corrections so far this year. 6% off the recent high would take the S&P to roughly 1040, which splits the difference between the 80-day and 100-day moving averages. (And don't you love it when a situation arises that befuddles most of us, we all become amateur technicians for a day?) I have said several times, and I have been wrong so far, that market advances like we have had are usually subject to sharp and severe corrections along the way. 10-12% is not uncommon, and a hit equal to 1/3rd of the bull market advance would not interrupt the longer-term positive market outlook. So, a 10-12% setback would take us below 1000 on the S&P and a 1/3rd correction of the advance that started last March would bring us all the way back to 963. But 963 would still be above the 200-day moving average.

I'm writing this on Saturday as we have a break in the action at our house in what was a wonderful Thanksgiving holiday. It's rare when all of your grown children can gather at the same time but that is the treat we had this weekend. The break in the action just now is the boys being pressed into service moving rugs so new mats can be put under them. I figured I would use the "over the age of 60" excuse to avoid heavy lifting. But thinking about Dubai and where a correction might run its course is making me opt for the heavy lifting. Mohamed El-Erian of Pimco was interviewed on Friday and thought the Dubai situation could well be a catalyst for a "long-overdue correction." Keep in mind, though, the most contrary opinion right now would be for a market rally!

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Vincent Farrell, Jr. is chief investment officer at Soleil Securities Group and a regular contributor to CNBC.