Farr: The Bahrain Tipping Point

I met yesterday with a retired three-star general who is still very active in US diplomacy. Of all his concerns in the Middle East, he felt the situation in Bahrain was the most volatile and dire. Other than knowing that Bahrain is a small island country attached to Saudi Arabia by an endless causeway, I didn’t know much else. But it is becoming increasingly clear to me that the transition in Egypt may not have been the end to this drama. As Egypt settles down to plan its future as a democracy, the rest of the region seems anything but quiet.

According to Wikipedia, “Bahrain, officially Kingdom of Bahrain, is a small island country with approximately 1,234,596 inhabitants (2010), located near the western shores of the Persian Gulf and ruled by the Al Khalifa royal family. While Bahrain is an archipelago of thirty-three islands, the largest (Bahrain Island) is 55 km (34 mi) long by 18 km (11 mi) wide.

Saudi Arabia lies to the west and is connected to Bahrain via the King Fahd Causeway, which was officially opened on 25 November 1986. Qatar is to the southeast across the Gulf of Bahrain. The planned Qatar Bahrain Causeway will link Bahrain and Qatar as the longest fixed link in the world.”

Bahrain boasts a GDP of about $26 billion, of which about a third comes from oil production. The country is heralded on several web sites I checked as the “free-est” economy in the Middle East. It is over 80% Muslim - both Shia and Sunni - and has a work force of around 600,000. Interestingly, it is home to the US Navy’s Fifth Fleet.

My conclusions are that this is not a big place, it does not have a lot of people, it is wealthy, and it is the 44th largest oil producing country (look here for some cool figures). So why all of the headlines, and why (other than the Fifth Fleet) is it such a concern of a three-star senior diplomat?

Bloomberg says that unrest in Bahrain will further destabilize the Persian Gulf. An analyst quoted by Bloomberg sheds a broader perspective, “Protests are becoming geopolitical. The fact that it’s spread to wealthy countries makes it look like it’s more a cry for democracy rather than economic.”

Credit default swaps on Bahrain’s debt jumped in today’s trading. Iranian war ships were scratched from parading up the Suez Canal. Israel is understandably alarmed by so much unrest on so many fronts. Long-time foes within the region are making opportunistic sounds over the prospects of ongoing confusion. We are evermore aware of the global economic fabric with which even the largest economies are tied. Watch the Middle East; I don’t think our markets will require much of an excuse to sound a temporary retreat.

As our markets continue their march higher, we are cautious. Today’s Wall Street Journal points out further reasons to be concerned:

It was the fastest climb of 100% since 1936, when the index took 501 days to rocket up to 16.15, from 8.06, according to Birinyi Associates. This time, it took 707 days.

Individual investors have piled into stocks with increasing fervor, a trend that often is seen by professional investors as a sign that a stock rally may have peaked. The Investment Company Institute on Wednesday reported inflows into domestic stock funds had reached $4.9 billion, the fifth week in a row of inflows and more than triple the previous week.

Moreover, volatility has been declining, another sign that investors may have become complacent about a near-term drop.

Donna Kardos Yesalavich explains why stocks ended solidly in the black despite a midday pullback after Israel's warning that two Iranian warships crossing the Suez Canal into the Mediterranean Sea were "provocations" that Israel couldn't ignore.

"In less than two years, the S&P 500 has doubled, which is great for those people that were prudent enough to stay in, but they've got to be cautious about overconfidence; we know that corrections happen quite regularly," said Erik Davidson, managing director of investments at Wells Fargo Private Bank.

"When you're up 100% and you've got this irrational exuberance, the only thing we have to fear is the lack of fear; that's when you've got to be afraid, as with tech or housing or Japanese stocks before," Mr. Davidson said.

Hang in there.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.