The Panic of 2008 ended in March 2009, when the S&P 500 fell to a low of 666 points. After that, the stock market, emboldened by optimism of “green shoots” of recovery, embarked on a powerful rally that was briefly interrupted by a small correction in June.

Today, the stock market is in an extremely technically overbought level. In lay-person’s speak, the stock market has arrived at a very bubbly level. This implies that the market is overdue for a trend reversal. But that does not necessary mean it is imminent because we have respect for this market rally.

For investors, what should they do?

If you have substantial long positions in the market, we believe this is the time to put on your hedges (e.g. long put options, short deep-in-the-money call options, stop losses, guaranteed stop losses, short CFDs on long positions, take some chips off the table, etc). For those who missed out on the March-June rally, Marc Faber advised at his latest market commentary that they should wait for a correction before entering the market.

What can possibly trigger a major correction? We looked high and low and found one possible Black Swan in one corner of the earth- Lithuania. In fact, this Black Swan may even trigger more than a correction- it can trigger another panic though it is hard to quantify how great that panic will be, given the propensity of the Fed to print money. As this news article reported,

Lithuania?s new president has admitted that her country could be forced to seek help from the International Monetary Fund if it fails in efforts to raise more money from foreign capital markets to prop up its teetering economy.
…
The fate of the Baltic economies is being watched across Europe amid fears that they could trigger devaluations and defaults in eastern and central Europe.

Sweden and other Nordic countries are especially sensitive because their banks expanded aggressively in the region and now face a rising tide of bad loans.

As the RBA’s most recent statement on yesterday’s interest rate decision said,

There is tentative evidence that the US economy is approaching a turning point, but conditions in Europe are still weakening.

The “green-shoots” can hardly be found in Eastern Europe (more generally, the “emerging” economies). Many European banks are highly leveraged to Eastern Europe.The following is the list of emerging market debt exposures of European nations:

Austria – 85% of GDP (Central & Eastern Europe)
Switzerland – 50% of GDP
Sweden – 25% of GDP
UK – 24% of GDP (mainly Asia)
Spain – 23% of GDP (mainly Latin America)

In contrast, the US amounted to only 4% of GDP.

Richard Karn wrote in his soon to be released book, Credit and Credibility,

Today, although the situation has improved in step with global equity markets, Western European bank exposure to Central and Eastern Europe alone exceeds $1.6 trillion.

The recent news of Lithuania can be a portent of more Black Swan contagion in Europe.

The following is the list of Central European refinancing needs in 2009 as a percentage of foreign exchange reserves:

Estonia – 346%
Latvia – 341%
Lithuania – 204%
Poland – 141%
Croatia – 136%
Bulgaria – 132%
Romania – 127%
Ukraine – 117%
Turkey – 110%
Hungary – 101%
Czech Republic – 89%
Kazakhstan – 82%
Russia – 34%

As Richard Karn continued,

Because the European central bank has not embraced quantitative easing and Western European banks have written down so little debt, especially compared with their US counterparts, a number of commentators contend the banking crisis has yet to fully hit Europe. Essentially, because European banks employed more leverage, they have less freedom to mark down debt, which makes them vulnerable in these conditions. In addition to the situation in Central and Eastern Europe, Western European banks face substantial US property losses they have yet to recognize, and are exposed to euro zone corporate debt to the tune of $11 trillion, equaling 95% of the combined economy, compared with US exposure of roughly 50%. If this were not enough, a significant portion of the Russian banking industry is under considerable stress, with $280 billion of a total $400 billion in debt to European banks being due in the next four years, and the issues regarding repayment and threats of non-payment that rattled markets regularly earlier in the year have yet to be resolved.

A contagion from Europe can easily trigger another global panic. That’s the reason why Kevin Rudd is not ready to declare “Mission Accomplished” for Australia with regards to the global recession (unlike the sheeps in the financial markets).

Watch this space.