L P L F I N A N C I A L RE SE ARCH
Weekly Market Commentary
v4
Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial
Highlights
Market participants have shifted focus from the
financial crisis to the oil crisis. The driver of the
new high in oil prices was geopolitics—rumors
that Israel and the United States have decided to
strike at Iran’s nuclear facilities.
As we noted back in May, we continue to believe
that during the summer months it is possible oil
prices will continue to climb and weigh on stocks
and that a sustained rally is unlikely to materialize
until the fourth quarter. In the meantime, U.S.
foreign policy actions may be driving the markets.
Conducting an extended psychological campaign
against Iran makes political sense; however, it is
causing havoc in the markets and is dangerous to
the global economy. The thought of this sort of
campaign escalating for months is creating a new
level of uncertainty for the markets. Markets
have proven again and again that they favor rapid
action over months of uncertainty.
July 7, 2008
Geopolitical Uncertainty Tops
Investors Concerns
Last week’s decline of 1% in the S&P 500 marked the full reversal of the
12% rally that had taken place from mid-March to mid-May as the worst of
the financial crisis passed. This disappointing decline returned the index to
a 19% peak-to-trough loss since the all time high on October 9, 2007. The
last time the S&P 500 was down 19% from the peak was in mid-March as
the failure of Bear Stearns marked the worst of the financial crisis. Market
participants have shifted focus from the financial crisis to the oil crisis, as can
be seen in the respective number of Google searches. [chart 1] In addition,
among the key worries that have driven the markets in recent months,
the number of online requests for information on the threat of Israel-Iran
conflict has soared as other searches on such topics as recession, subprime
mortgages, financial crisis, and the value of the dollar have faded. [chart 2]
As we noted back in May, we continue to believe that during the summer
months it is possible oil prices will continue to climb and weigh on stocks
and that a sustained rally is unlikely to materialize until the fourth quarter.
However, the steady march higher in oil prices may result in policy actions
that could prompt a stock market reaction. The policy actions of the Federal
Reserve were effective in stopping the financial crisis. What policy actions
may be taken to resolve the oil crisis? Here we must look to the Fed again
for rate hikes in the fourth quarter, which would be likely to end the financial
bubble that has developed in oil prices, as rate hikes have done in the past.
In the meantime, U.S. foreign policy actions may be driving the markets.
The stock market dropped last week as oil prices moved from a range
centered around the mid-$130s to the mid-$140s. The driver of the new
high in oil prices after three weeks around the mid-$130s was geopolitics—
rumors that Israel and the United States have decided to strike at Iran’s
nuclear facilities. These rumors have been featured on the TV and radio
talk show circuit for years. The latest version purports that Israel might
already have decided to attack Iran later this year. Clearly, if the U.S. and
Israel actually wanted to attack Iran, they wouldn’t talk about it or conduct
elaborate exercises; they would take action, striking without warning to
ensure maximum effectiveness. The intent of this “leak” is to warn Iran
and build enough pressure to fracture the internal politics in Iran, forcing
capitulation on the nuclear issue by convincing Iran that an attack is
inevitable if they do not.
Politically, conducting an extended psychological campaign against Iran
makes sense. However, it is causing havoc in the markets and is dangerous
to the global economy. The longer the psychological warfare goes on, the
more nervous market participants will become and the higher the price
of oil will go, building more pressure on the global economy. The thought
of this campaign escalating for months is certainly creating a new level of
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1 Google Search Trends for uncertainty for the markets. And, we know one thing for sure:
Financial Crisis and Oil Crisis Markets have proven again and again that they favor rapid action over
Financial Crisis Oil Crisis months of uncertainty.
3.0
What would be the outcome of a strike against Iran that the markets are
2.5
bracing for? Iran cannot choose to completely suspend the sale of their oil
2.0 without risking an utter collapse—both economic and political—the very
1.5
thing Iran is trying to avoid in the complex dealings over Iraq by using its
nuclear program as a bargaining chip. The United States has not purchased
1.0
oil directly from Iran for 30 years, so Iran cannot cut off shipments to the
0.5 U.S. in a targeted way. Instead, as an Iranian official stated last week,
0.0 they would attempt to block the Strait of Hormuz, through which Saudi and
Kuwaiti oil flows to the world markets. While the U.S. Navy’s 5th fleet would
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enter and secure the Strait, mines deployed along the long Iranian coastline
on the Strait could have a big effect. Uncertainty surrounding the possibility
Source: Google, LPL Financial of mines may push prices higher by slowing down the movement of oil
tankers carrying 20% of the world’s oil supply. Added upward pressure on
oil prices could come from much higher insurance costs for tankers and
their cargoes, and insurers may even be unwilling to take the risk. While
Washington could step in to provide insurance for tankers, the process could
take weeks given the bitter divide in Congress and a looming election. The
potential result could be temporary oil shortages for the first time since the
1970s. Last week, the stock and oil markets moved to price in this unlikely
but plausible outcome to the current standoff.
Market participants are bracing for months of uncertainty, but could there
be policy actions from Washington that bring about a near-term end to the
standoff? This could be the case, based on comments late last week from
named officials.
Europe, Russia, China and the United States made an offer to Iran on June
14, as tensions around possible attacks on Iran mounted. The incentive
deal offered economic and technological benefits to Iran in return for its
suspending its uranium enrichment program (but allowing Iran to retain a
civilian nuclear power program). Late last week, Iranian Foreign Minister
Manouchehr Mottaki responded to the package by suggesting a substantial
shift in the Iranians’ position and implying that they may be close to a deal
2 Google Search Trends for Israel-Iran, on the enrichment program. Perhaps not coincidentally, the U.S. agreed last
Dollar, Subprime, and Recession week to drop their demand to control all of Iraqi airspace as part of a security
israel iran dollar subprime recession treaty involving Iran. Of more strategic importance to Iran than its nuclear
14
program is its core interest in obtaining security guarantees on its western
12
border with Iraq. If Iraq is in control of its airspace, the U.S. would need to
10
request permission from Baghdad, and its Shiite-influenced government,
8 before carrying out airstrikes from bases in Iraq.
6
While this could certainly turn out to be another stall by Iran, it appears that
4
the United States moved the negotiation process forward by simultaneously
2
putting a plausible offer on the table and “leaking” the possibility of
0 impending military action. A deal over the enrichment program would be a
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huge step in eliminating the threat of attack and moving toward resolution
over the fate of Iraq. The Iranians may not want to wait until the U.S. election
to cut a deal. The last time they waited for an election in the U.S. to turn
Source: Google, LPL Financial the tide of negotiations, the Reagan administration replaced the Carter

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administration, which did not work in the Iranians favor. The uncertainty
surrounding waiting to cut a deal until the fall for the Iranians is high, making
it less likely that the current standoff will drag out for months. A deal could
come sooner rather than later. If so, that could bring down oil prices prior to
the fourth quarter and drive a powerful stock market rebound.

IMPORTANT DISCLOSURES
This report has been prepared by LPL Financial from sources believed to be reliable but no guarantee can be
made as to its accuracy or completeness. The opinions expressed herein are for general information only, are
subject to change without notice, and are not intended to provide specific advice or recommendations for any
individuals. Please contact your advisor with any questions regarding this report.
Investing in international and emerging markets may entail additional risks such as currency fluctuation and
political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially
less liquidity.
Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
Indices are unmanaged and cannot be invested into directly

This research material has been prepared by LPL Financial.

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