Saturday, August 18, 2007

More on Credit Hysteria

On Thursday morning, the Dow was down 8.2% from its highs on a closing basis with a Wednesday intra-day low of minus 10.7% (S&P down 9.1% and 12% respectively). In the face of this very normal correction the Fed dropped the discount rate 1/2% and signaled that it will do whatever it takes to calm the markets. Why?

If you want a blow by blow there is a torrent of commentary in all the media. You can read all the reasons why the economy is at risk and the sky is falling, reasons that have been extant for years by the way, that are suddenly urgent. There is a good article on Salon by Andrew Leonard that explains the basics in layman's terms. But let's go right to the bottom line first.

The bottom line is this is not the end; this is not the top. In the final analysis that's all you need to know. Of course we are playing probability games here, so there is always a chance that any given day is the end. But on this particular day the chances are very small. This does not mean that there are not issues, problems, perhaps even fatal problems with our financial system. It means that for the vast majority of us, unless we are directly involved with the mortgage industry, this is not the day that the piper is going to be paid. Why?

The most important indicator has to do with sentiment. Markets are products of human psychology. The fuel for the markets is fear and greed. Market tops are made with greed induced enthusiasm and bottoms are made with fear induced despair. The level of negative sentiment displayed over the past two weeks, rising beyond mere despair to the level of outright hysteria, is the sign of a market bottom, not a top.

However, the Fed move to drop the discount rate 1/2% with the economy humming along and the Dow down a mere 8% from its highs tells you something. It tells you that the Fed is very afraid of the credit bubble collapsing. This is a conversation for another day, but the practical implication is that the Fed will move aggressively to halt any downside momentum. I have learned from bitter experience that it does not pay to fight the Fed. It does pay, however, to follow in its wake.

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