Wednesday, July 25, 2007

When a Flood Isn’t a Tsunami

Yesterday’s decline, while dramatic and will almost certainly require time to repair the damage done, contained little in the way of new news. The catalyst for the plunge, courtesy Bill Gross and Countrywide Financial, centered on the recurring fears of contagion spreading from housing and opaque exotic credit instruments. Yet, while the technical damage of such a large plunge will likely take time to repair (9 to 1 down days generally do), there is a secular trend that continues to mitigate any sustained decline – money creation.

As the charts above make quite clear, money creation continues to be very robust. What is important to remember re the data is that it does not include the money creation that has occurred in the world of exotic credit instruments invented by the financial engineers of Wall Street. And, at $400 trillion, that is where the real danger lies.

Investment Strategy Implications

As I will point out in tomorrow’s blog, market declines, no matter how dramatic or severe, that take place in the middle of trading ranges and not at major inflection points are largely meaningless beyond the very near term. Therefore, in a world of abundant capital, it is advisable to think of market declines such as yesterday's as damaging floods that take time to repair but not quite the equivalent of a tsunami, which remains somewhere in our future.

To view a larger version of the above charts, simply click on the images.
Chart sources: Strategas, Federal Reserve Bank of Saint Louis, respectively.

1 comment:

Scott Richards said...

I agree with your basic conclusion but don't understand middle of trading range concept as we have just made a high.

Scott Richards


You are correct and I should have been more exact in stating that the highs recently made constitute the top end of the range as the highs were marginal.

The larger issue for me is the fact that big drops need to have two components to them to be very valuable:
1 - The advance/decline ratio for both the number of stocks and their volume needs to be 10 to 1. The volume did it yesterday but the absolute number. This point will be noted in tomorrow's blog.
2 - The price break (up or down) is infinitely more important when it takes place at a key price point. Yesterday's drop took place in the middle of nowhere.