Today's Correction Was Liquidity Driven

Includes: DIA, QQQ, SPY
by: Herb Morgan

Herb Morgan (Efficient Market Advisors, LLC) submits: Equity markets experienced indiscriminate selling today while the last of a stellar quarter’s earnings reports trickled in. Who would have thought at the beginning of this round of profit announcements numbers this good would coincide with such a drubbing? The consensus view was for earnings acceleration just north of 4% over last year but companies have delivered growth in excess of ten percent.

Traditionally, corrections after hockey stick run ups are considered healthy and somewhat expected. We rang in the new year at Dow 12,463, touched 14,000 on July 19th and have since retreated a mere 5.2% to settle at 13,270 today. Taken in perspective stocks as measured by the Dow are up 6.47% this year. Not being one to ignore the bull in the china shop however, we must consider whether or not there is decidedly more to this sub prime issue than meets the eye.

Equity investors have never been particularly affectionate towards uncertainty and are quick to pull the eject button when their visibility is clouded. There is a minimal level of uncertainty around the Federal Reserve and their willingness to provide a “put” to financial markets, but a 5.2% retreat in equities after touching a new all time high is hardly crisis time. Fed statements are more diaphanous than not these days with a clear bias towards price stability.

The significant and noteworthy uncertainty surrounding today’s sell off surrounds the extent of the reach of collateralized debt, loan, bond and mortgage obligations into our financial system. My gut tells me that this is a bigger problem than the markets currently realize. I and the ilk I run with are reserving space on our bookshelves next to the “Fall of the House of Hutton”, for whatever volume is soon to be penned detailing the conflagration of more than one player in this game.

Unless you invested in a hedge fund that had the words mortgage, loan, or bond in its name you are most likely going to experience only residual effects in the form of reasonable and modest declines in your otherwise healthy portfolio of investments. Swashbuckling hedge fund managers who used borrowed money to buy synthetic leveraged debt refuse known as “equity” will bear an amplified share of the pain of this unwinding as the stark reality of high water mark clauses come home to roost. The brokerage firms that lent hedge funds money to buy the aforementioned “equity” will need to mea culpa themselves over the next couple of quarters. I have no doubt there will be significant inquiry into the nature and causes of failure of proprietary hedge funds invested in firm manufactured debt instruments.

For those of you that do something other than run a hedge fund or securitize debt for a living I suggest taking the opportunity to profit from this temporary pratfall in stock prices and increase your tactical equity weightings now. It’s only a matter of time before the marginal focus of the stock market turns from sub prime back to an otherwise sturdy economy.