I have always held that the markets are so efficient nowadays that they correct as they go along.  This, I contend, is why we have not had a serious recession in twenty-five years.  Instead of building up mal-investment, over-consumption, and the mis-allocation of resources, the stuff of which recessions are made, the market has been dealing with these tendencies fast and furious.  It liquidates them as they appear.

But even during the best of times we are blind sided by an event or situation which develops that we never see coming.  I've always believed that the market  mirrors  the economy., its health or lack thereof.  Just watch the markets and interpret the message of the markets and you will know as much about what's going on as the experts.

For example, it is estimated that there are some 45 trillion dollars in derivatives.  Most people don't  know that there are such things as derivatives, let alone what they are.  But they don't have to -- the market does.  No one knows for sure exactly how much in derivatives there are -- not in dollars, yen, or euro's.  Again, they don't have to, the market does.  Many are afraid of derivatives because they are unregulated.  But they are regulated.  They are regulated by the market.  Esoteric subjects such as the sub prime mortgage problems and problems with hedge fund portfolio's are of great concern today.  They are coming under greater and greater scrutiny  The reason is because they are not transparent.   My advice is let the market deal with them.  Not all things can be transparent to humans such as a 45 trillion dollar derivatives market.  Let the market see through them -- that's its job.  Just as we leave the weather to Mother Nature, so we should leave any potential imbalances to the corrective stages of the market.  If and when we are blind sided by something, just let the market clear itself.  These adjustments are painful but will end faster by letting the market free to do its thing.

This having been said, as an investor I am always looking at the message of the market on a minute to minute, hour to hour, basis.  Just like a weather man, this is what I do.  Today, (Friday July 20th, 2007) I saw something I haven't seen in a very long time.  For a few minutes there was a whiff of crisis in the air.  In a period of about five minutes the stock market fell from down about 100 points to over 200 points, the bond market rallied as interest rates fell from 5.01% to 4.94%, while at the same time non-government paper rose in  yield, (very unusual)  and gold rose from up 2 dollars to up 10 dollars.  Just as a weather man takes heed of dark clouds forming, I started looking for snakes.

What would cause this unusual combination of market responses?  There are a lot of snakes in the bushes out there, but the market knows about most of them.  The market knows about inflation and signals it through higher gold prices, but a rising bond market contradicts that possibility.

The market knows about the credit concerns and has discounted suspect paper by raising the risk premium on most non-government non-guaranteed paper.  And it knows about the housing slump, derivatives, and hedge fund worries.  It's all out there.

But there may be a snake lurking the market has not got a glimpse of yet.  There are rumors that a sub prime fund in Australia, and two sub prime funds in England are in trouble. Most Americans think the housing boom was an American phenomenon, but it was world wide.  If the stock market continues down, which I suggested shorting Thursday, and if a fund or two folds, and if a few buy-out deals can't be financed next week, at the same time as the housing numbers come out, which should be lousy, we could have the makings of a re-instatement of the recessionary-disinflationary bias of years ago.

No one is looking for disinflation let alone deflation except for Gary Shilling who has been predicting a major housing fall and deflation along with falling treasury rates.  His views are no where near the market consensus and those that are looking for deflation are few and far between. 

Now, what happened today may be a ripple that in the scheme of things will disappear next week, but on the other hand I'm always on the lookout for that snake I don't see.

Paul Nathan
Paulnathan.biz