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Buzz and Banter



I feel compelled to comment on the dangers of relying on the positive relationship that Tony pointed out between the euro and equity prices. This has to do with the non-linearity of markets.

Everyone has heard traders say that "every market is different". This may be a casual observation, but in my mind it is one of the most profound statements in investing. I firmly believe that markets are not linear: relationships between macro variables (like interest rates or oil prices) to securities prices are not linear. A rise in interest rates may cause equity prices to fall in one environment and rise in another. This is because the only true driver of securities prices is money flow and the two drivers of money flow are liquidity and sentiment.

In an environment when the economy is slowing and liquidity is increasing, a decline in rates at some point will force money into stocks, (overcoming any negative sentiment). In an environment where the economy is picking up, a rise in rates and a consequential decrease in liquidity may not be enough to overcome the increasingly positive sentiment. Money will continue to flow into stocks.

My only point is to be careful in drawing conclusions about the direction of security prices based on macro variables. Take the intermediate step of determining the affect of a change in a macro variable on liquidity or sentiment first. Whereas a rise in rates a few months ago may have signaled to investors that the economy was picking up (where sentiment overcame the decrease in liquidity), at this juncture a further rise in rates (in conjunction with a fall in the dollar and a rise in the euro) may not have positive sentiment attached to it because investors may feel that the rise in rates will choke off any further growth.

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