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Of Proxies and Perceptions


...successful trading is an assimilation of four primary metrics: Fundamentals, technical analysis, structural forces and market psychology.

"Hey Harry-look at this. What's a matter with these cans? These cans are defective-they're springing leaks!"
--The Jerk

Navin R. Johnson, while down on his luck, told his wife that he was gonna bounce back and when he did, he was gonna buy her a diamond so big that it would make her puke. Marie looked at him and sadly replied "I don't wanna puke!"

Similar sentiment echoed throughout the Street yesterday as supply poured into the marketplace. It was only last week that we were eyeing new highs, after all, and the sudden spate of equity hate caught many investors leaning the wrong way.

I've long offered that successful trading is an assimilation of four primary metrics: Fundamentals, technical analysis, structural forces and market psychology. Their weighting will shift in importance at any given time but they'll collectively dictate the supply-demand equilibrium.

On Merger Monday, when we powered up to find a full docket of fresh deals, the great debate seemed to center on whether the buying binge is back and, if so, whether psychology would shift from sub-prime structural concerns to the promise of better tomorrow's.

Those deals were like a former flame seen after a long absence. Traders were reminded of the spark once shared and pined, in their mind, for the innocence of love and the passion it provides. The M&A boom was the backbone of the recent rally, we know, and optimism pitter-pattered the market higher.

Noticeably absent from the ascent, however, was a stealth sign that the all-clear signal had yet to sound. The banks and brokers couldn't rally with the tape and as they're the purest encapsulation of the finance-based economy, the largest weighting in the S&P and genesis of structural smoke, it spoke volumes.

When E.F Hutton---or Goldman or Citigroup or Bear Stearns-speaks through their price action, it behooves us to listen.

By now, you know the story in these names. Sub-prime, widely assumed to be a pimple in the broader financial complexion, is spreading like a rash through Wall Street portfolios. As the underlying securities of these complex derivative transactions are "marked-to-market," sudden losses and forced selling begets more of the same.

The carnage in this space-8% declines in a five session span by some of the largest financial institutions in the world-is the principal point of concern. The market is pricing in the potential for a broader contagion given our debt dependency, tightening credit parameters and an interwoven financial fabric with $370 trillion in underlying derivatives.

A "tail event," such as a contagion, is by definition a low probability affair. To our earlier point, however, the event itself doesn't have to occur to impact market psychology. Perception is reality on Wall Street and the slightest whiff of fear will affect a crowded tape with a slimming margin for error.

That's the nuts and guts of where we stand and the financials remain the truest proxy for this dynamic. If they bounce, they'll quickly shift sentiment and trigger a sharp squeeze. If they continue slide lower, they'll pull the equity spectrum along for the downside ride.

Earnings are coming out fast and furious and the fundamental metric will dominate the headlines for the rest of the week. As you're digesting these incremental inputs, however, remember that they're simply one ingredient in a much bigger structural brew.

Discipline over conviction as we find our way.

Random Thoughts:

  • Despite the fright, the S&P is a mere 3% from fresh highs. The downside simply seems more violent as psychology shifted after we seemingly broke out to the upside.

  • I entered this week with a short bias and sold half of my S&P put position into yesterday's slippage. I've rolled down my stops on the balance of the position to above S&P 1520 (the 50-day and the uptrend since February).

  • Pulling back the lens on the banks, they're indeed at a critical juncture. Yesterday's break below the February lows violated the uptrend that has been in place since 2003. While bears should be wary of a "false breakdown" given the near-term oversold condition, the bulls should remember that the BKX is still up 64% since the '03 low.

  • We're hearing of "bid wanted" situations in CDO land. If I saw that dynamic in stocks, I would typically buy into that emotional disconnect. I'm not so sure the same applies in these much thinner instruments but I wanted to pass along the flavor.

  • Fare ye well and remember that the definition of an investment should never be a trade gone awry

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