But how am I to know the good side from the bad?

Academics and other investment outsiders often marvel at the volatility of investment markets. The truth is that economic fundamentals, either with a specific company or the market as a whole, just don't change very much from day to day, or even month to month. Why is it that markets rise and fall so significantly every day?

Mass media reports on the stock market are very deceiving to the average reader. Today, with the Dow falling over 100 points, media reports from the USA Today and Washington Post blame "credit worries." If the Dow rises 200 points tomorrow, the headlines might read "subprime fears recede." We've seen such headlines during strong rallies several times this year. I've often wondered how the average reader interprets these kinds of reports. One day the market is worth 1% less because of housing problems, the next day its worth 1% more because... Housing isn't so bad? Put together these stories read like traders showed up at the NYSE one morning and thought "Holy shit, the housing market is bad. Sell! Sell!" Then the next day the same traders show up for work saying "Well, it really isn't that bad. Buy! Buy!" This view of the market has it as a sort of impulsive manic-depressive.

But of course, that's not really how it works. Academia would like you to believe that the market is made up of rational buyers and sellers. In their model world, the market for securities is based on rational estimates of fundamental value. Prices rise or fall because market participants re-evaluate value: if an owner of a security finds the price has risen above his view of fundamentals, he sells. And the opposite is true of buyers. Where buyers and sellers meet, through the magic of the invisible hand, the market has rationally set the price.

Of course, that's not how it works either. Unfortunately, this view cannot explain the volatility. We know that its common for a stock to rise or fall by 1-2% every day, often with no news at all. Same goes for credit spreads, futures contracts, swap rates, etc. These things move all the time for no fundamental reason.

The reality is that fundamental investors don't change their view on fundamental value much from day to day. Even when there is news on a company or on the economy as a whole, normally no single piece of news will change someone's mind about an investment. For example, if I'm bearish on rates because I expect inflation, I'm not likely to change my mind because CPI
prints low one month. If I'm long AT&T stock, I'm not likely to sell just because they have a mediocre earnings report. Normally fundamental investors have a longer term investment thesis, and therefore short-term events usually don't change the longer term view.

So if the market isn't manic-depressive, and fundamental buyers don't tend to jump in and out of their investments from day to day, who really is moving the market and why?

The answer is so-called fast money. Mostly prop desks at the big dealers and some hedge funds. One way to think about these traders is that they're trying to front-run the fundamental investor. But since it isn't immediately clear where the fundamental investor will buy or sell a given security, they are left guessing what every piece of news is worth.

But remember, they don't actually care what any security is actually worth. It doesn't matter. Only that they can get in at a certain price and get out at a better price. This is why securities sometimes seem to operate on momentum. Someone wants to buy XYZ CDS at 100. Someone offers at 110. That's lifted. Now someone thinks it's a good short, so they offer at 120. That's
lifted. Suddenly traders start to think someone has a buying program on, so now there is momentum. The next offer is 130, and it just keeps going until they stopped getting lifted. All that could easily happen in a thin market with no fundamental change in the company.

And of course, if XYZ is getting beat up, then other names in the same industry get beat up also. Maybe the buyer of protection on XYZ had a view specific to that company, but now there is momentum. Dealer desks will start buying protection against related companies. Suddenly a whole sector is 30-50bps wider on no news.

The same momentum can last for a long time. Because once its clear there are traders looking to short a name, the CDS becomes very one sided. See the ABX.

Now here is the rub. You can't know when the front runners are actually right, and when they are just pushing the market around. Recently we've talked a lot about MBIA, FGIC, and AMBAC on this blog. All three have seen their CDS spread pushed around quite a bit. The media and other commenters have remarked that the bond insurers are trading like they are junk-rated, which is an undeniable fact. Some have gone so far as to calculate the odds of bankruptcy. Others have commented that the CDS are not indicative of fundamentals.

The reality is that securities can and do trade far from fundamentals, especially thinly traded markets like CDS. But its also true that sometimes the market is right, even when it seems to be trading far from fundamentals. See the ABX.

So how can you know when fundamentals are changing versus just technicals? You really can't. I'm not sure where I'm going to come down on AMBAC just yet. But suffice to say where the CDS are trading won't influence by analysis. If you are a long-term investor, you really shouldn't worry about technicals. Trying to time technicals is a good way to lose a lot of money. Trying to graft fundamental meaning on technical movement is a good way to be completely wrong. As the Buddha said, "Know well what leads you forward, and what holds you back."