So what are the prevailing biases in markets?

As George Soros writes in his book The Alchemy of Finance, “I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also so-called fundamentals that market prices are supposed to reflect.”

So what is the prevailing bias in the market today? There are a number of them and they differ based on the market participant. The prevailing bias in the equity market is that the current credit crisis will be short-lived and that the Fed will be able to bail out the markets. That is a reflection of the reaction whenever the Fed takes action and the fact that the year to date returns are still down only single digits while the rest of the world’s equity markets are showing strong double digit declines. The equity market have punished housing and financial stocks but are willing to believe that a bottom can be reacted quickly as evidenced by the strong turn in the financial stocks earlier in the year. The second bias in the equity markets is that no one wants to fight the Fed. Put differently, the Fed will be effective at getting the economy moving. This is not like Japan during the 1990’s. There will be no liquidity trap and at the worst asset inflation from rising prices will not be bad for stocks.

Fixed income markets are much more negative about the economy and the Fed. Perhaps this is related to the fact that the credit crisis has hit this sector much more that the overall equity markets. Here, interest rates have been pushed down to negative real rates and we have seen a flight to quality that has pushed Treasury bill rates significantly below 1 percent. The front-end expects more easing but the impact of a recession is viewed as more important than inflation at least in the near-term.

The currency markets seem to believe that the US problem can be localized and the rest of the world may be decoupled with the United States. The dollar has taken a beating that suggests growth in the rest of the world can still be strong.

Commodity markets, while off of their highs have been very resilient based on the view that the rest of the world will have high demand from continued growth regardless of what happens in the US.

These biases are embedded in prices so any major change in prices will be based on whether there is a change in the expectations concerning these views. The worsening employment situation only confirms the current biases; consequently, there has not been a strong reaction.