Market correction. Was it the wrong guy with the poision gas or is it something else?

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As important as it is to understand the reasons for a market correction, it’s equally important to

understand the drivers behind an unexpected market rally.

Investors witnessed two market rallies this week fueled by short-term traders coming back into the

equity market after selling just a few weeks ago.

We make little attempt to time markets but we do pay attention to the drivers of short term

movements in order to better predict how markets will react in the future.

It Pays to Pay Attention.

The market corrections over the summer prompted us to devote considerable time to the subject of

how we use the fear and panic of short-term traders during a market correction to profit.

In doing so, an investor must understand why a correction is happening to determine if a fundamental thesis has change.

A recent example is when the market sold off 1.5% in late August, on news of the potential retaliation

towards Syria for the use of chemical weapons. As investors, we disagreed that Syria could disrupt the long-term earnings potential of the highest quality companies here in the U.S., and as a result, we took advantage of the fear and panic of short-term trader to buy select stocks that went on sale.

Now it’s human nature to investigate the cause for a market correction because even the most savvy and experienced investors will immediately react to determine the chances for even greater losses.

However,market also frequently rally unexpected and it’s equally important to understand the reasons

for a rally.

We witnessed two market rallies this week so let’s discuss why the market viewed each as a positive for short-term traders.

Doves vs. Hawks

The week began with big news out of Washington DC, as Larry Summers bowed out of the race to

become the next Fed chair. Mr. Summers was considered to be the frontrunner, and when he told

President Obama that he was no longer interested in the job, the market rallied on Monday.

To understand why the market appeared to be pleased with Mr. Summers stepping down, we must first discuss the difference between a market hawk and a dove.

A

hawk is a term used to describe someone who is less concerned with economic growth and more

concerned with the negative effects of inflation. As a result, they prefer high interest rates in order to keep inflation in check which can often lead to slower economic growth.

Doves, on the other hand, prefer low interest rates as a means to encourage economic growth

because lower rates generally increases consumer borrowing which is then spent on more goods and services. Furthermore, they feel that any longer-term issues with inflation are negligible and are outweighed by the benefits to economic growth. A hawk tends to disagree with policies that keep interest rates artificially low, which is precisely the goal of Quantitative Easing (QE), because they fear that inflation could run wild in the future. Hence, they are not big believers in the perceived benefits of QE and generally would like to see it disappear altogether.

Larry Summers has been quite vocal about his concerns with QE, and the market consequently

perceives him to be a hawk. However, Bernanke is perceived more as a dove, given his opinions

and strategies over his tenure so the notion here is that they do not see eye to eye on QE.

Part of the market weakness experienced since July can be attributed to the market “pricing in” the

chances that Mr. Summers would get the job. Short-term traders felt that once Mr. Summers became Fed chair, he would almost immediately roll back QE and these traders were selling in anticipation.

Once we learned that Mr. Summers was no longer interested, the market quickly “priced in” the new

frontrunner, Janet Yellen, who is much more dovish and has a history of agreeing with Bernanke’s past policy decisions. The bottom line is that the market surged because the continued policies of a dove (low interest rates to spur economic growth and lower unemployment) will more than likely continue with Ms. Yellen now in the lead.

Ms. Yellen is by no means guaranteed the job and President Obama will more than likely consider

other candidates before he makes his decision next week. The market is simply assigning a high

er probability that she will win the nomination.