We start our day without even thinking about it. We take for granted that the floor will support us when we step out of bed, that clean water will pour on demand from the lavatory spout to brush our teeth, and that hot water for our shower is just moments away. Confidence is defined in numerous ways and indeed changes in the circumstances. Webster defines it as “the state or feeling of trust in or reliance upon another” (person or thing, we could add).

For seven months markets demonstrated that investors held the highest degree of confidence in world economies, corporate earnings, policy makers’ decisions, and indeed in the global geopolitical fabric. Market volatility as measured by the Chicago Board of Option Exchange’s volatility index, know as the VIX, has been declining steadily to lows rarely achieved. It suggested that the world’s equity markets seemed very confident in the future. Some critics suggested that the level of confidence was too high – that investors were not pricing in enough risk.

Market declines on Tuesday drove the VIX up 67%, the largest one-day increase in that measure’s history. Did confidence really evaporate that quickly?  The last time it was as high as it is now was in June of last year. A four-year rally in equity markets was interrupted in May and June by concern that the U.S., under the new Fed chief Ben Bernanke, would go too far with its series of interest-rate increases. But those who were confident that Mr. Bernanke’s would not go too far and invested in stocks at those market lows reaped returns near 20%, even after this weeks’ declines.

You’ve heard a great deal about excessive global liquidity and the Japanese carry trade in the past few weeks. We’ll get to the carry trade in a moment. But first let’s discuss excessive global liquidity. It’s nothing new really. Following the terrorist attacks of September 11th 2001 our Federal Reserve and Central Banks all over the globe opened the money spigots. The global economy was soon awash in cash which in turn kept investors and businesses investing and consumers spending. It had the effect of boosting confidence that our leaders would do all they could to keep the economy going. As interest rates fell, borrowing became cheaper at all levels. Mortgage rates fell low enough to open up the possibility of home ownership for a whole new group of the Americans. Low rates also fueled a dramatic rise in real estate speculation. Confidence increased dramatically throughout the real estate world.

Excessive liquidity and a lack of confidence in a stock market that had delivered such losses in 2000 spawned an explosion in the number of hedge funds and private equity pools around the world; those large funds of specialized money scouring the globe for undervalued assets. The result has been the same as any other gold rush. The early pioneers find the easy gold, but as supply diminishes the numbers of new arrivals seeking it explodes and the returns plummet.  It’s fair to say that confidence in hedge funds and private equity is diminishing.

Now for the carry trade.Japan had become the world’s Wal-Mart for money. As that country struggled for years to dig itself out of a deflationary spiral, the Bank of Japan essentially took rates to near-zero. They were giving money away to spur business investment and personal consumption to the point that they actually put enough pressure on the economy’s production capacity to cause prices to reverse their declines and actually increase modestly.

The policy eventually worked in Japan, but as you might expect, unintended consequences developed. Global currency traders flocked to the cheap yen-denominated rates to finance their bets. When you can borrow money at only ½ of a percent you don’t have to find huge returns to make a nice profit. But unfortunately for the carry trade, the Bank of Japan recently telegraphed their intentions to stop the gravy train by increasing rates. But that threat alone was not sufficient to cause the flight from the carry trade. The Japanese government is not known for executing policy changes quickly. The last interest rate increase was seven years ago. The greatest pain for the carry trade is caused by themselves. They lost confidence together and are all stampeding through the same door at the same time. Problem is, they are madly competing with one another to buy back the yen they borrowed earlier at much lower prices and hence driving up the yen and down the dollar in the process. They are in a vicious cycle. Higher volatility also discourages the carry trade as it exposes positions to greater currency risk.

The recent sell-off at its earliest stages was blamed on China. Fortunately, we got out of China some time ago on the notion that a correction was overdue simply on price appreciation. What sparked the China meltdown was a warning from the government that they were going to clamp down on illegal stock market activity. That sound like a confidence-building statement doesn’t it? Turns out, traders saw that activity as delivering a pretty good chunk of the recent returns in the Chinese market. Many wonder if the Chinese ‘cold’ may give the rest of the world the flu.

So, what happened to the confidence? Is it gone or just taking a breather? Every economy is comprised of buyers and sellers, producers and customers. The answer to our question is and always has been focused on them. What is their current confidence level and where is it trending?

We discussed how upbeat business leaders were in last week’s Brief. The annual meeting of corporate CEO’s in Davos Switzerland was very upbeat. Indeed, corporate earnings announcements have also been very upbeat. While all acknowledge that the economy is slowing, they generally don’t see specific threats to their own businesses or to the economy as a whole. There are specific industries and companies with their own problems i.e. homebuilders and Dell, but they seem to be the exceptions.

Confidence among consumers continues to remain high. But as the economy slows it should come down some. One private measure released today showed that confidence fell last month from a two-year high as fuel prices rose and employment weakened. The most notable reduction in confidence came from the lowest income sectors of the economy. Wal-Mart’s results have telegraphed that trend for some time now.

Now the big question; will investors have confidence in the markets from here? Federal Reserve policy leaders like Ben Bernanke and William Poole have declared in speeches this week that they should. On Wednesday Bernanke said stock markets “seem to be working well” after Tuesday’s global rout and that he and the central bank still expect the U.S. economy to pick up. Differing from his predecessor, Alan Greenspan who this weekend said that recession was a possibility, Bernanke asserted that “there’s a reasonable possibility that we’ll see some strengthening of the economy sometime during the middle of the year.”

No matter what you label this week’s market decline, it was triggered largely by emotional reactions and exacerbated by a herd-mentality. The underlying fundamentals of the global economy have not substantially changed from last week when markets were exploring new highs. Perhaps the new highs were unwarranted, but maybe so are the declines. The doomsayers shrill is louder than ever in times like these, but the wise investors like Warren Buffet tune out the noise and take advantage of stock prices on sale. And Warren sounds pretty confident in the future too.