You heard a lot of silly excuses for last week’s negative stock market price action that produced one of the worst weeks of the year. Obama was going to raise your capital gains taxes. The fiscal cliff wasn’t going to get resolved. The pot-smoking commies had taken over the country. You had fire and brimstone, rivers turning into blood, mass hysteria with dogs and cats living together. For investors an Obama victory meant it was clearly time to panic. This was all a reactionary exercise in ex post analysis. Readers know that I have been mapping this move for weeks in an exercise of ex ante analysis.
My thesis ignored these issues and was predicated on what I believed to be the primary driver behind the price action: the positioning of hedge funds.
To understand the significance of their positioning you have to understand there has been a seminal change in the investment community over the past decade. Hedge funds used to generate alpha by betting against the crowd, but today they are
the crowd, and they are betting against themselves. As an investor class, hedge funds had been short the entire rally since last year and were being forced to cover and eventually get long.
On August 13 in The VIX (INDEXCBOE:VIX) According to a 20-Year-Old Seinfeld Episode,
I warned that investors were positioned for a repeat of August 2011 but that if we didn’t crash the pressure was on to get long:
But after two weeks into August risk assets haven’t crashed and now the market is at the post crisis highs, looking like it wants to break out despite decelerating economic and earnings growth. Investors are hearing it from both Costanza and Kramer and the uncertainty with whether they will get suckered yet again gets more intense the longer the market rally lasts. It is a dangerous time for all investors, retail and professional alike, but if this market remains bid into the Labor Day weekend, there will be tremendous pressure to get exposed to risk into year end.
On September 24 with the S&P
(INDEXSP:.INX) having closed the prior week at 1460 only five points below the previous weekly closing cycle high at 1465, I wrote in Bond and Stock Market Volatility Is Collapsing Post-QE3
QE III isn’t causing risk assets to rise; it is simply the catalyst to bring in the last holdout market skeptics to finally capitulate and jump aboard the rally train.
I’m on the record as having been bullish for a long time. But when scared money gets long, I start to get cautious. The catalysts of extreme bearishness and skepticism that have been behind this rally are finally starting to wane. There could be more room to run, but we are in the late innings of this move and this is where it could start to get turbulent. Instead of subscribing to this QE III equals risk-on nonsense, I believe it’s time to start playing defense.
Then two weeks later Bloomberg published its hedge fund index returns that showed Long Biased Equity HFs were up 5% for the month of September yet were still down on the year. It became evident that my thesis was playing out. On October 15 in Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets
, I noted this performance grab:
With a 5% gain on the month while remaining down on the year it’s pretty clear to me that this performance grab has been largely responsible for the push to new highs. No doubt the underexposed speculative community has been pushing prices higher as they cover and get long. Also the consensus belief that QE3 will see a risk-on rally is an obvious display of confirmation bias and points to the fact that the market is long.
That week the CFTC's Committment of Traders report showed large speculators (aka hedge funds) to be net long 135,000 S&P 500 E-Mini (ES) contracts. With the exception of one week in 2011, this was the longest they had been since early 2010.
The following week it was time to refine the market map as we entered a very important period that included an FOMC decision, mutual fund year end, employment, and the election. Realizing that hedge fund positioning was the primary driver of stock market price action and that they finally covered and went long above 1400 on the ES, I established that level as my pivot bogey. I had also cited the important 150-00 pivot level in the US 30YR Treasury
(INDEXCBOE:TYX) that had confined the bond market since the May employment report breakout rally on June 1.
On October 22 in Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade
Friday ES closed at 1424, not far above the level that brought hedge funds to cover. Next week we should at a minimum expect the market to test the area between 1425 and 1400. For the rally to stay in tact hedge funds will have to defend this area. If 1400 gives, the main buyers will then be under water and presumably turn sellers, putting a lot of pressure on the market. If 1400 holds, you should expect an attempt to rally the stock market to new highs possibly into month end and into year end.
As I have repeatedly said the 150-00 level on the US bond contract is real and must be respected regardless. After Friday’s rally the US bond contract is entering intermediate resistance at both price and momentum between Friday’s closing level up to 148-00. With the Fed on deck Tuesday and with stocks poised to test lower levels, investors should expect the market to challenge this area.
The respective markets were clearly recognizing these pivots and looked to be on a collision course. Over the ensuing weeks these levels would be tested, respected, and violated. On October 30 in Saying Goodbye to the Bernanke Put
I drew the lines in the sand:
If the market takes out 1400 over the next two weeks, it will be Katy bar the door as hedge funds that have been the main bid since summer will be looking to get liquid before year end.
However if after the election the US bond contract is above 150-00, it sets up for a rally to new highs into year end.
And the potential repercussion of a QE asset reflation unwind while the Fed is still active:
If there has been one constant in the Bernanke Put, it has been a reduction in volatility, however, if he loses control, that put will be worthless. That will no doubt see a spike in implied volatility premiums which will correspond to a significant widening of risk premiums, threatening all leveraged positions and wreaking havoc across financial markets.
The following week Hurricane Sandy disrupted financial markets and the month end trade was fairly muted. Stocks flirted with 1400 but held into the payroll report. Bonds similarly consolidated the previous week’s rally into 148-00 holding there on a test Wednesday. Recall the employment data was much stronger than expected and was one of the best reports of the year. The US bond contract responded with an immediate gap below 148-00 while stocks were rallying. When markets opened it was another story. Stocks could not hold the opening gap and proceeded to trade south for the whole session closing the week at 1414. The bond contract was aided by the weaker stock market and rallied back through 148-00 to close at 148-13.
Coming into election week the markets were behaving exactly according to plan and they were setting up to challenge both pivots on the rising prospects of an Obama victory. In the Most Important Election in a Generation
I laid out the scenario:
I think the odds of an Obama victory are high based on the projected Electoral College math. I also think -- regardless of who wins -- there is a big head fake coming and that the initial market reaction may need to be faded. You will have a lot of pressure on the 1400 level if Obama wins and the large short base in the Treasury market could ignite a short squeeze. I am inclined to let both moves settle before reassessing.
I couldn’t have scripted it any better. After Obama’s convincing victory in the Electoral College on Tuesday, markets responded as you would have expected with stocks gapping lower and bonds gapping higher. This was almost too predictable.
The short squeeze in the bond market was on as price traded right up to 150-00 on Wednesday and sliced through it on Thursday trading as high as 152-08 before settling the week at 151-20. The stock market also headed straight for its 1400 pivot out of the gate on Wednesday taking it out on Thursday trading as low as 1373 on Friday before settling at 1379, finishing out one of the worst weeks for stocks since June.
So here we are. The catalysts I identified for the setup are behind us. The course I have charted for the past three months is unfolding exactly according to plan and we are at a critical juncture. The hedge funds top-ticked this market and now they are in trouble. They couldn’t defend 1400 and they are under water. Going into year end you can believe that the name of the game is liquidity. That means we could be encountering significant selling pressure.
This week is going to be very tricky and sets up for the head fake I referenced. The stock market has clearly done some serious technical damage, but unless we are crashing there should be an attempt to back test 1400, at the very least to work off oversold conditions. Friday is the monthly options expiration, and judging by the heavy put activity last week, it’s quite possible we see a countertrend rally to burn off that premium. It certainly wouldn’t be the first time. I wouldn’t even rule out an attempt to rally back toward the old highs into Thanksgiving, however if we are putting in a cyclical top, that’s a rally you will want to sell.
For the bond market we have a similar setup. Last week’s short squeeze was swift and severe. The US bond futures contract traded over two standard deviations above the regression line we have been following since June’s breakout rally. Traditionally that is not a move you want to buy. When the market settles down a bit I expect a back test of 150-00. Obviously that level needs to be respected, and if we hold convincingly, you have to prepare for higher prices and lower yields.
Regardless of how the week plays out you have to realize how important this area on the S&P 500 is from a technical perspective. There is a reason this was the short/long pivot for hedge funds. The 1370 level on the S&P has been a major pivot going back to 2007. To see where this came into play, simply draw a horizontal line on a weekly and you can see how the market has respected this pivot a number of times. You can allow a little wiggle within 10 points, but I would not fade a move from this area in either direction.
Since writing about Billy Ray Valentine clearing out the suckers in Trading the Wrong Playbook Bubble,
I have suspected this entire rally off the 2009 lows was a giant clearing out the sucker's trade. The mission of this market was to run as high as was needed to flush the shorts. The fact that the hedge fund community would finally get long and top-tick the market above the 1370 five-year pivot suggests the suckers were finally cleared. If my thesis is correct that the hedge funds are the new crowd investor that dominates price action, the stock market could be in for a significant move lower regardless of the fiscal cliff getting resolved or QE attempting to prop up asset prices.
As we enter the holiday season and year-end trading environment, do not get caught up in all the melodramatic market commentary blaming taxes, the fiscal cliff, the prospects of a recession, or earnings growth deceleration. Those catalysts are well-known and, in my opinion, largely irrelevant. From here and into 2013 it’s all about speculative positioning, sentiment, and the prospects of the QE asset reflation trade blowing up in Ben Bernanke’s face.