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Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade


The big trade in 2013 might not be about the effect of a fiscal policy debacle; it might be about the effect of a monetary policy debacle.

To understand what is driving market dynamics you have to understand that there is a difference between market prices reflecting discount and market prices reflecting flow. The market hasn't been rallying on a growth discount; it's been rallying because of the flow of underexposed investors, namely the hedge fund community. Back in June I noted this discrepancy In Trading the Wrong Playbook Bubble.

At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.

The massive underperformance of the investment community is attributable to a wrong playbook bubble. This market cycle doesn't care about growth or discount, it cares about positioning and sentiment.

Last week I noted the outsized September performance of Long Biased Hedge Funds as an example of this market flow dynamic.

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.

This is also evident in the CFTC commitment of traders report in the E-mini S&P contract (ES). Large speculators, aka hedge funds, had been net short for over a year until they finally covered and went long in September as price broke through the 1400 level. Friday's report showed the large specs entered the week long 135k contracts. With the exception of one week in 2011, this is as long hedge funds have been since Q1 2010.

Understanding how this market dynamic is in play is key to identifying the risks in the stock and bond markets over the coming weeks.

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.

In terms of the bond market I do not want to assume that what's bad for stocks is good for bonds and vice versa. 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. Nevertheless bond market price action needs to be interpreted independently of stocks market price action.
No positions in stocks mentioned.
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