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Rally Off 2009 Lows Flushes the Hedge Fund Shorts

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Hedge funds top-ticked this market, couldn't defend 1400, and now are under water. Going into year end, you can bet the name of the game is liquidity. That means we could be encountering significant selling pressure.

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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.
No positions in stocks mentioned.
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