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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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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.

Twitter: @exantefactor
No positions in stocks mentioned.
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