Q&A: An In-Depth Look At The Anatomy Of The Current Supply/Demand Imbalance Propelling Equities Higher

QUESTION:
Hi Ryan,

I've been a subscriber for about six weeks, and I've got a question that I hope
you'll be willing to answer if you get a free moment. (Actually, I've got about a
hundred questions, but I thought I ought to start with just one.)

What I can't get clear on is how you are inferring the general invested position of
funds. Since September, your view has been that funds really have got to get into
equities, and they have a lot of money lying around to do it with. You certainly
seem to be right about it, but how did you come to that conclusion?

I can see that one can make some fair guesses based on price action, especially when
combined with calendar demands, but for me that would just be a guess. You seem to
have much more insight into the matter.

And then (sneaking in a second question), What makes Ryan think that there is still
more buying to be done?? Why not conclude that all the buying was done with the run
up to the election? Again, I can make the inference that the market is impatient to
go higher based on the price action, but I'm not sure that I can see fund buying as
the cause.

Anything you could point out about what I should be looking at to get some feeling
for the positioning of the large players would help me a lot and would be most
appreciated.

Thanks,
XXXXXXXXXXXX

ANSWER:
Hey XXXXXX,

This is a great question and Im glad you asked it.

So if you go back and think about the environment we were in from mid-April to late August you'll remember that the market was dealing with some very severe issues: European sovereign debt issues, flash crash, extreme volatility, low liquidity, Hindeburg omens, and most importantly deflation worries. During those 4+ months we saw extreme equity outflows on a weekly basis, and more importantly fund managers who were seeing signs of deflation everywhere took their risk exposure down to bare minimums, meaning they reduced their stock holdings down to only the highest quality names, were heavy in bonds, and heavy and gold (due to concerns over currency devaluations). So you really have to imagine that during those 4 months almost every single market participant had really been flushed out of the market. Every single portfolio that needed to reduce risk had already done so, and whatever positions were left these were clearly positions which were not gonna get sold for a while (if they werent sold during all these issues hitting markets, then really when is it going to get sold). So the conclusion has to be that if we started rallying there would be very little supply of stock for sale. We know that sellers had capitulated, I mean this wasnt 1 or 2 weeks of issues, this was 4.5 months of everything but the kitchen sink being thrown at equities. So we know that supplyside of the equation had gotten very low.

Now at the same time, Im well aware that Goldman (big manipulator of markets) is well aware of these supply/demand imbalances and once I started to see them rally the market at the beginning of September (end of Q3) I knew there would be some chasers. Now keep in mind since supply is low we don't even need a huge amount of buying pressure to push higher pricewise. There's nothing really on the ask anymore, so any big market participant who came in buying would likely move prices rapidly. Now if you look at the chart of the S&P, I assumed that the initial move in early September from 1040 to about 1125 was probably not bought into by many funds simply because we had seen the market top at 1125 twice before only to pullback severely (once in mid-June another in early August). And moreover the next move to 1150 was also likely met with a ton of skepticism since it was the January 2010 top and also had the potential of forming a massive head and shoulders. So again, probably not a ton of demand during the initial portion of this rally all the way up to the 1150 level, most likely it was Goldman positioning for higher prices knowing precisely how this move would play out (I always try to think like Goldman, its so important to imagine yourself as having the power to manipulate markets because we know for sure manipulation exists - in order to anticipate possible manipulation we need to think like manipulators.) One other aspect I felt was propelling this market higher was all of these September puts which were bought throughout August on this Hindenburg Omen (in addition to all these other worries_. I knew someone must've been selling em and would for sure wanted to expire them worthless (bearishness had gotten extraordinarily high and this Hindenburg Omen on the front page of Yahoo was a huge red flag that someone was trying to sell a huge amount of puts).

So now its the beginning of October and we're at 1150 on the S&P where I still believe many funds had been waiting to see if this market could breakout above the January highs. If it did, they'd have the green light to get long again. Now thinking about the government, I knew they wanted to see higher equity prices heading into the holiday season. If we simply topped the market at that point, no one would be spending any money during the holidays, earnings would stink, unemployment would remain high, and this whole economic malaise would continue to go on into next year. It was certainly in the governments interest to see this market push higher in order to create wealth and attempt to catalyze this economic activity. And we had clear evidence of their intentions with all these POMO injections and the chatter of another round of QE. So government wants markets higher, Goldman is likely long, funds are still underexposed to equities AND now we're going into year end where fund managers need to show performance numbers or they're unemployed. They no longer have the luxury to sit there and debate if this rally is for real or not. If it breaks above 1150 they have to get long, and we know Goldman must be well aware of this time constraint (the calendar is by far one of the most powerful forces behind stock price behavior because it can literally force veyr large funds into positions regardless of technicals or fundamentals).

So we know theres very low supply, and very high sidelined demand in addition to a government which wants to see higher equity prices. Secondly, I know there's an enormous amount of capital sitting in the bond market. $100s of billions of "hot money" has just been deployed into the asset class as it was literally the only trade in town outside of Gold, and I knew that it would likely not sit in that market for very long as yields were sitting at historic lows...if any other higher-yielding market resurrected itself, that capital would surely would come flowing in rapidly. If the bond market was broken down, a ton of that money is going into equities, especially if equities are pushing towards highs as funds certainly dont want to show some deflationary portfolio at year end when the market is starting price in inflation. So I knew this would be something Goldman would look to do, crack the bond market to have additional money flow into equities. Thirdly, there was the very real possibility that this economy would start to show signs of bottoming especially if this market was pushing past its highs. The influence of higher stock prices on an economy is tremendous (people feel wealthier they spend more, people spend more corporate earnings go up, earnings go up companies may hire more, companies hire more incomes rise, incomes rise people spend more, etc).

So all these things pointed to a market which I knew was almost certain to be engineered higher. And the biggest driving force behind higher prices in my opinion would be this lack of supply. I knew everyone had been flushed out which meant I knew we would be seeing very very shallow pullbacks, we simply dont have enough sellers to tank significantly and I knew we had a ton of buyers who were just waiting for any pullbacks to get long.

Low supply+ very high demand = higher prices

And here we are sitting just below those 1220 highs just as we expected several weeks ago. Has all this sidelined demand been met since S&P 1150 (a mere 40 points lower)? Doubtful, which means we still have a long way to go in this rally. Again, keep in mind that supply levels are low, funds are not on the ask at this point in time, they are very heavy on the bid, bond capital is still in the process of being redeployed into equities, and main street is likely just starting to resume interest in equities here as we look to print new highs. This heavy demand coupled with very low supply levels is a recipe for very rapid price appreciation which I expect to see for the foreseeable future.

I hope this explanation helped, and definitely feel free to ask the 100 other questions you have Im more than happy to answer them. Also if you need any clarification on anything just let me know.

Ryan
[e-mail]

www.matrixanalytix.com

Comments

[Fred G Sanford]

Makes me wonder if I should put some money back into equites. However, I think I will wait for the next crash and buy low.

[Shell Game]

Good post, thanks!

[RichardP]

Useful answer.  Thanks.

I noticed that not once was the underlying financial health of the company mentioned as a factor in determining the stock price.  Seems like we could detach the stock market from all its underlying companies and the stock prices would keep on keepin on, up or down, based on the factors Ryan mentioned in his article.