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Reversal vs. Pullback

Submitted by naufalsanaullah on 10/04/2009 03:43 -0400

Since the huge move in equities off of March lows, especially as of late, portfolio managers have been bidding up stocks by buying on the dips in an effort to make up for dismal 2008s and remain competitive, which is tough when benchmark averages are up 40-60%. Reminiscent of liquidity-fueled bubbles past, especially the dot-com bubble, common equity in effectively insolvent companies is showing record volume, as daytrading this greater-fool game is the only functioning strategy.

But chasing beta can only work for so long, as a market whose participants are exclusively chasing each others' momentum trades is doomed for a drastic change in its landscape. The key of course is to find the greater fool before it becomes you, and the inevitable reversal of this rally is going to be twice as sharp as the way up.

The S&P 500 is down about 5.1% since its recent top at 1080 on September 23. Many are questioning whether this is a pullback that will eventually resolve into a continuation of the rally or the beginning of a reversal (the reversal) that will send stocks declining. I am in the reversal camp and think that this is the beginning of a sharp, drastic sell-off in stocks.

In attempting to identify this mini-selloff as a pullback or reversal, it is important to trace the catalysts of the rally itself and analyze their sustainability, at these levels specifically. By far the most significant factor regarding the rally is the newly-injected liquidity driving it. As monetary supply increases, as do asset prices, through currency debasement. This can become a self-fulfilling positive feedback loop via the carry trade, as the USD depreciates further, financing demand for higher-yielding assets (such as equities). Also important to the rally are the bank earnings and economic data "supporting" an economic recovery, as they are being used as post-hoc fundamental basis to the move in equities.

The "monetization liquidity" fueling the rally comes from the $300B in long-dates Treasuries announced back in March as part of the Fed's QE. The POMOs executing the injection have been covered extensively, and the end result is primary dealers end up sitting on the cash. Only about $7B (about 2.3%) of the original $300B remain to be injected. Without this liquidity (which correlates very well with the S&P's performance since spring), the rally loses its legs and momentum switches to the downside.

Though liquidity is the primary catalyst to the rally, the move has been magnified by the USD carry trade and by portfolio underperformance against benchmarks. The carry trade, which magnifies the move down in the dollar and the move up in equities, relies on a USD supply increase (liquidity injections) offsetting a demand increase (deleveraging/debt liquidation). Because the liquidity is drying up, deleveraging should regain control of the USD's price movement and an unwinding of the carry trade should result, leading to a spike up in the dollar and a sharp drop in stocks and commodities. The underperformance of portfolios against benchmark indices showing 50-70% rallies in half a year has led to a crowded momo beta-chasing trade as PMs attempt to offset 2008 losses in a blatant greater-fool game (AIG and CIT volume explosions prove that much). An exponential stream of freshly minted dollars is required for the momentum to continue and for the momo trade to work, and as liquidity dries up, the momentum on the way up will reverse to the downside-- and may accelerate.

And then there's the "fundamental" basis to this rally. Bank earnings have been a bunch of accounting shenanigans, boosted with AIG CDS unwinds, trading/i-banking profits due to an engineered market rally in which every company is issuing boatloads of secondaries that all need underwriting and lack of trading competition (Lehman, Bear, Merrill RIP), and a steep yield curve in Q1-Q2 2009. "Extend and pretend" accounting only works temporarily, and as option ARMs reset and borrowers default, assets marked at par tank down very, very quickly, eating away bank equity and ruining 10-Qs. Banks went on a spree in their Q1 and Q2 earnings reports with accounting tricks and those will come to bite them twice as hard in Q3 and Q4. The trading and i-banking profits are dependent on a continuing rally (positive feedback loop) as well as lack of competition (which is now 100% priced in). The yield curve is flattening, as long bond yields topped out in June, and this should hurt bank earnings as well in Q3 and Q4 earnings reports. As for economic indicators, look no further than this to tell you why there's no recovery.

So liquidity is drying up and that effectively screws up all of the engines to the rally, leading to a sharp sell-off. But what's to say the Fed won't pump more liquidity into the market? Well, for one, it decided against expanding its QE, so the liquidity injections have stopped, at least for now. Moreover, the USD is back to last summer's levels, and further decline could break important support and send it spiraling into substantial debasement. Most importantly, if injected liquidity continues expanding, bond yields (which are currently forecasting deflation in the short run, at odds with equities) will skyrocket, leading to very unsustainable interest burdens and a debt crisis. The controlled demolition of the USD requires liquidity financing inflationary rallies, sharp corrections via deleveraging, and then continued bleeding of the USD to prop up other assets. Let the USD hit free-fall, you have a monetary crisis. Let monetary supply remain stable and the USD to rally on demand via debt liquidation and you have deflation (arch nemesis to Ben Bernanke). The plan is to debase the dollar slowly, with an episode of deleveraging as the political capital for bailouts/QE/USD depreciation dries up, until bank deleveraging has hit a pivot point, excess reserves can be unsequestered for use besides mopping up asset depreciation, and holders of Treasuries/USD (who see unique systemic and crowded demand each deleveraging episode through the "safe haven" thesis) are reduced to bagholders. Thus, the USD is ready for its next wave up, and this means a big reversal in equities.

As my readers know, I don't offer any timing without the use of charts and technicals. The chart below quite comprehensively summarizes all that needs to be said about equities:

Credit markets were terrific forecasters for the impending trouble back in 2007 and again are showing signs of big trouble ahead. Just look at some of the distribution in these bond ETFs. These are reversal candles, not pullbacks on low volume:

LQD is my favorite development of all-- IG corp bond ETF breaking obvious rising channel since March on huge distributive volume? Taaaaank tiiiiiime.

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Sun, 10/04/2009 - 11:32 | 88190 SpartanTnT

Excellent work..thanks

Mon, 10/05/2009 - 17:51 | 89249 Anonymous

"I am in the reversal camp and think that this is the beginning of a sharp, drastic sell-off in stocks."

Not today...

Sun, 10/04/2009 - 11:57 | 88203 Anonymous

Notice how the big volume on the two ETF's came in on Thursday before the "official" release of the employment data.
Those well connected trading desks got the inside scoop.

Sun, 10/04/2009 - 16:00 | 88348 Anonymous

Is it possible the ADP number has become believable?

Sun, 10/04/2009 - 12:02 | 88205 Banker1944

Good assessment of trend developments. Still can't be sure what will happen.

Sun, 10/04/2009 - 12:08 | 88209 Gunther

Naufal, very well reasoned.

Sun, 10/04/2009 - 13:00 | 88240 Lionhead

+1. The charts never lie. The distribution is quite obvious to all that are TA analysts. When time is up, it's up.......

Sun, 10/04/2009 - 12:55 | 88238 There ya go again.

Very well put , thanks !!

"Thus, the USD is ready for its next wave up,

and this means a big reversal in equities. "

Any guess how high the dollar goes ?

Sun, 10/04/2009 - 13:07 | 88249 Dadoomsayer

Good work indeed.

There are some serious pyschological reasons to stop going up as well.

Almost everyone I know is looking for a top at 1122. Tops and bottoms that have a large consensus are almost never reached.

There are so many people that are now conditioned to buy the dips.

The thing that really turned me bearish this last week was the market action. In the past few months the moves up have been fast and there were very few sellers (I imagine they were shorts), now there are a lot of sellers and few buyers. Market is stickly going up, and fast and furious going down.

Mutual funds trade in the last 2 hours of the day (most funds have a time of 2:15 as a cutoff for buying and selling) and that is usually when the real direction of the market is seen. The direction has changed in the last 2 weeks from buying to selling.

I was in the camp of buying the dips. I even have a postit on my monitor that says BUY ALL DIPS!!! With the market action of the last week, I am now going to be selling all pops. (time to change the postit)

Good luck all!

Sun, 10/04/2009 - 13:14 | 88257 Anonymous

Naufal, you're a very good writer. Appreciate the clarity of expression.

Sun, 10/04/2009 - 14:26 | 88300 joebren

It's not a reversal, it's risk aversion. The outcome is the same. LQD:TLT. Watch out below.

Sun, 10/04/2009 - 16:03 | 88350 putbuyer

I gained 2 pounds reading your article. Thanks bro.

Sun, 10/04/2009 - 16:14 | 88357 A Man without Q...

I'm not convinced we will see the sharp rally in USD. The general acceptance is for the dollar to weaken in the medium to long term, so I expect plenty of selling into any strength. If you are looking at risk aversion, maybe trim equity holdings and move into foreign currency sovereign debt..

Sun, 10/04/2009 - 18:49 | 88414 Anonymous

Sun, 10/04/2009 - 21:13 | 88475 Anonymous

The dollar short trade is very one sided now as the dollar has become a new carry trade vehicle so any scare in the market could cause a huge short covering rally

Mon, 10/05/2009 - 02:36 | 88615 A Man without Q...

The Dollar is not the carry vehicle in the same way, say JPY has been. If I am funding a US equity position or a commodity position, trimming my risk does not involved an fx trade, so unwinding is USD neutral.

I am of the opinion if I want to reduce risk, I don't think going long USD is the answer...

The big risk in all of this is more about central banks intervening to support the USD, a coordinated action could get very messy, but the question is how much unity there is right now...

Sun, 10/04/2009 - 21:47 | 88494 Anonymous

Good sentence structure. Logically ordered, etc.

You're crazy if you think the market is done going up. I have one ticker for you if it is so easy to pick out the top: FAZ. Just try to monetize that pig after everyone else picked the same time to buy it.

Sun, 10/04/2009 - 22:31 | 88509 pooplagrande

Well written...very hard to argue with that.

Sun, 10/04/2009 - 23:37 | 88551 Grand Supercycle

The Dow and SP500 daily chart still looks toppy and USD and VIX continue to give bullish warnings.

[I warned of an impending stockmarket crash back in early 2007]

MORE:
www.zerohedge.com/forum/market-outlook-0

Mon, 10/05/2009 - 01:10 | 88586 QuantumCat

Great analysis... and with everybody short the dollar, the deflation pump is primed to bring us "the mother of all reversals." So, does the obvious strategy work here? Obvious is usually wrong, right?

The FED, US Treasury, and GS will not sit idly by while the market spirals down in a deflationary crash. The usual ploy of bailouts and programs designed to socialize losses through government debt will not be able to keep up with the onslaught of a market panic. So, this is the question... what novel action might these control freaks take in the face of shear panic across all asset classes? At some point, this deflationary ride down may not provide profitable trades due to some novel government intervention. Might "Establishment" counter parties be protected?

Hmmm... perhaps they'll call it the Investor Safe Haven Act of 2010 to prevent payment transactions to "evil" short-selling retail speculators.

In the end, they're going to make sure nearly all of us lose... and confiscate your gold just for good measure.

Mon, 10/05/2009 - 07:21 | 88649 Ned Zeppelin

I worry those who have prepared for a sharp equities reversal will be staring at a screen announcing that trading has been suspended.

Mon, 10/05/2009 - 07:59 | 88655 Anonymous

They can't suspend trading for ever....

Mon, 10/05/2009 - 11:01 | 88868 Anonymous

Great article. Concerning the USD, I think its hard to say....we had huge uncertainty last year with all asset classes down and the dollar higher, excuse being that the speed of the drop caused USD rally for ultimate safety. Perhaps there has been sufficient time to ignite long term change for the USD, and unless any potential drop is severe, the USD does not have to rally. Ultimately there is still no other totally viable currency to go to. On the Rally, the 1120 area is just have way back from 1080....also it would make what could be considered an incremental high on the move up from 667 to 1080...with a spike/failure in that area giving people reason to call a top.

For now, the pull-back as been just that...a normal move down after a sustained move higher. Not enough to merit a call for a top. As much as I cannot believe the mkt is where it is given the overall crap situation the larger economy is in...the trend is still up. I'm still shopping for that low risk play over the long term where prices move back through 667!

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Reversal vs. Pullback

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