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On November 12, I wrote my first "What's Driving The Markets..." article, and I have decided to continue offering updated insights and forecasts under this title as market dynamics shift and present legitimate reasons for further commentary. I plan to offer my views on short-term price action as well as the intermediate term "drivers" of market price within the context of the major trend dynamics.

Let's get started - the obvious question today is what to expect going into the end of the year. Do we get a "Santa Claus" rally or will the "fiscal cliff" be the overriding influence moving into year-end?

In my last article, I noted that there are 4 primary market drivers to consider and I don't see much change here:

  1. The "fiscal cliff."
  2. The debt ceiling debate.
  3. The prospects of credit rating downgrade.
  4. Continuing deterioration in the eurozone.

The issues above will drive the market going into the end of the year. Paradoxically, all these drivers must necessarily be seen as bullish market movers in the short term despite their extremely bearish nature.

Let me explain that seemingly illogical assertion. The market participants - at least those that trade on a daily basis - are anticipating the end of the bull market correction. We are no longer in a bull market but denial seems to be the overriding influence in the markets today. I will expand on this assessment

Traders just don't like the short side. It has negative connotations and there seems to be an irrational denial of the fundamentals. The fundamentals are so bad that I consider them unprecedented, but we will deal with that in a minute.

The point is this - we all know that the "fiscal cliff" poses a real threat to the markets. We know that in 2011 when Congress dealt with the debt ceiling issues that the markets had a mini crash. We know that all the major credit rating agencies have threatened further downgrades, and we all know that the eurozone is on the verge of imploding.

Trader sentiment is decidedly negative but also hopeful. Traders are looking for something - actually anything - to hang their hat on that will reverse the bear market trend and allow the "Bernanke bull market" to continue. Consequently, even the slightest hint that a resolution to these problems might be forthcoming will produce a very short-term counter trend spike in market prices.

There is some empirical support for my thesis that the 4 major market drivers will work to motivate buyers. Consider Tuesday's speech by Fed Chairman Bernanke. I listened to his speech from start to finish and he offered very little that one would construe as positive.

In fact, he cautioned us on the seriousness of the "fiscal cliff" and upcoming debt ceiling debate. He hinted at the consequence of Congressional dysfunction on the matter of dealing with the debt ceiling in the next few months and reminded us of the 2011 debt ceiling debacle that precipitated a mini market crash of sorts even though Congress did eventually cobble together a solution to the problem.

He even explained in pretty straightforward terms that monetary policy tools can't really resolve these problems. In spite of this decidedly negative and cautionary position taken by the Chairman, the markets managed to turn his remarks into a positive. After a brief sell off during Bernanke's speech, buyers moved into the market buying the dip and prices erased most of their losses. Bernanke was talking after all and doesn't that always mean higher prices?

The answer to that question is no. The "Bernanke bull market" is over. How do I know that? It's in the numbers and the numbers paint a very clear picture. We all know that the economic recovery - if you can call it that and I don't - has been muted at best.

There are 5 very serious problems facing us today that absolutely preclude a continuation of the bull market:

  1. Quantitative easing hasn't worked.
  2. Fiscal stimulus has worked, but we are running out of money.
  3. The unemployment situation has deteriorated during Obama's first term after factoring in the decline to 30-year lows on labor participation rate.
  4. The rapidly deteriorating situation with our major global trade partners virtually assure a decline in GDP and therefore more layoffs.
  5. The overhang of underwater housing - though not mentioned often - is a serious threat that will likely resurface if we enter into a recession.

Let's talk about QE

The general belief amongst traders is that the Fed has a printing press and can print enough money to guarantee a floor under asset prices. That is not true, but the general consensus of opinion - based on a lack of understanding of monetary policy - is that it is true.

The chart below reflects excess money reserves held in the nation's banks:

(click to enlarge)

Excess reserves are simply idle funds and do nothing to drive GDP or unemployment in the desired direction. They just sit there. It is only when the banks use that money to make loans to businesses and individuals that the cash on a bank's balance sheet moves into a depositor's account. At that point, this money is at least in a position to drive GDP growth.

This situation is discussed in Keynesian economic theory. It is the classic Keynesian "liquidity trap." "Liquidity traps" are the result of fear and apprehension. People and businesses - for whatever reason - are afraid to borrow. They elect, instead, to pay down debt and increase savings.

This is a huge deal and tends to validate my argument that QE won't - or at least shouldn't - drive assets higher. It is an increase in M2, but practically speaking, it shouldn't even be considered as M2 until it moves into a depositor's account.

M2 expansion can only drive economic growth if it is circulating in the economy. Excess reserves don't circulate in the economy. Excess reserves are reflected as an asset of the bank, not the depositors. Why is that relevant? It is relevant because the banks don't spend that money - it just sits there doing absolutely nothing to drive GDP.

The most recent number for excess reserves is $1.418 trillion. If we subtract that from current M2, we end up with the amount of M2 that is actually available for use to drive GDP. That number is $8.873 trillion. At the end of December, 2008, M2 was $8.212 trillion. The take away here is that the very modest real increase in M2 (M2 - trapped reserves) correlates well with the very modest GDP growth we've been able to muster over the last 4 years.

That is the truth behind the hype - QE is a failed policy and nothing is likely to change in the near term. Even so, it will continue to drive traders who simply don't get it and most don't get it.

Technicals

I would be remiss if I didn't discuss the technicals. There is little doubt we have - for the moment - turned down. It is my opinion that the recent counter trend bounce that began last Monday may cause some to argue that the bull market is back in full play.

Whether the recent upside move is proof of the end of a bull market correction or a correction in a major bear market is yet to be determined. For what it's worth I want to go on record as stating that it is the former - a correction to the short-term oversold conditions in a major bear market.

All relevant indicators suggest that we have broken down. The S&P 500 made 3 separate attempts to put in new highs following QE3 - spaced about 3 weeks apart - before breaking down. The market has now moved below the 50 and 200 day moving averages with the recent rally pulling the S&P back to the 200-day average.

I expect the rally to fizzle out here and a new fractal should be produced on the charts that will push the S&P down to the 1300 level. The first of these patterns produced a bounce of about 34 points before declining from the high by about 85 points. The recent bounce back up to the 200-day MA should fail and a new down leg should commence assuming the pattern continues as I expect it will.

That down move would put us around the 1300-1320 level. Time spacing is about 10 trading days from rally peak to the bottom of the fractal, so I see the market moving lower into the end of the month with a possible bounce in the 1300 area. I don't preclude a capitulation sell-off though and would not be inclined to buy the 1300 area as the risk is high in my opinion.

Complacency has been the general sentiment in the markets despite the rather significant pull back in recent weeks. There are still a lot of traders buying the dips and almost no fear at the moment. I do expect that sentiment to shift, and when it does, we will see a "capitulation" sell-off that will confirm that we are now in a bear market.

Concluding thoughts

As I see it, any suggestion that a solution to any of these major headwinds is in the offing will motivate buyers to jump in, and that will drive prices higher until they finish spending their money. Following that, the market will sit relatively idle for a day or two while traders who bought scratch their heads - seemingly confused - and ponder why there was no upside follow through. Thereafter, the market will put in another down leg.

Long-term buy and hold investors, including institutional and retail investors, will have no impact on market movement going into year-end. They have spent and now they are holding. One caveat to that is the potential for significant selling in anticipation of tax hikes in 2013. Other than that, market shifts are likely to come from the remaining retail traders that manage their own portfolios and the two way hedge funds.

Volume has been relatively thin and market volatility will reflect that lack of participation. Don't be surprised to see market spikes like we saw on Monday, but these spikes will prove very short lived. The smart money traders understand the dynamics of the macro headwinds and won't jump on board.

The question then is this - do we get a "Santa Claus rally" going into the end of the year or do we continue the slide that began shortly after the QE3 announcement? The historical odds favor the "Santa Claus rally." We've only had 3 instances in the last 20 years where the 4th quarter closed lower than the 3rd quarter.

That makes my call for the bear side of the argument particularly bold, but I am making it nonetheless. Our fundamental situation both domestically and globally is so dire that it is hard to see any other outcome.

Source: What's Driving The Markets And Where Do We Go From Here?

Additional disclosure: I am short a group of tech stocks, financials and crude oil. I am long the VIX.