Last weekend, I wrote an article -- "Are There Ethical Implications To The Fed's Self-Proclaimed 3rd Mandate" -- setting forth my thesis that the Fed was manipulating stock prices outside the scope of their legal mandate, and perhaps more directly than most believe. In that article, I created a chart comparing the Fed Balance Sheet to the DJIA. The correlation coefficient of the two metrics since the onset of QE1 was .90.
This week's price action tends to support that thesis. Price action in recent days is something akin to watching paint dry, with Wednesday being excruciatingly boring. I think we all want something to happen here -- either a breakout to all-time highs or a pullback. My point in the article referenced above is that the Fed's newly printed money is the ONLY THING driving prices right now. The charts below suggests that I am right, and sets up the discussion for what happens next.
As you can see, the Fed got very aggressive with money printing from about December 25, 2012 thorough January 25, 2013, at which point no further balance sheet expansions occurred and the chart above began to flat line. Of course, the same thing happened to stocks, as reflected by the Dow (DIA) chart.
Here's How I See It
As far as I am concerned, QE4 was initiated solely for the purpose of providing the extra money needed to fade the downward pressure in stocks that was bound to occur as Congress took on the matter of the "fiscal cliff." Whether I am right or not is beside the point -- the charts above offer substantial proof of the fact that the Fed did, in fact, keep a floor under stocks during the contentious debate on the fiscal cliff, even if that was not their intent, and I think it is naive to assume that it was not.
So one must wonder why the Fed backed off in the last week of January. The answer seems rather obvious to me -- the Republican House took the debt ceiling problem off the table by "kicking the can" into May of this year, thereby removing the last of the near-term issues that could act as a catalyst that would precipitate a market crash.
I'm reminded of Doc Holliday's line in the movie Tombstone -- "my hypocrisy only goes so far." I suspect that is something akin to what Bernanke is thinking at the moment, and the reason the Fed has backed off. Perhaps to the chagrin of the bulls, the Fed seems to be out of the game for the moment.
Keep in mind the only positive the Fed can site relating to their monetary policy initiatives since QE1 is that the stock market has responded. No other relevant metric has shown any signs of improvement, so the Fed does have a vested interest in preventing a market collapse. That said, it is not likely they want to distort reality too much -- in other words, once again, "my hypocrisy only goes so far."
Where Do We Go From Here?
Since the Fed backed off on their money printing, the market has been stuck in neutral. I think it's useful to consider the players in the market at the moment to attempt to ascertain which way we go from here.
Of course, we always have the high frequency traders that serve to create a little volatility, but one wonders if that isn't about all that's left. Wednesday's market action seemed to indicate as much. We opened lower, the algos bought the dip and we rallied into positive territory, only to settle back to the unchanged line at the end of the day. That suggests there were no takers for the algos to unload to as they pushed the market up off the early lows.
How about the long-term bulls and those new retail investors that finally came off the sidelines in January? It would appear they spent their money on the way up in early January. They certainly didn't seem to be in a buying mood Wednesday. If there were buyers for the algo traders to unload to, then we probably would have put in some decent gains on the day, and we didn't do that.
In fact, we have been in a pretty horizontal market since the Fed backed off in late January, suggesting that the only players left are the algos, and they might just be playing with themselves at the moment. That makes sense to me, as I think most traders and investors acknowledge that the market should, by all rights, pull back from these levels a little.
That means the "buy the dip" bulls need the dip, and they haven't gotten it, so they aren't -- as of now -- buyers. On the other hand, the bulls still believe, and they certainly don't want to get out at these prices, as we could spike higher and push through the all-time highs.
I suspect the logic goes like this -- let the market tell us where it's going, and then react accordingly. If that is the case, then I would suspect that the hard core bulls will do nothing but wait for a lower buying opportunity, but one wonders about the short-term traders and the new money retail crowd.
My guess is the new money and the shorter-term traders have stops just under the lows, and in pretty significant quantities. The big question is, how many stops do reside at these levels? Normally, we would have stops a little less concentrated than we do today.
Consider that even the bulls are anticipating a pullback. Most traders think such a pullback would actually be a healthy thing, as we all know the market can't continue on its current trajectory. I think we have, for the moment, run out of buyers, and we will drift lower toward those stops solely on the basis that nobody wants to buy these levels.
If A Correction Is Imminent, Then How Far Do We Pull Back?
Consider that normally stops are well dispersed, as the views of market participants are diverse. That doesn't seem to be the case today, as even the bulls readily admit a correction is likely in the coming days/weeks.
The likelihood of a high concentration of stops is increased by the fact that we are at all-time highs, and the underlying economic metrics are not so good. Another factor that suggests a high concentration of stops is the record high level of leverage being employed today. A good synopsis of this dynamic is provided by Paulo Santos. The final point is that the stop price seems self-evident to all at these price levels, as the recent lows provide a fairly close and logical price level to place stops. In other words, stops are not widely dispersed, but heavily concentrated.
Assuming there is a heavy concentration of stops just under recent lows, and I suspect that is the case, a sharp sell-off could occur as these stops are triggered. The fact that the market is heavily leveraged could produce a broad market sell-off similar to the one Apple (AAPL) has experienced over the last few months. What could add to this downside pressure is the possibility that the algo traders -- also heavily leveraged -- could get stuck and be forced to run for cover.
As I see it, there are 3 possible support levels that could bring the bulls back on board. The first is the November lows around 12,500. The second is the June lows around 12,000, and the worst case scenario is the October 2011 lows around 10,500.
Before discounting the worst case scenario, I will remind readers that the Apple sell-off wasn't adequately explained until the stock had fallen from $700 to $500 -- approximately a 30% pullback. A pullback on the Dow to the 10,500 area would be about 25%. My point is that by the time market pundits offer an explanation for why the market has fallen so far and may not bounce back anytime soon, it will be too late -- at least that was the case with Apple.
A final point -- keep in mind the Fed may be done for awhile. After all, we did turn into negative territory on GDP in the 4th quarter, and unemployment did tick back up. Business and consumer sentiment is in the dump, and there is just not a lot to justify these price levels from a purely fundamental perspective.
Without the Fed, this could be a pretty serious pullback. One has to consider how far the Fed is willing to go, or for that matter, how far they can go and still remain credible. My guess is a pullback of 25% might just fall within their tolerance level.
Disclosure: I am long TZA, TECS, UVXY and FAZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.