A Market At Equilibrium - At Least For The Moment

Includes: DIA, SPY
by: Joseph Stuber

Last week I wrote an article pointing out that the market was - at the present time - in somewhat of an equilibrium balance between buyers and sellers. I presented two charts to support my point. The first being the DJIA (NYSEARCA:DIA) and the second, the Fed's Balance Sheet. These charts are repeated below with a few extra data points added.

It seems we are still in that state of equilibrium I referenced. We have a market in waiting with neither the bulls nor the bears demonstrating much conviction. We will discuss my basic thesis in a moment but first a look at the updated charts.

(Click to enlarge)

(Click to enlarge)

The point these charts make and a point I have been making in the last few weeks is that the Fed is the single driving force in market movement reaching back to the onset of QE1. The correlation between the Fed's Balance Sheet expansion and the stock market is stunning. We all know that the Fed has had an impact on market price over the past several years but I don't think many believe the Fed's impact has been as highly correlated to stock prices as these charts indicate.

The charts above show the short term correlation between the Fed's Balance Sheet and the Dow. The following chart dates back to the onset of QE and presents a longer term view. The correlation coefficient is .90 and suggests that nothing else has really mattered since the Fed took on their 3rd mandate to support stock prices.

(Click to enlarge)

  1. Series 1: Fed balance sheet
  2. DJIA
  3. QE start/stop
  4. Twist

I have a few problems with this 3rd and self proclaimed mandate. First, it is not one of the Fed's jobs to manipulate stocks; second, it has created a wide divergence between base economic metrics such as GDP and unemployment and the price of stocks; and third, it has effectively produced a very dangerous bubble in both stocks and bonds.

None of this really matters at the moment though as the Fed remains the only game in town and its actions seem to be the single best indicator of market direction. In fact, based on some pretty negative economic data and politically charged fiscal matters in recent weeks, the Fed seems to have managed a major coup in that they have driven the markets higher in spite of these negatives.

In last week's article on this subject I suggested that the Fed would back off on balance sheet expansion since no really contentious fiscal matters were likely to act as a downside catalyst since the last of these -- the debt ceiling -- had been kicked into May with a temporary congressional reprieve. The debt ceiling will obviously resurface in coming months but it won't drive market prices in the very short term.

I also suggested that the Fed - without much fanfare - initiated QE4 merely to allow for additional money printing that would likely be needed to back stop stock prices during the contentious debates on the spending cuts, tax hikes and debt ceiling in December and January. The Fed's balance sheet did expand in lock step with stock prices from the announcement of QE4 to date.

So, with all the really troublesome fiscal issues temporarily off the table my thoughts were that the Fed would back off and let the markets operate on their own for the time being. That of course means that the Fed's balance sheet trajectory would flatten out. A look at the Fed's tentative purchases scheduled for February and the actual balance sheet expansion suggests that this in fact has occurred. The table below shows the Fed's proposed or tentative estimates on Treasury purchases for the month of February:

























The low end of the range is $10 billion and the high end is $13.25 billion in treasury purchases during the period reflected. The actual Fed balance sheet expansion was only $6.28 billion, reflecting that the Fed is backing off a little for now. I'm not suggesting that this will continue as the Fed has informed us of its intentions to continue purchasing assets to the tune of $85 billion a month.

On the other hand, the rhetoric on Fed asset purchases has ramped up a bit in recent weeks with more talk of a discontinuation of QE sooner rather than later. Assuming the debt ceiling increase is limited to $1 trillion in 2013, the Fed's commitment implies it will purchase approximately 50% of that increase with the balance of the promised Fed asset purchases being mortgage backed securities. Talk about a corner on the market -- a little prudence here might be advised.

That presents another dilemma for the Fed. Stock investors have come to count on the Fed to back stop stocks and the Fed has risen to the occasion so far. Stock prices have become particularly resistant to any correction at all as investors know that any negative data that might serve to put downside pressure on markets will not do so as the Fed will absorb all the selling pressure.

Has the Fed backed itself into a moral corner here? Does a discontinuation of asset purchases that would let the market operate normally constitute a kind of "bait and switch" trap for investors?

The table below reflects Fed securities holdings going back to December 5 of last year for those who care to look at the breakdowns:



































































Factors that could tip the balance

We are in a state of equilibrium at the present but it is not so much that buyers and sellers are equally balanced - it is that neither side is doing much of anything at all. Volume - or lack thereof - is probably the single biggest risk to a steep downside move at the present.

Low volume equals a lack of liquidity. A lack of liquidity means volatility and volatility could precipitate a really large move in either direction. I see the downside having a much greater probability of occurring than the upside.

There are two groups that could lend support on a pull-back - the Fed and the "buy the dip" bulls. So far these two factions have stood in the gap and prevented any significant market correction with the one exception being the crash in August of 2011.

As I stated last week, my guess is the magnitude of the stops just under the recent lows will result in a large surge in sell-side volume. We know the Fed has ample dry powder if needed, but one wonders whether it will get any "buy the dip" support this time. I suspect the dip buyers will continue until a sharp sell-off occurs at which point it will quickly take cover. The idea here will be to wait until the market tells them the pull back is over.

Consider that the recent sideways movement in the market -- at close to all time highs -- has set up a very logical place to position stops. I've said this before but it is worth repeating - normally stops are not highly concentrated at a specific price level. The horizontal price action in recent days at close to all time highs significantly changes that dynamic.

Of course the high level of leverage being employed today also implies that those using that leverage are likely to be using close stops. I can see the logic employed by hedge fund managers and traders. Wanting to position for a possible break out to the upside, they take highly leveraged long positions but do so with close stops realizing that the market is clearly overbought and subject to a pull back.

The contrarian premise probably used here is that since everybody is expecting a pull-back it probably won't happen. I use that kind of logic myself at times and suspect there are a lot of traders seeing it that way. Almost all pundits are saying the same thing - play it long but with close stops. Again, a high volume of stops just below recent lows could result in an implosion to the downside in a market with little volume and therefore little liquidity.

Another catalyst could come from this week's G-7 statement on currency devaluation. Draghi's statements last week on the euro resulted in a sharp and relatively deep sell off. As usual, the "buy the dip" algos and short term traders stepped in once the euro began to stabilize and pushed the markets back up.

Don't underestimate the impact of such a statement, though. Intraday stock price movement is directly correlated to the euro right now. As I write this I am tracking the euro which has moved up a half cent from 1.3370 to 1.3420 in just a few minutes. The Dow has moved in perfect lock step from a low of 13,940 to 13,977.

A perfect storm is setting up

Timing a sharp stock market crash is exceedingly hard to do. Those who see the fundamentals with objective clarity know that a stock price recalibration is coming at some point. That said, those same pundits - myself included -- have been disparaged for their "dooms day" warnings as stocks have plodded along based purely on the flawed logic that the Fed can back stop any stock market crash.

Clearly the Fed has been able to thwart any and all sell-offs aided by its own cash and the cash of those who jump onboard any rally - at least so far. The only exception to this in recent years was the August, 2011 crash. The volume was just too much to withstand as traders rushed to the exits in mass.

With almost all the market moving catalysts off the table for the time being there is a sense of complacency in the markets. It is just that situation that sets up the "perfect storm". Whether or not it happens in February I can't say - it will happen though and I do see a lot of counterintuitive factors that could induce just such a sell off in the coming days.

I will close by reiterating a portion of a comment I made to a reader this weekend regarding the nature of top picking:

"Perhaps the most memorable experience I had as a young man just starting out was a client who took $2,000 into $250,000 in the (commodity) bull run from May to September of 1973. He was pressing his bet with profits unlike anyone I have ever seen and the market just kept going up.

My boss advised me to tell him we were in a blow off top and that he should not be greedy but instead take off some of his longs. He did follow that advice and we were a bit premature on the call. I remember him being very upset with me and demanding I put the trades back on. I did as he instructed.

A week or so later the market turned and with a vengeance. Limit down multiple days. He was so heavily leveraged that when we finally got him out he had lost the $250,000 plus another $100,000 and he didn't have the money.

I was responsible for deficit accounts and the partners of the firm took me to the bank and co-signed a note with me for the $100,000. They proceeded to take 50% of each month's paycheck for the next 12 months. Finally, my trader paid the $100,000 but it took his entire wheat crop for that year to do so.

Consider this was 1973 and I was 22 years old and only one year into my career. That event shaped much of my thinking from that point on. Point being I am always open to all possibilities and looking for the turning points. That story also explains why it doesn't bother me to be a little early as I know the consequence of being just one day late."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. I am long FAZ, TZA, TECS and UVXY.