Is the Equity Market Rally Over?

The S&P500 fell almost 4% this week on strong, but not huge volume.  The VIX (or fear) index, however, went ballistic; it jumped over 52%.  The rise in volatility suggests that the complacency that dominated the fall and winter might be coming to an end.  Even though prices did not collapse, traders were willing to pay much higher insurance premiums to protect against further price drops.  A lot of folks got scared all of a sudden.

The economic data were mostly weak, as usual.  Housing starts fell–a lot more than expected.  Producer prices were mostly flat to slightly higher, suggesting that upstream prices could eventually push up prices for goods and services.  Initial claims spiked well above than the consensus estimate, and continuing claims (when adding in extended and emergency claims) approached a stunning 12 million.  Leading indicators were better than expected, while the Philly Fed survey came in below expectations.

Technically, the S&P500 broke some critical new ground this week.  For example, the uptrend that began in March 2009 was broken decisively, on the weekly charts.  The next major level of support, below Friday’s close, will be at the 200 day moving average; this is about 1010, or 7% lower.  The daily charts are also strongly pointing to more downward movement over the next two weeks.  On the monthly charts, the last two consecutive down weeks are adhering to the top of the two year old downtrend line that began in November 2007.  If prices fall again over the next two weeks, then this downtrend will have successfully reasserted itself.

So what happened to cause the sudden change in sentiment?  And how do we determine if this is a minor pullback, or the start of something larger?

Dozens of pundits can throw up dozens of differing causes of the change.  One of the most compelling explanations is the reversal of the key driver of the prior rally–the Federal Reserve’s liquidity program is coming to a close, and the markets are bracing themselves for the withdrawal of the Fed’s purchases.  After pumping almost $1.7 trillion (of newly created money) into the capital markets, the Fed has become a major buyer in several of the largest credit markets–the MBS, the agency debt, and the U.S. Treasury markets.  Without any doubt, the Fed’s purchases have boosted prices across most asset classes AND they have lowered volatility.

Naturally, the shutdown of such a massive buying program will cause prices to stop going up so steadily and with low volatility.  Without even SELLING any of its newly acquired assets, the markets will pull back from the otherwise higher anticipated prices. 

But will this be a minor pullback, up to 10%, or the something more severe, say 10% to 20%?

It’s impossible to know with certainty.  But the major “test” will be the market’s ability to bounce up from resistance.  If the S&P does NOT fall through the 200 day moving average of 1010, and then bounces up from there, then the bulls will probably cheer and start buying again.

But if the 200 day is broken, then there’s a lot of room to fall to the next level of support–first near the 900 mark, and then near the 800 mark.

If the Fed keeps its promise and shuts down quantitative easing–and the political message generated by the Massachusetts senate election will make it much more difficult for the Fed to keep printing money–then the chances of a more meaningful correction rise. 

Soon, we will be able to see exactly how much of the rally was driven purely by the Fed’s printing presses running on overdrive.

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