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After QE-1 ended, the market dropped -17%. After QE-2 ended, the market dropped -21%. Now that Operation Twist/QE-3 is over, many believe the market will drop again. In my 18 years of trading, I have never seen the market move more on sentiment and psychology than I have seen in the past 2 years. It would make perfect sense for the market NOT to correct here, but rather to scream to new highs by year-end.
There are many who believe the ONLY reason the stock market recovered over the past 5 years was due to the various bond buying programs of the Federal Reserve. While I agree this was PART of the reason, one can’t deny that the economy has recovered, the banking system has stabilized, and the overall low interest rate environment has helped to provide liquidity. We can still have a low interest rate environment without QE, especially because there remains a globally coordinated effort to keep rates low.
The “V-bottom” created in October was definitely not a normal occurrence. I have seen high levels of institutional selling in the past (which creates the left side of the V), however, I have almost never seen the market rebound from that selling with the velocity and the non-stop grind up as it has over the past 2 weeks (creating the right side of the V). Usually, the market backs and fills or stays down for 3-12 weeks before attempting a rally.
Normally, these V-bottoms are failure prone, but I believe it was caused by the capitulation of several hedge funds who were short bonds (US Treasuries) and long oil. Essentially, they were betting on a stronger economic recovery and for market conditions to “return to normal.” The pain of being wrong for so long caused a forced liquidation in the beginning of October. You could see it while watching the tape that the selling wasn’t normal, and it culminated with an extreme move on 10/15/14.
Going forward, I expect the market to digest its recent gains over the next 1-3 weeks before a possible year-end rally. Of course, there will be some shakeouts along the way to keep the Bulls honest, but right now, there are many stocks acting well and every little dip is being bought by the institutions. It’s possible that the market is forecasting a more favorable “business friendly” political environment, especially if the Republicans take over the Senate in next week’s Mid-Term elections.
One last point: Seasonally, we are about to enter the best time of the year for the US Stock Market. Again, I am expecting some pullback/digestion over the near-term, but I wouldn’t be surprised to see us make new highs into year-end. If that happens, it would confuse many market participants who believe that this 5-year rally was mostly caused by the Fed, and that the market should drop now because the Fed is out of the way. As they say, the market tends to fool the majority.