Monday, January 16, 2012

A Useful Fiction: Everybody Loves a Melt-Up Stock Market

A sudden sharp decline in stocks may not thrill retail investors, but it would be catnip for big trading desks that used the melt-up rally to get short.

One of the more useful Wall Street fictions is the naive notion that big players and small-fry equity owners alike love low-volatility "melt-up" markets that slowly creep higher on low volume. The less attractive reality is that big trading desks find low-volatility "melt-up" markets useful for one thing: to sucker retail buyers and less-adept fund managers into an increasingly vulnerable market.

Beyond that utility, low-volatility "melt-up" markets are of little value to big trading desks for the simple reason that there is no way to outperform in markets that lack volatility. The retail crowd may love a market that slowly gains 4% for the year, barely budging for months, but such a market is anathema to big traders.

It's always useful to ask cui bono--to whose benefit? In this case, highly volatile markets don't benefit clueless retail equities owners, as they are constantly whipsawed out of "sure-thing" positions.

From the big trading desk point of view, this whipsawing provides essential liquidity, as retail traders and inept fund managers trying to follow the wild swings up and down provide buyers.

I have a funny feeling the "smart money" has built up a nice short position here and as a result the market is about to "unexpectedly" decline sharply. The ideal scenario for big trading desks here is a sudden decline that panics complacent retail traders and managers into selling (or leaving their stops in to get hit).

Then, a few days later, as the carnage deepens, presto-magico, the big traders become buyers and the sudden decline ends.

Frankly, the market is looking like it's ready for a "surprise" decline. Various sentiment indicators are suggesting massive, widespread complacency--not bullish euphoria, but bullish complacency that reflects the general belief that the European Central Bank and the Federal Reserve have "fixed" the European credit crisis, and they have the power and will to "backstop" any market decline.

The most telling evidence of this is the VIX volatility index has declined for months and reached a level that typically reflects strong bull markets and widespread confidence. Yet there is abundant evidence that the global economy has rapidly decelerated and is now contracting.

This is only one widening divergence that historic precedence suggests will be settled with violent increases in volatility and sharp "unexpected" declines.

As noted here many times in 2011, "the only trade that matters" is the DXY dollar index, as stocks have long been on a see-saw with the dollar: when the dollar rises, stocks decline, and vice versa. Yet for the past three weeks, stocks have risen along with the the dollar.

This divergence has caused many traders to start looking at currency pairs such as the euro and Australian dollar or the euro and the Japanese yen for guidance as to the next move.
Bulls would have us believe the inverse correlation between the dollar and the stock market has been broken by this 3-week long aberration. That is possible, but a 3-week move burdened by numerous massive divergences simply isn't enough to dissolve a correlation with years of history behind it.

Generally speaking, there is an inverse correlation between "risk assets" such as stocks and "risk-off" assets such as the dollar and U.S. Treasury bonds.

Another analyst, M3 Financial Analysis, posted a series of charts of the eurodollar, the dollar and the Treasury bond market. His summary: "Critical Mass approaches as financial system begins to dissolve from within..."

But Doubting Thomases have become few and far between, and those betting against the melt-up are getting lonely and tired. This is ideal set-up for a sudden crash: low volatility, widespread complacency and faith that the market can't go down because Central Planners won't allow it, and so on.

At least one trader sees a similarity to the 2008 market just before it melted down in a big way. Anyone who looks at charts will find these compelling, or at least "food for thought."

Lastly, major downgrades of European nations caused a near-invisible decline in U.S. stocks on Friday. Bulls can interpret this to mean the market is resilient and easily shrugs off bad news. Analysts such as those listed above see this as divergences being pulled ever wider, and the point at which the rubber band snaps back might come as early as Tuesday.

Before you conclude that everybody loves a low-volume melt-up market, ask cui bono of a sudden, sharp decline that pushes volatility up and panics investors who thought the era of being whipsawed had ended.

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