Market manipulation, short-covering rallies and cyclical bulls

There has been a lot of chatter in the markets about why U.S. equities continue to rally.  Three distinct viewpoints have surfaced, two of which are bearish and one which is bullish.  Let me share those theories with you.

1. Market Manipulation aka. the Plunge Protection Team

In this storyline, someone (probably the famed Plunge Protection Team) is manipulating the market to push it higher.  Michael Panzner pointed out this view last Friday in a post called “Manipulation, Anyone? Now, Michael’s site is called Financial Armageddon, so you know he’s bearish and the post reflects this.

Coming as it did on the last day of the week at the end of a month, some might find the action that took place near today’s close to be rather interesting.

From 3:54:28 pm to 4:00:02 pm, S&P 500 e-mini futures rallied 17.25 points on approximate volume of 356,300 contracts, or 19.3% of the total turnover from 9:30 a.m. until futures finished trading at 4:15 p.m.

Hmmm. Manipulation, anyone?

2. Short-covering rally

But, while Panzner thinks outright manipulation is to blame, he is not alone in seeing this upward move as suspicious.  Others point to technical factors as responsible for why the market(s) is rallying (It is not just the U.S. – as I write this the Dax has rallied 4% AND the S&P 500 is up over 2%).  Yves Smith pointed out a post over at the Market Ticker which sees short covering as very much a factor in Friday’s late-day rally.

What does this all mean?  A few things:

1. The stops up there are gone.  They were potential rocket fuel for next week and the propellant to take us to – and potentially through – the 200DMA on the cash.
2. A bunch of someones had a lot of contracts that were short taken out on them.  Those nearly 250,000 E-mini contracts did change hands, and odds are a very large percentage of them constituted stop-loss orders on contracts sold short from when we were up toward 933 a few weeks ago.  Those traders are going to be quite pissed off, but that’s the risk of the game.

Next week is very likely to be extraordinarily violent, especially Monday.  /ZN (10 year Treasury futures) has seen an insane drop in open interest over the last few weeks.  This little game undoubtedly severely damaged open interest in the E-Mini /ES contract.

Thin markets are dangerous markets.  While the E-Mini still is very liquid, the removal of these stops from the order book leaves the door open for both little resistance if the market decides to move higher early next week, and also provides the potential for irritated shorts to re-establish their positions short, driving the market lower.  Those who wound up long during that little ramp job are likely to be rather nervous as well.

For my part I shorted that spike.  Not large, and I am fully prepared to hedge it Sunday evening if necessary or just take it down, as there is every possibility, this close to the 200MA, that we will at least hit it on the cash, and blowing through it on volume and continuing higher cannot be ruled out.

I will note, however, that the last time we saw this sort of dislocation activity start up into the close it it too began with these sorts of “rocket shot” moves higher – and once the shorts were all blown out by having their stops run, the market essentially pancaked.

Look sharp – the sharks are in the water and you taste good.

For those of you who need a translation of what this means, I would say this: someone who was short had to liquidate a very large position due to a margin call and this forced the market up.  In fact, many people believe (Meredith Whitney included) that much of the recent rally has nothing to do with fundamentals and is a short-covering rally plain and simple. Even so, it is a powerful rally nonetheless, and the shorts are getting killed.

3. Bull-Market/Secular Bear Market Rally

Then there is the bullish view.  This view sees the market rally as a real bull market based on the potential for economic recovery sometime in the second half of 2009. Some think this is a secular bull – a view I am not discussing in this post.  Others see this as a cyclical bull-market a.k.a bear market rally  I would put Jeremy Grantham in this category.  I would also put myself here, although I do think short-covering has made this rally dangerously over-bought.  Paul Kedrosky recently made the bear market rally story very well in an interview with Tech Ticker’s Aaron Task (see the attached video as well).

Kedrosky thinks the S&P could approach 1100 by year-end, which would translate into the Dow well above 10,000.

Nonetheless, he believes it’s a bear market rally and unlikely to continue into 2010 as the market to get hit by fears of a “double-dip” recession.

How long the rally last is dependent on how long authorities can prop up the economy artificially.  Remember the huge rally from 2002-2007 that took the Dow and S&P to new highs?  That was a very long bear market rally.  So, it is not altogether clear where the market is headed over the medium term. In my view, the U.S.market is going to eventually re-test its 2009 lows (which are 14 year lows when adjusted for inflation).

For now, there are enough doubters about how ‘real’ this rally is to provide road kill for the uptrend, making the kick up that much more powerful.  Witness today’s breathtaking surge to the upside. When and whether systemic weakness re-asserts itself is another question altogether.  For now, the bulls have gained hold.