ES Market 1, Politicians No Score

Last week we wrote that the market’s response to the government shut down, and subsequently the debt ceiling, was “muted.”

That was a masterpiece of understatement. In fact the market responded with one big yawn. You could see that in the reaction to the news the political snake-oil show had been concluded: the E-mini S&P 500 (ES) as just one example of the broader market came roaring back: up 100 points in a brisk 7-day rally that is still continuing.

If this was the World Series, we would call this one a clear win for the market. Congress, not so much.
It is as if they manufactured a crisis, and nobody — with the usual exception of the chattering classes —noticed. Or cared. That reaction to these rolling crises is becoming more common, for an excellent reason: market participants are focused on much more important events —the activities of the Fed.

THE FED

For many traders the Fed’s “untaper” announcement in September — quantitative easing continues unchanged —-after weeks of hinting that this time they were really going to do it, was a key event.
Many now believe that the Fed no longer has the ability to end its bond-buying activities, or even slow them down. In fact the rumor floating around the markets —and floating the S&P higher every day — is that the Quantitative Easing program will be expanded.

It appears that $85 billion a month is no longer sufficient. The greedy market, like Oliver Twist, wants more.

We think the Fed is caught between a rock and a hard place. Continuing QE-forever will blow the asset bubble bigger and bigger. We can already see the evidence in the current rally. But even hinting at a minimal “taper” in the bond-buying program (and the zero interest rate policy it facilitates) is enough to crash the market.

We think that faced with a choice between crashing the market now and blowing a bubble that will have more serious consequences, but only at some point in the future, the Fed will kick the can down the road — again — and opt for letting somebody else manage the problem.

This is becoming the conventional wisdom in the market. For example, we are beginning to see hedge funds, which have been underperforming the broad market, plowing back into equities in an attempt to save their year in the fourth quarter.

WHAT HAPPENS NEXT?

We are still deeply suspicious of the current rally. It is showing all the signs of a bubble, and sooner or later, bubbles break. But we think this bubble has room to go higher… just not in a straight line.  In the short term there is room for a pullback to 1725-27. If that support holds, the rally will resume.
Our first target at 1738 has been reached. We have further targets at 1759 and 1772-77. At some point in the progress toward those targets there will be a retracement. But that will be an opportunity for short-term traders and it will not signal the end of the rally.

This market is very strong. As long as the major support level at 1687.50 holds for the rest of the year, the direction is up.  The retracements, when they occur, will be seen as a time for new buyers to get in, and the trapped shorts to get out.

And the Fed? The lesson of September is clear. Watch what they do, not what they say.

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Naturus is the web-name of Polly Dampier, the brains behind www.naturus.com, a subscription service for active traders.