The End of QE 3 Does Not Spell The End of The Bull Market

The Federal Reserve's third "quantitative easing" program officially ended last week. Many traders hold the view that equity markets have become addicted to central bank stimulus and that the end of QE 3 will therefore result in a significant fall in equities, just as the end of QE1 (2010) and QE2 (2011) corresponded with drops of 17-20% (chart from Nautilus).

Weekly Market Summary

It's hard to argue that the price action of US equities is not bullish. SPX and DJIA ended the week at new highs. NDX stayed near the new highs it made last week, apparently digesting its gains. NDX was flat for the week while SPX and DJIA added another 1%.

This is mostly reflected at the sector level as well. Financials, technology, industrials and transports are cyclical leaders all making new highs this week.

But what is curious is that the market is being led more by defensives. Staples, utilities and healthcare are also at new highs. Since the September 19 top, SPX has added 1%, but defensives have handily outperformed. Utilities is the sector star by a mile.

What Fund Flows Tell Us About Current Investor Psychology

It is true that "disbelief" is an important factor in driving equity prices higher. That is a large reason why powerful Year 3 Presidential rallies have followed recessions, bear markets and/or corrections larger than 20%; these events have had the effect of moving investors out of equities and into the relative safety of fixed income and cash (post).

The question now is whether the recent 10% correction in equities created enough disbelief among investors that they moved out of equities. If they did, a strong and sustainable rally lies ahead.

Lipper tracks fund flows into and out of both mutual funds and ETFs. The last 10% correction in SPX in mid-2012 caused a $20.6b equity outflow from the April top to the June low (left side of the chart below). Fund flows were negative for 8 of those 9 weeks. No doubt, this was significant in setting up the long rally that followed (chart from SentimenTrader).

Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects

If you even passively follow equity markets, chances are high you have already read a number of articles about "Year 3 of the Presidential Cycle". That period is starting right now, and it's incredibly bullish. In the chart below, we are entering the steep ascent where the SPX has risen 22% in a year on average (since 1950).

Weekly Market Summary

After dropping to a 6 month low in mid-October, SPX has since risen more than 10% in two weeks. The bounce has been at a torrid pace.

We had been expecting a more complex bottom to form at the low. Why? The market had risen 60% since it's last 10% correction in mid-2012.  A more typical basing at the low, to reset sentiment and breadth, seemed warranted before resuming the uptrend. This now appears to have been wrong.

Instead, SPX, DJIA and NDX all rose to new bull market highs this week. SPX has now completed its 9th "v-shaped bounce" since 2013. According to Dana Lyons, "v-shaped bounces" occurred once every 1.6 years from 1950 to 2012; since then, they have occurred every 2 months (post). To us, that reflects an unflinchingly bullish and aggressive investor psychology. The data supports that view.

This market is well-known for doing the unprecedented. According to SentimentTrader, SPX traded more than 0.5% above its 5-dma for 10 days in a row in the past two weeks. In the prior 75 years, this has only happened twice before, both at bear market lows (1982 and 2002). In other words, a rare rip higher, that has only happened after multi-year bear markets, just occurred after a mild, four week drop. It's incredible and completely unexpected.

Perhaps the most distinguishing characteristic of the current rally is this: SPX has made a series of 12 daily "higher lows" in a row. According to Paststat, there have been only 9 other instances in the past 20 years where SPX has made more than 10 "higher lows" in a row (post). This raises the question of what typically happens next.

We normally think of strength like this as initiating a broader move higher. But that was the case in just 2 of these 9 instances: December 2003 and July 2009. Both of these came within a few months of a new bull market, and in both cases, SPX continued higher. December 2003 is shown below (left side of chart).