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Deja Vu - Will the End of QE Lead to 20% Correction?

SAN DIEGO (ETFguide.com) The stock market updates investors on a need-to-know basis. Obviously, Mr. Market feels that all we need to know is available on a real time bases ... no matter how much we want to peek into the future.

One heavily debated question is how the withdrawal of QE2 cash will affect stocks.

Here we will examine two schools of thought. One is plain vanilla, straight to the point, and requires no fantasy or analytical ability. It's so deceptively simple it might just be right.

The second viewpoint is more like a rocky road mocha almond fudge kind of approach that includes whipped cream and considers various variables.

Plain Vanilla Approach

The plain vanilla approach simply asks:

1) What was QE2 supposed to do?

2) What did QE2 accomplish?

3) What happened when the last round of QE stopped?

1) What was QE2 supposed to do? Ben Bernanke's goal was to create a wealth ripple effect by artificially inflating stock prices.

2) What did QE2 do? The stock market rallied. In addition to playing the yield curve, big banks (NYSEArca: KBE) and financial conglomerates (NYSEArca: XLF) were given the license to 'invest' free money uninhibited and indiscriminately.

Look at large cap (NYSEArca: IWB), mid cap (NYSEArca: MDY) and small cap (NYSEArca: IJR) stocks. They are all up.

Look at the nine main S&P industry sectors: Consumer discretionary (NYSEArca: XLY), consumer staples (NYSEArca: XLP), technology (NYSEArca: XLK), industrials (NYSEAra: XLI), materials, utilities, health care and energy. All sectors, whether cyclically sensitive or not, are up.

Ironically, the only sector missing in the line up of this year's success story is ... financials. Yes, the sector that's been gorging on free money is in the red. What does the market know that we don't? We shall soon find out.

3) What happened when the last round of QE stopped? QE1 came to its conclusion in April 2010. From April to June 2010 the main U.S. indexes a la Dow Jones (DJI: ^DJI ), S&P (SNP: ^GSPC ), and Nasdaq (Nasdaq: ^IXIC ) lost around 20% until Mr. Bernanke carefully planted the seed of QE2 hope.

Rocky Road Mocha Almond Fudge Approach

As the name implies, compared to plain vanilla, this approach considers more variables to come up with an educated, but not overanalyzed, conclusion.

Like water in a bathtub floats all the rubber ducks, QE2 has floated all the stocks.

The key question is where will cash come from when the QE2 spigot is turned off?

The most recent data from the Investment Company Institute shows that mutual fund cash levels are at 3.4%. This is an all-time low. What does this mean? If you plot mutual fund cash levels against the S&P you will see that cash levels were at multi-decade lows at the 2000 and 2007 peaks and at a multi-year high during the March 2009 low.

Mutual fund managers as a group, follow the crowd like most everyone else. It's therefore best to take their actions as a contrarian indicator. From a supply/demand perspective this makes sense too. If mutual fund managers are already invested near the max, they don't have much money left to drive stocks up further (detailed analysis featured in the ETF Profit Strategy Newsletter).

Another way to calculate 'investable cash' is to look at margin debt and available cash. The NYSE publishes data of margin debt and free cash of member brokerage firms. Based on this data, 'investable cash' is at the lowest level since the 2000 and 2007 peak (detailed analysis of mutual fund assets and 'investable cash' is featured in the ETF Profit Strategy Newsletter).

The conclusion to the cash flow question seems simple and logical. There is very limited new cash left to lift the 'rubber ducks' once QE2 has run its course.

Technical Trouble

There were a number of troublesome technical developments leading up to the May 2, high at S&P 1,370. On April 25, the ETF Profit Strategy Newsletter pointed out a VIX sell signal. On April 26, the S&P closed above its upper Bollinger Band and the Newsletter pointed out that any further gains for the S&P were very limited.

Most importantly, the S&P ran into important resistance. On April 3, the ETF Profit Strategy Newsletter commented: 'There is a fairly strong Fibonacci projection resistance at 1,369. In terms of resistance levels, the 1,369 - 1,xxx (reserved for subscribers) range is a strong candidate for a reversal of potentially historic proportions.'

The initial meeting with the 1,369 Fibonacci resistance resulted in a 50+ point decline. But there's a silver lining for anyone who didn't have a chance to get out at the top.

Expect the Unexpected

Last week's AAII and II sentiment surveys showed a sizeable drop in investment advisor and retail investor bullishness. Both groups were less bullish last week than they were in mid-March, following the Japan earthquake low at 1,250.

Since the value of those polls rests largely in their contrarian application, there is a very good chance that the immediate downside is limited and even hope for another sizeable rally leg.

But now is not the time to use hope as an investment approach. QE2 is running out and the market has respected the 1,369 resistance as if it was a larger scale top.

Using important structural support/resistance levels (such as 1,369) investors can gauge the up and downside potential effectively and avoid buying/selling at the wrong time.

The ETF Profit Strategy Newsletter outlines important structural support/resistance levels including the one support level that needs to hold to keep the bullish potential alive. Continuous updates are provided every Sunday and Wednesday evenings.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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