Lee Adler is beginning to see signs of change in the bias of the U.S. equity market. So if you aren't already paying attention to Lee's research, it is time to start. More than any other influences, the factors Lee studies determine the flow of money in the U.S. and the world and therefore dictate the direction of the U.S. stock market and other financial markets.

The following is a brief excerpt from Lee’s most recent 30 page report for subscribers. The full report contains more details, charts and invaluable insights. The reports are an excellent tool for those who do not want to be blindsided by major market moves, such as the meltdown of 2008.  Click on this link to get the WSE's Professional Edition risk free for 30 days! ~ Ilene

Is It Time To Switch from Buy the Dip to Sell the Rip?

Last week I warned about the huge slug of new Treasury supply that would hit the market on Thursday, July 31 when the Fed gives virtually no support. I wrote that, “That’s likely to cause some indigestion until mid August when the Fed’s next round of MBS settlements takes place.” While the size of the downdraft was surprising, its timing wasn’t. Additional analysis of the August Treasury schedule and the Fed’s next step in tapering suggests that all of August may be problematic for the markets with the next respite not until mid September. 

Withholding tax collections through July 31 showed a strong rebound in July, recovering from softness in June. Net new Treasury supply will likely remain at or below forecast for the foreseeable future, at least until the US economy weakens on a sustained basis. Even with reduced support from the Fed, decreasing Treasury supply could allow US markets to continue bumping along in a trading range but given the evidence of what happened on Thursday, I no longer think that it’s likely that the range would still have an upward bias, at least not a material one. The outlook has shifted from one of “Buy the dip,” to “Sell the rip.” 

Below are several key points from this report:
• The Treasury settled $65 billion in new paper on Thursday, July 31. In the absence of material help from the Fed at the turn of the month, the necessity of absorbing that amount of supply caused some liquidation of stocks, as expected. Dealers stood aside to let the market drop. 
• The Fed will now purchase just $15 billion of Treasuries per month throughout the month, and approximately $25-30 billion of MBS gross purchases all settling at mid month. That’s no longer sufficient to cover 100% of monthly Treasury issuance, which should cause worsening problems for the markets at the end of each month as QE declines. 
• Bond funds had their smallest inflows in the current 24 straight weeks of inflows. Public buying is essential to maintaining any semblance of equilibrium in the bond market but without major buying by the Fed, Primary Dealers, FCBs, and banks, the public will again be left holding the bag when yields ratchet up.

[...]

Primary Dealers dumped Treasury coupons in the week ended July 23 bringing their accounts to the largest net short position since 2011.

[my emphasis]

The chart above shows a correlation between primary dealers' treasury holdings and yields. The yields are plotted on an inverse scale. So as treasury holdings increase because the primary dealers are buying, the prices of treasuries are higher and the yields are lower. As the primary dealers selloff treasury holdings, the prices of the treasuries are lower while the yields are increasing. This is what Lee means by "Long and Wrong, Short and Stupid." (Ideally, you do not want to go long treasuries when the prices are high and the yields are low. And you don't want to go short treasuries when the prices are low and the yields are high.) 

In the full report, Lee discusses whether the current decline in the market is a preview of how the markets will react as QE comes to an end. Will the Fed be forced to bring QE back or are we at risk of the Fed's non-action and a crash in equities? 

The above is content from the WSE's Professional Edition. To read the full report, click this link to try WSE's Professional Edition risk free for 30 days!