Since the huge move in equities off of March lows, especially as of late, portfolio managers have been bidding up stocks by buying on the dips in an effort to make up for dismal 2008s and remain competitive, which is tough when benchmark averages are up 40-60%. Reminiscent of liquidity-fueled bubbles past, especially the dot-com bubble, common equity in effectively insolvent companies is showing record volume, as daytrading this greater-fool game is the only functioning strategy.

But chasing beta can only work for so long, as a market whose participants are exclusively chasing each others' momentum trades is doomed for a drastic change in its landscape. The key of course is to find the greater fool before it becomes you, and the inevitable reversal of this rally is going to be twice as sharp as the way up.

The S&P 500 is down about 5.1% since its recent top at 1080 on September 23. Many are questioning whether this is a pullback that will eventually resolve into a continuation of the rally or the beginning of a reversal (the reversal) that will send stocks declining. I am in the reversal camp and think that this is the beginning of a sharp, drastic sell-off in stocks.

In attempting to identify this mini-selloff as a pullback or reversal, it is important to trace the catalysts of the rally itself and analyze their sustainability, at these levels specifically. By far the most significant factor regarding the rally is the newly-injected liquidity driving it. As monetary supply increases, as do asset prices, through currency debasement. This can become a self-fulfilling positive feedback loop via the carry trade, as the USD depreciates further, financing demand for higher-yielding assets (such as equities). Also important to the rally are the bank earnings and economic data "supporting" an economic recovery, as they are being used as post-hoc fundamental basis to the move in equities.

The "monetization liquidity" fueling the rally comes from the $300B in long-dates Treasuries announced back in March as part of the Fed's QE. The POMOs executing the injection have been covered extensively, and the end result is primary dealers end up sitting on the cash. Only about $7B (about 2.3%) of the original $300B remain to be injected. Without this liquidity (which correlates very well with the S&P's performance since spring), the rally loses its legs and momentum switches to the downside.

Though liquidity is the primary catalyst to the rally, the move has been magnified by the USD carry trade and by portfolio underperformance against benchmarks. The carry trade, which magnifies the move down in the dollar and the move up in equities, relies on a USD supply increase (liquidity injections) offsetting a demand increase (deleveraging/debt liquidation). Because the liquidity is drying up, deleveraging should regain control of the USD's price movement and an unwinding of the carry trade should result, leading to a spike up in the dollar and a sharp drop in stocks and commodities. The underperformance of portfolios against benchmark indices showing 50-70% rallies in half a year has led to a crowded momo beta-chasing trade as PMs attempt to offset 2008 losses in a blatant greater-fool game (AIG and CIT volume explosions prove that much). An exponential stream of freshly minted dollars is required for the momentum to continue and for the momo trade to work, and as liquidity dries up, the momentum on the way up will reverse to the downside-- and may accelerate.

And then there's the "fundamental" basis to this rally. Bank earnings have been a bunch of accounting shenanigans, boosted with AIG CDS unwinds, trading/i-banking profits due to an engineered market rally in which every company is issuing boatloads of secondaries that all need underwriting and lack of trading competition (Lehman, Bear, Merrill RIP), and a steep yield curve in Q1-Q2 2009. "Extend and pretend" accounting only works temporarily, and as option ARMs reset and borrowers default, assets marked at par tank down very, very quickly, eating away bank equity and ruining 10-Qs. Banks went on a spree in their Q1 and Q2 earnings reports with accounting tricks and those will come to bite them twice as hard in Q3 and Q4. The trading and i-banking profits are dependent on a continuing rally (positive feedback loop) as well as lack of competition (which is now 100% priced in). The yield curve is flattening, as long bond yields topped out in June, and this should hurt bank earnings as well in Q3 and Q4 earnings reports. As for economic indicators, look no further than this to tell you why there's no recovery.

So liquidity is drying up and that effectively screws up all of the engines to the rally, leading to a sharp sell-off. But what's to say the Fed won't pump more liquidity into the market? Well, for one, it decided against expanding its QE, so the liquidity injections have stopped, at least for now. Moreover, the USD is back to last summer's levels, and further decline could break important support and send it spiraling into substantial debasement. Most importantly, if injected liquidity continues expanding, bond yields (which are currently forecasting deflation in the short run, at odds with equities) will skyrocket, leading to very unsustainable interest burdens and a debt crisis. The controlled demolition of the USD requires liquidity financing inflationary rallies, sharp corrections via deleveraging, and then continued bleeding of the USD to prop up other assets. Let the USD hit free-fall, you have a monetary crisis. Let monetary supply remain stable and the USD to rally on demand via debt liquidation and you have deflation (arch nemesis to Ben Bernanke). The plan is to debase the dollar slowly, with an episode of deleveraging as the political capital for bailouts/QE/USD depreciation dries up, until bank deleveraging has hit a pivot point, excess reserves can be unsequestered for use besides mopping up asset depreciation, and holders of Treasuries/USD (who see unique systemic and crowded demand each deleveraging episode through the "safe haven" thesis) are reduced to bagholders. Thus, the USD is ready for its next wave up, and this means a big reversal in equities.

As my readers know, I don't offer any timing without the use of charts and technicals. The chart below quite comprehensively summarizes all that needs to be said about equities:

Credit markets were terrific forecasters for the impending trouble back in 2007 and again are showing signs of big trouble ahead. Just look at some of the distribution in these bond ETFs. These are reversal candles, not pullbacks on low volume:

LQD is my favorite development of all-- IG corp bond ETF breaking obvious rising channel since March on huge distributive volume? Taaaaank tiiiiiime.