Over the past 7 weeks, stocks have moved lower in a relatively calm, and controlled manner with small daily losses and the occasional oversold bounce higher. These oversold bounce rallies usually begin with a gap up in morning trade following higher overnight futures prices but so far during this correction each and every rally has been reversed the next trading day.

       This type of market action can be difficult for many investors and traders looking for a bottom to the interim down trend in equities. The volatile and violent “snapback” rallies are even more frustrating for short sellers who find themselves covering positions at a loss only to see their favorite short move lower the following day.

       In my opinion there are three main factors at play in the current market. The first is valuation. Stocks are said to be cheap by most Wall Street long only managers who are more or less fully invested in all market climates from the long side. To brokers pitching clients a long only approach, there is always a bull market over the horizon as these managers have the luxury of relative performance benchmarking and the ability to “not time the market.” If the market drops, the goal of these managers is to lose less than the index. In the long only manager’s view, the market always rises over the long term, so gaging the absolute valuation of the stock market is futile and the main concern to these investors is buying stocks that attractive relative to other stocks in the market. For the rest of us, we don’t have the luxury of earning money whether the market rises or falls — if the market falls, we lose money. In the hedge fund industry, when the market falls we must preserve capital. The basic idea for most investors is to never lose money and to be on the right side of the tape day in and day out. Valuations of the overall market are absolutely key because most stocks are at least 70% correlated to the overall stock market. During market corrections, most stocks fall regardless of valuations by about the same percentage as the overall market. this trend was evident in 2008, as liquidity driven factors forced people to sell stocks regardless of PE ratios or growth rates. When looking at the valuation of today’s market, it is clear that on a longer term PE 10 basis that the market is expensive at 23X ten year average earnings. Robert Shiller argued this point quite clearly on Tech Ticker, stating that the market is 40% overvalued and that it’s not “different this time.” So for the first main factor driving equity prices, we have to score one for the bears — stocks are expensive, not cheap, on an absolute basis.

       The second factor that will decide the direction of equity markets in the coming weeks is the technical picture of the major index funds. Traders and hedge fund managers pay particular attention to the 200 day moving averages. Many famous trend followers use only the 200 day moving average system to invest in the equity markets. When the market crosses below the 200 day, these managers and traders sell and go short the stock market in a mechanical fashion. Managers like Bill Dunn, Paul Tudor Junes, Monroe Trout, and many others will be looking closely at the 200 day moving averages which were breached on Wednesday for the NASDAQ 100. The S&P 500 held the 200 day, however, so we have conflicting signals on the technical front for stock prices going forward. That said, the markets could crash if we finally do get a break below the 200 day as many HFT and systems traders will be unloading their long book and going net short on stocks here. Even if you don’t think technical analysis works, you should study the discipline because many other investors do believe in a trend following approach and their actions will drive the prices in the markets over the near and medium term. So for the second factor driving equity prices, we are very close to getting a second bearish confirmation on stock prices. With that said, many other technical indicators are short term bullish because the markets are oversold on the RSI, MACD, and Stochastic. We are truly at a crossroads and I expect more whipsaw action in the days to come.

       Finally, the third factor that affects the direction of stock prices is the Federal  Reserve monetary policies. Since August of last year, the stock market has glided higher on a wave of easy money stimulus. Short sellers have been all but bankrupted, and there are very few bears left int he equity market. This is worrisome because the FED is winding up their QE program in less than two weeks and the backstop of stimulus will be gone from the market altogether. Many investors have argued that the Fed’s low interest rates and reinvestment of proceeds will result in a de facto QE3, but the bottom line is that without more Quantitative Easing, the third factor driving stock prices, the FED, will be almost entirely out of the market. This is also very bearish for equity prices over the medium term. Remember, however, that the FED will be in the market for the next two weeks and that we may see a sharp bounce from oversold levels before resuming a larger correction this summer.

       In conclusion, I believe that equities are fairly expensive, are flirting with a major technical sell signal, and are losing the “Bernanke Put” which has pushed stocks up some 26% from last year’s lows. I feel playing defense here will be very important and that value investors would be well served holding a higher percentage of cash than normal.