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So, What's Happening?

The current action in the stock market is being manufactured by hedge funds. Normal markets do not operate the way we have seen since mid-September.

How do I know this? There are reports out of the S&P Futures markets that the hedge funds are selling S&P Futures short, piling onto the trade in order to drive the market down as a way to hedge against their long portfolios.

Hedge funds notoriously sell those things that are easy and available to raise cash to fund redemptions. The S&P Futures market is very deep and can handle the huge volume of short sales that are being traded. This is fairly common tactic that happens at panic/capitulation stages of the market.

One very likely outcome from this is that we will finally get the catalyst to bring the $4 trillion sitting on the sidelines in mutual funds and money markets that would normally be invested in equities to start buying. All of these short positions will get underwater once sentiment changes, and you will see an equal and opposite reaction begin to occur. The velocity we have had to the downside over the past three weeks will turn into velocity to the upside as S&P futures are bought to cover the positions.

The hedge funds shorting the S&P futures is the only logical explanation for the downward spiral we've been in. This type of activity does not last long, and with interest rate cuts coming at us (Australia acted today, Bernanke said today that cuts here were likely) we should see a positive turn of sentiment and have the buying begin.

With so many signs of a bottom being formed and liquidity flooding the system, the market is set to turn up once sentiment turns. When that happens, the hedge funds will be caught on the wrong side of the trade and need to buy to cover. This is the scenario I see playing out in coming days.

Credit for the source material for this goes to Doug Kass of The Edge.