The Overnight Report: Break Out!

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By Greg Peel

The Dow closed up 229 points or 1.8% on Friday. The S&P was up 1.8% and the Nasdaq 2.6%.

The movement of the Dow in 2008 has featured an 11.5% slide from the last peak in late December at 13,551 to the Soc-Gen trough in late January at 11,971. The Fed’s 75bps emergency rate cut then sent the index to the next peak of 12,743 before weakness set in once more. From that point the Dow made successively lower highs and successively lower lows until the Bear Stearns bottom of 11,951 in early March, which again brought a 75bps cut.

From that point on the highs have been higher and the lows have been higher, taking the Dow to a point where it would have to break out of the pattern one way or the other. Last night’s rally took the index to 12,849 – 7.5% from the bottom and eclipsing the previous high of 12,743. The Dow has broken to the upside. Wall Street is excited.

It was the first time this year a solid move (such as Wednesday’s 256 points jump) has been consolidated with another good move, coming on Day Two. The enthusiasm of the buyers has been justified. The market is now officially bullish. Volume, however, was still not excessive. (And there are many earnings reports yet to come).

With no economic releases to spoil the party on Friday Wall Street took the Google lead-in and held it. Google released a Street-smashing first quarter result after the bell on Thursday, and in Friday’s session Google shares rose an almighty 20%. The tech sector was dragged along in Google’s wake, which is why the Nasdaq outperformed with a 2.6% rally.

But the big result for Friday was always going to be America’s largest bank and Dow component Citigroup. Citi posted a loss of US$5.1bn in the first quarter with further write-downs of no less than US$14bn. Woohoo! What a cracking result!

It was enough to spur on Wall Street, because the first quarter loss was only half that of the fourth quarter and the Street had been bracing itself for something potentially much worse. The write down of US$14bn suggested to the market, by its magnitude, that this was once again a “kitchen sink” revaluation. Citi has also jettisoned around 14,000 employees, which is good news for costs. It looks, to many, like there is light at the end of the tunnel.

The Google and Citi results were not the only good results on the day, nor the only results. But they were the ones that mattered. Wall Street was over the moon.

So on to the realities. To date the US reporting season has shown a 37% fall in company profits. However, if you take out financials that’s actually a 5% rise. Nevertheless, the spread between the headline PPI to the headline CPI as revealed this week confirms that profit margins are collapsing. Retailers are dealing with much higher costs in raw materials in general, and energy in particular, and funding their businesses at much higher rates. High prices cannot be passed on to consumers hit with the same problems at the pump and the supermarket, and with negative equity in their houses. Real wages are plummeting down a slippery slope and have been since the credit crunch began. Every recession is preceded by a fall in real wages. The one bright side is that export profit margins remain strong on the weaker dollar as an offset, and the 64 million dollar question is as to whether it will be the rest of the world that saves the US.

The London interbank offered rate (Libor) is on the move gain. Don’t be distracted by the “London” part – Libor is the benchmark funding rate for every bank in the world. The spread of Libor over Fed funds traditionally trades at 5-10 basis points. In August last year – the first real credit explosion – the spread blew out to over 100bps. Following extreme action from the Fed to cut the cash rate, pump in billions upon billions of liquidity, open the borrowing window to the investment banks, and save Bear Stearns, on Friday Libor was back up at 93bps over Fed funds. Banks across the globe are still not lending to each other. And while it seems the US banks are currently bearing their souls (which it was suggested they had also done at the end of the fourth quarter), news from outside the US remains eerily scant.

As commodity prices continue their push north, various Fed governors last week began to strengthen their anti-inflation rhetoric, despite what was considered a fairly reasonable CPI. 30-day bills are trading at around 1%, which is an indication of where Wall Street believes the Fed will reach with its rate cutting. But there is also a growing belief the Fed has begun to drop big hints about maybe not cutting further at all. The next scheduled rate meeting is on April 30.

Not only is there a waning expectation of further hefty cuts, it has become more clear that the G7 sees euro US$1.60 as too high a price. The forex market is building a base under the US dollar, believing it may not be allowed to collapse further due to halted rate cuts or even G7 intervention (in reality, the G7 need only hint and then let the market do the rest). With the Dow running hot on Friday, the greenback had another positive day.

This triggered another sell-off in gold, which fell US$21.80 to US$916.20/oz. If the US dollar really has found a base, there may not be much to stop gold heading straight back to US$850 or below. The Aussie dollar was a little weaker at US$0.9343, torn between US dollar buying and yen selling.

Base metals remain in a state of flux, with volume thin and intraday volatility high. With supply scarce (and a strike in Chile) base metals are looking for the break-out, but questions over a US recession and global demand, and now an apparently strengthening US dollar, meant metals were mixed and largely directionless once again on Friday.

But despite a stronger dollar, the other big news on Friday was oil. Oil began the day weaker on the stronger greenback, until news of yet another pipeline sabotage in Nigeria sent crude soaring once more – up US$2.14 to US$117/bbl.

The bulls suggest that if the Dow can rally 229 points when oil jumps to US$117 then this must be a very positive sign. The bears shake their heads in dismay and ask just how long it will take for an even higher oil price to flow through to even lower profit margins and even weaker consumer spending.

Once again Wall Street has shown that it really, really wants stocks to go up, and it will take any excuse. It’s not really that hard to understand why when you consider (a) real cash rates are now negative – if you’re hiding in cash for safety you’re losing money; (b) the ten-year bond rate is at 3.75% and about as low as it’s ever been, meaning if one buys bonds instead of stocks one is looking at virtually no upside price potential; (c) gold is now looking fragile on a more stable US dollar; and (d) with commodity prices as high as they are, and all the recessionary indicators, can one really buy commodities at these prices?

The money, it would seem, has to go somewhere. But how long will it take before investment in equities can actually be rewarded with stronger net profits? And are we sure there are no more potential spontaneous combustions to come from out there in the rest of the world? These are the ongoing uncertainties, and uncertainty is evident in the fact stock market volumes have remained weak all month.

The SPI Overnight was up 79 points. If that prediction proves accurate on Monday then we’re right back at or around the old 5500 level in the ASX 200 yet again. If this is the beginning of a fresh Wall Street rally, then the index will be looking to have another go at the bridge too far – the 5700 level. To break 5700 one assumes the two significant sectors of banks and resources will need to be strong. For resources, driving factors from here could be a break up in the copper price, an iron ore settlement at much better than +75%, or a revised bid for Rio Tinto ((RIO)). Oil is with us, but gold is against us. For banks, half-year earnings reports due toward the end of next month will have to show that analysts are now overdoing their earnings forecast downgrades, and overestimating increases in bad loan provisions.

The scene is set.

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