The Overnight Report: More Switching As Commodities Collapse

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By Greg Peel

The Dow closed up 14 points or 0.2% while the S&P lost 0.2% to 879 and the Nasdaq closed relatively square. 

The fear factor was exacerbated in the oil market last night following a conflagration of news. Having already fallen 12% from its highs in a week on withering economic confidence, crude dropped another US$2.79 or 4.4% to US$60.14/bbl at the close. Commodity traders have begun to get panicky.

Wednesday is the day for the US Energy Information Administration to update weekly inventory status. During oil’s surge from US$32 to US$72 the market has rather ignored the fact crude inventories have continued to build and summer gasoline demand has proven disappointing, or perhaps more correctly the market has chosen to “look through” the immediate data, banking on green shoot economic recovery and Chinese demand. Last night’s data showed inventories of gasoline and other products had edged up again to eleven year highs, and while crude inventories did show a fall it was not as much as hoped.

Now in nervous mode, this time the oil pit took heed of the data. Nor did it help that the Commodities Futures Trading Commission has begun to make noises about limiting speculative positions. Nor did it help that this fresh bout of uncertainty in financial markets has sent investors back into the safe haven of the reserve currency.

The US dollar index rose again last night to 80.68 despite a big fall in the dollar against the yen. That fall is best explained as the unwinding of the yen carry trade, in which hedge funds exploit cheap yen lending rates to fund risk positions in commodities and other instruments. But with the US cash rate now at zero, the dollar has also become a carry trade vehicle in the most recent bout of risk trading. Hence it rose against the euro, pound and Swiss franc for a positive index result.

Base metals finally lost their bottle last night having only crept down over the week despite oil’s big falls. Technical stop losses were triggered in the rush and aluminium, copper, lead and zinc all lost over 3%. Nickel lost 5% and tin lost close to 7%.

The combination of a stronger US dollar and weaker commodity prices unsurprisingly sent the Aussie tumbling, down 1.2 cents to US$0.7782. Nor could gold stem the tide of the rush into US dollars and the subsequent reduction in inflation hedging brought about by weaker “real” commodity prices. Gold fell US$15.20 to US$909.30/oz.

Having closed on its lows on Tuesday, the stock market initially rallied from the bell and the Dow managed to add 56 points. But it wasn’t to last. The selling wave hit again in the energy, materials, industrial and other sectors leveraged to economic recovery. The Dow fell to down 76, bounced a bit, and then tried again.

That’s when the cavalry showed up again. Just as was the case on Monday, buyers began to pour into the defensive sectors once more – healthcare, consumer staples et al. Somewhere in between lie the banks, which have now been largely split into those deemed more risky and those deemed not quite so risky. And this time there was also a recovery in tech stocks, which otherwise like a strong economy into which to sell more iPhones etc and a weaker US dollar to promote offshore demand. Investors decided the big-ticket names like Microsoft had been hit a bit hard over the week, and support emerged.

The S&P 500 broke through the technical level of 878, falling to as low as 869. But the bounce took it back to a precarious 879.

So what we now have is an interesting development. Ever since the big rally began in March commentators have been assuming there would need to be an interim pullback. Arguments then raged about whether such a pullback would take us right back to the lows, or as to whether there was enough cash still on the sidelines which had missed the rally and was looking for a pullback to get in. It was thus possible, they argued, that any pullback would only be minor.

That’s sort of what’s happening, but perhaps not quite the way things were anticipated. At this point the stock market is not falling out of bed because the market is simply switching its long stock positions from more risky to more defensive ahead of the earnings season. In late 2008 Wall Street simply sold everything. Defensives weren’t quite as trashed as risk stocks but still sold nevertheless. Stocks, in general, were divested. But this time Wall Street is not selling everything. It is remaining long stocks to a degree, just realigning portfolios to a more cautious stance.

At the same time the market is buying put protection again as evidenced by the VIX which rose to 31 last night.

This would imply that while Wall Street has become a bit nervous again, it is not predicting Armageddon. The Armageddon factor seems to have been dismissed now – barring any left field shock ahead of course. Realistically, stock markets never bounce out of disaster in a straight line. They spend time consolidating a bottom formation – often in a volatile manner, but nevertheless building a more stable base from which to launch a more justifiable yet less overly exuberant rally. And then one day you wake up and realise you’re in a bull market.

But don’t get too excited yet.

Will Street will nevertheless be hoping that Alcoa – the traditional first cab off the rank in any earnings season – will prove a symbolic first flower of spring after the recessionary winter. After the closing bell, Alcoa announced a June quarter loss of 26cps against Wall Street’s expectation of a 38cps loss. This was great news, and as I write Alcoa shares are up 5% in the after-market.

Yes – it was a loss. But then Wall Street is expecting the June quarter to show an average loss of over 30% in the S&P 500.  To avoid more wholesale selling, average results need to be either on this mark or “less bad”, as was the case with Alcoa. Guidance is also important, although one presumes few CEOs will run the risk of being anything other than cautiously confident and may even continue to play things down in order to look better next quarter. Or maybe Wall Street has it all wrong and this season will be another shocker. It remains to be seen.

Wall Street also took heart from an announcement last night that Wells Fargo intends to grow its securities trading business when all about are reining theirs in or closing proprietary desks altogether. Once a vanilla commercial bank, Wells Fargo acquired Wachovia in the great bank rationalisation of 2008 and thus inherited a proprietary business. At one point, Wells was the highest market cap bank in the US following the near demise of the likes of Citigroup and Bank of America, but eventually it, too, succumbed, and was required by the stress test results to top up its capital. Now it would seem Wells is back on its feet and raring to go, although that didn’t prevent a 1.8% drop in its share price last night.

If ever there was a good day for the US Treasury to try to sell another US$30bn of long bonds then this was it. The US$19bn of 10-years was over three times oversubscribed as investors rushed back into the safe haven. The 10-year yield fell a steep 15 basis points to 3.3%, and once more the great inflation fear of last month waned further.

News from across the pond was that the European Union first quarter GDP result was reconfirmed as a 2.5% drop. The first quarter now seems a long time ago, and a loss is a loss, but given the UK saw its final estimation downgraded to an even bigger loss the EU result was actually a positive. But Europe closed when Wall Street was on its lows, so stock market falls transpired.

The SPI Overnight fell 4 points. Australia was able to come back from the brink as well yesterday, but only because the commodity-based sell-off was halted by the extraordinary jump in consumer confidence.

Consumer confidence is an enigmatic beast. One must appreciate that while the survey is taken in real time, the result is always based on what has past. Thus a flabbergasted Westpac chief economist could only suggest the combination of government hand-outs and first homeowner grants, lower interest rates, a stronger stock market, and a hangover from the “no recession” GDP result was enough to spark such joy. While this might be rear-view stuff, recessions are less about numbers and more about attitude. If you think things are looking bad then you will not top up your inventories, you will not employ staff, you will not spend your hard-earned on discretionary items. You will, indeed, cause a recession. But if you think things are looking rosier, then you might relax the shackles, buy new stock, buy a house, buy a car, and generally generate a positive GDP result.

Therefore, a positive consumer confidence number is not necessarily a reason to go barrelling in to push the stock market ever higher, but it may be a reason not to send the stock market much lower. By the way, both BHP Billiton ((BHP)) and Rio Tinto ((RIO)) closed 1% higher in New York last night.

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