The Overnight Report: We Have A Rally

This story features COMMONWEALTH BANK OF AUSTRALIA. For more info SHARE ANALYSIS: CBA

By Greg Peel

The Dow jumped 379 points or 5.8% to 6878 while the S&P jumped 6.4% to 719 and the Nasdaq jumped 7.1% to 1358 (which takes it back above November lows).

The fourth up-day amongst seventeen down-days on Wall Street was triggered last night by some good news and sustained on further good news. The rally effectively lasted from the opening bell to midday, at which point the Dow was up 331 points. It then wobbled along a roughly straight line before finally kicking a bit more on the death.

I noted yesterday that the momentum on Wall Street was to the downside, such that traders were happy to simply stay short until somebody gave them a reason not to be. This has led to an oversold market, but one in which a sudden snap-back rally was never going to cause any heartache. Those playing the short side are so far ahead, one day’s rally and short-covering scramble was never going to be a disaster. FNArena has noted often that the longest, sharpest stock market rallies occur not in bull markets, but in bear markets. There was more than one piece of good news last night, and hence a 380 point jump.

The rally was led by the financial sector. That is, sentiment was led by the financial sector, for the financial sector is too small now to make much of an impact on the indices, and makes hardly any impact on the Dow (note the difference between Dow and S&P percentage gains). The star of the day was Dow component Citigroup, the shares of which rose 37%. But that’s only US39c.

The trigger was a memo to staff from Citi CEO Vikram Pandit. In it he stated that he was “most encouraged” with how strong business had been so far in 2009, and suggested the first quarter is so far the best since the third quarter of 2007. January and February were profitable months, and the capital position is “strong”. Indeed, given government backing, Citi is the “strongest capitalized large US bank”.

This came as a shock to Wall Street, which had assumed Citi to be as good as insolvent. Its shares have traded as low as US97c from their high around US$55 in 2007. Only last month, Citi was pre-empting further government capital injections and asking for a public stake of 40% in order to survive. It’s no wonder Wall Street had assumed the worst.

The Citi news naturally sent all bank stocks on a run. The financial sector is at the heart of the GFC problem, and the GFC will not end until the financial sector is fixed. Thus such good news from a bank sparked a rally across the board. Volume was strong and 90% of the S&P 500 stocks traded to the upside. This was as solid a rally as has been seen in a long time.

The rally might have peaked out at midday once short-covering had reached a sufficient conclusion for the day, but it didn’t. It didn’t because the next piece of good news came from the chairman of the House Financial Services Committee, Barney Frank, who suggested that the “uptick rule” could be reinstated in the next month or so.

The uptick rule ensures that short-sellers can only sell at the offer and not the bid. This means a buyer must buy from a short-seller and a short-seller cannot sell to a buyer at the previous traded price or a lower price. A short-seller can only sell when the price “ticks up”. This subtle difference ensures short-sellers cannot hammer down share prices. In a pique of sheer idiocy, the SEC rescinded the uptick rule in July 2007. We all now know what happened next.

[The Australian government and ASIC bowed to pressure from the ASX last September for a compromise that tightening of the local short-selling rules (and the ban on financial short-selling) should alleviate the need for the uptick rule. We do not have an uptick rule in place]

The uptick news is positive for stock markets – markets that have been beaten down relentlessly for about 20 months before anyone decided maybe rescinding the rule might have been a tad foolish. Not that the uptick rule would have prevented a bear market, but it would have relieved some of the volatility, particularly during the redemption selling waves of last year (more redemptions coming up next month). Indeed, the VIX volatility index crashed 11% to 44 last night.

This uptick news from Frank came a day after he had also announced another point of controversy in the sector will be addressed and discussed starting Thursday. This is the mark-to-market requirement. Marking CDOs and other toxic assets to market when there is no market provides a good indication of fear but not of value to maturity. Many CDOs are prime, not subprime. Marking to market wipes out bank capital in the short term on write-downs, forcing the need for new capital (such as government injections) which may not have been even necessary if mark-to-value had been allowed to remain.

The problem with mark-to-value is that banks had been using vague notions to hide realistic write-down probabilities. But on the other side of the coin, mark to a market that doesn’t exist means going way in the other direction. In the middle lies a compromise, which is why Barney Frank has suggested the rules may be “relaxed” rather than returned to original form. Ben Bernanke is not in favour of the latter, but admits that mark-to-market has caused some distortions.

The combination of an uptick rule reinstatement and relaxation of mark-to-market was enough to sustain the morning rally on Wall Street – a rally which started with the wonderful Citigroup news. But just how wonderful was it?

There has been a glimmer of hope surrounding Australian banks ever since Commonwealth ((CBA)) announced that bank analysts were materially underestimating FY08 revenues. The analysts were duly chastened, but increased revenues nevertheless are only half the equation – the other half being increasing write-downs for bad debts. Local bank analysts are currently arguing over which number will prove the larger in FY09, or even FY10.

The “profit” that Citigroup has supposedly posted in January and February is pre-write-downs.

Meredith Whitney has become a legend in stock analysis circles, having been the only bank analyst to call a disaster from Day One of the credit crisis. Whitney immediately suggested US banks would need to cut dividends and raise capital – a claim that bank CEOs denied multiple times, until they did. They now have public capital. So strong has been the demand for Whitney’s advice that she has left Oppenheimer and set up her own firm.

Early this morning she spoke to CNBC, and suggested that on any of her own measures, Citi has not made any profit. Not in any business. And she cannot see how Pandit could call the bank’s capital position “strong”.

Whitney is nevertheless unopposed to buying bank stocks at present given such low levels, but one would buy for the bear market rally, she implies, not for the bottom of the crisis. She suggests that the next wave of bank troubles will soon begin as consumer credit card lines are pulled – over US$2trn of them.

And that brings us back to the bear market rally argument. As noted at the outset, last night’s rally represented only the fourth up-day among seventeen down-days on Wall Street. No rally has been sustained. However, last night’s rally was more voluminous and broad than any other before it in recent times. The sellers were looking for a reason to stop selling. Have they found it?

There has been momentum building outside of the actual selling – momentum of sentiment – that a rally is surely due. Bear market rallies are fierce and can often run all the way to a 50% retracement of the previous peak. In fact, that’s exactly what happened this time last year. The Dow retraced from March (after Bear Stearns) to May and recovered 50% of the fall from October 2007. Then reality set in once more. (Sell in May and go away). If you consider the last peak to be in August last year (before Lehman Bros) then a 50% retracement would put the Dow back over 9000.

Or if you want to go bigger picture (and technical analysts will do what they like) you could argue for a retracement of the whole bear market down from 14,000 and thus reach back over 10,000.

These are all nice thoughts, other than you could go back to 10,000 and still be in a bear market, thus suggesting an ultimate target below 6000. But first of all we might at least need to put two or more days of rally together.

The breath of the rally last night was also reflected in a “flight from quality” or an emergence out of safe havens. The US ten-year bond gained over 10 points of yield. The VIX, as previously noted, dropped 11%. Selling returned to the yen, sending the Aussie flying up nearly one and a half cents to US$0.6457 (boy there must be some whiplashed Aussie spot traders around town).

And gold crashed US$26.80 to US$895.40/oz, breaching solid support st US$900.

Oil fell US$1.33 to US$45.74/bbl after some recent strength after the US government declared that the 2009 average oil price will be lower than previously thought (US$42). What the oil pit didn’t seem to pay much attention to, however, was the announcement that Chinese vehicle sales jumped 25% in February.

Base metals like a good Wall Street rally, and so they were all up 1-3%.

The SPI Overnight jumped 99 points or 3.1%.

Strap in.

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