The Overnight Report: Grinding Higher

This story features SIMS LIMITED. For more info SHARE ANALYSIS: SGM

By Greg Peel

The Dow rose 37 points or 0.4% while the S&P gained 0.3% to 1030 and the Nasdaq added 0.2%.

The Dow Jones average has now finished higher eight days in a row, for an average of 55 points per session. Amidst those eight days the S&P 500 marked one down-day of less than one point. Wall Street is grinding its way higher.

With the exception of the 155 point gain last Friday, the feature of this upward grind has been the incapacity of the indices to mark meaningful falls before buyers emerge, or to really kick on with gains before profit-takers spoil the party. It has become a battle of wills. On the one side is the argument that suggests the market is overbought and needing a pull-back, and that fresh positive economic data are only justifying where the market is now rather than providing a reason for it to be higher, and on the other side is the argument that there is still simply too much money on the sidelines – money that has missed a 50% rally to date.

There have also been other factors at work.

A constant factor of the rally from March has been the inverse relationship between stocks and the US dollar. This relationship is counterintuitive in the context of a “normal” market. A rising stock market signals expectation of a growing economy. A growing economy should be supportive of that economy’s currency. Economic growth puts pressure on the central bank to raise interest rates to control inflation. A higher interest rate – a greater currency value.

So given the 50% Wall Street rally from March you’d expect the US dollar to be higher. In fact it’s about 13% lower. The reason is that this is not a “normal” market. The deflationary effect of the GFC has ensured no upward pressure on inflation and thus interest rates. This lack of pressure means the US Treasury can keep issuing record volumes of bonds to fund its deficits and thus put pressure on the currency. When the GFC hit in earnest last year, the world rushed out of the “risk trade” of stocks and commodities and into the “safe haven” of the reserve currency. Stocks and commodities fell and the US dollar rallied. Now we are simply seeing a reversal of that “fear” trade.

If the global economy grows, demand for commodities grows, putting upward pressure on commodity prices. But if the reserve currency also rises on economic strength, there is a dampening effect on those commodity prices, particularly from the speculator’s point of view. This time around, however, the global economy is growing (led by China) but the US dollar is falling. Thus we have a double-whammy effect of rising commodity demand coupled with a weaker reserve currency. This is a speculator’s dream on the one hand, but also a clarion call to commodity funds to keep topping up their portfolios while chasing the market.

Stock market commentators have noted that the bulk of recent buying, particularly in this “second leg” of the rally, has been from the large mutual funds who did not move nimbly back in March. It is a chasing trade. But the “sheer weight of cash” argument underscores this reality. London metal traders have noted that recent buying in base metals has come only from commodity funds. The “real” industry players are just not in there. But a weaker US dollar underpins this trade.

What we thus have had is a stock market rally that has been led by the heavily beaten down financials offering spectacular returns from low bases, a tech sector that is America’s most important export sector and which benefits from a weaker dollar, and by the materials sector which is being driven by both Chinese demand and a weaker dollar. Every time the stock market rallies, the US dollar falls. Every time the US dollar falls, commodities rally. Every time commodities rally, the stock market rallies. Every time the stock market rallies, the dollar falls. Every time…

We are reminded that a reliable lead indicator of commodity prices – the Baltic Dry Index – is now down 45% for the last six weeks.

Another factor that has been at work in this last eight-day stock market grind revolves around four financial stocks – AIG, Fannie Mae, Freddie Mac and Citigroup. Some 25% of all shares changing hands in the last week – a week in which volumes have otherwise been very light as the summer holiday period heads towards completion – has been in these four stocks alone. Note that the US government owns most of the first three, leaving only a minimal volume of “free floating” shares. Citigroup is the US bank with the largest minority government investment.

AIG and Fannie Mae shares are up 100% for the week. Freddie Mac is up 75% and Citigroup 25%. As one commentator noted of the first two, “Are they really twice the companies they were a week ago?”. The answer is clearly no, and the reason for the extraordinary gains comes down to some positive corporate news coupled with a major “short squeeze”. It is still not clear whether AIG, Fannie and Freddie will even survive intact. There has been a good deal of short positions established in these entities. But a couple of promising signs has sent the shorts scrambling to cover. And with free floating stock so limited, those three are very difficult to borrow. Thus you have spectacular short-covering rallies.

Another consideration is the rule which limits buying stock on margin to companies with share prices over US$5.00. In July, AIG implemented a one for twenty stock consolidation to lift its share price over the US$5 mark. Citigroup has been pushing toward that figure, and last night closed at US$5.05. Margin call buying has suddenly been brought back into the game. (F’n’F are still trading around the US$2 mark.)

The activity in these four financial stocks alone has been dragging the wider financial sector with it. JP Morgan is up 7% for the week and Goldman Sachs 6%. These numbers don’t look spectacular, but these most respected of banks would once be happy with such share price movements in a year.

Last night the Dow plunged to be 84 points down on the open. The impetus – apart from the force of those expecting a pull-back – was weakness in Asian markets driven by news that China plans to address overcapacity in its commodity production industries. This raised (probably overblown) concerns about derailing the Chinese growth machine. But there the Dow turned around and made steady progress throughout the session before closing up 37.

Good news came in the form of the first revision of the US second quarter GDP. The first estimate released earlier in the month was a 1.0% drop. Economists had expected this revision to show a 1.5% drop but instead it was steady at negative 1.0%.

There was also good news in the form of the weekly new jobless claims number, which after a couple of weeks of rises fell 10,000 last week. The continuing claims number showed a drop from 6.25m to 6.13m, reversing the trend of the last couple of weeks.

There was also an announcement from the Obama Administration that now that “cash for clunkers” has ended, the next stimulus program will be a US$300m pool to provide rebates on purchases of new, energy-efficient whitegoods. One tap turned off and another one turned on.

What didn’t draw much attention was news from the Federal Deposit Insurance Corp that the number of US banks on the danger list had risen from 305 in the March quarter to 416 in the June quarter. Draws on the FDIC’s insurance fund meant the pool is now 20% lower in the second quarter from the first, to US$10.4bn. That’s the lowest level since 1992, although at this stage the FDIC suggests it is not intending to ask the Treasury for a top-up.

The Treasury’s US$28bn auction of seven-year notes went off without a hitch last night, and with 61% foreign central bank participation. Thus ends another record week of auctions, once again indicating that the world has not yet lost its appetite for US debt. This also helped to spur on the stock market in afternoon trade.

Another impetus for the market, and the Dow in particular, was news from Boeing that after years of delay, the first 767 Dreamliner will be rolled out by year-end. Boeing shares rose 8% on the session.

The US dollar fell 0.7% on its index last night to 78.06. Most of the fall came in the afternoon, post the Treasury auction and once the stock market kicked on. This sent oil back up US$1.06 to US$72.49/bbl. London closed before the bulk of the US dollar drop however, leaving base metals mixed on quiet trade.

Gold rallied US$3.90 to US$949.40/oz as the US dollar fell, and similarly the Aussie leapt up over a cent to US$0.8400 over the 24 hour period, with a bit of earlier help from surprisingly strong Australian second quarter private capex growth.

The SPI Overnight managed only a 4 point gain.

Earnings watch today includes Caltex ((CTX)) and Sims Group ((SGM)).

For the full list of reporting dates and major economic data releases please refer to the FNArena calendar.

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