The Overnight Report: Seller Beware

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By Greg Peel

The Dow closed up 75 points or 0.7% but the S&P posted a 1.1% gain to 1083 and the Nasdaq also rose 1.1%.

Let's start with yesterday's trade in Australia. The market opened a little weaker as might have been expected following the disappointing after-market earnings report from IBM which threatened to send Wall Street lower on last night's open. But the ASX 200 turned around to ultimately post a near 1% gain.

The kicker came with the late morning release of the minutes of the RBA's July meeting. From the minutes the conclusion was that the RBA has absolutely no intention of raising its cash rate in the current uncertain global environment unless the June quarter CPI numbers, due just before the August meeting, surprised to the upside. The RBA is actually expecting the headline number to exceed its 3% target limit, but it expects underlying inflation (which excludes volatile items like food and energy and smooths seasonal factors) to have drifted lower. It would thus have to be a very big CPI shock for the RBA to move.

This is good news for the stock market because it means funding costs for businesses will not rise at a time when anyone outside the resources sector is still struggling with the two-speed economy. It should, however, have been benign to weak news for the Aussie dollar.

But the local market does not control the Aussie dollar, foreign markets do. So it was that at lunch time, when RBA governor Glenn Stevens was speaking to a room full of economists, the question was posed as to whether the RBA would hold back on raising rates during the election campaign. The answer should have been bleedingly obvious, given the RBA did exactly that to Howard in November 2007, but Stevens nevertheless confirmed that the RBA didn't give a tinker's cuss whether there was an election on or not. If the RBA needed to raise, it would.

Well the popular media jumped all over that one and decided, erroneously, it meant a rate rise in August. Word spread, and the Aussie has shot up 1.5 cents in 24 hours to US$0.8836 despite the US dollar index being slightly higher in the same period. US stock investors like a strong Aussie irrespective of local funding costs because it increases their winnings. And so we had a strong afternoon in the stock market.

It was a risk, because IBM threatened to bring down Wall Street early in the proceedings last night, and that's exactly what it did. The Dow fell 157 points from the bell. Had that been the end result, the ASX 200 would have been looking a bit high and dry.

There is a groundswell of belief building in the US and elsewhere that Wall Street will have to go lower in the third quarter before recovering for a strong performance in the fourth. You might even say consensus has the S&P 500 at 950 by about September/October and at 1250 by December. The question is: If the S&P is going to go from 1080 now to 1250 by December, why would I wait for 950? Everyone will be trying to buy at 950.

The answer is: because stocks can be bought more cheaply in the third quarter for more significant gains by year-end. But what this also means is that we really have no reason to fear another big plunge, and hence we don't need to buy put option protection. Indeed, high levels of volatility offer the opportunity to sell out-of-the-money puts for a good premium, and then when stock prices drop down in the third quarter you are put the stock at a nice low price that you wanted.

Seems a great idea. Problem is, everyone's doing it. Take a look at a 5-day graph of the volatility measure of the S&P 500, the VIX:

Note that every day volatility jumps on the open, fuelled by weak US data or disappointing earnings reports, and then drifts down again. And note that despite blue chip reports being more negative than positive over that five days, and all the double-dip talk, volatility, and thus demand for protection, is back where it started. Everyone's selling puts, not buying them.

This does raise the spectre that if there were to be some left-of-field calamity, the downside would be accelerated by short put holders bailing fast. But it also means the target of 950 in the S&P may be very hard to achieve. There are too many “buyers” (selling puts is a proxy for buying) trying to set themselves in the meantime.

Now – moving out of the derivatives market and into the stock market, after Wall Street opened down from the bell last night it did nothing but rally all session. And it rallied despite another 5% drop in housing starts and yet another revenue miss from a major – this time leading investment bank Goldman Sachs.

Explanations from commentators for this turnaround were few last night. I'll offer four: (1) When everyone sells puts, the market makers in the middle have to buy stocks to hedge; (2) of course the housing data was weak, hasn't it been for months now?; (3) the blue chips are mostly missing on the revenue line, but the actual beat-to-miss ratio so far in the broad market on the revenue line is 65/35; (4) there was a certain rumour that went around regarding the Fed.

The rumour was that the Fed has noted the huge amounts of cash sitting on US bank balance sheets at present and the sad lack of lending to businesses at present. One of the GFC countermeasures the Fed established a while back was to offer banks to park their cash with the Fed for a 0.25% interest rate. In order to encourage lending, the Fed was about to drop that rate to zero, the rumour suggested.

This, of course, would be a big boost to the US economy were it to occur, but most commentators suggested this is more of a last resort weapon in the Fed's armoury. Either way, Wall Street finished on a strong note, particularly on the broader indices.

Aside from Goldman Sachs, there were good earnings reports from the likes of Harley Davidson and Whirlpool which, as two consumer discretionary names, brings into question the belief the US consumer is dead. And if one needed anymore confirmation that at least some US consumers are alive and well, it came after the bell. Yahoo's post-bell earnings result was disappointing, but Apple's simply blew the world away. Sales of every single i-Thing were greater than Wall Street had expected.

And while all this was going on, all of Ireland, Spain and Greece last night issued sovereign debt which met strong demand. Leaks also suggested that Spanish and even Greek banks were set to pass the ECB's stress tests (results due Friday), and that the only bank so far that might fall short is Germany's Hypo Bank which the government had to nationalise at the depths of the GFC.

All good news from Europe, albeit cynics still believe the stress tests have been set up so that near everyone can pass in order to take the pressure off Europe.

Throw everything into the mix, and it was a good 24 hours across the globe. Last night commodity prices were stronger despite the US dollar index being slightly higher at 82.80, with oil up US90c to US$77.44/bbl on the expiring August contract, and all base metals bar aluminium up 1.5-2.5%.

There are also those looking to buy the dip in gold, so it was up US$8.10 to US$1192.20/oz. But these peaks are getting lower each time.

The SPI Overnight rose 41 points or 0.9%.

It's another big earnings night in the US tonight, with results due from 131 companies including Morgan Stanley, Coke (Dow), eBay, Qualcomm, Starbucks, Wells Fargo and United Technologies (Dow). Fed chairman Ben Bernanke will begin his two-day testimony to Congress so all ears will be peeled.

Australia's highlights today are BHP Billiton's ((BHP)) quarterly production result and Woolworths' ((WOW)) quarterly sales result.

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