Was last week's market exuberance rational?

Published October 17, 2011

WALL STREET INSIGHT


The Dow surged to within 9% of its 2011 peak last week


By ROB CURRAN


THE stock market swung back to exuberant territory from panic mode last week, and now details of the euro rescue plan and its effect on banks will determine whether the exuberance was rational.


This is, by any measure, the most volatile market since the 1930s. Less than two weeks after coming to the brink of a bear market, the Dow Jones Industrial Average surged last week to within about 9 per cent of its 2011 peak.

After Google's earnings suggested that the slowdown in global growth had thus far spared the technology sector, the Nasdaq Composite garnered its biggest weekly percentage gain since 2009.

'We used to move 10 per cent, 12 per cent in a year; now we're moving 10 per cent or 12 per cent in a day (sometimes),' said Anthony Conroy, head trader at brokerage BNY ConvergEx in New York. 'The volatility is tremendous, and that tells me there's not a lot of commitment to positions . . . there's a lot of trading but not much investing.'

Since July, the market has had two gears: 'risk on' and 'risk off'.

In 'risk on' gear, economically sensitive commodities such as oil, compromised currencies such as the euro, and risky stocks such as micro caps and banks shoot up.

Whenever there's a scare about the creditworthiness of a European nation or bank, everything goes into reverse - the 'risk off' gear. Treasuries, the US dollar and, until recently, gold futures rally, while commodities, stocks and just about every other asset plunge.

Now, the two missing elements that reportedly caused this extreme volatility are on the horizon: a clear plan to save the euro, and clear signs of life from the economic recovery in the US.

On the euro front, the International Monetary Fund and its partners have agreed to save Greece from default, while French and German leaders have reportedly hammered out a broad agreement on a bank recapitalisation plan, likely to be detailed following the meeting of G-20 finance ministers this weekend. The euro has rallied against the dollar.

'It looks like Europe at the moment has a handle on things and at least they've managed to put off anything disastrous until next year,' said Frank Lesh, analyst and broker at FuturePath Trading in Chicago.

'One of the reasons we've seen a rally (last) week is because of 'no bad news out of Europe'.'

Don't pop the champagne just yet, however.

The rescue plan must be enacted swiftly to avoid a 'deep' recession in the eurozone, warned Credit Suisse. European banks are under such stress that they will likely drastically reduce lending to businesses soon, unless the cavalry arrives.

'Euro area governments need to avoid another long gap between announcement and implementation,' Credit Suisse analysts wrote in a research note.

In the US, the ripple effects from the European crisis have not yet materialised to the extent feared.

'The recovery is still here, folks,' JPMorgan chief executive Jamie Dimon reportedly said at a press conference following the quarterly earnings release from the second largest bank in the US.

Indeed, retail sales growth in September was the strongest since April. Plus, several of the companies most sensitive to changes in discretionary spending, such as pet-supply store PetSmart, motor-home maker Winnebago and trucker JB Hunt Transportation Services, reported that demand for their goods and services is increasing.

Still, veterans say chances of a bear market and a second global recession have not vanished with the summer sun. Despite Mr Dimon's optimism, JPMorgan's third-quarter profit declined and executives refused to predict whether there would be improvement in 2012.

Aluminium maker Alcoa also saw its profits fall and its business in Europe soften.

Where odds of a double- dip recession were about 50/50 a week ago, they are about 30/70 after the improvements in Europe and retail sales, said Mr Conroy of BNY ConvergEx.

The US economy's heartbeat is still weak, and readings of housing and joblessness remain critically close to recessionary levels.

Economic indicators this week will allow further diagnosis of the US economy's health, including several reports on the beaten- down housing market and regional factory data.

Apple and Microsoft will reveal whether Google's fortunes are indicative of broader trends when they report tomorrow and on Thursday, respectively.

On Friday, General Electric, a company with a bird's eye view of both global manufacturing trends and credit conditions, will weigh in with its quarterly report and outlook.

Crucially, more of the largest US banks, including Goldman Sachs, Citigroup and Bank of America, will reveal the state of their earnings, and of consumer and business borrowing.

Many analysts expect Goldman to report tomorrow what would be its second quarterly loss since going public. Goldman, BofA and Citi will all face questions about the extent of possible losses from their holdings of European bonds, and their entanglement with European banks.

'It's about banks,' said Mr Lesh of FuturePath Trading. 'That's why we sold off (in the first place).'

Protests all over the US reflect the nation's conflicted feelings about the 2008 bank rescue; now European regulators must choose between the ire of the markets and that of their citizens.