With the changing of the US presidency, the market has been offered a new hope that Obama may be able to soften the depth of the current recession by helping the banks, getting stimulus legislation passed & generally making consumers feel better because they can feel optimistic about the future.  We have no idea whether Obama will be a good president or not, but the US people will naturally tend to hope for the best now that Bush has departed.

As ever in financial markets, this is all about confidence.  In the short term it doesn’t matter whether a US Bad Bank will make things better or not, merely the confidence that it will causes the financials to rally.  Whether the rally eventually holds depends upon how workable the scheme proves to be – there is no point killing the patient by buying dodgy assets off them at such a low price that the writedowns incurred bankrupt the bank.  This is the advantage of insuring suspect loans rather than buying them off the banks.

The evidence that the market is currently using confidence to price banks, rather than some form of expected p/e ratio, can be seen in the performance of BARC (in particular) over the past two weeks.  Its share price plunged over 20% in the last hour of trading a fortnight ago to close at 98p on Friday 16 Jan, below the prior 128p closing low of 20 Nov 2008.  This prompted the BARC Board to pre-announce 2008 earnings of £5.3 bln over the weekend.  The share price duly rallied when it opened the following Monday but this rally petered out quickly and within 2 hours the shares were back down at 100p; they then went on to halve during the rest of the week and closed at 51p on Friday 23 Jan.  The fact that the shares could not sustain a rally and fell to fresh lows after the company announced earnings were going to be better than expected was proof that the market was valuing BARC on confidence, not earnings prospects.  The BARC Board clearly had a re-think over the weekend and published an open letter, clearly spelling out the capacity of BARC to absorb future losses from bad debts without turning to anyone (shareholders, Middle East petro-dollars, the UK Government, etc.) to raise fresh equity capital, and clearly stating that BARC were talking to the Government about insuring some of their loans.  The UK Government’s proposal to provide insurance against dodgy bank assets was key in making the BARC statement believeable, and BARC have doubled in price back up to 100 this week.  The sting in the tail for BARC management is that buried in the detail of the Government’s announcement about providing insurance to banks is a statement about the Government requiring a say in remuneration policy…but I don’t think many people are going to shed a tear about Bob Diamond being paid less than 20 million this year.

 At least we can look at the 44th US President and hope he manages to instil some confidence.

Post Script:  During the week when bank share prices troughed (with BARC around 50p & RBS around 13p) Paulson & Co closed their short position in RBS.  Hats off to them for shorting high, riding the short down through two rights issues and not forgetting to close it near the bottom.

Notwithstanding the recent carnage in bank share prices, the Government is behaving in a logical & consistent manner.  Having decided on the eight banks which are to form the core of the UK banking business sector going forward, the Government, now owning listed equity stakes in two of them on behalf of the UK taxpayers, is now committed to defending its investments.  Wiping out shareholders via nationalisation at zero pence per share is not an option as this would destroy its existing £37 bln investment on our behalf and it would not be consistent with the Government’s stated policy of ”managing the Government’s shareholdings in the recapitalised institutions on a commercial arms-length basis and with the aim of realising value for the taxpayer”.  Vague promises about recouping the money upon eventual relisting would not wash with the electorate.  By allowing the companies to remain listed on the stockmarket, the Government can argue (with some justification) that the valuation of the companies is temporarily depressed, it is not a permanent investor in the banks and its investments will be sold when value has been recovered.  Note that the same 8.5% discount to the prior day’s close was used to decide the RBS rights price, just as in October 2008 with HBOS, LLOY & RBS.  The Government has also reiterated that it stands ready to inject equity into other banks, if asked to do so.  Never mind Gordon Brown being “angry” with RBS for losing so much money, he is just quickly learning what being a shareholder is all about – you invest in a company, the management mess up & then sting you with a rights issue to prevent the company from going bust (and to pay their severance)! 

The Government’s next logical step, after making sure the banks retain enough capital to remain in business by offering to insure their dodgier assets against unforeseen losses, is to support borrowing by companies & individuals.  Hence the guarantees for asset-backed securities and direct Government lending via the fund to purchase assets such as corporate bonds, commercial paper, syndicated loans and asset-backed securities (mortgages, credit cards & car loans).  Expect this fund to grow from its initial £50 bln, especially if the MPC take up their option to use it to implement quantitative easing in the UK.  The MPC’s purchases won’t be funded by issuing Treasury Bills, instead the cash will just be printed.

The FSA has now worked out & published its policy on bank capital ratios.  Banks will be expected to absorb losses by running down their Core Tier 1 capital ratios to a low of 4%.  The Government (via the FSA) eventually wants to move to a counter-cyclical bank capital regime whereby capital is built up by retaining profits in the good times so that banks are sufficiently well-capitalised to withstand future recessions.  It is a beautiful irony that this is exactly what Gordon Brown was supposed to have done when he was Chancellor – run Budget surpluses during the boom times so as to be in a strong position cometh the eventual recession.  But Gordon says “Do as I say, not as I do”.

Have we finally found a level of support for the indices?  Since the Dow’s most recent 6 Jan 9,088 peak, it has fallen six days in a row until it bounced off the 8,000 round number yesterday and ended the day with a positive close.  This coincided with the S&P printing an intra-day low 1.5 points below its 61.8% retrace level (818.50) of the 21 Nov – 6 Jan rally and the FTSE also put in an intra-day low 3 points below its equivalent 61.8% retrace level (4,093) yesterday (although the FTSE closed before the rally kicked off in the States around 5.30pm London-time).

Secondary indicators support the idea of yesterday being a reversal day too – volume of 436 mln was the highest since the 19th December futures & options expiry day.  Also the Vix bounced off the underside of its 50-dma yesterday too, closing at 51 after an intra-day high of 55.

In the UK, the FTSE has been scared lower by rumours of an impending £20 bln ($30 bln) rights issue from HSBC.  This is the same HSBC that declined the UK Government’s offer of recapitalisation last October, stating they didn’t need the Government’s help.  BARC and STAN also declined Government help but both subsequently raised capital at a share price which represented a much greater discount to the 8.5% discount to their closing price on Friday 10th October 2008 which HBOS, LLOY & RBS secured.  HSBC closed yesterday at 547.5 pence, a 30% discount to their 10 Oct 2008 close of 790 pence.  Maybe HSBC are indeed the Seller who have been pressuring the London stockmarket.  I am not privy as to whether HSBC are going to launch a rights issue or not, but if they do then there will be a large slice of humble pie to be consumed by the poor HSBC director tasked with going cap-in-hand to the UK Government to ask for their help in underwriting this one!  Maybe the Hongkong & Shanghai Banking Corporation will ask the Chinese to part with $30 bln of their forex reserves instead.

Post Script:  On 19 Jan 2009 HSBC announced that “it could not envisage circumstances where it would ever seek capital support from the UK Government”.  They didn’t mention the Chinese…

The market indices have extended their Christmas rally in the early part of January although volume has been much lower than we experienced in December.  The FTSE has been stronger than the S&P or Dow.  So what is going on and can we trust this low-volume rally?

The closing months of last year were dominated by stories of forced selling by hedge funds as they liquidated assets in order to repay investors who had asked for their money to be returned to them on 31 Dec 2008.  Investors in Bernard Madoff’s funds got a nasty surprise when they found out there were no assets to be sold & no money available to repay them.  However the share prices which prevailed at the end of 2008 represented fire-sale levels at which buyers could be found to absorb the forced selling.  Volume on the Dow spiked to 550 mln on 19 Dec 2008 which was futures & options expiry day.  Since then volume has generally been below 250 mln shares per day.

What could easily happen now is markets could continue to rally from oversold fire-sale levels to a level where the buyers who bought those shares (which the hedge funds dumped) are prepared to take profits.  Bear market rallies occur when the panic/forced selling dries up and this rally would naturally be on low volume due to the absence of forced sellers.  Selling from margin calls also dries up in this environment as rising prices boost portfolio valuations.  This rally could well be extended when the investors who receive money back from hedge funds decide to re-invest their cash.  Such is the stuff of which sharp bear market rallies are made.

Ask yourself who are the natural sellers of shares at the present time – the lack of willing sellers means the path of least resistance for markets is higher for the time being.  Corporates may provide some supply as they seek to strengthen their balance sheets; witness this week’s placing by SSE of 5% of its share capital (42 mln shares placed at £11.40 on a dividend yield of 5.8%), raising £479 mln.

In this environment we are also seeing individual shares rally despite announcing earnings below analyst’s forecasts.  The reason is shares are rallying from levels determined by fire-sale selling and not from prices based upon earnings expectations.

So what could derail this rally?  In the absence of another large Lehman-style bankruptcy either future earnings expectations will have to take take another downturn or the forced sellers will need to return.  It will pay to keep a close eye on the performance of individual shares as they announce their earnings.  If, in general, companies continue to rally after releasing earnings (no matter how poor those results are) then this current rally still has some way to go.  In the meantime keep watching the volume & price action for clues as to a possible change in the upwards trend.