The Dow made it as far as 9,918 in the rally after the FOMC statement was released on Wednesday 23 Sep 09 before turning around and selling off for the rest of the week.  Does it matter that this rally off the March lows hasn’t made it all the way to the magic round number of 10,000?

The bears keep pointing out that the market is on too high a p/e ratio for a new bull market to be truly underway and therefore a big correction must be just around the corner.  However see “Is the Bear Market Over?” for the reasons as to why the Dow is unlikely to take out the 6 March 6,470 low.

The bull’s case can be summed up in a beguilingly simple way:  The Fed and the BoE are determined to keep interest rates close to zero and carry on printing money until a sustainable economic recovery is underway.  As it is the stockmarket’s job to discount the future then it doesn’t matter what the shape of the economic recovery is going to be (V, W, U or the more exotic Square Root sign), it is more important that an economic recovery is on its way and therefore the market will keep on rallying in order to discount the coming recovery and will continue to frustrate those people who are looking for a big pullback so that they can buy into the market.

The problem the bears have is that anyone disagreeing with the bullish argument above is essentially saying that the central banks are going to fail in their mission to reflate the economy and help an economic recovery to take hold.  There is a very old saying in the markets which goes “Don’t Fight the Fed”.

The central banks have more money than individual stock market participants and thus far the Fed has promised to print $1.75 trillion (they are slowing down the rate of spending as the economy appears to be entering a gentle recovery but rest assured, they will print more money if the economy stumbles again in 2010).  The BoE is set to print £175 billion and they are not slowing down the printing presses as the Governor would prefer to print £200 billion and then see how the economy is getting along.

Possible events which could derail the current rally include a sharp sell-off in the Government bond markets, the monoline insurers being downgraded, problems emerging in German banks once the 27 Sep elections are safely out of the way, Spanish banks admitting they are in trouble with their loans to property buyers and developers (how are the Spanish workers going to generate enough money to service their mortgages when nearly 20% of them are unemployed?) or the US economy slipping back into recession next year now that the boost to demand created by their “Cash for Clunkers” program has expired and especially if the Bush tax cuts are reversed at the end of 2010.  However for now these potential problems are hiding over the horizon and, with interest rates close to zero, the stockmarkets may continue to frustrate the bears and just carry on squeezing higher, climbing the “Wall of Worry”.  We have already had the “Dash for Trash” and therefore the next part of the rally will have to be led by the big quality blue chips.

One of the old routes for a traveller from England through France and on to Italy passed through the French city of Troyes, situated between Reims and Dijon (nowadays at the junction of the A5 autoroute (from Paris) and the A26 autoroute (from Calais) – the A26 is still called the Promenade des Anglais and to this day sees a steady procession of vehicles bearing UK plates heading to & from the Channel).  Many centuries ago the only way for travellers to pay for goods & services was with gold & silver coins.  Troyes gave its name to the troy ounces in which gold is still traded today.

However there was no standardised system of weights & measures in the Middle Ages and merchants who travelled across Europe had to contend with each different city they arrived in having its own definition of how much an ounce or pound weighed.  There were the pound of Toulouse, pound of Cologne, the Wool Pound, Mercantile Pound and London Pounds.  Pity the poor traveller who was handed an ounce of gold in one city which weighed less than an ounce of gold when he got to Troyes.  Never mind the fact that there are 12 Troyes ounces in a Troyes Pound but we all know today that there are 16 ounces to the pound we use in cooking, etc (strictly called the Avoirdupois ounce).  And we haven’t even touched upon the Kings’ habit of debasing their currencies by having coins minted of alloys which contained progressively less and less than 100% pure gold – there were many ways in which the merchants of the Middle Ages could be hoodwinked! 

Silver is also traded in troy ounces.  Sterling Silver is an alloy which contains 92.5% pure silver (the rest is usually copper).  Centuries ago the Spanish minted silver and gold coins.  The Spanish silver coins were called Reales and a 1 Reale coin contained 0.125 ounces of silver.  Thus the 8 Reale coin contained one ounce of silver - the 8 Reale coins were the Pirates’ fabled Pieces of Eight.

Gold is once again in the headlines now it is trading above $1,000 per troy ounce.  The Comex gold futures contract (symbol GC) is based on 100 troy ounces of gold which means if you own one contract at expiry you will receive 3 one-kilogram gold bars of at least 99.5% purity.  This is not quite 100 troy ounces of pure gold but it makes the GC futures market function better.  Being short-changed in gold is something people have got used to over the centuries!

In terms of grams, a Troy ounce = 31.1034768 grams whereas an Avoirdupois ounce = 28.349523135 grams.  Curiously a Sterling Silver coin weighing exactly one Troy ounce contains nearly one Avoirdupois ounce of pure silver, just as today’s Krugerrands (made of 22 carat gold alloy) actually weigh more than a Troy ounce so as to contain exactly one Troy ounce of pure gold.

So don’t fall for the age-old trick of thinking that your 9-carat rose gold bracelet which your kitchen scales tell you weighs one ounce is worth anywhere near one thousand dollars.  In fact as rose gold is usually gold alloyed with copper and 9-carat gold only contains 37.5% gold, your rose gold bracelet would be more accurately be described as a copper bracelet.  All that glitters is not gold – as the merchants may well have said in the taverns of Troyes after a good day’s trading in the Middle Ages!

There has been much speculation about the prospect of Tesco competing strongly with the existing UK banks as it increases its finance footprint and starts to offer loans to its customers.  Tesco already has stores spread nationwide which could serve as a branch network to the millions of customers who already shop there each week. Last year Tesco also bought out RBS’ 50% stake in their Tesco Personal Finance joint venture which means TSCO now has roughly 6 million accounts and deposits of £4.5 bln.  Today Tesco announced a deal with Fortis whereby the latter will provide motor & household insurance underwriting and claims management with Tesco doing the retail pricing and marketing.

However if we follow the money then the prospect of Tesco crushing the existing UK banks by its entry into the banking market seems less fearsome.  The big question is where is Tesco going to get the money from which it would wish to lend out to its customers?  The Bank of England (which will once again resume its proper role as banking regulator if, as currently seems likely, the Conservatives win the next election) will not allow Tesco to fund its lending via the wholesale markets (this is the business model which got Northern Rock into trouble and the BoE will not allow it to happen again anytime soon), so TSCO is going to have to compete with the rest of the banks for its share of retail deposits.  These retail deposits are highly sought after at the moment as every bank (except HSBC with its loan-to-deposit ratio of 90%) is keenly trying to increase its retail deposits so as to shift their loan-to-deposit ratios down towards 100%.  This is the structural problem in the UK banking sector at the moment – there are not enough customer deposits to go around and so most banks will continue to shrink their loan books.

The implication is Tesco are going to struggle to quickly attract tens of billions of pounds sterling in retail deposits and therefore their capacity to extend loans to customers is going to be limited to how fast they can attract deposits.  As Tesco do not intend to run their banking subsidiary at a loss (and have little experience in assessing credit quality), they are going to grow their banking business relatively slowly.  Calm down dear, its only a supermarket trying its hand at banking.  This is nothing new as the Co-op has been in the banking business since 1872 and announced recently that its customer deposits increased 21% in the first half of 2009.

The other way for Tesco to fast-track its way into banking would be to buy Northern Rock off the UK Government.  However NRK holds deposits of £19.5 bln and has a mortgage book of £66.7 bln.  However although the TSCO-to-buy-NRK deal has been rumoured, Tesco would still face the same problem of how to attract sufficient deposits to pay off the billions which NRK still owes to the BoE.  Also NRK’s loan book is said to be of low quality and questions would arise as to whether Tesco is capable of assessing NRK’s outstanding loan book, as in order to get a deal done, a significant chunk of NRK’s mortgage book would remain with the Government.

The existing UK banks needn’t spend too much time worrying about serious competition from Tesco over the next decade.

If LLOY and RBS manage to drag out their “detailed discussions” with HM Treasury over the exact workings of the Asset Protection Scheme then with luck the UK economy will have recovered to a sufficient extent such that LLOY in particular will be able to avoid ever actually formally signing the documentation and entering the scheme.  LLOY stated in their H1 2009 results that they are ” working with HM Treasury to finalise the detailed terms and conditions and operational mechanics of the Group’s intended participation in the Government’s Asset Protection Scheme. The operation of the scheme and the impact on our business (and the consequential impact on our lending and the wider economy) is complex.  The Group expects to conclude these discussions and agree terms and conditions which are in the interests of shareholders”.

In their recent results LLOY were much more optimistic in their outlook than RBS.  LLOY currently have a Core Tier 1 capital ratio of 6.3% and if the economy recovers they could well generate enough operating earnings to cover future impairments (LLOY commented “impairments in the second half of 2009 are expected to be significantly lower than the first half with progressive reductions thereafter”) and thus survive the FSA’s stress test that Core Tier 1 capital may not fall below 4% over the cycle.  Formally entering the APS would effectively cap LLOY shares at 150 pence for the next few years.

RBS reported a Core Tier 1 capital ratio of 6.4% in their H1 2009 results but look unlikely to escape entering into the APS no matter how V-shaped an economic recovery anyone predicts (RBS commented the “APS is key to RBS’s short-term ability to withstand stressed scenarios, though important issues remain to be confirmed”).  Entering the APS would effectively cap RBS shares at 65 pence for the next few years.

From HMT’s viewpoint, not having to take on the liability of insuring 90% of £235 bln of LLOY future write-offs as well as £305.5 bln of RBS future write-offs is clearly a very desirable outcome so its suits HMT as well to allow the current “detailed APS negotiations” to drag on as long as the economy looks to be recovering.

Never formally enacting the APS would remove very large contingent liabilities from the Government’s balance sheet and the APS would have served its purpose by shoring up confidence in the UK banking sector when it was most needed at zero cost to the tax payer.  Such an outcome would be in the best interests of LLOY’s shareholders (with the Government being the largest shareholder) and would also cause a large jump in the LLOY share price which would present a window of opportunity for the Government to be able to sell some shares in LLOY at a profit for the taxpayer.  One way to play this is via a long LLOY/short RBS money-for-money pairs trade as RBS is not strong enough to get by without the APS.  If the banks give back part of their gains since March then LLOY and RBS should broadly track each other; but if LLOY do wriggle free of the APS then they will substantially outperfom RBS.  In the meantime do not expect an early end to the APS negotiations.