Given that low Base rates are here to stay for a long while yet, which assets will benefit most from the BoE’s low-rates-for-yonks policy (which is primarily directed at halting the recession and, as a consequence of growth, reducing unemployment)?

Normally government bonds sell-off (higher yields) when the market sniffs an economic recovery but with so much spare capacity in the economy to be worked through, Base rates will remain low until a recovery is well under way and unemployment has turned decisively lower.  In this environment short-dated government bonds should continue to do well, especially for those within 5 years of maturity.  Longer-dated yields may well go higher (especially once the BoE finishes spending its QE money) with the result that we may see a very steep yield curve sustained for quite some time.

Credit spreads on corporate bonds should carry on tightening, although there will come a limit when the absolute level of the coupon offered scares investors – lending money to a BBB-rated corporate at, say, 3% for 5 years will surely make investors think twice.  The margins currently enjoyed by banks will also serve to stop credit spreads from tightening too far as banks enjoy better protection on their loans (so logically the credit spread on corporate bonds ought to be greater than banks’ lending margins).  A steep yield curve also benefits banks greatly too.

Commodities follow a price path all of their own as they offer no yield, so they offer little attraction to income-seeking investors.

Which brings us to equities. Yields in excess of government bonds coupled with low Base rates until a recovery appears mean that equities could quite easily become over-valued against the current backdrop of macro policy.  Companies with big pension schemes may not join the party as the combination of tightening corporate credit spreads and bond yields being held down by QE buying will result in lower AA-bond yields (which are used as the discount rate with which pension scheme liabilities are calculated).  This will temporarily result in bigger pension scheme deficits which the market may well take fright at (again) for those companies affected (the usual suspects are British Airways, British Telecom, etc.), but the effect will subside once the BoE stops propping up the gilts market and long-dated gilts sell off (higher yields).

Once the supply of fresh equity from companies raising money to pay down debt and get their balance sheets into better shape has largely abated, the coast will be clear to bid up the price of equities.  Any type of a recovery (slow & protracted would be ideal) will result in companies growing their top-line sales revenues, whilst all the cost-cutting implemented since the credit crunch hit in summer 2007 means that lots of that top-line growth will translate into higher profits.  And high unemployment rates also mean that workers won’t be getting much of this profit growth.

The obvious risk to this all-out bullish view is that the economy double-dips badly and the hoped-for GDP growth never materialises.  Until that prospect (which looks very unlikely at the moment) seems much likelier to happen, it will not pay to be bearish on equities.  The Bank of England is too worried about spare capacity bearing down hard on inflation to care much, for the time being, about an asset bubble developing in equities.

One year on from the bankruptcy of Lehman Brothers and we have seen global stockmarkets spend six months plummeting to a low in March 2009 and then another six months rallying back again.  The Dow and S&P are now 15% below the levels at which they stood on the Friday before Lehman went bankrupt on the weekend of September 15th 2008.  The FTSE is just 5% below its close on the eve of Lehman’s bankruptcy.  We are still amidst the fog of war and nobody can quite work out whether stockmarkets are now too high following the impressive 50% rally since March or whether stockmarkets still have room to rally because an economic recovery may be starting (which then leads to an argument about whether the stockmarkets will fall again next year should there be a double-dip recession).

If we track back to the week before Lehman went bankrupt then stockmarkets had already fallen 20% from their highs in October 2007 and they were discounting some type of a recession and had not yet begun to rally in anticipation of an economic recovery.  The bankruptcy of Lehman changed the outlook so severely that markets sold off savagely to discount some type of 1930’s-style depression (with leveraged players being forced to liquidate which pushed share prices down even further).  The governments and central banks stepped in with some determined spending of taxpayers’ money and as the spectre of a depression has receded, stockmarkets have rallied back to their current levels (which are still below where they were on the eve of Lehman’s bankruptcy).

So have stockmarkets rallied too far or do they still have room to rally some more?

Although markets never move anywhere in a straight line, it feels as if they still have room to rally further as the tentative economic recovery which has begun goes on to establish itself more firmly.  Given that on the eve of Lehman’s bankruptcy markets had not yet even begun to discount an economic recovery then in order to discount whatever shape of economic recovery we are about to experience, stockmarkets should logically be higher than where they were in early September 2008.  The US and UK are likely to report positive economic growth for the quarter just ended when GDP data is reported for Q3 2009 and only time will tell whether they go on to report another quarter of growth in the final quarter of 2009 (see One Quarter at a Time).

So stockmarkets may well continue to climb the current Wall of Worry for the next couple of quarters and we can then start to consider the possibility of whether there will be a double-dip recession in 2010.  Although central banks continue to print money and interest rates will stay rooted near zero for a long while yet, a sense of normality is starting to return to corporate life with takeover activity returning to stockmarkets (Kraft/Cadbury and Balfour Beatty/Parsons Brinckerhoff being just two recent examples) and companies are finding it possible to raise equity capital (even though they are most unwilling to get deeper into debt).

Tentative it may be, but the recovery (which may well be long, slow & grinding) is only just beginning.   The fog will clear from the battlefield over the next few quarters and investors will be able to assess things more clearly.  The bad memories of the last year are still fresh in investor’s minds but stockmarkets look forwards, not backwards.

Over the past 6 weeks the FTSE has repeatedly pushed above 4500, only to fall back on each occasion.  The best recent closing high was 4506 on 1st June and the other intra-day highs of the past 6 weeks were 7 May 4520, 19 May 4512, 20 May 4504 and 10 June 4505.

There have been two lows at 4295, creating a double bottom, in between these repeated attempts at 4500 and therefore we now have a very clear recent trading range of just over 200 points established on the FTSE.  The key question is in which direction are we going to break out of this trading range?

There are a couple of key moving averages also currently muddying the picture.  The FTSE has been trading around its 200-dma (currently 4309) during the past 6 weeks but has now closed above it for the whole of June thus far.  The FTSE has also run into its 50-week moving average (currently 4484) in the last two weeks and this 50-wma is providing some resistance at the moment.

However in June so far the FTSE has traded in the upper half of its recent trading range and it looks like the odds now favour a break higher away from this 4295-4506 consolidation area.  Watch the price action for two daily closes above 4506 and let the market show us where it wants to go next.

After first showing signs of weakness on May 7 ahead of the publication of the much-leaked results of the US banking sector stress tests, the Dow posted a high at 8587 the following day.  The market then drifted down for a week, reaching 8230 last Friday (May 15).  The Dow then staged a rally and exceeded its May 7 high by just 5 points (close enough to call it a double top), reaching 8592 in the first hour’s trading on May 20, before rejecting this level and selling off to close near its lows for the day.

During the day yesterday (May 21) the Dow dipped below 8230 and created a lower low in the process, suggesting this market correction has further to run.  There may be a bounce back towards 8405 today though, ahead of the holiday weekend.

Just how much further the indices are going to correct is the key question nobody knows the answer to.  If the Dow gave back half of its rally off the 6 March 6470 low then that would equate to a fall of just over 1,000 index points which would severely rattle the bulls and have the bear camp screaming that we are heading back down below the March lows towards 5,000.

Expect the “Sell in May and go away” crowd to also make some more noise soon about the markets topping out.  Objectively we have had a sustained 11-week rally, there is corporate supply of fresh equity emerging (especially in the banking and REIT sectors) and the markets are due a rest after the Q1 results season.

However it is still early enough to protect any gains you have and see how the markets pan out over the coming months (and two daily closes above 8587 would cause a change of view).  However if the Dow does give back half of its recent rally then there are support levels at 7450 (Nov 2008 lows) and 7280 (20 Mar 2009 close and 61.8% retrace), around which it will be worthwhile paying attention to how the market behaves.

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.