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.