Monday Review: Animal Spirits Overcome the Stress Test

by: Vikram Saxena

In my post over the weekend I had written that the Stress Tests for Banks are unlikely to have a significant negative effect on the equity markets. I was hoping for some sideways action, which would provide an opportunity to initiate new long position. What I did not expect was how the market would completely ignore any news about the banks having to raise more capital.

The ES futures were trading higher prior to market open, in spite of the news that Citibank (NYSE:C) and Bank of America (NYSE:BAC) would need to raise multiple (double digit) billions as a result of the stress test. The move up was driven by positive economic news coming from Asia, with Chinese manufacturing expanding for the first time in 9 months, and a new $120B foreign currency reserve pool to help Asian countries defend their currencies and tolerate economic shocks.

Animal Spirits Are Alive and Kicking

Animal spirits (a term used by Keynes to describe psychological factors which move the market) were alive and kicking yesterday. The market ignored all negative news about the stress tests, instead focusing on the positive news about better than expected existing home sales data. During the middle of the day, a headline claiming that Wells Fargo (NYSE:WFC) too will have to raise additional capital hit the wires. It hardly caused a blip on the screens. Later in the day, S&P placed a large number of banks on negative credit watch. That news too caused a sell-off which was over within the blink of an eye.

The 875 Barrier

A few weeks ago I had written that an article where I described how the 870-875 level on the S&P500 is a major dividing line which, once crossed, may propel the market higher. The S&P500 finally closed above the 875 level last Friday. I was not particularly impressed by the market action on Friday, since the market could not trade above that level, failing multiple times, till a surge in the last few minutes lifted the market. However a weekly close above 875 is an important event, which clearly was not ignored by money managers.

Technical Buying: Foreign Markets

This buying initiated by the close above the 875 was also fuelled by the markets in Japan and Europe which were closed part of the last week. European markets were closed on Friday to celebrate (with riots) May Day. Japan was closed on Thursday. With the US equity markets bullish, each of the foreign market had an extra day of gains to make up when they reopened after the holiday. This created a positive feedback cycle reinforcing the rally.

Sector Divergence: Financials lead but Big Tech Fall

The rally was led by the financials (NYSEARCA:XLF), the Commercial REITS (NYSEARCA:IYR), banks (NYSEARCA:KBE), materials (NYSEARCA:XLB) and energy (NYSEARCA:XLE). Consumer driven technology like bell-weathers Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and Research In Motion (RIMM) had strong days.

However, the significant divergence I noticed was that core large tech cap heavyweights like Cisco (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL) finished the day in red. This divergence between the consumer oriented technology companies versus the core business oriented technology companies suggests that the sentiment towards consumer spending has become more positive, especially when compared to corporate technology spending.

Trading Plan

I belong to the camp which has missed out on the last 5-7% of the move while waiting for the pullback. Regardless of my medium to long term view, I can not ignore what the market is doing right now. Market sentiment can often not be rationalized; however animal spirits have to be respected.

I am primarily in cash with some index puts (IYR, IWM), though I continue to trade the intra-day moves. Unless of course we are in a trend-down day where the change in market sentiment is clearly visible, I will scale out of my index put positions on any weakness in the markets. My TLT positions showed a ray of hope today; I plan to scale out of them too, but have a slightly longer horizon.

On the long side, I continue to hold my stock and options position in TSO, while I closed my CTSH position yesterday since it had run up quite a bit ahead of earnings. I am planning to establish some long positions in the Energy , Materials and Home Builders sectors on a pull back. Given their extended state of these and my reluctance to chase, I will be hedging those positions either by buying some out of money puts on the long positions, or by buying calls instead of stock.