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A tospy-turvy day saw the Dow end modestly lower by 29 points. The glass half-full bull argument of the day focused on the the VIX index (which is in layman’s terms, a measure or gauge of fear in the market) which fell below 30 for the first time since last September. Bears would counter by highlighting the weak full year guidance from bellwether tech stock HP (NYSE:HPQ) after the bell.

My position is that H2 is going to bring some nasty (negative) growth surprises, and with a market that prices an ever more V-shaped rebound out of the crisis, that is going to hit risk-assets hard. But, let’s say that view is wrong. Let’s say that the recent pick-up in growth is not just a recoiling of demand and inventory cycle but the start of a genuine recovery taking us to trend growth or better. The inflation implications of this, against a background of very low rates, wide-open fiscal taps and QE, are frankly terrifying.

While the last paragraph may have given this impression, I am not actually trying to sit on the fence. The directional view is clear; near-term risks are to a 10% sell-off in risk from over-bought levels, later in H2 I expect a bigger sell-off to fresh lows. And while there are those who are cheering banks repaying TARP funds, my take is that is merely a cynical PR exercise and the real motive is to allow them to resume business as usual on the old pay front/bonuses front.

Today’s Market Moving Stories

  • Jap Q1 GDP, fell 4.0% QoQ in Q1, -15.2% QoQ annualized, the worst result on record. While the headline number was almost in line with expectations, household consumption and capital expenditure were much weaker. Net exports accounted for more than half of total GDP decline.
  • Nissan Motor Co. (OTCPK:NSANY) rose 4.8 percent after the automaker said on Tuesday that orders for its low-emission cars are up 30 percent in Japan so far in May from the same period a year earlier, helped by new government tax incentives for low-emission vehicles.
  • ECB chief economist Stark tells FAZ the ECB will “concentrate” on the initiatives that have been announced, i.e. covered bond purchases and longer LTROs. He said the “free fall of the economy could be over” and things are slowly looking up for next year.
  • Obama administration plans stripping the SEC of power in a regulatory overhaul to be revealed next week, shifting more duties to the Fed.
  • AMEX (NYSE:AXP) plans to cut 4,000 jobs, roughly 6% of its workforce, in order to trim $800 million from its labor outlays in 2009. The firm said “While we have remained solidly profitable at a time when some parts of the card industry were incurring substantial losses, we continue to be very cautious about the economic outlook and are therefore moving forward with additional reengineering efforts to help further reduce our operating costs,” Chairman and CEO Kenneth I. Chenault said. In related news, Congress is aiming to clip the wings of credit card companies.
  • GM is weeks away from filing for bankruptcy, Reuters reported, citing several industry experts. The firm is unlikely to meet a June 1st deadline to restructure, leaving it with little choice but to file for bankruptcy protection.
  • According to Bloomberg data, profits at the 314 companies in the Stoxx 600 that have reported earnings since April 7 dropped 44 percent on average. This compares with a 35 percent decline in earnings at 450 companies in the S&P 500.
  • It was another good day for agri stocks and grains as more bad crop news from Argentina pushed corn and soya ahead. The bombed-out agri stocks sector (grain handlers, fertilisers), resurgent of late, continues to advance on crop news.
  • Moody’s rating agency took aim with a cannon at the Spanish banking sector and put a total of 34 banks on review for downgrade. It seems that they have noticed that Spain is having a recession.
  • Anglo American (AAUK) & Xstrata (OTC:XSRAF) are the subject of some vague merger rumours this morning.
  • Air France (OTCPK:AFLYY) up 11% plus after reporting a smaller than expected loss.
  • How Obama is like Spock.

BoI’s “Good” Results
The market’s reaction to Bank of Ireland’s (NYSE:IRE) results yesterday (May 19th) was distinctly positive. The shares rose 23.7% to 133.5c as investors shrugged off the widely anticipated news that impairment guidance had been raised to the earlier ’stress’ level of €6bn (4.4%) over three years, and management’s acknowledgement that things could yet get worse ‘in the event of even further deterioration…or further prolonged low levels of activity (in property markets)’. AIG Death Star?

The fact that the core equity Tier 1 ratio at end-March 2009 came in ahead of expectations (6.2% versus our forecast of 5.7%), coupled with the announcement of a €1.4bn tender for non-core Tier 1 debt, which could be equity enhancing to the tune of €700m, overshadowed the impairment update. The market clearly shares the view that the odds on the bank’s survival as a listed independent entity have improved appreciably . That said it must be understood that the results are still somewhat overshadowed ahead of the NAMA transfer, and management do not have any insight into the “haircut”, other than to highlight its lower relative exposure to troubled assets.

Ahead today

  • Earnings watch: Reporting today we have Target (NYSE:TGT) ($0.59), Deere (NYSE:DE) ($1.07), and Limited Brands (LTD) (-0.04)
  • BoE May Minutes (08:30 GMT). The MPC left the Bank Rate on hold at 0.5% and announced a further £50bn of quantitative easing at its May meeting. I expect support for both of these initiatives to have been unanimous. Overall, I do not expect any major revelations this month for a change
  • FOMC Minutes (18:00 GMT): Fed sources suggested that policymakers viewed the recent run-up in rates as a reflection of an improved economic outlook rather than a signal that the pace of Treasury buying should be stepped up. In addition, they noted that the goal of the program was to boost lending, not to target government bond yields. Still, with speculation over larger Treasury purchases continuing to circulate, the FOMC’s discussion and assessment of its quantitative easing operations to date could prove illuminating. Also important will be the updates to GDP forecasts by members of the Fed.

What To Do If The Bear Market Rally Has Ended?
Proto-bear David Rosenberg who recently left Merrill Lynch has resurfaced and he hasn’t stopped dishing out phenomenal research reports. His introductory report from Gluskin Sheff is a must read. Excerpt follows:

"The bulls enjoyed and the bears endured a massive 37% rally in the S&P 500 from the March 9th lows to the May 8th highs. Both in terms of duration and magnitude, this proved to be the most intense rally during this 20-month long bear market. And, the bounce has been so impressive that it has taken what was widely considered to be a massively undervalued stock market in early March to one that is now at least moderately expensive. (The FTSE All-World market P/E ratio on forward earnings estimates is now around 15x, well above pre-Lehman collapse levels and nearly double the lows for the cycle.)

We will be watching to see whether the lows hold as they did in March 2003, which symbolized the onset of the cyclical bull phase at the time; or whether this turns out to be a violation of the lows as was the case in the summer of 2002, which represented the final severe leg of the tech-induced bear market of that prior cycle.

For the near-term, it matters little because the testing process does seem to be in place right now and this carries with it well-established investment patterns. Over the past year, we have seen four other testing phases (they all failed as the market did break to new lows). Under the proviso that the S&P 500 hit an interim peak back on May 8th at 930 (it is down 3% since, even with yesterday’s bounce), here is what the recent historical record tells us to expect (at a minimum, take profits).

  • The average length of the testing phase is 53 calendar days and 38 business days (versus 45 calendar days and 33 business days for the interim bear market rallies).

  • On average, the S&P 500 undergoes a correction of more than 20%.

  • The sectors that led during the rally, corrected most during the selloff. This means that financials, consumer discretionary, materials and industrials should underperform in the next few months, while health care, consumer staples, utilities and telecom services should emerge as the leaders.

  • Market volatility more than doubles, on average.

  • Bonds rally, with the 10-year Treasury note yield down nearly 15 basis points, on average.

  • The flight-to-safety during these periods means that the Canadian dollar declines (on average by 10%), while the trade-weighed U.S. dollar rallies more than 6%.

  • Commodity prices decline an average of 15%, again as cyclical trades unwind.

  • Corporate spreads (Baa) widen an average of more than 60 basis points; it is very important to be focused on high-quality paper
    during these market testing periods as high-yield spreads widen, on average, by more than 300 basis points (and keep in mind the vast outperformance, which is typical, during the bear market rallies).

  • What we discovered during this process was that gold performed quite well during both the bear market rallies and the subsequent sell offs (and despite the flows back in the U.S. dollar). This may be an indication that gold is in a secular bull market.

  • So what works best during the retest? Health care, staples, utilities; high quality bonds; the U.S. dollar.”

And finally…
Play the game

Disclosures: None

Source: Preview from Europe: To V or Not to V?