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Equity markets melted up yesterday, despite weak economic data, on fairly low volume. I know that it will feel manipulated to some of you, but really it’s just thin. It doesn’t take much volume to move prices around, and when the market wasn’t able to break below 1120 it was set up to go the other way for a little bit. The sharp action is actually a great gift for investors who have been making deals with the Creator for a better exit point. The market should continue lower after a brief interlude – perhaps only a day or two, once people figure out that the catalyst today was a smokescreen.

That catalyst was certainly not the economic data, which continues to be weak (although really, who cares about wiggles in New Home Sales when they are at 1/3 the level of a decade ago?). The catalyst seems to have been an announcement from the FDIC.

I ought to preface what I am about to say by pointing out that the FDIC is a horribly-run agency that effectively backs bank deposits with a vague promise that surely Congress would step in and bail it out if necessary – since as its own Chairman admitted in 2009, the FDIC has been effectively insolvent for several years with a negative balance in the deposit insurance fund (DIF) – until the most-recent quarter finally turned it positive again although not positive enough to do very much with a big bank failure.

Tuesday’s announcement by the FDIC was that the list of problem banks shrank for the first time since 2006 (when there were 50 problem banks). There are now “only” 865, down from 888 problem banks. Oh, that’s soothing. The FDIC also pointed out that loan-loss provisions at insured banks declined 53% from a year ago, to 19bln, and that of course that helped net income at banks. The market took this as good news – credit must be improving – instead of the more-likely accurate read that at least some of this is earnings management. Credit probably improved over the last year. But 53%? That seems quite unlikely over the last quarter or year or 3 years. Now,maybe banks were dramatically over-reserved, and that is possible since in the “kitchen-sink quarters” of 2008 and 2009 one of the uses for the big declared losses was assuredly to set aside reserves to manage future quarters of shortfall. (Over- and under-reserving intentionally are both illegal, but everyone does it and everyone knows that everyone does it.) This is a good time to remind readers who are investors in equities that if you haven’t read Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, you really should.

But a decline in the number of problem banks, that is great news, right? Well, my friend (and outstanding credit expert) Peter Tchir actually looked at the numbers, and with his permission I am quoting his findings at length:

The data also seems to be a bit misleading. Did any banks actually move from the “problem” list to a better list? If the entire 23 bank decline was from banks improving, that would be good. But I don’t think that is the case. The number of insured banks declined from 7,574 to 7,513. So the number of banks covered by the report declined [my note: by 61, if you’re following along]. And that makes sense since 22 failed and 39 were absorbed via mergers.[my note: 22+39=61] So the number of problem banks declined by 23, and 22 banks failed. I assume once a bank fails it goes of the “problem” list since it is not covered by this report? So at best, 1 bank moved off? Yet of the 39 mergers, were those all of non-problem banks? I find that hard to believe. I suspect that if the list was disclosed, we would find that not a single bank migrated from the “problem” list to a better list on its own. And that some new banks were actually added to the problem list.

As Peter pointed out to me, pretty much anyone could have done this work. The difference between Peter and successful traders and investors like him is that he actually did the work.

I should also note that fixed-income people tend to be more comfortable with numbers than stories, and when you look at the action in the markets there is a strange dichotomy between the elation felt by equity investors, who sent the S&P higher by 3.4% and the NASDAQ by an incredible 4.3%, and bond investors, who pushed 10-year note yields higher by all of 4 basis points. And, by the way, bonds were positive on the day until just after 2:00ET.

Someone out there thinks the problems did not vanish overnight.

Inflation readings were mixed. While gold dropped 1.6%, many commodities were higher and the indices gained on the day. TIPS were weaker than nominal bonds, falling 9bps to put the 10y TIPS at 0.10% and dropping 10-year inflation swaps to a 10-month low of 2.41%. One-year inflation swaps seem very cheap at 0.84%, even though core inflation is 1.8% and rising and energy inflation over the next year (which can be hedged in futures) is implying a drag of a whopping 0.1%. So 1-year inflation swaps imply roughly half as much core inflation as we are almost certain to get. When 1-year inflation swaps were above 2.5%, I advocated selling them while buying gasoline; at this level, I’d be buying 1-year inflation swaps and selling gasoline.

I’ve gone this entire comment without remarking on the earthquake that rocked Virginia and the DC area. That’s because I don’t think it had any market impact, other than causing a brief jump in bonds. Several nuclear reactors shut down automatically, and at least one is being powered by diesel generators right now, and I am sure that reminds people of the Japanese quake. But there was no tsunami, no containment vessel was breached, and the diesel generators are all online and not under water. So the country was shaken, but not stirred.

On Wednesday, Durable Goods (Consensus: +2.0%/-0.5% ex-transportation) will be driven higher by aircraft orders. Thursday will bring Initial Claims, but neither of these is as important as Bernanke’s speech on Friday at Jackson Hole. I expected a bounce into Bernanke’s talk, but it seems to me we’ve gotten in a single day more than I would have looked for. That doesn’t mean we’ll trade lower Wednesday, but I expect we’ll have difficulty building on Tuesday’s gains and I wouldn’t be surprised to see ebbing elation in the equity market. Since I expect liquidity to get increasingly poor over the few days leading up to Bernanke’s talk, ‘ebbing elation’ may be enough to send prices back down.

Source: Elation Should Ebb