Shorts Didn’t Front Run The Current Rally
Following an inert trading session Monday, the major U.S. markets jumped higher yesterday. The Dow closed up 156 points (1.87%), the Nasdaq was higher by 26 (1.89%), and the S&P climbed by 19 (2.17%). Nearly 3 stocks advanced for every decliner on both the Nas and Dow, and NYSE volume was a plucky 1.6 billion shares (18% better than the 3-month trading volume average). For the third time in April, the Dow closed up on the year, this after not being able to mount any rally into positive territory in February and March.
“Despite a brutal 1Q03, we are in still in the season of equity inflows” The Word. April 14, 2003
According to TrimTabs, for the week ended April 16 net inflows into equity funds jumped by $6.7 billion. AMG Data estimates that inflows were a little weaker, at $5.7 billion. These inflows, which are the strongest of the last 12-months, are one of the main reasons why the markets have been able to mount a widespread rally on mediocre news.
Earnings Season Supports Stocks
1Q03 earnings are running at +9.7% (compared to 1Q02) while revenues are averaging +3.1%. These totals will likely change before the current earnings season is over. Nevertheless, and ignoring the fact that cost cutting (layoffs) is largely responsible for the EPS spike, these manipulated numbers are not that bad.
Incidentally, and although dated by a couple of days, the earnings/revenue gap is larger than the norm in tech stocks: “62 of Silicon Valley's 340 public companies have reported their first-quarter results. Their combined sales total $16.9 billion, down 1 percent from $17.1 billion the year before.” Mecury News
As for 2Q03, last Thursday analyst earnings estimates were calling for a 6.4% advance, down from 7% on April 1 and 10.4% in January. Much the same downtrend is taking place in the 3Q03 estimates, while the 4Q03 estimates have remained between +21.3-21.5% for the entire year.
Although speculating on EPS estimate trends is hardly an exact science – it is difficult enough to fully understand 1 company’s rendition of GAAP let alone 500 (S&P) – it should be remembered that Wall Street and corporate America attempt to boost stock prices by sculpting investor psychology (aka ‘managing earnings’). In other words, if 2Q03 estimates continue to drop this would be bad news, but possibly only for a period of time. Come 2Q03 earnings season, which kicks off in July, the lower the estimates are the better this will be for stocks.
No Washout Means Shorts Holding On
One of the reasons why the current rally is not as convincing as previous rallies is because it did not follow a definite ‘washout’ period. Contrary to heightened bouts of investor fear (the markets tend to bottom when the VIX hits its highs), investor complacency can mark market tops.
Another indicator of a washouts is seen in trading volume. For example, following 9/11 volume spiked as weak hands crumbled, as was the case during the sell offs (turning points) in July and October 2002. No such volume spike occurred to mark the March 2003 bottom.
Incidentally, on the topic of trading volume the markets have not followed the expected path. Rather, even after 3-brutal years NYSE volume continues to consistently electrify (Nasdaq volume on the other hand has declined sharply, which some believe indicates a “drop in speculative interest”.)
When combined, VIX and volume considerations make the case that no washout has occurred. However, before jumping the gun and arguing that this is bad news for the markets, it is important to recognize that since no washout occurred that short sellers may have been tricked into believing that no bottom had arrived. Yesterday the NYSE confirmed this speculation when it reported that short interest actually increased by roughly 60 million shares for the month ended April 15 (reflecting transactions through April 10).
The Latest ‘Scandal’: Front Running
Morgan is about to raise a beaten down tech stock to a strong buy, a takeover announcement between two companies is due -- the volume on related issues always shoots up beforehand as insiders and ‘front runners’ place trades.
Front running - the practice of ‘illegally’ trading ahead of clients order/insider news – is not a new concept. For example, in December 2002 Tucker Anthony Incorporated was hit with front running charges, and in January 2003 Keane Securities Co., Inc. of New York City was caught in the act. However, front running usually goes unreported by the media, and the regulators usually issue a small fine and quickly cover the problem up (Tucker and Keane ended up paying $80,000 in combined fines when they were caught in the act, with the statement “consented without admitting or denying guilt”)
With reports surfacing in recent days that NYSE specialist firms have been dabbling in front running, the media at last attacked the issue. However, the NYSE – which is Chaired by the front running firms in question – has since denied FR practices were under review.
Needless to say, the most comical part of the ongoing FR story is that firms actually front ran news of the investigation:
“Some on Wall Street were asking whether any investors may have got wind of the NYSE's probe before everyone else, since shares of LaBranche and the American depositary receipts of Dutch-based Van der Moolen -- another specialist house -- both began falling mid-afternoon last Wednesday on heavy volume.” Reuters (WSJ)
How does the NYSE combat front running? A start would be to crush nostalgia: turn the NYSE trading floor into a museum and get with the electronic age. After all, when a firm or broker weighs the opportunity of making huge sums of risk free money with the risk of being fined a tiny amount of money, morality goes out the window.
The Question of Short Covering
The economic news is not suggesting that the U.S. economy is improving. However, and although the investor should be careful when trying to forecast tomorrow’s economy, news that consumer confidence continues to rebound (ABC Weekly poll), Iraqi oil is beginning to flow, and managed corporate earnings are not that bad (yesterday a handful of insurers and drug stocks beat the street), is apparently enough for the markets to trade higher on the expectation of an improving economy.
Yes, weekly jobless claims have failed to suggest that the employment situation is improving, and this weeks Leading Indicators (for March) was an entirely negative report. Nevertheless, and remembering that shorts did not anticipate the current bear bounce and may just now be being squeezed, the current rally, like many before, is based on momentum and capital (in)flows.
Brady Willett
BWillett@fallstreet.com
www.wallstreetwishlist.com
April 25, 2003
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