Why This Stock Rally Isn't Signaling a Market Turnaround

Not many traders believe that the more than 10 percent rally since Oct. 3 is really predicting a bigger and better European recapitalization plan or a reacceleration in the U.S. economy. Many believe it is simply a move within a new trading range that will last until the end of the year.

NYSE traders

The S&P 500 bounced within a six percent range for about seven months to start the year. Investors made money if they bought the S&P 500 at about 1260 and sold the benchmark at around 1340.
After a dramatic August selloff, a new range has been established for traders to play in, they said. Buy the S&P 500 at around 1120 and sell it at 1220.
“Driving such sideways trading is the up and down economic data that keeps the U.S. teetering between a recession [cnbc explains] and a recovery and continued uncertainty around the euro-crisis with the Merkel/Sarkozy pledge to stop the banking and sovereign debt crisis in Europe without offering details, providing a perfect example of why uncertainty lingers,” said Abigail Doolittle, a technical analyst with Peak Theories.

Further undermining the long-term validity of this rally is that the exact same stocks that were sold the most during the recent drop from the top of this new range to the bottom of it are the ones that are up the most in this latest comeback.
“The 50 stocks that held up the best during the correction have averaged a gain of just 3.76% since 10/3 (the worst of any decile), while the 50 stocks that were crushed the most during the correction are up an average of 17.01% (the best of any decile),” wrote Bespoke Investment Group analysts, in a note to clients. “Clearly investors thought that the sell-off became overdone, and they were happy to buy the stocks that got beat up the most.”

What’s more, the stocks that had the most investors betting against them, are also leading this latest comeback. A trademark short-covering rally, traders said.

Beyond the money

“The 50 stocks with the smallest amounts of short interest are up an average of 7.88%, while the 50 stocks with the highest short interest are up an average of 12.16%” since Oct. 3, according to Bespoke.
“The market was due for a rally on merit, however, the velocity of the rally is what we can blame on short covering,” said Jim Iuorio of TJM Institutional Services. “We have merely gone from the lower end of a trading range to the upper end of that range.”

Volcker Rule May Cut Fixed-Income Revenue 25%

Wall Street’s fixed-income desks could suffer a 25 percent decline in revenue under a Volcker rule proposal that may outlaw so-called flow trading, according to brokerage analyst Brad Hintz.
The draft proposal, written by regulators including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corp., forbids market-makers who trade debt securities for customers from amassing positions “in expectation of future price appreciation,” Hintz, of Sanford C. Bernstein & Co., wrote today in a note to investors. “Thus flow trading may be prohibited.” Such a move would cut fixed-income revenue by 25 percent and reduce profit margins by 18 percent, Hintz estimated.
Goldman Sachs Group Inc. (GS) and Morgan Stanley would be the most negatively affected if the rules were adopted because they are most dependent on fixed-income revenue, Hintz wrote. U.S. regulators are crafting guidelines to implement the so-called Volcker rule included in the Dodd-Frank legislation passed last year, which aims to prohibit deposit-taking banks from making speculative bets with their own money.
“At this point, the Volcker rules are simply proposals,” Hintz wrote. “We hope the final rules will be revised and give greater consideration to how brokers will earn a reasonable return from market making.”
The Volcker rule draft, also written by the Office of the Comptroller of the Currency and the Securities and Exchange Commission, was leaked last week. The proposal would be more damaging to fixed-income trading units than to equities businesses, which make a larger portion of their money from client commissions, Hintz wrote.

Bid-offer Pricing

Fixed-income traders have become more reliant on reaping revenue from price moves in the market because the profit margins from buying and selling to clients, known as the bid- offer spread, have shrunk in recent decades, Hintz wrote.
“As bid-offer pricing narrowed, the Street increased risk- taking when facilitating client trades, which enabled them to respond quickly and profit from changing demand conditions,” Hintz wrote. “By deploying balance sheet to amass inventory ahead of demand, flow trading allowed the firms to partially offset the deteriorating economics in pure execution.”
Goldman Sachs and Morgan Stanley (MS), both based in New York, were the biggest and second-biggest U.S. securities firms respectively before they both converted to bank holding companies after the bankruptcy of smaller rival Lehman Brothers Holdings Inc. in September 2008. The two companies, which are now the fifth- and sixth-biggest U.S. banks by assets, came under the regulation of the Federal Reserve and won access to Fed programs, such as the discount window, that are designed to protect deposit-taking banks.
The Volcker rule was named after former Federal Reserve Chairman Paul Volcker, who has argued that banks with access to Fed lending programs should be prevented from making speculative bets with their money or from investing in hedge funds or private equity funds.