The Overnight Report: Not Quite Five

The Dow closed down 7 points while the S&P lost 0.3% and the Nasdaq lost 1.9%. The Nasdaq had outperformed on the upside and, as per usual, has thus been subject to a bigger fall.

It was a close run thing. The Dow only tipped into the negative at the death having been up 170 points just before 2pm. If Wall Street had closed at that point it would have made five consecutive days of rally for a 15% gain in the S&P in a little over a week. The last time a five-day, double digit rally occurred was in November last year, but before that you have to go back to the 1930s to tick both boxes.

In which case a small dip is not too disappointing. Within the 15% rally the financial sector had put on 45% and thus it is no surprise some profits were taken in the afternoon session. Bank stocks led the pullback. Volume was fairly light so neither the buying nor the selling showed great conviction.

Wall Street opened higher and rallied throughout the morning following several lead-ins. One was the G20 finance ministers vowing to reignite bank lending. Another was an appearance by Ben Bernanke on the US Sixty Minutes program in which he suggested the possibility the US could begin to move out of recession as early as late 2009. Bernanke also stated that the big banks would simply not be allowed to go to a zero share price.

More concrete, however, was an announcement from the UK’s Barclays Bank that it, too, was profitable in the first couple of months of the year. The British bank joined its US counterparts which made similar claims last week. Barclays also announced it was shopping around all or part of its highly successful iShares ETF sponsoring business as an alternative to joining in the UK government’s bank investment and guarantee program. The market considered it a positive that Barclays may not need a government capital injection and thus sent its shares soaring 22%. The bank led a 3% broad market rally in London which was reflected throughout Europe.

The potential offset to the good news could have been a big hit for the energy sector in the wake of the OPEC decision on Sunday not to cut production. Wall Street was braced for a solid fall in the oil price but while oil looked sunk from the opening bell, suddenly the buyers moved in. At the end of the session oil was surprisingly up US83c to US$47.08/bbl.

Commentators put oil’s resilience down to two factors. One is the simple encouraging lead out of Wall Street over the last week coupled with feelings that oil had been oversold. The other is the implicit good news within OPEC’s decision not to cut. OPEC has instead decided to clamp down on members who flout the quota restrictions and to rein in overproduction. While OPEC has threatened this before with little success, the market sees it as a production cut of sorts nevertheless.

The other good news driving the finance sector has been anticipation of a relaxing of the mark-to-market rules. Last night the Financial Accounting Standards Board weighed in with its opinion, suggesting that the rules on valuing "level 3" assets (those without a visible market, such as CDOs) would remain but greater flexibility could be allowed. FASB tightened the rules in November 2007 and thus sent bank balance sheets crumbling from asset write-downs.

FASB has suggested that perhaps cashflow could be used as an alternative gauge of value rather than just last traded price. As CDOs have hardly traded, last traded price is misleading. Many CDOs are of prime quality but tainted with the same subprime brush regardless. If a consistent and unencumbered flow of mortgage payments is still forthcoming on these assets then perhaps such cashflow is a better indication of true value.

The end result of any relaxing of the mark-to-market rules would be that for the first time since the subprime crisis began, we will be suddenly talking about "write-ups". Banks would be able to lift the value of "toxic" assets on the balance sheet and alleviate some of the pressure to raise fresh capital. It may be that first quarter earnings results for the banks could actually look healthy.

But no one is foolish enough to consider that any other part of the broad market is looking for healthy results. As we approach the first quarter reporting season, the fear is stock analysts are still too optimistic in their forecasts and that a rash of downside earnings surprises could stop this bear market rally in its tracks.

More good news for the market in general may come on Wednesday after the Fed completes its two day committee meeting. While no one expects the funds rate to be changed, there is anticipation on what Bernanke might have to say about the Fed buying US Treasuries. For four months the Fed has suggested it may need to buy the government bonds, which is "monetization of debt" and highly inflationary. It basically means the US Treasury prints money to give to the Fed to buy Treasury bonds which are used to cover the printing of the money in the first place. Monetization of debt is a bit like a shot of adrenalin. You might use it in an emergency but too much adrenalin and your body would explode.

The good news is that given the Fed’s foray into the mortgage asset market has been successful in bringing mortgage rates down, perhaps it won’t need to go to the extreme of buying Treasuries after all. Perhaps this will be announced on Wednesday. The only problem with this argument is that one of the reasons US bonds have been extensively bought by the market is because the market assumed the Fed was behind it. And you "don’t fight the Fed". The US does not want to see a run on its bonds by any stretch of the imagination.

In the meantime, a more positive feel on Wall Street has been fuelling a timid withdrawal from the "safe haven" trades. That includes the US Treasuries and gold. Last night gold fell US$