Stocks surged higher on Tuesday — a day of the week that has shown a penchant for strength lately, dubbed “Turbo Tuesday” by traders — pushing the Dow Jones Industrial Average within a hair of the 17,000 level for the third time since early June. The other major averages were on the move too, with the Russell 2000 small-cap index returning to its early March high, and the Nasdaq Composite in free air.
The catalyst, aside from simple upside momentum, wasn’t clear. The rest of the market was quiet. The dollar was unchanged. Commodities unchanged. Treasury bonds didn’t move. Macroeconomic data was mixed to weak, with construction spending disappointing. And the geopolitical situation is a hot mess as with the Iraqi parliament essentially quitting, Ukraine ending a ceasefire against separatist fighters, Japan flexing its muscles, and Israel on the attack.
None of this seemed to matter. Will the upside move in the Dow Jones and other major indices continue?
Much depends on Thursday’s payroll number and the upcoming Q2 earnings season. If the jobs report is strong, it could force a reevaluation of when the Federal Reserve will start hiking interest rates. Capital Economics was out with a note to clients Tuesday warning that the recent rise in inflationary pressures suggests the first hike could come as soon as March.
As for earnings, Alcoa (AA) will kick things off next Tuesday when it reports after the bell.
For their part, CEOs are far from optimistic. The Bloomberg CEO Sentiment Index, shown above, has been flat lining all year. Companies that have reported early are sounding a cautionary note highlighting rising cost pressures, slow household income growth, and the fragility of the recovery.
According to FactSet, expectations are very high: The combined S&P 500 earnings growth rate expectation for the first half of the year is 3.7% — which is expected to increase to 9.9% for the second half of the year. Breaking down the expectations by sector, analysts are looking for financials to carry the burden, with earnings growth of 15.5% for the second half vs. a -2.7% decline in the first.
The problem is that the banks have been pressured by the relative market calm we’ve seen lately. Long-term interest rates have drifted lower, with the 10-year Treasury yield dropping from 2.8% at the start of the second quarter to just 2.5% now. That hits bank profit margins. Moreover, the drop in market volatility and bond market volume will weigh on trading and brokerage revenue. And mortgage activity, despite the recent drop in borrowing costs, remains moribund.
Banks have been tapping loan loss reserves as a way to manage earnings in this environment, but that’s a finite piggy bank that can’t bolster results forever. Just look at JPMorgan (JPM) as an example. The bank has pulled down its loan loss reserve from nearly $26 billion in early 2012 to less than $16 billion now.
So there are hurdles ahead, even if Russia doesn’t move into Eastern Ukraine or Iraqi oilfields aren’t set ablaze.
What, then, explains what happened in the market on Tuesday?
It was all about liquidity. Although the Federal Reserve has started pulling back on its QE3 bond purchase program, there are still days when it’s actively and aggressively buying up bonds. Tuesday was one such day, with upwards of $3.25 billion being pumped into the financial markets. There are only two other days like this in July.
Also, the big banks pumped about $189 billion into the financial system Tuesday as end-of-quarter window dressing was removed. This involves banks selling riskier assets, using the cash to borrow ultra-safe Treasury bonds from the Fed, putting them on their balance sheets to boost capital ratios for regulators and investors, and then reversing the trade when the new quarter starts.
This behavior has been growing more and more noticeable as more and more banks are apparently getting in on the action.
And finally, as the most heavily weighted stock in the Dow, a 2.8% surge by IBM (IBM) on no major developments boosted the overall trade despite relatively narrow participation in Tuesday’s rally.
Add all this up, mix it in a bowl, and draw your own conclusion.
My guess is that we see a short-lived push over the 17,000 level for the Dow Jones — to great fanfare and excitement — before the issues above get traction and encourage some profit taking in extended areas like semiconductors.