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Bulls Go on the Offensive

Liz Rappaport

Tuesday's bounce makes a lot of sense from a technical perspective. But proof of whether it's a "dead cat bounce" or the start of a true rebound won't come until Wednesday, when more fundamental evidence is in hand.

"I think we rally right into the beige book, and then we'll see what this [bounce] is really made of," says Alex Grace, a trader and hedge fund consultant.

There's no question that Tuesday's rally was much stronger than any of the tepid advances since last Tuesday's plunge. After stabilizing trading sessions in Asia and Europe, the Dow Jones Industrial Average surged 1.3% to close at 12,207.59. The S&P 500 jumped 1.6% to close at 1395.41, its largest day gain in four months, and the Nasdaq Composite finished up 1.9% to close at 2385.14 -- its best day since October.

On the NYSE, 80% of stocks were advancing --- the most since July last year, while 78% of Nasdaq stocks were climbing. Meanwhile, upside volume topped 90% in both venues.

All 30 of the Dow's stocks advanced, led by 2% or greater gains in Alcoa(AA Quote), American Express(AXP Quote), Citigroup(C Quote), Disney(DIS Quote), IBM(IBM Quote), J.P. Morgan Chase(JPM Quote) and Altria(MO Quote).

Among the most active on the Nasdaq, large-cap tech companies Apple(AAPL Quote), Intel(INTC Quote), Cisco(CSCO Quote), and Microsoft(MSFT Quote) added over 1% each.

Shares of eBay(EBAY Quote), Oracle(ORCL Quote) and Brocade Communications(BRCD Quote) each jumped more than 3%.

"This is a solid bounce," says Todd Leone, head of listed trading at Cowen & Co. "But it may just be a dead-cat bounce. Much of this is technical."

Tuesday's rally was fueled by extensive hedge fund buying of the indices and the index-based exchange-traded funds. Traders were responding to fear and caution in the market, evidenced by extreme readings of defensive bets on puts relative to optimistic call-buying.

At one point intraday Tuesday, the Chicago Board Options Exchange's total put/call ratio (including both the equity and index puts and calls) reached 1.45. A put/call ratio over 1.0 shows investors are making more bets the market will fall rather than rise, which is unusual given the market's long-term upward trend. The level of fear such a high put/call number suggests is often viewed as a contrarian indicator.

Technically, the market needed a breather from intense selling pressure. But the fundamentals, or the economic data, on Tuesday didn't exactly support the rebound.

Fundamental Matters

Productivity in the fourth quarter was revised down to 1.6% from an initial estimate of 3%. More significantly, unit labor costs jumped sharply to 6.6% in the quarter and 3.4% on a year-over-ear basis.

The 6.6% pace is the fastest in six years. While some economists explain away the increase as year-end bonus season, the tight labor market and upward-creeping wage inflation have been key concerns for the Federal Reserve. Higher unit labor costs will help keep the Fed attached to its tightening bias.

The 10-year Treasury note sold off a modest 7/32 to yield 4.53% in reaction, but bond investors were more fixated on the growth story, which took a blow from a weak factory orders report. Factory orders declined 5.6% in January, after a 2.6% increase in December. Analysts had expected orders to fall 4%.

"When bond traders see evidence [of] economic moderation happening, they want to turn that into a recession bet," says T.J. Marta, senior fixed-income strategist at RBC Capital Markets. Marta notes that this has been traders' mindset throughout this rally -- to embrace negative news about economic growth and price in future rate cuts.

But Tony Crescenzi, chief fixed-income analyst at Miller Tabak and RealMoney.com contributor, says the weakness is "old news" because durable goods orders are 55% of factory orders, and the market already knew that was exceptionally weak.

Elsewhere, pending home sales dropped 4.1% in January, more than the 1.2% decline analysts had expected.

But it seems investors still are paying more attention to words and psychology these days vs. fundamental data. Soothing words from U.S. Treasury Secretary Hank Paulson in Tokyo helped spark a rebound in the mortgage-lending sector. "Credit issues are there, but they are contained," Paulson told reporters, according to newswire reports. He said the U.S. financial industry will not experience "a big impact" from the subprime mortgage meltdown.

New Century Financial(NEW Quote) regained 10.1% after a disastrous 70% decline Monday. Accredited Home Lenders Holding(LEND Quote) gained 9.5% and Countrywide Financial(CFC Quote) added 4.7% on the day.

Private lenders were further aided when Fed Chairman Ben Bernanke urged Congress to bolster regulation of government-sponsored mortgage giants Fannie Mae (FNM Quote) and Freddie Mac (FRE Quote), which nonetheless rallied 3.2% and 1.2%, respectively.

Wednesday's beige book will help square off for traders whether the economy is slipping further than Bernanke says. If the report reveals strength, the market could keep rallying. If it reflects the weakness investors fear, the sound of a cat falling back to earth will be easy to discern.