The Day After, Whom Do We Thank for the Party?

Indications suggest "not for long" is the answer to the question on everybody's mind -- how long will it last? -- in the aftermath of Wednesday's remarkable rally.

News reports about anthrax-tainted mail at a Federal Reserve facility provided a ready excuse for major averages to rescind some of Wednesday's big gains, which many say was likely to occur regardless. Of late, the Dow Jones Industrial Average was down 0.4%, the S&P 500 was off 0.8% and Nasdaq Composite was lower by 1.6%.

Some of yesterday's big gainers were spearheading today's early decline, including tech giants Cisco (CSCO Quote), Microsoft (MSFT Quote) and Brocade (BRCD Quote).

Those who were hoping Wednesday marked the beginning of tech's long-awaited revival and find themselves disappointed by today's early losses should consider the following points:

Wednesday was the Comp's eighth-biggest percentage gain in history. But all but one of the Comp's top-10 percentage gains have occurred since the market topped in March 2000, suggesting big one-day gains aren't necessarily bullish.

Prior to Wednesday, the Comp had risen more than 5% in one day 10 times since its peak in March 2000.

Even the most staunch tech bulls don't believe the recovery is going to be uninterrupted. ("If tech is beginning to turn, it's not possible it goes straight up in a straight line," said Frank Husic of Husic Capital Management, who is bullish on tech, as reported Wednesday.)

Conversely, some of Wednesday's big losers were up at midday, including gold miners and homebuilders. Similarly, the bond market was recovering from its slide, losses that Jim Bianco of Bianco Research forecast would occur here Tuesday evening. (He didn't predict it would happen yesterday, but said the bond market would have a "seizure" if the stock market posted a substantial rally.)

The action will no doubt reinforce the views of those who "think yesterday's gains were nothing more than a relief oversold rally," as Kent Engelke, capital market strategist at Anderson & Strudwick, suggested. "Many were becoming downright despondent, as it appeared that the only direction was down. In this environment, any type of good news would be greeted with glee."

Traders' reluctance to believe in the rally's staying power was evinced by the spike in the one-day Arms Index, which was trading well over 1.00 today (lately at 1.33) after declining to 0.38 yesterday. The Arms Index measures the ratio of advancing issues to declining issues by the ratio of advancing volume to declining volume.

This ratio of a ratio is a measure of sentiment, which is a contrarian indicator, i.e., higher Arms readings are signs of fear and thus considered bullish and vice versa for low readings.

So if early weakness reinforces the skepticism, that would be the best thing for the bulls.

Recommended Reading

In the May issue of his "Fed Focus" reports, Paul McCulley, managing director at Pimco, has some delicious commentary on Federal Reserve Chairman Alan Greenspan, including the following: "At the end of the day, [Greenspan] sees his job as making sure that there is sufficient action somewhere to keep the lights burning in the betting parlor ... and he's willing to socialize -- bailout! -- the downside of all that action, when necessary, with what we call 'round here the Greenspan Put: a willingness to slash short rates, transferring income from the risk-averse to the risk-seeking, when the risk-seeking run out of will or wallet, or both."

McCulley's commentary, which can be found on the Pimco Web site, reminded me of a comment made late Wednesday by a source, who shall remain nameless.

"This kind of a rally was extraordinary ... so extraordinary that I have to consider buying power outside of the bounds of the usual technical, short-covering bear market rally variety," he said. "And I can't help coming to the conclusion that covert Fed intervention may have been present today."

As I said late Wednesday in RealMoney's Columnist Conversation, that's a delicious conspiracy theory because, like all great conspiracy theories, it can't be proved or disproved. But as the minutes of the FOMC's Jan. 29-30 meeting revealed, the Fed has discussed "unconventional" steps it could take in a zero or very low interest rate environment. Theoretically, these steps could entail open market purchases of equity futures in an effort to give the market a lift and compel short-sellers to cover.

Maybe they decide to "test" them Wednesday?

"Whoever or whatever was buying yesterday targeted the shorts in the equity and futures markets, which reminded me of my days as a prop foreign exchange trader ... when the Federal Reserve or the Bank of Japan, or the Bundesbank entered the [foreign exchange] market to support or 'redirect' their currency by relentlessly driving the shorts out of their accumulated large positions," recalled Michael Paulenoff, founder of 2MStrategies.com. "My gut tells me that yesterday's relentless action hinted at that kind of buying power -- and lord knows, the up move came at a very vulnerable time for U.S. stocks, the U.S. dollar and the U.S. economy."

Paulenoff denied having any knowledge of such activities, but noted there was nary a "hiccup to the downside" Wednesday even though many traders claimed to be selling into the rally. Fed officials don't speak to the press during weeks of FOMC meetings, so they're not talking -- not that they would ever admit to such activities if it were true.

But if there is "any grain of truth" to theory, and "the 'powers that be' are intent on keeping the upside pressure intact," Paulenoff expects "to see tail winds from yesterday's advance propel stocks higher for a while, until more of the huge short position is knocked out."