Equities Act as if They've Found the Floor

Building on yesterday's midday revival, stock proxies opened solidly higher today only to retreat through the late morning. With some observers suggesting the rally had run its course, the equity market then did something quite unexpected (as it's wont to do): It rallied sharply into the close.

The Dow Jones Industrial Average closed up 1.6% to 9269.22, just a hair off its intraday high. The S&P 500 finished at its intraday best, up 1.8% to 990.64 while the Nasdaq Composite climbed 2.1% to 1459.22.

The rebound in equities came at the expense of gold and U.S. Treasuries. The price of the benchmark 10-year note fell 19/32 to 100 14/32, its yield rising to 4.82%.

The rally was aided by the Commerce Department's report that the economy grew by 6.1% in the first quarter, its fastest pace in two years and up from the previous estimate of 5.6%. Also, Pfizer's (PFE) $10 billion share buyback provided further encouragement and some of yesterday's big losers, including J.P. Morgan Chase (JPM) and Citigroup (C), recovered much of their lost ground. Pfizer rose 5% while J.P. Morgan gained 3.9% and Citigroup rose 5.8%.

Accounting concerns bedeviled firms such as Clear Channel Communications (CCU), down 12.7%, and General Motors (GM), down 3%, amid ongoing concerns about the fallout from WorldCom's (WCOM) scandal.

But the optimists held sway today and while there's great debate over whether the bottom was reached, a consensus is emerging that a tradable bottom was established yesterday morning. All but the most hardcore of bears have said repeatedly that stocks could rally -- even sharply -- at any given moment, and perhaps that time is upon us.

But Diane Garnick, global equity strategist at State Street Global Advisors, which manages $808 billion in total assets, said, "I really don't like where this is heading."

Citing the widening financial crises in Latin America (although Brazil's Bovespa rose 3% today), the downward pressure on the dollar (which continued although the euro was unable to match yesterday's intraday high), and Vladimir Putin's assurances that there're no WorldComs in Russia, Garnick lamented: "I can't help but feel like it's July 1998."

Of course, history never repeats itself exactly and there are myriad differences between now and the summer before Long Term Capital Management's implosion and resultant market plunge. The question is whether those differences are positive or negative for financial assets.

The Russell Shuffle

Among the many developments affecting the market -- and potentially accounting for its strength since midday Wednesday -- is the end of the quarter. Concurrent with that is the reconstitution of the Russell indices, which occurs at the close tomorrow.

Every year, Frank Russell Co. uses closing prices on the last trading day in May to rebalance the Russell 3000, the index of the 3,000 publicly traded companies in the U.S. with the largest market caps. Changes to the Russell 3000, in turn, affect the Russell 2000, Russell 1000 and Frank Russell Co.'s some 20 other indices. More to the point, the annual rebalancing necessitates changes at index funds, which have approximately $215 billion linked to various Russell indices.

With that much money on the table, even a reshuffling of assets within Russell-linked funds can affect the market. Last year on reconstitution day, for example, the Nasdaq had to extend trading an extra hour, the result of its electronic execution systems being overwhelmed by the reconstitution-driven volume.

"The goal of every indexer is to rebalance the entire portfolio while maintaining the smallest possible market impact," said State Street's Garnick. "But it's so big it happens anyway [because] so many people with the same goals and objectives are on one side of the market."

The problem is that although index funds begin anticipating changes to the Russell indices as much as six months in advance, they are hamstrung from acting before the reconstitution. The fear is of incurring tracking error, which occurs when holdings get out of line with the index. Along with fees, tracking error is how indexers differentiate and market themselves (and you know they don't want to lower fees).

Still, it's not as simple as "indexers buying and selling all they need at the close on June 28," according to Brad Pope, head of U.S. equity index product strategy at Barclays Global Investors in San Francisco. That common misperception "underestimates the sophistication and experience [necessary] in being able to manage" the reconstitution, Pope said. "Clearly the Russell reconstitution is very large with a lot of moving parts."

So large are the moving parts and so important is the reconstitution to indexing giants that neither Garnick nor Pope would discuss their strategies heading into tomorrow. Nor would they reveal what they've done to date to prepare for the reconstitution.

Fair to say, however, that both firms and their competitors have been doing some buying of names destined to be added to Russell averages and sold those primed to come out. That activity is contributing to the market's volatility (in the true sense of the word) and helping boost trading volumes, which totaled 1.85 billion in Big Board trading and 1.75 billion in over-the-counter activity today.

In order to make those trades, indexers are demanding a lot of liquidity from the market, which broker/dealers seem more than willing to provide (for a transaction fee, of course), thanks to the Federal Reserve. The Fed added $5 billion in temporary reserves to the banking system today, which isn't an unusual development, but doesn't hurt either.

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