Concern Takes a Holiday

Stocks rally as disappointing earnings are set aside. Plus, examining the financials.
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High-profile profit warnings in techs, a mostly inverted yield curve and panic-selling in Tokyo were brushed aside Thursday as major averages rebounded from two days of selling. The move likely began Wednesday afternoon when Wall Street began to recover from its lows, and the rebound continued overnight in Asian and European stock markets.

This show of bullishness was attributed to strong results from

AMD

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and

Pfizer

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, which helped in digesting disappointing results and/or guidance the past two days from

Intel

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,

Apple

(AAPL) - Get Report

,

Yahoo!

(YHOO)

and

eBay

(EBAY) - Get Report

.

The

Nasdaq Composite

rebounded the most, adding 22.17 points, or 0.97%, to 2301.81. The tech-heavy index had lost 1.6% over the preceding two sessions. The

S&P 500

gained 0.6% to 1285.04 and the

Dow Jones Industrial Average

rose 25.85 points, or 0.24%, to 10,880.71.

So what might be driving this bullish action?

Chris Johnson, market strategist at Schaeffer's Investment Research, notes that the way stocks rebounded Wednesday afternoon and Thursday -- strong volume and calm buying of the dips -- suggests the heavy presence of built-in-bids, typically the trademark of big institutions and of hedge funds. "This is still a trader's market, not an investor's market," Johnson says.

Still, the strong gains seen in stocks in the first two weeks of January have whet speculative appetites. Even if retail investors had not fully participated in the first two weeks of the rally, TrimTabs Research notes that domestic mutual funds had positive inflows of $1.1 billion in the week ended Jan. 18, compared with negative flows of $300 million the prior week.

But the momentum is still being driven by large institutions, and also by hedge funds, according to Michael Metz, market strategist at Oppenheimer.

"If you're a hedge fund, you've had a pretty good few weeks and you hope to continue that for at least another few weeks, especially as you may have to sit conservatively on the sidelines for the rest of the year," he says.

Long known as a so-called permabear, Metz turned bullish for stocks last year (so much for perma labels) upon assessing that the "world is awash in liquidity." This concept may indeed help explain the latest bullish run of the stock market in spite of 13 rate hikes by the

Federal Reserve

and a slowing economy.

Awash in Liquidity

Long-term rates in the bond market have barely budged since the Fed went into tightening mode almost two years ago, suggesting that the Fed has indeed lost control of a what is now a globalized financial system.

"It all goes back to bank deregulation 20 years ago and the growth of money-market funds, which represent trillions that are not controlled by the Fed," Metz says. "Corporations are now net lenders, not borrowers; there's lots of financing done by brokerage firms and hedge funds, this is a completely free market at work."

Few things contradict the idea that monetary conditions are tighter now than before the Fed began raising rates as much as the impressive rally seen in financials over the past few months.

In textbook theory, as the Fed lifts the cost of money, lending and risk-taking become more scarce and financials tend to underperform. As a matter of fact, financials did underperform the broad market for most of 2005.

But since the stock market rebounded from lows hit in October, the financial sector of the S&P 500, which includes both banks and broker/dealers, gained 7.5% for the fourth quarter and has gained 1.2% in January through Wednesday's close. Breaking down the sector: The Philadelphia Banking Index rallied 14% from its Oct. 12 low of 93.27 to its Jan. 9 high of 106.21, while the Amex Broker/Dealer Index has rallied 25% from its Oct. 13 low of 167.21 through Thursday's close.

It's not just tighter monetary conditions that should work against financials. The yield curve, which plots the yields of short to long-term bond yields, has inverted several times over the past few weeks, meaning short-term yields topped long term ones. That negative spread works against banks, which typically make money by borrowing at normally cheaper short-term rates and lending at higher long-term rates.

Because the Fed has given signals that the end of its tightening campaign may be in sight, financials have gotten a new life on the hope that the yield curve would eventually steepen, helping banks fatten their profits.

But Merrill Lynch strategist Richard Bernstein, who downgraded financials to Merrill's second-most unattractive sector in the S&P 500 this week, says bulls for the sector have gotten too far ahead of themselves.

It might be an extensive period of time before the yield curve steepens, Bernstein believes. In the meantime, he notes that the last two times the yield curve inverted under Chairman Alan Greenspan's leadership -- in 1989 and 2000 -- financials were the second-worst performing sector (consumer discretionary being the worst) until a broad-based profit recession ensued.

Wall Street, it should be noted, is starting to be more discriminating when it comes to the broad financial sector. The Philadelphia Banking Index reached a high of 106.21 on Jan. 9, and has since dropped 2.7%, including a 0.9% drop on Thursday.

JPMorgan

(JPM) - Get Report

, which is in the banking index even though it has extensive trading activities, has lost 1.6% since reporting weak trading results Wednesday.

Citigroup

(C) - Get Report

, which is expected to post results on Friday, is likely the next big test for the sector.

Broker dealers, meanwhile, are still riding high. The Amex Broker/Dealer Index closed at an all-time high of 208.75 on Thursday. It was helped along the way by blowout earnings from

Merrill Lynch

(MER)

on Thursday.

Their secret? They can basically enjoy riding the high seas of global liquidity, whether that's through turning into hedge funds through proprietary trading, advising investment banking clients for mergers and acquisitions, or simply by collecting trading fees.

As a matter of fact, Johnson's Schaeffer is placing a contrarian bet on the likes of

Goldman Sachs

(GS) - Get Report

and

Bear Stearns

(BS)

, which he believes may have been unfairly associated with financials' vulnerability to higher rates and the yield curve.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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