Was the market rally a stress test gamble?

When President Obama mentioned in an Oval Office interview on March 3 that he thought stocks were a good long-term buy, I was hoping his timing was good but respectfully doubted that many individual investors would follow his tip. Between then and May 6th, the Dow rose 26.6 percent from 6,726 to 8,512. I have been thinking that this rally may have been a short-term hedge fund trade on the stress test results. If my guess is right, the market will move sideways from here -- unless it can find a new game to bet on.

The stress test results released last night revealed that of the 19 financial institutions under examination, 10 need to raise $75 billion by November. Of the banks needing new capital, I was most surprised by Bank of America (BAC) and Wells Fargo (WFC), which need $34 billion and $13.7 billion in new capital respectively. The reason for my surprise was that BoA's CEO Ken Lewis kept insisting his bank did not need capital as did Wells Fargo's big owner, Warren Buffett.

It is not too hard to imagine how traders could bet on the stress test results. They could have hired some experts in banking financial statements to conduct their own stress tests and compare the results to what they thought the government would find. Then they could bet on the gap between what investors expected and what they thought would really happen.

If you look at what happened to four of the stocks, it suggests that much of the rally was due to betting correctly on positive results from the stress test winners and incorrectly on negative ones from the losers. For example, between March 3 and May 6, stock in two winners rose an average of 73 percent -- Goldman Sachs Group (GS) up 69 percent from $82.37 to $139.22 and JPMorgan Chase (JPM) up 77 percent from $21 to $37.22.

But the more interesting result is what happened to the biggest stress test losers. If you had placed a bet on two of them, you would have made out much better -- up 216 percent. For example, between March 3 and May 6, shares of Fifth Third (FITB) -- 9.87 percent of which are short (3 to 5 percent is normal) -- skyrocketed 216 percent from $1.67 to $5.27 and Citigroup (C) stock -- with 22.96 percent short interest -- also rose 216 percent from $1.22 to $3.86. Maybe the losers did better than the winners because short sellers were desperate to cover their overly pessimistic bets against their survival, forcing them to buy the shares to repay their stock loans.

My theory is that the market is currently populated largely by big hedge funds who are placing bets on short-term events such as the stress test results. My hunch is that individual investors -- many of whom might look to invest for the long-term benefit of their 401ks -- are staying away from stocks despite the recent rally. (Many individuals were burned by the dot-com bust, the housing collapse, job losses, spiking credit card interest rates, and the decimation of their 200.5ks.)

But unless the government comes up with a big new gamble to play, I don't know what would drive a further market rally. One thing that could happen is that mutual fund managers are feeling forced to throw money into a market that's rising because they don't want to be embarrassed by missing the upward move in the market.

But avoiding fund manager embarrassment at the end of the quarter is a pretty thin basis for a rally. And if the economy and earnings start getting worse at a faster rate, those stocks could all come tumbling down.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi and Wells Fargo shares and has no financial interest in the other securities mentioned.

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