JOHN HEINZL

 Head fake or the real deal?

As stock markets surge this spring, everyone wants to know the same thing: Is the rally signaling an upturn in economic growth and corporate profits, or is it just a bad joke that will end in tears for all concerned?

Nobody knows, of course, but people can guess. And right now, some folks are guessing it’s a head fake, particularly when it comes to the bounce in U.S. markets.

Since March 10, the Dow Jones industrial average has surged nearly 10 per cent. That’s only about half the advance of Canada’s main index from its January lows, but U.S. investors clearly aren’t as glum as they were a few months ago. You might even say they’re downright cheerful.

Which raises the question: Is their optimism warranted?

Probably not, says Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets.

The aggressive easing actions of the U.S. Federal Reserve Board, combined with the rescue of Bear Stearns, “has reversed very dire sentiment that pervaded the investment community in early to mid-March, when markets appeared to be on the brink of a systemic financial risk breakdown,” he wrote.

“Indeed, sentiment seems to have returned to a possibly undeserved calm that leaves equity markets vulnerable to some downside risk.”

Here’s the problem: Rather than being driven by improving fundamentals, the market has been lifted by a “massive” short-covering rally, Mr. Levkovich argues.

Short sellers borrow stock and sell it, hoping the price will tumble so they can buy it back at a discount and return it to the owner, pocketing the difference between the higher and lower prices. But if the price unexpectedly rises, short sellers will often rush to close out their positions and cut their losses. This buying, in turn, sends prices even higher, forcing more shorts to cover.

What makes him so sure short-covering was behind the rally? The short interest ratio – the number of short positions as a percentage of a stock’s float – has tumbled to levels not seen since 1999 and 2000. In other words, an awful lot of shorts have been squeezed, and that’s driven prices up.

That’s not the only reason he’s skeptical of the market’s advance. The calm that has settled over markets is bound to give way to bouts of volatility as analysts chop earnings estimates over the next several months. Typically, when credit conditions tighten, weaker industrial activity follows with a lag of about nine months, which suggests another pullback in stock prices could be looming.

Other U.S. market strategists share his concern.

Given the possibility of further economic and earnings pain, Brian Belski at Merrill Lynch argues that it’s still too early to be bargain hunting for U.S. financials and consumer discretionary stocks.

“While investors seem to be shrugging over near-term earnings weakness … we simply do not believe that the fundamental outlook supports their view,” he said in a note.

As for the Canadian market, whether the rally has legs will depend largely on two things: the direction of energy prices and the fate of financials. On the first score, Toronto-Dominion Bank CEO Ed Clark sounded a note of caution yesterday, saying prudent bankers should assume that “dramatically lower” commodity prices are coming.

Which means financial stocks, and banks in particular, will have to pick up the slack, or the record levels the S&P/TSX scaled this week could prove fleeting indeed.

By Reuters

 Will Main Street Rain on Wall Street Parade?

 Wall Street seems to have concluded that the worst of the credit crisis is over and investors are looking to better economic times ahead, but Main Street is sending the opposite signal.

While banks have raised cash by the billions to shore up balance sheets that were battered by bad bets on mortgages and other loans, the front-line staff in charge of doling out that money to consumers and companies remain downbeat, suggesting that the economy may stay in the doldrums for some time.

The U.S. Federal Reserve’s quarterly survey of senior loan officers, released this week, showed widespread tightening of credit. The percentage of banks reporting tougher lending standards was close to, or above, historical highs for nearly all loan categories in the survey.

Banks clamped down on loans to companies large and small, to prime and subprime mortgage holders, and on credit cards, home equity lines and other consumer credit. Most banks blamed a less favorable economic outlook for the tightening terms rather than their own bruised balance sheets.

That does not bode well for spending, which accounts for the bulk of the U.S. economy, or for corporate profits.

“Main Street has just entered the act. The peak of the pain is not visible yet,” said Asha Bangalore, an economist with Northern Trust in Chicago.

The consumer strains are well-documented. Aside from the credit contraction, gasoline and grocery prices are on the rise, the housing market remains distressed, and consumer confidence is at recessionary levels. Tax rebate checks are in the mail, but that alone cannot compensate for the credit clamp-down and inflation pressure.

“Given that households are strapped financially, it is far-fetched even with the stimulus checks to expect a sharp increase in consumer spending,” Bangalore said. “You have seen auto sales numbers for April, they posted a sharp drop.”

Meanwhile, the Standard & Poor’s 500 index is up nearly 13 percent since mid-March a