Short-covering rally no rescue for markets

The gyrations of the Australian market yesterday and New York overnight are good illustrations of the role of shorters and liquidity in a bear market. They are also a possible warning for what might come for miners and the Australian dollar.

New York stock was boosted because the Federal Reserve injected funds to help the battered banking system and then, as the finance sector shares began to rise, we saw massive covering of short positions. This makes it look as though there has been a huge rush of buying and the market jumps even further.

In Australia, the sharemarket fears that the tighter banking conditions will spill over into asset price falls and serious banking bad debts, which might affect dividend rates.

As a result, banks have been heavily shorted.

That scenario remains a real medium term possibility, but when the Commonwealth Bank announced it had secured most of its overseas funding and the ANZ and the Commonwealth recovered a big chunk (but not all) of their overseas borrowing costs by raising mortgage rates by 0.35%, there was a rise in confidence.

As bank shares started to rise we saw the shorters covering which, like New York, multiplied the advance.

I sympathise with those who are suffering under interest rate strain. But partly because banks are caving in to pressure from Wayne Swan and Kevin Rudd and not recouping their costs, we are facing a credit squeeze that will hit the price of houses and be much worse for home owners than a small rise in interest rates.

At the same time, there is no doubt that one the big forces driving down bank shares has been Australia’s dumb superannuation and index fund managers lending their clients’ scrip to shorters.

Those advocating shorting say that it helps create rallies in the market – like we are seeing in New York and in Australian banks. A danger is that the shorters and their silent partners, the Australian superannuation and index fund managers, may be just stupid enough to try and create a run on a bank unless the ASX gets serious over scrip lending.

But for the moment that’s not on the agenda and in Australia a new game emerged yesterday – shorting miners.

As the US recession becomes a reality, the traders noticed that commodity shares were one of the few parts of the market that had not taken a beating. So they began playing the bank game with commodity shares and were helped by reports coming out of China that demand for copper would be reduced because those making appliances and other manufactured goods could not recover the high prices in the marketplace – particularly in the US.

Today’s rise in New York may postpone that game for a while, and hedge funds were taking a different view in oil and buying heavily.

However, in the longer term I believe that the extent of the fall in global sharemarkets is likely to be the forerunner of a global downturn of some magnitude later in 2008.

If I am right, despite demand for Chinese infrastructure like power stations remaining strong, it will be difficult for total Chinese demand to be able to hold peak commodity prices.

That means our dollar will come under pressure.

This first appeared in Business Spectator.