The long and the short of market mayhem

How can financial shares rise when profits are plunging? And why the exit from energy? Simon Evans takes stock
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The Independent Online

Bull markets create their fair share of geniuses but the bear is an altogether different beast. Correctly predicting that financial stocks were set for meltdown enabled Crispin Odey, a veteran City hedge fund manager, to pay himself a near- £28m bonus earlier this year.

Being short on the sector – selling borrowed shares in anticipation of a fall in price and then buying them back – swelled Odey's fortune to more than £300m.

But financials haven't been the only game in town. Placing bets on energy firms has been the other way to boost your bonus in 2008.

The oil price surged to more than $140 a barrel earlier in the year – in 2005 the same barrel could have been bought for $45 – while commodity plays in gold, copper and coal were winners too. But last month the market's love affair with energy and related stocks came to an abrupt end, with financials now the place to be.

Merrill Lynch's monthly survey of fund managers, released last week, showed that those backing oil and gas had fallen from a net 52 per cent to just 11 per cent in one month. Over the same period the value of stocks in the banking arena, for example, has surged.

HSBC, Europe's biggest bank, which earlier this month reported that its profits over the first half of the year had slumped by nearly 30 per cent, has seen its share price increase recently from less than 720p to more than 850p. Shares in Royal Bank of Scotland, forced to tap its investors for £12bn to shore up its ailing balance sheet earlier in the year, have risen by 40 per cent. Barclays, another bank that has had to plug holes in its finances, has gone up by nearly the same amount recently.

But last week there was another reversal of this trade. On Thursday, banks slipped as some analysts predicted that further writedowns linked to the credit crunch could be needed. Goldman Sachs said Barclays could be forced to look for as much as £1.5bn in fresh capital.

Of course, while banks fell, energy and mining stocks jumped once again. Rio Tinto climbed 3.5 per cent and BHP Billiton nearly 5 per cent.

For the man on the street, making sense of the vacillations of the stock market has never been tougher.

"Traditionally, banks and resource stocks were positively correlated: if one sector went up, so would the other," says Jan Luthman, fund manager at Walker Crips Asset Managers. "A year or so ago, that relationship broke down."

He puts the July shift in sentiment in favour of financial stocks down to trading anomalies rather than any long-term fundamental change: "What you saw was a short squeeze with bears closing out their positions."

In layman's terms, traders betting on the continued decline of financial share prices decided to bring an end to their trade by buying the stock back and returning their borrowed positions. The rush to close out stakes forced share prices up.

So why were traders so spooked? After all, banks reporting during July and August hardly delivered positive news.

"We saw some pretty incredible things in July," says Mr Luthman. "We had all the shenanigans surrounding Bradford & Bingley, the rescue of [housebuilder] Barratt and the HBOS rights issue. That City institutions bailed out the B&B rights issue at a price of 55p, when the shares were trading at 35p, was absolutely bonkers. There are also still plenty of questions about Barratt and the valuation of its land bank, which allowed it to renegotiate its finances."

He adds: "Our interpre-tation of this was that a major bank or housebuilder would not be allowed to fail because of the chain of events a collapse could trigger. Corporate corpses are being kept alive on a drip-feed of capital. In that scenario, short sellers have nowhere to go."

Spooked by the closing out by hedge funds, many traditional fund managers took fright and sought to buy up financials and sell their holdings in energy and resource stocks. A fundamental improvement in the health of the financial sector would seem to have had little to do with the rally.

But some still believe the financials arena could be ready for a sustained re-emergence. One of the sector's most ardent "supporters" has been the former Credit Suisse, now PSigma, fund manager Bill Mott, who moved into financials at the end of last year. So far, however, sticking with financials and ignoring resources and energy means Mott's fund languishes 59th out of 93 in its sector.

If the next direction of financials remains in doubt, what of the other side of the trade that has boosted the coffers of so many fund managers in recent years: energy and resources?

Ralph Brooke-Fox, a fund manager at Resolution Asset Management, thinks fundamental factors do seem to be at work that could break the reverse correlation between the two sectors. "There are signs that supply and demand could be closer together than in recent times," he explains. "People are buying smaller cars that are cheaper to run, for example, while on the supply side responses from the likes of the Saudis seem to be having more effect than some had predicted."

But once again others disagree. "The energy trade will be back," says a blogger on a financial website. "Oil and the US dollar are having a temporary respite but overriding factors for high oil will return. Long-term trends and Asian demand will make the energy play good for the long term. China will use 20 million barrels a day by 2020 – about the same as the US uses today. Now is a good time to get into some en-ergy stocks and funds!"

Mr Luthman agrees: "The long-term drivers for global energy remain. I also think there is a major political dimension to all this. Resource security is a huge issue and it's one that's only going to get more prescient."

In the next few months we'll find out whether his, or other punts in an increasingly difficult market to predict, turn out to be right.

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