MarketView for October 28

Summary 

Wall Street chalked up its second-best day ever on Tuesday, partly on the hope that the Fed will cut interest rates at the conclusion of its meeting on Wednesday. The Fed is expected to cut its benchmark fed funds rate by at least 50 basis points. Add in the bottom feeders that were taking advantage of the fact that stock prices have been driven down to their lowest prices in more than five years and you had a pretty good day on Wall Street. Now the question of course is whether the markets can build on the .momentum or if it is a dead cat bounce.

A key catalyst in Tuesday’s trading was a large drop in the Japanese yen after a news report that the Bank of Japan may cut interest rates later this week. A sudden strengthening of the yen during the past week had been destabilizing stock markets around the world, and Tuesday's reversal of that trend was greeted with relief by the Street.

The yen's recent rally forced an unwinding of the so-called "carry trade," a phenomenon of Japan's low interest rates, in which investors borrowed yen to finance investments in higher-yielding assets, such as U.S. stocks. On Tuesday, the dollar achieved its biggest gain against the yen since 1974

Shares of capital-hungry companies such as the telecoms posted the day's sharpest gains, including Verizon Communications, and AT&T. Verizon ended at $31.65, up 14.6 percent, and AT&T finished at $27.61, up 13.2 percent. The major oil stocks gave the Dow its largest boost after British major BP Plc reported a record quarterly profit, beating expectations Exxon climbed 13.3 percent to $74.86, while Chevron soared 13.5 percent to $70.02. The big energy producers' shares gained even as front-month oil futures slipped 49 cents to settle at $62.73 a barrel.

Shares of Boeing jumped 15.5 percent to $48.91 after the aircraft manufacturer reached a tentative agreement with its largest union to end a strike and stop revenue losses estimated at $100 million a day.

These advances by the Dow Jones industrial average were surpassed only by the rally on October 13, when the Dow jumped 936.42 points and the S&P 500 climbed 104.13 points after governments pledged to pour cash into struggling banks and a Japanese banking group completed its investment in Morgan Stanley.

Wal-Mart saw its  share price rise after the world's largest retailer stuck to its 2009 sales growth forecast, saying it will weather the economic turmoil now and could come out even stronger than its rivals when the economy rebounds. Wal-Mart rose 11.1 percent to $55.17.

The rally came despite an economic picture that remained gloomy after data showed U.S. consumer confidence tumbled to a record low in October as the financial crisis made Americans anxious about their jobs and pessimistic about the future.

Whirlpool Corp fell 8.3 percent to $45.87 after the world's biggest appliance maker said it would cut 7 percent of its workforce and slashed its 2008 earnings outlook amid weakening demand.

Crude Prices Continue South Along With Consumer Confidence

The price of crude oil fell below $63 a barrel on Tuesday as concerns over faltering demand offset OPEC comments suggesting the producer group could throttle back output again to support prices. Domestic sweet crude settled down 49 cents per barrel at $62.73, before rising to $64.10 in post-settlement trade. London Brent crude settled down $1.12 per barrel at $60.29.

Oil demand in the United States and other large consumer nations has fallen for the year due to the slumping economy, dragging crude off record highs above $147 a barrel in July. Gasoline demand fell by 6.4 percent last week versus year-ago levels.

Crude prices found support early on evidence that OPEC would act on last week's decision to cut production as the United Arab Emirates state oil company reduced volumes to term customers. OPEC ministers will take further steps to prop up the oil market, and could call another meeting before their next scheduled talks in December, officials of the producer group said on Tuesday.

The global economic decline already has cut fuel consumption. Some on the Street are saying that $50 per barrel, roughly seen as the cash cost of production for many newer oil projects, is possible in the short term.

OPEC's announcement last week it would cut output by 1.5 million barrels per day initially did little to stem oil's fall as the market was skeptical the group would really reduce supplies. Government inventory data due out on Wednesday is expected to show a rise of 1.4 million barrels in crude stocks. Distillate stocks were seen up 800,000 barrels, with a rise of 1.2 million barrels in gasoline stocks.

The credit crisis that began with failing subprime mortgages has widened into a worldwide rout, with investors dumping stocks and commodities, shunning higher-risk emerging markets and seeking out the safest government bonds and currencies.

Meanwhile, consumer confidence fell to a record low in October as the economy appeared to be sliding into a deep recession, while threatening to pull the rest of the world along with it.

The Conference Board's consumer confidence index dropped to 38 in October from an upwardly revised 61.4 in September. It was the lowest reading since the research group's index began in 1967. The previous low was 43.2 in December 1974.

The Street Is Betting On a Half-Point Drop

As the Fed began a two-day meeting, Wall Street is betting that the end result will be a cut in the fed funds rate, the rate at which banks theoretically lend to each other, of a full half a percentage point in a continuing effort to bring the economy back on track..The Fed is expected to announce its decision around 2:15 p.m. EDT on Wednesday.

The financial futures markets were looking at a 44 percent likelihood the Fed would lower borrowing costs by a dramatic three quarters of a point, which would take them to territory not visited since July 1958.

Finally, there a few on the Street who are voicing the opinion that the Fed may be on the way to cutting rates all the way to zero, as Japan was forced to do to counter deflation in the 1990s. A more-forceful three-quarter point cut would be insurance against a deflation risk. However, a lack of a clear deflationary threat at this stage may lead the Fed to opt for the more-incremental half-point move.

Deflation is a general ongoing decline in prices and was at the root of Japan's 'lost decade' of stagnation in the 1990s. In a deflationary environment, consumers pare spending in anticipation of lower prices and the real cost of debts soar, leading to a rise in defaults and bank failures.

With rates pegged at zero, Japan had to escape its deflationary trap through "quantitative easing," flooding the financial system with liquidity to get the money supply circulating faster. The Fed has already injected over $1 trillion into markets to thaw them out, at times letting the federal funds rate drop below the current official target of 1.5 percent. The statement the Fed will issue announcing its rate decision may also contain important hints on the future.

"Even if deflation is unlikely, officials will want to counter any increase in real interest rates as inflation tumbles," Morgan Stanley economists told clients on Monday, adding that a half-point rate cut was "virtually certain." Real interest rates rise as inflation falls, tightening monetary conditions faced by borrowers even if policy remains steady.

Volkswagen May Have Central To A Major Short Squeeze

Volkswagen saw its share price almost double after Porsche set plans in place to raise its stake, triggering a squeeze for short-sellers. Shares of Morgan Stanley, Goldman Sachs and France's Societe Generale fell sharply on speculation they were caught in the squeeze. Porsche on Sunday said it had accumulated indirect control of 74.1 percent of Volkswagen, and planned to raise its stake in the world's third-largest automaker to 75 percent in 2009.

The increased stake would leave less than 6 percent of Volkswagen's shares still floating in the market. Porsche said its stake included 42.6 percent of Volkswagen voting stock, and options for a further 31.5 percent. It had previously reported a 35.1 percent stake in voting shares.

Volkswagen shares rose as much as 93.3 percent in Tuesday trading, giving it a market value of 296 billion euros ($376 billion), and surpassing the $343 billion that Exxon Mobil was worth on Monday. The automaker's shares closed up 81.7 percent, rising 425 euros to 945 euros. Dealers said traders who had sold borrowed Volkswagen shares, hoping to buy them back at lower prices, panicked at Porsche's announcement.

Speculation about SocGen's, Morgan Stanley's and Goldman's involvement fanned worries about the industry's ability to weather a credit crisis that has led to the demise of several large financial companies and prompted government interventions worldwide to avert a financial system collapse.

SocGen shares fell 4.67 euros, or 12.3 percent, to 33.34 euros. Morgan Stanley fell as much as 26.1 percent and Goldman as much as 11.5 percent, before optimism that central banks will lower benchmark interest rates drove the major stock indexes to gains of between 9.5 percent and 10.9 percent. Morgan Stanley closed up $1.47, or 10.7 percent, while Goldman rose 69 cents, or 0.7 percent, to $93.57. However, both lagged the Standard & Poor's Financials Index , which rose 12.5 percent.

Goldman declined to comment, but people inside the company said it had no Volkswagen losses. Morgan Stanley spokesman Mark Lake said that company has no exposure to the automaker. SocGen could not immediately be reached, but earlier Tuesday said it was sticking with its third-quarter earnings forecast.

What happened with Volkswagen is being viewed on the Street as a black swan event or something that a risk management model could not have predicted, or something expected to occur particularly rarely -- such as a "once in a century" event -- but which occurs more often.