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"Bad Bank" Does Not Trump "Bad" Market

A "bad bank" does have some positive elements and in the long run could help both the economy and the financial markets. This morning's futures tell me people are focusing on the positives many of which are significant and real. However, when managing risk, especially in a bear market, it pays to play devil's advocate. For investors rushing to buy SPY (S&P 500 ETF), DIA (Dow 30), QQQQ (NASDAQ), or XLF (Financials), it may pay to temper your enthusiasm a little.

Bear markets are cruel. They continue to give investors reason to hope as they destroy years and years of hard work. The latest reason to hope is speculation the government is going to sweep toxic assets into a government owned (taxpayer owned) "bad bank". As a result, today will be a "feel good" day for investors. However, as of Tuesday's close the S&P 500 has already lost 6.4% this year. With this morning's "feel good" futures hitting 857, it takes the YTD loss down to 5.0%. In terms of the big picture, a close today at 857 on the S&P 500 would "reduce" the loss on the S&P 500 for the entire bear market to a "more manageable" 45.6%.

We have seen many of these bailout inspired "feel good" days during the bear market. The market cheered the bailout out of Bear Sterns, only to retrace all the gains while moving to lower lows. When Fannie and Freddie were bailed out by you and me (taxpayers), the market "felt good" only to move on to lower lows and more losses. When AIG was bailout out by...you guessed it...you and me, it was seen as a positive. Stocks went on to make new lows. TARP was hailed by the markets as the answer to all our problems...stocks moved higher in anticipation...then made new lows. When the formerly "big" three were given government loans, the market breathed a sigh of relief ...then...you guessed it...moved lower.

Here we go again. The "bad bank" is this morning's feel good story. The futures are higher on "speculation" the government will set up a bad bank. The problem is a familiar one for money managers....we do not know what the rules are and how the "bad bank" will be set up. Will it be good for shareholders in banks? Will it be bad for shareholders in banks? We are not sure because we have no details on the latest bailout, only speculation and a few sound bites. The basic goal of the bad bank according to this morning's news reports is to "get lending going again". In an overleveraged world, is more credit really the answer? I thought too much credit was the problem.

If you were unfortunate enough to get bad advice and "stay the course" as a buy and hold investor during this "crisis", then it is understandable that you are looking for any reason to hope. Unfortunately, successful investing has nothing to do with hope. Successful investing requires positive fundamentals and positive technicals. I hate to throw cold water on today's latest hope parade, but as I have my morning coffee, the technicals remain negative with long-term downtrends present in almost all asset markets. Obviously, the fundamentals are not good and will get worse before they get better. Therefore, as we enter this morning's trade, we have the least favorable conditions for investors consisting of a negative alignment of the technical trends and fundamental trends. Speculation and sound bites about the "bad bank" do not trump bad technicals and bad fundamentals. We can "hope" the bad bank will reverse these trends, and it may, but there will be plenty of time to get reinvested when observable conditions improve.

The purpose here is not to evaluate the merits of a "bad bank", but let's quickly look at the major challenges facing investors. Does the "bad bank" help with too many homes on the market? Indirectly it will help, but it is going to take time. Does the "bad bank" change the demographics of the baby boomers and their resulting need to save? No. Does the "bad bank" eliminate the overleveraged balance sheets of many non-financial businesses and consumers? No. Does the "bad bank" help with concerns about the expansion of the money supply and threat of future inflation? No, it makes this problem worse. The basic concept of living in a world with less leverage? Leverage will still be frowned upon. Will it bring back the cash cows of financial firms? Not significantly. Will it stem the slide in housing prices? Not in the short run. Will it restore the credibility of Wall Street? No, it will make people even more upset with the endless bailouts. Will it reduce the supply of strip mall space? No. Will it move us closer to a free market where supply and demand efficiently allocates resources? No.

Can a "bad bank" do any good? Yes. If done properly, it can help clean up the balance sheets of banks. If the toxic assets are taken on by the taxpayer and moved off the balance sheet of banks, private capital will be more willing to come off the sidelines. The "bad bank" idea does have some merit. In fact, many of us thought this is where we were going to end up - it was only a matter of time. Why it took so long is a topic for another day. Stocks will rally today and maybe for some time, but we need to see some serious improvements in market internals before becoming interested as prudent investors. This morning people are buying the rumor of a "bad bank". Be careful because in the coming days and weeks, they may be selling the news. It pays to err on the side of patience in a bear market.


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