The S&P 500 is up 30.5% since March 9, 2009. Stocks reflect the future health of the economy, in general, and more specifically, the discounted future cash flows a company will add to their coffers. More simply, companies with rising stock prices are supposed to make more money and eventually distribute that cash to investors in the form of dividends, along with re-investment in the company to increase the future value of the stock even more. So we must be out of the woods, right?! Quick, everyone invest in stocks! Not so fast: (1)

There are such things as bear market rallies. That is, in a down market, a brief resurgence happens, but it isn’t a full-fledged recovery. This may be what we’re experiencing. The government put 19 major banks through “stress tests” to determine their capital needs under a “worst-case” economic scenario.

The goal was to find out what would happen to these banks’ balance sheets, and how much capital they would need to survive, in an ultra-bad situation, some of which are listed here:

What if unemployment rises to 10.3 percent?
What if home prices plunge 22 percent?
What if overall economic growth drops to negative 3.3 percent?
And the assumption that losses from credit card debt holdings will not exceed 20%.

If any of this were to happen, banks would lose more value/capital from increased defaults on mortgages, auto loans and credit cards.

Are we really that far away from this doomsday scenario for banks? Consider that national unemployment is currently 8.9% and economic growth declined by 6.1% in terms of real GDP last quarter. On the plus side, median national home prices, the point at which half of all homes are sold for more and half are sold for less, has risen each of the last three months since February. Not to harsh your mellow, but, real estate analysts would warn that the cost of owning a median home, compared to the median income in the U.S. (for those that still have a job), are still way out of whack. In addition, a lot of empty properties continue to sit which will force home values down. (2) (3) (4)

It’s not entirely convincing to me that the stress tests offer a true “worst-case” scenario for the economy. Even if it does, 10 of 19 major banks are still in need of more capital to stem the tide:

Bank Stress Test Results

Traders drive the stock market. Some traders are equipped with more information than others about the underlying health of the companies they buy, but irrational exuberance affects all investors. How can the value of credit card companies possibly be increasing? The stock prices of Visa, American Express and Discover have been increasing in virtual lock step with the S&P 500 despite the fact they own a bunch of exploding debt. That is, debt from consumers who surely won’t be able to pay off their credit card bills. Remember, the stock market is supposed to reflect the future health of the economy, in general, and more specifically, the discounted future cash flows a company will add to their coffers. With the S&P as our compass, the future looks merry and bright for credit card companies. I can assure you it’s not. One wild card for American Express is that they were able to change their classification to “bank holding company” earlier this year, allowing them more access to Federal bailout dollars.

So why has the stock market increased 30.5% in about 9 weeks? Part of it is driven by day-traders who look to make quick returns and aren’t as concerned about the long-run direction of the economy or the individual firm they’re trading. But the other part is the huge amounts of cash the Federal Reserve and Treasury have been pumping into the economy. This money finds its way to the stock market and fuels a resurgence, but not because the fundamentals of the economy are markedly better.

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(1) Yahoo! Finance S&P 500 Stock Chart

http://finance.yahoo.com/q?s=^GSPC

(2) Bureau of Economic Analysis Data

http://www.bea.gov/

(3) Bureau of Labor Statistics

http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000

(4) Real Estate Home Appreciation – Last 12 Months

http://www.realestateabc.com/outlook/overall.htm

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