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The Unsustainable Rally

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Debt-fueled growth, banks' short-sightedness don't make for a new bull market.

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A spate of recent research reports pose these urgent questions: Has the government stimulus has been enough to heal the markets? Are we past the crisis? Was that the bottom? What about the green shoots?

Most of these studies focus on the credit market, which I find to be a much more rational -- if not much larger -- market than equities. It's perplexing to me, however, that people are fixated on so many credit-market indicators. Has the credit market thawed? Are spreads tightening? Are banks going to be healthy again?

First of all, the only places we've seen tightening is where the government has intervened to prop up pricing. The alphabet soup bowl is overflowing with acronyms - TALF, TARP, PPIP, etc. So yes, the indicators are starting to register fewer warning signals then before. Hooray for intervention. Hooray for the late-night and weekend strong-arm sessions - the ones that made sure that my ATM card would work when I went to buy soup for my family.

But why the focus on those 19 banks? There are so many US banking institutions which, taken together, are systemically important - but they're organizationally separate. I still believe this group of banks is facing a massive problem with loan quality, and with the oncoming commercial real estate exposure that they were so involved with.

Regardless of the oncoming problems of the smaller bank universe, the large banks have provided Washington with a stage on which to demonstrate their commitment to solving this crisis. However, unless you just woke up from a very long nap, you have to realize all the shenanigans surrounding the "stress tests." Saturday Night Live had a brilliantly funny take on this recently: SNL suggested that the banks had moved from a Pass/Fail system to a Pass/Pass system.

The solutions that came out of the stress tests revolved around raising more capital - particularly for high-profile players like Wells Fargo (WFC), Citigroup (C), and Bank of America (BAC). This, however, has taken the form of selling business units and spinning out profitable groups into joint ventures, each of which provides no new cash for the banks - but the accounting regulations allow them to book these transactions as capital-additive.

After selling or spinning out the profitable groups, the banks then issue more shares, thereby diluting existing equity holders (see State Street (STT), US Bancorp (USB), Capital One (COF), and BB&T (BBT)). So now they'll make less money going forward, but have to answer to more shareholders. And somehow, there's a rally in stocks!

It's a miracle on Wall Street that (almost) nobody plunged to their death.
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No positions in stocks mentioned.
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