Posted on April 14, 2009 - by Jeflin

Bullish Days Ahead But Bear Is Lying In Wait For The Kill

Photo by jenny downing

We are into the fifth week of upswing in the stock market. While stock valuations remain attractive for value investors, the market is overbought and a major correction is overdue.

That is not to say that this bear rally is all fluff. “Green shoots” are sprouting and there are positive long term implications for the general economy. From Ben Bernanke’s purchase of Treasuries and toxic mortgage based securities to the recently concluded G20 summit, where a $1.1 trillion stimulus for the International Monetary Fund (IMF) and other international institutions was announced, a bullish vibe has developed.

US retailers are also wearing a smile with improved sales, in a sign that shoppers may be regaining confidence to open their wallets after more than a year of recession. Of those which reported March sales, more than half topped Wall Street estimates, and a handful even raised their quarterly earnings outlook.

New jobless claims also fell more than expected by three percent last week. Nevertheless, the figure which is still above 650,000 and remains at a 26-year high is not pretty and is not enough to fuel the rally by itself.

What gave the rally extra legs was the announcement by Wells Fargo that it expected a “record” net income of 3 billion dollars for the first quarter. Following earlier reports by Bank of America, Citigroup, JP Morgan and Goldman Sachs that January and February were profitable months, investors were already upbeat on the financial sector’s earning reports.

Still, Wells Fargo took the cake by topping market expectations with a 50% surge in earnings as compared to a year ago. The main contributor was its newly acquired bank, Wachovia while the easing of mark-to-market regulations also played a part in lowering provisions for bad loans. The new rules allow banks to value their assets, instead of marking them at the price they will get in an open market currently.

There is a strong case that mark-to-market accounting undervalues assets and unreasonably hurts the balance sheets of financial institutions, especially when the market is frozen. Billions of dollars in assets have been written down and resulted in the credit crunch and worsening recession.

The banks have been lobbying left, right and center with a seductive argument that lending is curtailed because they cannot meet regulatory capital requirements. But they will have enough capital if they ignore the market and value assets at what they think they’re really worth. Congress swooned at their theory and have been pressuring the FASB to change or be changed.

FASB caved in, and financial institutions are now free to apply the new rules to their financial statements for the quarter that ended on March 31st. Knowing that Mr Market can be susceptible to mood swings and manipulations, having the “discerning” bankers exercise judgment in valuing their assets can reduce the irrationality. However, I am concerned that a practical idea can be taken to extreme in the hands of greedy and irresponsible people.

The banks could hide reality from investors under the pretext of distressed market and take matters into their own hands. Investors are no closer to knowing how much an asset is really worth. The banks can justify themselves with complex models by employing the best mathematicians and using the most advanced super-computers but we know how ineffective modelling can be when assumptions are flawed and the unexpected happen.

Will the banks assessing their own assets make them less toxic? Are the new valuation of assets based on what the banks could get selling it today or at a later time when the market comes up? Now, long run can be a misleading guide to current affairs by glossing over short term problems. Everything will even out in the long term, as any statistician will attest and the best thing is it doesn’t matter because “in the long run, we are all dead.” Read more…

Related posts:

1. The Year Ahead in 2010
2. Wait for market correction
3. Vix index is on the rise and has exceeded 30 in recent weeks on growing uncertainty…..expect more volatility ahead?!