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In the midst of a downturn, why does the stock market typically recover before the economy does? Shouldn't we have to wait for employment to improve or for GDP to turn positive? That kind of clarity would make it easy on us but unfortunately that's not the way it works. The market recovers before the economy because confidence is the real driver of the market and confidence can be restored before the data improves. Confidence trumps economic data, it trumps technical analysis, and it trumps corporate earnings. Without confidence, a sense of despair sets in that turns the market into a sea of negativity that swallows up any sign of good news.

HOW CONFIDENCE WAS LOST

Hank Paulson, George Bush, and Christopher Cox made the terrible mistake of sacrificing confidence in order to get the $700 billion TARP passed. The SEC refused to alter mark-to-market accounting thereby linking the collective balance sheet of the entire financial system to real estate. They looked the other way on naked short selling. There was no uptick rule. I was flabbergasted when I heard Paulson say that this is the type of crisis that only comes along once or twice in a hundred years. No sir, this was a typical correction that turned into a crisis because of mismanagement.

Throughout this chaotic process I have been one of the few people who has stood up for Paulson's policy decisions, but I've recently come to a realization that his dismantling of confidence far outweighs any fundamental positives of TARP. Just look at the trillions of dollars lost in stock market wealth since the bailout was passed. If there's one thing you never mess around with, it's the confidence of an economy and that's exactly what was done.

Rewind the tape back to the end of September and you'll hear President Bush perfectly summarize the propaganda of fear the was on display when he said, "failing to act fast risks wiping out retirement savings, rising foreclosures, lost jobs, closed businesses and even a long and painful recession". His dire warnings caused the mark-to-market balance sheet debacle of Wall Street to spread into a panic on Main Street. This was a severe mistake. Instead of fixing Wall Street's problems on Wall Street they got the entire nation involved. The tactic of using fear to drive policy brings unintended consequences.

The threat of future despair has an interesting way of becoming a self fulfilled prophecy. I'll never forget hearing CNBC's Maria Bartiromo say in an April interview with Tim Russert, "We could be talking ourselves into a recession..because all of the headlines and all of the negativity out there".

LOOKING FOR A RESTORATION OF CONFIDENCE

How often does confidence get crushed? Not very. It creates a once-in-a-generation opportunity for those who can identify its return. Let's identify some potential catalysts for a restoration of confidence:

  1. With each passing day we get closer to the inauguration of a President who ironically built his entire image on hope. The timing of this change in power is just what the market needed. New blood can't arrive soon enough.
  2. We look forward to a December automotive proposal that might revive the walking dead of GM (NYSE:GM), Ford (NYSE:F), and Chrysler. This proposal should mark the beginning of a permanent switch to alternative fuels and should prop up the beaten down auto suppliers TRW, Visteon (NYSE:VC), and Lear (NYSE:LEA).
  3. January 2nd is the day that the SEC will recommend a change in the mark-to-market regulation, similar to what Europe has already done. This change, along with the government's new precedent of protecting shareholders, should do wonders for JP Morgan (NYSE:JPM) and Bank of America (NYSE:BAC).
  4. Obama has vowed to sign the mother of all stimulus packages the day he takes office. Infrastructure will be a big part of it as outlined by Monday's $500 billion proposal from Nancy Pelosi . Look to add Fluor (NYSE:FLR), KBR, and the iShares infrastructure IGF.
  5. History. Even in the early 1970's, the most equities sold off in one year was 17%. 40% selloffs do not last when glimmers of hope begin to enter the market.
To those economists who argue against the fundamental impact of stimulus, I would say you don't understand the necessity of confidence. Anything to restore confidence during times like these is positive and the fact that these confidence-enabling events aren't going to happen tomorrow is actually a good thing. When such events happen quickly in a panicked atmosphere, the goodwill of the event comes and goes in the same day.
Investors should be careful not to underestimate our ability to manage our way out of this recession. After all, mismanagement got us into this crisis in the first place. If government remains on this proactive path then the message is simple-you don't have to rip on Warren Buffett anymore. You don't have to throw away the buy and hold history books. We now have leaders who understand what confidence is all about. Or at least I hope we do.

Disclosure: Long BAC, VC.

Source: A Restoration of Confidence in the Markets Means Everything