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If you examine second quarter earnings reports carefully, you’ll discover no basis for enthusiasm. The so-called “improved” bank earnings we’ve seen, over the last two quarters, are mainly the result of creative accounting. There has been a widespread failure to mark down the value of assets deeply in the red.

The “mark to market” rule is gone[i], and banks are taking full advantage. However, since 1993, they have been required to report the fair market value of their holdings annually. A new rule requires the disclosure every quarter. So, in spite of the removal of mark to market accounting practices, we’ve got more data to work with now than ever before. Big banks are adept at changing the rules of the game, but the numbers disclosed in many recent 10Q quarterly earnings reports tell a very depressing tale.

Actually, even under the previous "mark to market" rule, commercial banks were allowed to mark assets that they were allegedly keeping "for investment" and "not for sale" to imaginary values.

This was a huge hole in the rules, through which a great deal of mischief was wrought. Banks have been marking "investment" assets to fake values for a long time. But, that doesn't change the facts. No bank would give you a loan based on tainted collateral, so why would you invest in a bank that holds tainted collateral to back its loans, when the bank would be insolvent if it were forced to repossess or foreclose and sell the collateral, especially at a time when repossessions and foreclosures are soaring?

A close reading of earnings reports shows that banks are carrying assets at “values” that are inflated far above fair value. Wells Fargo (
WFC) shows on page 120 of its report that the fair market value of various assets is actually $34.3 billion less than the amount they are being carried at.[ii] Bank of America (BAC) shows, on page 79, a similar unwritten-down “loss” of $64.4 billion; Regions Financial (RF) shows on page 37, 22.8 billion of unwritten down losses, and this is more than its shareholder capital of $18.7 billion and, under a strict mark to market standard, the bank would be considered insolvent; SunTrust Banks Inc. (NYSE:STI) has a $13.6 billion gap as of June 30, 2009, and that amount exceeds its $11.1 billion of Tier 1 common equity; KeyCorp admitted that its loans were worth $8.6 billion less than the value the bank carries on its books; its Tier 1 common was just $7.1 billion.[iii]

Imagine if we marked all these assets to market value? That would put all these banks very close to failure.

Yet, on August 14th, 2009, a rather humorous event occurred. Nearly insolvent BofA-Merrill Lynch, upgraded the even more insolvent Regions Bank to a “BUY”. While other stocks fell, Regions Bank stock rose by 8.46%!

It is sometimes incredible how foolish people can be, and how investors listen slavishly to the nonsense spouted by big bank analysts. People act irrationally when it comes to investing. They tend to buy when stocks are at their top, and sell at the bottom. Why? Irrational exuberance is a problem that will never go away, and the financial market cheerleaders are experts at catalyzing it.

But, while investors should blame such cheerleaders for high levels of dishonesty, they should also blame themselves. They get taken in by this nonsense, time and time again. The cheerleaders of this rally are the same people who led investors off the cliff in October, 2007, and many times after that. Why do people keep listening?

There is an incredible amount of spin surrounding earnings “surprises on the upside”. But, ignore the hype, for a moment. Ask the critical question. “What standard are you measuring against?” The truth is that earnings have virtually collapsed across the board, compared to last year. A sustainable bull market cannot be built by loading the airwaves with news that earnings are “less terrible than they might have been”. Only bear market rallies can be built from such defective bricks.

So, let’s concentrate on the hard facts, as unpleasant as that may be.

Unemployment is soaring. California was recently issuing IOUs because it could not pay its bills. International trade flows are drying up, once again, illustrated by a deep fall in the Baltic Dry Index, after a short-term reprieve resulting from Chinese commodity buying fueled by a $600 billion stimulus program. More than 150 publicly traded U.S. lenders own nonperforming loans equal to 5% or more of their holdings which, according to former regulators, is a level of nonperformance that threatens bank survival.[iv] The number of bad loans is rising, not falling.

By next year, Deutsche Bank predicts that the number of mortgages that are “underwater” will rise to 48% by2011.[v] Underwater means that the owner owes more than his property is worth, and that means that they are far more likely to default on their payments. More than 16,000 businesses filed for bankruptcy in the 2nd quarter, the highest in the three-month period since 1993, according to the American Bankruptcy Institute.[vi] The number of business failures rose 64% from the same quarter a year ago and Chapter 11 business filings more than doubled in the first half, compared to the first half in 2008.[vii] Consumer confidence fell dramatically in June and July.[viii]

Yet, in spite of it all, the S&P 500 is now trading at a hefty 18.6 times earnings, the highest valuation since 2004.[ix] Some people say that this is because the Federal Reserve is using Goldman Sachs’ trading software to goose prices upward. I don't know, and won't offer an opinion on that. I won’t even go there. The techniques that can potentially be used in a market manipulation of the type alleged are beyond the scope of this article.

However, there is little doubt that stock values are currently floating on a sea of Fed supplied liquidity. Value investors, however, know that the time to buy is not when stocks are being floated, but, rather, when there is metaphorical “blood in the streets".

After a 50% run in stock prices in a 5 month time span it is time to sell. Value buyers will purchase “every stock in sight” only when stocks sell for 6 – 7 times earnings, they will be highly selective at 10 or 11 to 1 ratios, and won't buy anything at 18 – 19 times profits.

If the Federal Reserve ontinues to print more and more electronic “Federal Reserve Notes” (aka dollars), we will experience an incredibly destructive episode of hyperinflation the likes of which this world has never seen before. Because the U.S. dollar is the world’s reserve currency, and, because of this, the devastation wrought by such an event would far exceed that of the German Weimar Republic 1919-23, when the Mark collapsed to 1/trillionth of its original value. The sudden collapse of the U.S. dollar might trigger such a deep tumble of the world financial system that it migh be impossible to recover. The world might be thrown into a permanent state of civil disorder, and a second “dark ages” of a sort. I am counting on Bernanke & Co being smart enough not to do it.

I conclude, therefore, that the Fed will ease up on creating the ever bigger “sea of liquidity” needed to keep this rally going. The risks are just too high. Folks like Ben Bernanke may, someday, be irresponsible enough to do that, but I don’t think that day has come yet. The sea of liquidity will be drained, if only partially. Once that happens, nothing will be left to support stock prices. You can fool some of the people all of the time, and all of the people some of the time, but you can’t fool all of the people all of the time. Stock indexes will fall to their natural levels, which is far below where they now are.

In my opinion, over the next month or two, we are going to see a serious drop in stock prices. I don't know how far they will fall, or for how long, but, remember, it took only two months of falling prices to reach the deep low on March 6, 2009, and we’ve got several years to go before we exit this depression completely.

I do know, however, that David Rosenberg, formerly the Chief Economist for Merrill Lynch, says that the current rally is a mirror image of one that happened during the Great Depression era, just before the total market collapse. He is one of the few big bank analysts I've respected for many years.

That being said, I doubt that this market will follow the same pattern as it did during the Great Depression. For one thing, history never repeats itself exactly. For another, the attempts at government intervention,are so huge that they are bound to create a different nominal outcome, regardless of what the real values end up as.

Because of what the government has done, and other governments around the world have done, it is much more likely that the nominal outcome will be hyperinflated, so that, in the very long term, the index numbers will look like they are rising. In effect, however, the value of the market will probably follow the Great Depression pattern, as Mr. Rosenberg suggests, at least with respect to their real value.

But, the very long term is one thing, and the here and now is another. The
pattern of massive rallies, and big falls, seems very likely to repeat itself, several times, over the next year or two, until the first part of this depression is over. Value oriented investors will be ready, willing and able to buy heavily at the bottoms of various Ws, while taking profits at the tops.

Disclosure: No positions in any of the stocks mentioned in this article


[i] Although, the Financial Accounting Standards Board (FASB) is now talking about reinstating some form of it.

[iii] Id.

[vi] Id.

[vii] Id.

Source: Will the Market Crash?