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The strong technical action of the stock market over the past two weeks argues that a short-term bottom, represented by the late November lows, is in place and prices should be stable to higher into the end of the year.

The S&P 500's ability to rally above key resistance in the 1490-1500 area, and the broad-based nature of the recovery, which featured strong rebounds in the beaten-down financial and real estate sectors, suggests that the selling pressure reached an exhaustion point in late November, and the bulls now have the upper hand.

The plan announced by the government last week to freeze mortgage rates for troubled home owners, combined with expectations of further monetary easing from the Federal Reserve, are buoying the market and creating a sense that a reprieve from the credit and housing crisis is in the offing.

As we have noted in recent reports, investor sentiment became highly pessimistic during November's sharp stock market decline. From a short-term perspective, a great deal of bad news related to the credit/real estate crisis and the related risk of an economic recession became priced into the stock market, which set the stage for a year-end recovery. Now with attention focused on the recently announced bailout scheme and the Fed's continuing efforts to reflate the credit system, sentiment may well continue to improve and support higher stock prices in the short run.

Apart from the tremendous "moral hazard" involved with the proposed mortgage bailout, we are dubious that it will do anything other than prolong the corrective processes at work in the housing and mortgage markets. Given that (1) the delinquency rate (on all mortgages) is at a 20-year high at 5.6%; (2) the number of foreclosures reached an all-time high in the third quarter; (3) the supply of homes on the market, at 10.5 months of sales, is the highest since 1985; and (4) hundreds of billions of dollars of mortgage debt is scheduled to reset to higher interest rates in 2008, it is no wonder that politicians felt compelled to act, especially coming into an election year.

But while the government's scheme may boost psychology and stem foreclosures in the short term, it does not alter the basic problems that too many people are living in homes they can't afford and that home prices overall are still significantly out of whack relative to incomes. Most likely, the government's efforts will simply delay the day of reckoning, as Peter Schiff of Euro Pacific Capital summed up nicely in an editorial last week:

Ostensibly, this plan is being offered in an attempt to stem the tide of foreclosures that might otherwise cause further weakness in home prices. The reality of course is that current home prices are still too high, having been a function of the lax lending standards and rampant real estate speculation that got us into this mess in the first place. A return to prudence in lending also means a return to prudence in pricing. Everyone seems to agree that a return to traditional lending standards is a good idea, but no one seems willing to accept a return to rational prices as a consequence. The government's attempt to orchestrate such an outcome is doomed to failure, as it is impossible to maintain bubble prices after the bubble has burst!

Source: Mortgage Bailout: Good For Investor Psychology, Not Much Else