Buy the Rumors, Sell the Facts

Includes: DIA, QQQ, SPY
by: Luca Avellini

In my opinion, amid the enthusiasm that followed the announcement of a possible bailout, some have lost sight of the bigger picture.

The numbers: 700 billion. Why? Is it enough? Is it too much? Nobody really knows, because in the credit market most positions are traded over the counter. Some are even kept off balance sheet. Unless all banks fully open their books, it will remain a guessing game and a dangerous gamble. The government committed to fix a problem without really knowing its full extent, also because they seem to forget that this is not just a US issue: a significant portion of IRSs, CDOs, CBOs and so forth, are traded cross border. The administration is asking Congress for a blank check with no real plan. Maybe Congress should ask them what they exactly want to do with that sum, and then decide. At the moment, it looks like the government is getting into a position with little upside and unlimited downside.

Timing: Between the collapse of Lehman (LEH) and AIG (NYSE:AIG) and the announcement of the plan, only a few days went by. Granted, the Fed surely knew about the situation before most of us did, but it still feels like a very short time to put together a real plan. In other words, they announced they had a plan, when in reality they should have said: Now we know that we need to come up with a plan.

The real issue anyway, in my opinion, is something else. Will the plan, if it works, be able to boost the overall market, or will it just buy time, hoping to eventually fix the banking system? The two are not the same. The S&P didn't lose 20% since October 2007 because of Bear Stearns, or Lehman, or AIG. It fell because US consumers are buried under a mountain of debt, salaries are not moving, unemployment is rising, housing values have collapsed, and high energy costs are making everything more expensive. Is the plan going to change that? The average Joe is not going to buy a new car because the government bought some bad paper from Citibank (NYSE:C) or Chase (NYSE:JPM), nor is he going to take on a third mortgage to pay off the first two. And the investment banks are not going to rehire the tens of thousands of people that were laid off.

Finally, we should ask what this immense liquidity injection is going to cost in the long run.  The price of printing or injecting money at a fast pace into the marketplace is inflation. We already live in an inflationary environment thanks, to a large extent, to higher commodity prices. It will just get worse because central banks traditionally fight inflation by increasing interest rates. But the Fed cannot do that because liquidity is one of the reasons we are in this mess in the first place.

Fixing the entire financial framework will not take days, or weeks. And unless the government shuts down the exchanges, business will resume, but it won't be business as usual.

I agree that the Fed had to do something. I'm just not so sure they know what they are doing.

Disclosure: Short SPY (put options).