Relief Rally Likely in Wake of Bailout Legislation

Includes: DIA, QQQ, SPY
by: J.D. Steinhilber

It appears that Congress grasped the urgency of the financial crisis, and worked through the weekend to reach a compromise bailout package, which will in all likelihood be signed into law early this week.   Few people familiar with the issues deny that government action is needed to stabilize the financial markets.  In recent weeks, the financial crisis evolved from event-driven to systemic.  A crisis of confidence caused credit markets to freeze, which is an untenable situation in a credit dependent economy such as ours.  As debt markets have plunged into a state of disarray, short-term money markets, which are fundamental to the day-to day operation of our economy, have ceased to function. Naturally, a taxpayer-funded bailout of the banking system is objectionable and regrettable, but with the financial system teetering on the brink of collapse, the alternative is worse. The greatest danger right now, and the reason that government action is required, is not "toxic" mortgage debt, but the loss of confidence, growing fear, and panic in our financial system. 

Assuming the bailout legislation is passed by Congress and signed into law by the President, it remains to be seen how well it is implemented, and how much of the cost of cleaning up the bad debts is born by taxpayers versus the firms currently holding the assets.  The critical variables will be how much the government pays for the assets and what the assets are ultimately worth.  A number of analysts have suggested that the government may actually make money on this bailout, by buying assets cheaply and buying them at the bottom of the cycle.  We find that suggestion to be ludicrous.  Hundreds of billion of dollars of additional bad debt needs to be written off.  Hopefully, the government can administer this bailout in such a way that as much of this cost burden as possible will be absorbed by the stock and bondholders of the financial firms holding the bad debts rather than the U.S. taxpayers. 

This is an exceedingly confusing and challenging period for investors.  The extreme pessimism and fear we have seen in the markets in the past two weeks suggest that the stock market has made a short to intermediate term bottom, and that once the bailout is signed into law, stability will return to credit markets and stock markets will embark on a relief rally, which could persist into the fourth quarter after the election uncertainties have passed. 

It is also possible that we are making an important longer-term bottom in the stock market. Market history teaches us that financial crises, because of the fear-driven market evacuations they cause, produce excellent longer-term buying opportunities, and perhaps we will look back on this as one of those times.  However, we are going to need many more convincing signs of a lasting market bottom to conclude that we are at the end of this bear market. 

The economy and our financial system are undergoing a wrenching transformation and deleveraging period, and it remains to be seen how painful and long lasting this adjustment will be.  Government intervention will in all likelihood stabilize markets in the short run, but will delay the corrective processes in the longer term. Given the upheaval in the banking system (which will lead to tighter credit), the continuing imbalances in the housing market (i.e. excess supply and overvaluations relative to incomes and rents), and the need for consumers to de-lever their balance sheets and rebuild savings, we would not expect a strong economic or stock market recovery out of this.