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Stress Test
New York: April 27, 2009
By John Stephenson

Not only has the weather started to turn sunny, but the stock market is beginning to show signs of life after the heart-pounding drops of the last six months. So encouraging is the latest rally in the stock market, that economists have likened it to the first “green shoots” of recovery. Many economists are even predicting that next year, the U.S. economy will return to trend growth rate of over two percent. Goldman Sachs surprised everybody with their strong earnings in the first quarter, with the beleaguered financial stocks lifting the stock market higher.

Share prices are up strongly around the world in the past seven weeks. According to data compiled by The Economist , more than two-thirds of the 42 stock markets that they track experienced gains of more than 20 percent over the last two months. Indeed, if the first quarter earnings by U.S. financials are to be believed, the wheels of commerce may soon be turning smoothly. And that's great news for shell-shocked businesses and consumers who have been unable to obtain the necessary credit to keep on spending.

With the financial system at the heart of this crisis, the favorable earnings reports could not have come at a better time. But, are they to be believed? It's hard to say, but according to some pundits, there is more bad news to follow. With job losses continuing to mount, consumers will be on strike as uncertainty looms large. And that in turn, will drag down corporate profits and keep them weak until there can be a sustained turn around in the global economy. Skeptics, such as Nouriel Roubini, an economics professor at New York University (NYU), reckons that investors sooner or later are going to wake up and realize that bank losses are massive, and that some of America 's largest banks are effectively insolvent.

That day of reckoning could come sooner than one might think with the U.S. government set to release the results of their stress test of the U.S. banking sector on May 4th. The tests are being conducted on the nation's nineteen largest banks, to determine how they would fare over the next two years under a couple of different economic scenarios. Collectively, these nineteen banks hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system. If any of these major institutions is shown to be financially vulnerable (insufficient reserves), a wave of panic selling could ensue. The U.S. Federal Reserve has already indicated that preliminary data show that some banks have “substantially reduced” reserves leaving them vulnerable to a further deterioration in the stock market.

While the stress tests will undoubtedly show some weakness in the U.S. banking sector, what isn't being said is really more worrisome. Ken Lewis, the chief executive officer of Bank of America, recently testified under oath that he not only knew about the dire financial situation of Merrill Lynch prior to his firm taking over Merrill, but he was forbidden by the U.S. Treasury Department from speaking publicly about it. So desperate has the U.S. government become that it is attempting to solve the crisis in the financial services sector by denying that a problem really exists.

If that weren't alarming enough, the Financial Accounting Standards Board has yielded to enormous pressure from Barney Frank and other members of Congress to change the accounting rules by changing the rules governing mark to market accounting — effectively sweeping the toxic debt of American financial institutions under the rug and away from the prying eyes of stock analysts. To the government's way of thinking, out of sight is out of mind . Goldman Sachs, stellar first quarter earnings were the result of another accounting manipulation, where they changed their year end from November to December. By changing their year end to December, Goldman was able to avoid announcing the staggering $780 million dollar losses that occurred in the month of December. Deteriorating fundamentals and the systematic reporting of fraudulent earnings should be huge red flags to investors to avoid the financials, until their earnings can be believed.

As highly levered firms, such as hedge funds, continue to sell assets into illiquid markets and investors realize that bank losses are massive, the bear market rally we have been experiencing will be over. Sagging consumer confidence, deflationary pressures and surging defaults on corporate bonds will all conspire to keep a lid on earnings for the foreseeable future.

But while a quick rebound is unlikely, the massive fiscal and monetary stimulus actions that governments from around the world have been conducting have brought us back from the brink of disaster. A worldwide depression appears to have been avoided and eventually earnings will stabilize, bargain hunters will once again return to the stock market and a long sustained bull market will ensue.

When global growth returns, stocks linked to global growth, rather than U.S. growth, will be the place to be. That's good news for the much maligned resource sector and also for the largest and best capitalized technology companies. While technology stocks have had their fair share of problems (e.g. tech wreck and stock option scandals), the largest companies have a truly integrated global supply chain. Computers and televisions, for example, are assembled in one country, but the sub-components, such as the circuit boards, are produced in other countries.

With future world trade likely to grow faster than global GDP, companies offering leverage to a rebound in global trade are the place for investors to be. Commodity companies and the large well-capitalized technology companies will be the place where savvy investors will experience the biggest bang for their buck when the world economy begins to grow again.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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