Bank Stress Tests and the All-Clear-to-Rally Signal

Earlier this week I repeated that I've been cautiously bullish (too cautious, I also said) since October.

I also told you I was optimistic that all the major indexes would break through the important psychological, headline, and large-round-number resistance levels they started flirting with two weeks ago.

Boy, was that an understatement.

On Tuesday, markets blew the lid off of any impediments in their way.

In fact, the price action was so fast and furious you'd have thought the Federal Reserve said something about keeping interest rates low, or maybe that some good news about bank stress tests had leaked out.

And to think, only one week earlier, markets had a steep fall from grace on account of Fed Chairman Ben Bernanke not saying anything about another round of quantitative easing.

What a difference a week makes.

In case you missed the psychology of the market, it went like this...

The Little Mind-Game Twist That Scared the Shorts

On Tuesday the week before, the markets fell because Bernanke was more optimistic on the U.S. economy than he has been. So markets thought the liquidity party might be coming to an end.

Then this Tuesday, the FOMC minutes reiterated the Fed's pledge to keep fed funds between 0% and ¼% through 2014.

After the markets initially digested the FOMC minutes as being negative - because again there was no mention of further easing - they made the most of the news and decided that a statement confirming rates would be kept low until the end of 2014 was a lot better than no mention of the extended timeframe.

That little mind-game twist scared a lot of shorts.

As the major indexes were flirting with resistance levels, and failing to convincingly break out, traders were becoming more negative and more short positions were being put on.

Also, investors, sitting on great profits since the huge run-up from October, began to put on hedges and even sold into last Tuesday's blow off.

But with the Fed saying they were staying the interest rate course they'd set through 2014, short-sellers decided there was too much upward momentum to fight. They began to cover.

And then some tidbits about the bank "stress tests" started to leak out...

Bank Stress Tests: A Beauty Contest for the Public's Benefit

Seems the markets remember the rally in 2009, the last time we got news that, although some banks needed to add capital, the whole system was in better shape than the public had come to fear.

It's all about timing.

A little short-covering, a breakthrough above resistance levels, and a good pinch of reality that banks aren't under stress at all. It all makes for an explosive rally.

But seriously, did anyone think that we were going to find out that the banking system was about to go down the drain? Of course not.

Who conducted the stress tests?

Why, that would be the Federal Reserve, who just happens to already know everything they need to know about the 19 big banks they were "testing!"

It wasn't a test. It was a beauty contest put on for the public's benefit. The Fed wanted to show how beautiful America's banks were, and would be, in the face of some horrible disaster.

The whole exercise was like an episode of "American Idol," or some awards show.

Here's what it looked like to me.

The never-say-too-big-to-fail, naughty-nineteen bank contestants, all of whom made it through the first round of stress-test auditions in 2009, were anxiously awaiting the judges' scores to determine who would be the 2012 American Banking Idol.

The winner would be picked by the pageant's executive producer (the Sisterhood of Bankers for Bankers, otherwise known as the Fed), who used its own internal accounting peeps (allegedly run by Madoff's former accountant from his community service workshop) to tally the votes.

The rules this year required all contestants to spend untold hours (though most have tallied them and will complain bitterly) and untold sums of money (which they can write off, like they do with all those pesky settlements) to determine how they would fare if:

  • the stock market fell 50%,
  • U.S. GDP shrank 8%, and
  • unemployment was 13% (as measured by the simple birth/death ray total participation dissecting model, divided by seasonal adjustments and political mandates, times the square root of U6), in other words, not too far from where it actually is now.

But that's not all. Some of the more international contestants would have to make assumptions about Germany directing the European Union to march under its boots and what might happen if Euro-zone members flying the euro currency rag don't all say "Achtung Baby."

The figures the judges were watching, as the contestants paraded in their skivvies, included leverage ratios and Tier 1 capital that the banks would openly display under the dire scenario, starting now and staggering quarterly through the end of 2014.

While it should be noted that the judges' votes are final, the banks themselves will conduct a separate, self-directed, look-in-the-mirror evaluation of their figures and flaws, as required under Section 165 of the most exact and concise law ever not written - the Dodd-Frank Act.

I bring this up because some beauty contestants may balk at how a group of presumptuous outsiders sees them, as opposed to how they actually see themselves.

However, I'd like to point out that no one's calculations really matter anyway, on account of the fact that there is no common mathematical thread woven through anyone's internal modeling of risk weightings, duration exposure analysis, counterparty risk, or operational and reputational risk metrics.

So the judges will judge, don't worry about it, because they're all too big to fail, anyway.

Now imagine the anticipation, waiting for the Fed's determination about America's banking idols.

The envelope please.

"And the winner is..."

"Ladies and gentlemen, this is amazing... We have a tie... The winners are... all of the banks!"

Accepting the award on behalf of all the banks will be the on voted "Most Congenial to Regulators," Wells Fargo, and the bank voted "Most Dismissive of Its Critics," the lovely JPMorgan Chase.

In case you didn't stay up late enough on Tuesday night, here's a copy of their acceptance speech.

"This is unbelievable! First, we'd like to thank the Federal Reserve for painting such a dire future that they knew none of us could survive, so they had to accept our submissions without asking any of us who made them up. And we'd like to thank all the regulators for covering up for us these past four years when most of us, okay all of us, were insolvent and they all lied for us. Thank you. And, last but not least, we'd like to thank the public for believing in these meaningful contests, for listening to each of our CEOs and our regulators when we tell you that we're all healthy and you go ahead and buy our equity and wholeheartedly embrace our subordinated debt, which you know is government backed. Thank you all. We'll see you next year."

So much for stress tests.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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