Two Interesting Analysis about the EFSF

This is a follow-up on my posts from last Thursday and Friday about the EFSF:

• A Great Shortcut To The End of the Euro and the UE
• The Whole Plan Is Just Smoke And Mirrors

We are now starting to see the realisation that it's all smoke and mirrors and nothing has actually been accomplished...

Here a couple other comments from respectable market participants:

Hussman's comments on the EFSF:

So to start with, the EFSF is not actually an operating "bailout fund" at present - it's a shell corporation with a business plan and a certain amount of promised capital - not yet in hand - from European governments, in search of additional funding from private investors. 

Its intended business is to a) partially insure European debt, using capital from European governments, which these governments will obtain by issuing debt to investors, or b) to purchase European debt outright, by issuing EFSF debt to investors, leveraging capital obtained from European governments, which these governments will obtain by issuing debt to investors. 

In effect, European leaders have announced "We have agreed to solve our debt problem, leveraging money we do not have, to create a fund, which will then borrow several times that amount, in order to buy enormous amounts of new debt that we will need to issue." As Jens Weidmann, the President of the German Bundesbank objected about this plan last week, "It is tied to higher risks of losses and to increased sharing of risks. The way they are constructed, the leveraging instruments are not too different from those which were partly responsible for creating the crisis, because they concealed risks." Moreover, the benefit to private investors is suspect. 

The basic idea of leveraging the EFSF is to provide enough "credit enhancement" to make European debt attractive. What is the value of that credit enhancement? Well, if the expected recovery rate is 80% or more, and the probability of default is fairly low, then the insurance (a promise to take "first loss" of 20%) isn't really needed in the first place. If you do the math, the expected effect on yields is something on the order of 1-2% on 1 year debt, and a fraction of a percent for longer dated debt. 

Unfortunately, when the insurance really is needed (assuming more typical recovery rates around 50% and default probabilities higher than 15% or so), a 20% first-loss provision does little but reduce an extremely high interest rate to a lower, but still intolerably high interest rate. Given debt-to-GDP ratios of 100% or more, that protection does nothing to avoid certain default except to delay it for a small number of years. 

On that note, don't look now, but even if you were to assume an optimistic 80% recovery rate, Portugese yields already imply certain default within less than 2 years. Assuming a more typical 60% recovery rate, the probability of a Portugese default within 2 years was 68% as of Friday (that same recovery rate produces an implied default probability of 88% within 3 years, and 100% within 5 years). 

Bob Januah, via M3 Financial Analysis:

This latest bailout relies on the market not calling what I see is a huge "bluff", because if the market does call it, the bailout simply won't be credible or even deliverable. It is instead akin to a self-referencing ponzi scheme, and I can't believe eurozone policymakers have even considered going down this route. After all, we all have recent experience of how such ponzi schemes end, and we all remember how eurozone officials often belittled and berated US policymakers for their role in the US housing/CDO/SIV financial bubble.

The VXO remains too darned low to signal the end of this selloff

There aren't so many contrarians who would tell you not to buy the dip, and so I thought I would share their opinion with you, as I am still short this silly and irrational market and it's good to have two heavyweights on my side on this call.

Adam Hamilton, one of my favorite financial analyst and newsletter publisher published the following analysis this Friday evening:

[...]
Note today that despite the recent sharp SPX selloff, the rVXO has merely climbed to 1.14x at best. This is still well below the midpoint in this indicator’s secular trading range! Last summer’s SPX correction saw an rVXO peak near its end of 1.53x, and the last pullback in March 2011 went as high as 1.39x in the trading week surrounding the SPX’s bottoming. So just like in absolute terms, also in relative terms the VXO remains too darned low to signal the end of this selloff. Fear just isn’t high enough yet.
[...]
The bottom line is trading stock fear yields the best buying opportunities within any ongoing bull market. Traders can only expect to buy low when everyone else is scared and selling, driving down stock prices to bargain levels. The implied-volatility indexes, particularly the classic VXO, offer the best way to objectively measure collective fear. Waiting for levels where past selloffs bottomed leads to great buying ops.

And today’s stock-market selloff, though substantial, has yet to get anywhere close to the fear levels seen after the rest of this bull’s pullbacks and corrections. This means sentiment is not rebalanced yet, hence more selling is highly likely to spark the necessary fear levels to eradicate residual greed. So be careful here, don’t get suckered in to the countertrend rallies until the VXO signals fear is high enough to buy.

And John Hussman:

Despite the short-term oversold condition of the market, I should be clear that we are presently observing a combination of evidence that is typical of early bear markets - having some potential to be reversed, but with a generally dangerous record overall. This evidence includes the present combination of unfavorable valuations and unfavorable market action, developing concern from the most accurate version of our recession warning composite, [...] a recent advance that has already passed the historical norms for extent and duration of cyclical bulls within secular bears [...], and the neutral intermediate-term but hostile longer-term evidence we observed at the early May peak [...]. All of this presently holds us to a generally defensive investment stance.

Wait & Pray

Present Conditions Are Among The Most Extreme in History, says Hussman

This week, in his market commentary, John Hussman defines the technical criteria he has been using for calling the current market conditions "overvalued, overbought, overbullish, rising-yields syndrome". He's conclusion is that present conditions are among the most extreme in history.

So not including the cluster of signals we've observed in recent months, we've seen 6 clusters of instances in post-war data (we're taking the 1997, 1999 and 2000 cases as separate events since they were more than a few months apart). Four of them closely preceded the four worst market losses in post-war data, one was quickly followed by a 12% market decline, and one was a false signal over the short- and intermediate-term, yet the S&P 500 was still trading at a lower level 5 years later.
[...]
Examining this set of instances, it's clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges [...]

As of last week, the Market Climate for equities was characterized by an unusually extreme profile of overvalued, overbought, overbullish, rising-yield conditions. [...]

Following the Federal Reserve's policy meeting last week, Ben Bernanke gave a press conference. From the standpoint of what I continue to view as a terribly reckless policy, Bernanke actually did a fairly good job in that he both avoided any allusion to further rounds of QE while also avoiding any panic about a near-term reversal of the Fed's bloated balance sheet.
[...]
What is still fascinating to me is that when Bernanke discusses his claims of "success" regarding QE2, nearly every metric he offers is an indicator of financial market distortion instead of real economic activity. [...]

What inflationists still haven't understood — explained

I've been mentioning this fact since I move from the inflationist to the deflationist camp: very few people understand the current monetary system, and the most knowledgeable of these few people are Robert Prechter and Mish. Harry Dent is also one of the very few deflationist, but he's predicting deflation based on other data and theories than the monetary system.

What Hussman is surprised about, and what Bernanke tells us is exactly what Robert Prechter explained in detail in a long interview back in late September 2009, almost a year ago. I can't go in the details of the interview, but I just listened to it again, and it's very much worth listening to it.

Well this week, Hussman weekly commentary contains a quote from Ben Bernanke which I hope will make all the inflationist think, and potentially flip sides:

Last week, Ben Bernanke appeared before Congress for his regular Humphrey-Hawkins testimony. For most of that testimony, it fascinated me that every time the Bernanke said that the Fed has taken no losses on its operations, there was absolutely no remark that the reason the Fed has not lost money is that the Treasury, directly (Fannie, Freddie) or indirectly (AIG) has made the liabilities held by the Fed whole.

From that perspective, the critical part of Bernanke's testimony was the following exchange with New Jersey Congressman Scott Garrett of the House Financial Services Committee. [...]

SCOTT GARRETT: You bought over a trillion dollars of GSE debt, and to that point, under normal circumstances, on the Fed's balance sheet what you have on there are Treasuries, or if you had anything else on there, I assume you would have a repurchase agreement for those securities on your balance sheet. Now of course around two-thirds of that are in GSE debt.

BEN BERNANKE: Correct.

GARRETT: So right now, those are guaranteed - whether they're sovereign debt or not, we don't know - but they're guaranteed by the U.S. government. But they're only guaranteed to when? 2012, right? After that, Congress may in its wisdom make another decision, and at that point in time, you may be holding on your balance sheet - two thirds of your balance sheet - something that is not guaranteed by the Federal government. First of all, you don't have a ... do you have a repurchase agreement on those with anyone? No.

BERNANKE: I don't know what you mean by a repurchase agreement. We own those securities.

GARRETT: You own those securities. Right. So there is no repurchase agreement outside to buy them back. You own them.

BERNANKE: Right.

GARRETT: So after 2012, if they're no longer guaranteed, is it fair to say that you may at that point in time actually engage in fiscal policy, because you basically are creating money at that time? And I know that you'd agree that it would be an unconstitutional role for the Fed to engage in fiscal policy - so where will you be at 2012 if they had to take a haircut on those because they're no longer guaranteed?

BERNANKE: Well, first from the government's perspective, I, uh, such an act would, uh, there would, the Federal Reserve would lose money which the Treasury would gain. There would be no overall change to the position of the U.S. government. Secondly, the Federal Reserve act explicitly gives..

GARRETT: How would we be gaining? How is the Treasury gaining?

BERNANKE: Well, if there's a bad mortgage and the Treasury.. it requires $10 to make it good, if the Treasury refuses to do that then the Fed loses $10, so one way or another the government's going to lose $10. But I would just say two things, one is that I think, uh...

GARRETT: But if you didn't purchase them in the first place, it would just be a total - then what would have occurred? There would not have been the creation of that $10. Now that you've purchased them, and in essence if we don't back them up, then you will have created that additional $10.

BERNANKE: Well, I hope that doesn't happen, because I think it's very important for financial stability and confidence that we, that we guarantee...

GARRETT: Let's play out that hypothetical that it does happen.

BERNANKE: Well, then the Fed would lose money there. But let me just point out that the Federal Reserve Act, that we did not invoke any emergency or unusual powers to buy those agencies. It is explicitly in the Federal Reserve Act that we can buy Treasuries or agency securities and so we did not do anything unusual there.

GARRETT: In what status were they when you bought them? Were they in conservatorship at that point?

BERNANKE: Um, yes.

GARRETT: Is it normal practice for the Fed to buy agency securities when they're in conservatorship? Was that ever done before?

BERNANKE: It's never been in conservatorship before.

GARRETT: Well, there you go. So the normal practice is not what was followed here. It just seems to me that we may have gone down a different road than we've ever gone down in U.S. history, where the Federal Reserve has engaged in buying a security, it's not Treasury, it's not guaranteed by the full faith and credit of the United States for its lifetime, nor is there any repurchase agreement from any other entity that you purchased - that you have a trade with an agreement with - and that the Fed in essence could have created money if the government does not guarantee them. At least, that could be the situation we could find ourselves in 2012. 

[Hussman's comment:]
It's important to understand that historically, the Fed has never actually "created money" out of thin air. What it has always done is purchase Treasury debt, paying for that debt by creating "Federal Reserve Notes" (see the top of your dollar bill). When it has purchased other types of securities, it has historically done so using "repurchase agreements." These enable the Fed to sell those securities back at a known price, even if the security itself was to default. By restricting the vast majority of its purchases to U.S. Treasury securities, the Fed has always operated under a budget constraint: Congress has always had the sole, Constitutionally enumerated power to authorize the spending that creates government liabilities, and the Fed has merely affected whether those liabilities were held by the public in the form of Treasury debt or in the form of Federal Reserve Notes (money).

For example, if Congress votes on a billion dollars of spending, and the Treasury issues debt to finance this spending, the Fed might buy that billion dollars of Treasury debt and create a billion dollars of currency to pay for it. But notice that from the standpoint of the public, the end result is still a billion dollars of government liabilities, that was explicitly authorized by Congress. The Fed was never involved in spending decisions, which is fiscal policy.

Hussman on the economic (non-)recovery

In the ocean of insanity, it's good to find someone who thinks almost straight and brings some interesting points and ideas on the table. John Hussman is among them. Here are two small quotes from his latest weekly commentary:

Wall Street seems to have no concept at all that every bit of growth we've observed over the past year can be traced to government deficit spending, with zero private sector expansion when those deficits are factored out. As I noted last week, if one removes the impact of deficit spending, "the economy has recovered to the point where the year-over-year growth rate since early 2009 now matches the worst performance of any of the 50 years preceding the recent downturn." In effect, Wall Street's is seeing "legs" where the economy is in fact walking on nothing but crutches.
[...]
According to Bespoke Investment Group, there have been 58 "corrections" of 10% or more in the Standard & Poor's 500 since 1927. In 33 cases, the corrections stopped short of the 20% bear market threshold and the market went on to higher highs, while 25 times they grew into a full-grown grizzly. But in the 32 instances when the market has dropped as much as this one has -- 14.4% from the April 23 peak through Monday -- the outcome has been heavily weighted to the losing side. Only seven times drops of that size stopped short of the 20% bear mark. In the 25 other times the decline extended to 20%, the average bear market decline was 35.5%.

History shows that oversold markets usually fall even more

Hussman wrote a couple weeks days ago about this counter-intuitive yet extremely important fact: oversold markets can get even more oversold, and usually actually do so! This conclusion is based on historical data and is empirical:

Historically, we can identify 19 instances in the past 50 years where the weekly data featured broadly negative internals, coupled with at least 3-to-1 negative breadth, and a leadership reversal. On average, the S&P 500 lost another 7% within the next 12 weeks (based on weekly closing data), widening to an average loss of nearly 20% within the next 12 months - often substantially more when the Aunt Minnie occurred with rich valuations and elevated bullish sentiment.

The most recent instance was November 9, 2007, which was followed by a market loss of more than 50%, but the instances also include September 22, 2000, prior to a nearly two-year bear market decline; July 14, 1998 prior to the "Asian-crisis" mini-crash; July 27, 1990, at the beginning of the pre-Gulf War plunge; October 9, 1987, just prior to that market crash; July 2, 1981 at the beginning of the 1981-82 bear market and again in May 21, 1982, following a strong rally during that bear market, leading into a steep decline to the final lows; November 9, 1973 (just after a swift rally during the 1973-74 bear market, and leading into the main portion of that loss); and November 21, 1969, at the beginning of the 1969-70 bear market.

Given my aversion to market "forecasts," I hesitate to interpret this record as a hard prediction of what will occur in this particular instance. This is particularly true because in a handful of instances (2/9/68, 9/12/75, 10/20/78 and 4/30/04), the outcomes were fairly benign. Still, the average outcome has been awful.

On a side note, he wrote about Geithner's trip to Europe, and the least we can say is that he's been spot on (read Mish's Europe Politely tells Geitner where to go):

Treasury Secretary Eddie Haskell Timothy Geithner has scheduled a trip to Europe this week to urge European leaders "to pay better attention to potential market reactions to policy moves, and to accelerate the European rescue program." This promises to be a fiasco. What could European leaders possibly find more arrogant than to be lectured on bailout policy - not simply by the U.S., but specifically by a one-trick pony bureaucrat whose chief trick is the ability to smoothly talk the language of prudence while simultaneously prostituting the fiscal stability of an entire nation for the benefit of bondholders who made bad loans

Black Thursday, May the 6th 2010 - One week later - What Happened?

A week later, I thought it would be good to see if any valuable information/lesson can be retrieved from the amazing drop we experienced.

Interestingly enough, Mary Shapiro, the SEC Chairman, admitted [via CalculatedRisk] during her testimony before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises that they didn't know what happened:

At this point, the root cause of the sudden disappearance of liquidity in many stocks is unclear.

Hussman on Black Thursday:

Thursday was a fascinating day in the market, featuring a 20-minute span in which the Dow moved from a loss of about 300 points to a loss of nearly 1000 points and then back again within a span of about 15-20 minutes. While the decline and recovery was interesting, the fascinating part was the eagerness of investors to view the decline as a "glitch" in trading. My hope is that the opening quotations in this weekly comment are sufficient reminders that illiquidity is not a "glitch," but a typical feature of panicked markets. In a market where active market makers have increasingly been replaced by "high frequency" trading algorithms that can be switched off at will, it is important for investors to avoid the assumption that there will be a willing buyer close at hand if risk concerns begin to escalate.

If you spend a good portion of your time studying price-volume behavior, "air pockets" of the type we observed last week become familiar parts of the landscape

Hussman's view on the banking profits

I am glad to read that Hussman shares my opinion on both the banking profits: just smoke and mirror and the fact that news come after the market event (rationalization process), and not the opposite. Here's a quote from his weekly market commentary:

As of last week, the stock market remained characterized by strenuous overvaluation, strenuous overbought conditions, overbullish sentiment, and hostile yield pressures. The fraud charges brought against Goldman Sachs by the SEC may or may not provide a catalyst for market weakness, but significant risk is already baked into observable market conditions. The present syndrome tends to be followed by large and abrupt losses (though with somewhat unpredictable timing). To the extent that investors tend to attribute market fluctuations to the immediate news surrounding them, the Goldman Sachs issue may become more of a subject of investor attention in the weeks ahead than it deserves. But really, is anybody actually surprised?
[…]
Meanwhile, it is notable that the "favorable" earnings reported by J.P. Morgan and Bank of America in the first quarter were due to reduced provisions for credit losses - charges that are largely discretionary. In the fourth quarter of 2009, J.P. Morgan charged $8.9 billion against earnings to provide for credit losses, but in the first quarter of 2010, it charged $7.0 billion. Thus $1.9 billion of the $3.3 billion in earnings reported by JPM reflected reduced provision for credit losses. Likewise, the main factor driving Bank of America's earnings was a reduction in loss reserves. Indeed, the provision for credit losses was $3.6 billion lower than it was a year ago (when delinquency rates and credit losses were running at a fraction of current levels).
The reduced provision for credit losses might be reassuring were it not for the fact that delinquencies, foreclosures, non-performing loans, commercial mortgage strains, and actual charge-offs reported by various sources have been either unchanged or accelerating. Bank of America, for example, reported that 30-day delinquencies on residential mortgages hit a new record of 8.5% in the first quarter (though the surging FHA-insured portion will allow them to pass some of the consequent losses off onto the American public)
[…]
It seems equally unwise to celebrate "favorable" bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting.

Hussman's short term outlook

There hasn't been any meaningful pullback for 12 months now. Euphoria is leading the markets higher and higher, and the slightest 1% decline sees a lot of 'buy-the-deep' players. Junk is soaring more than high quality (Russell 2000 versus the Dow Jones Industrial). Call Put Ratio is a new lows since 2007.

Banks and hedge funds are back in business as usual, which worries me even more than anything. Hiring is going on like crazy, I've seen so many people get poached for big salaries, and receive so many phone calls from head hunters that I feel like I'm back in mid-2007...

Let's get our dose of reality, otherwise there wouldn't be any reason to call this blog Reality Lenses ;-) Here's a brief quote from Hussman's latest weekly commentary:

The Strategic Growth Fund is fully hedged at present, and would be even on the basis of current valuations and yield pressures alone. We now have our put options in a "staggered strike" configuration, which essentially uses about 1% of assets to raise the strike prices of our protective index puts. This is the most defensive position the Fund has held since the 2007 peak. Importantly, the added risk of this position, relative to that of a "plain vanilla" fully-hedged stance, is only about 1% in option premium. As always, the primary risk when we are fully hedged is the potential for our stocks to behave differently than the indices we use to hedge (this difference has also driven the bulk of the Fund's returns since its inception). Given that we currently observe conditions that have previously been followed by market declines of 10% or more within a period of several weeks, I view a very tight defense as important, but I don't expect that we will maintain this level of defense for a significant length of time. We are not relying on a decline, but we certainly are defending against the potential.

As I've noted before, getting past the window of the next few months will relieve a great deal of the "two data sets" uncertainty that we have faced recently. We are far less concerned about the possibility of marginal new highs in the indices over the near-term than we are about the likelihood of unsatisfactory long-term returns, and the potential for an abrupt "air pocket" based on valuations, overbought conditions, and yield pressures, not to mention the very palpable risk to the "all clear" thesis that investors not only take for granted, but have now priced stocks to depend on.

As of last week, the Market Climate for stocks was characterized by now strenuous overvaluation, strenuous overbought conditions, and hostile yield pressures. Under those conditions, even positive market breadth has not typically been sufficient to produce positive market returns, on average.

Robert Prechter was right

After about a two-week-break I have to play catching up. I just finished reading John Hussman's weekly commentary, and I highly recommend reading it in its entirety.

Here's an interesting quote from Hussman that follows the news that the US Treasury has announced they provide unlimited support to Fannie and Freddie's securities:

"The Federal Reserve has expanded the U.S. monetary base by more than 150% since the beginning of the recession. That is not a typo. The monetary base has soared from $800 billion to over $2 trillion. Much of this has been accomplished through outright purchases of mortgage-backed securities (not repurchases) [...]"

One thing that hit me when reading this was the how much Robert Prechter was right and that he had predicted this would happen.

During the interview I have posted here, he explicitly mentions that all the MBS that the Fed has bought have only been acquired because they were guaranteed by the US government and that the Fed has no intention on making losses on those securities and it will force the US government to make the guaranty explicit and reimburse any loss.

These actions are of course far less inflationary than outright money printing. The trillion dollars worth of MBS that the Fed and Chinese have bought are now going to be transformed into debt that will sit on the Treasuries balance sheet and burden the US government and citizens since the Treasury will have to borrow to make the Fed and the Chinese whole.

So in one sense, we can guess that the Fed is twisting Geithner's arm and forcing him into this action. We can also think that the trillion dollar of additional debt that might fall on the back of the US will further limit their ability to borrow and spend, which should lead into deflation until/unless the Fed decides to monetize the Treasury's debt.

I will listen to that interview one more time tonight, and so should you ;-)

Finally, here's John Hussman's very insightful take about the current market conditions:

At present, stocks are characterized by an overvalued, overbought, overbullish, rising yield profile that is generally coupled with poor average returns. Though the tendency is for the market to actually make marginal new highs for some amount of time following the emergence of these conditions, very steep and abrupt subsequent breaks are also the norm. Defensive positions in that sort of environment promise to be frustrating, because of that tendency for the market to creep to new highs, retreat a bit, and then press to marginally higher levels. Still, despite this tendency toward further marginal progress, the fog tends to be thick, and the cliff tends to be steep.

Great Depressions bear rallies vs current Greater Depression bear rally

The greater the crash, the greater the fear, and the greater the rebound, rationalization and hence bear market rally.

Hussman has published several of these already (check below for related posts) and today's chart of the day is yet another example:

Related posts:

• What kind of recovery is the market pricing pt2
• Dead cat bounce
• What kind of recovery is the market pricing pt1

You can subscribe to the chart of the day for free by following the previous link.

What kind of recovery is the market pricing -or- just how much is the market overvalued? pt2

Just two months ago, I published a post quoting Hussman's interesting work about the recovery currently priced in the market's valuation. A couple of weeks ago, they published yet another impressive chart which is still worth to have a look at.

Well, this week, William Hester is publishing yet another set of very informative (and worrying) charts, some of which I am pasting below.

As you can see, not only has there been no recovery at all in any indicator (job losses are still happening at a scary rate, defaults on mortgages and loans as well, commercial real estate is collapsing, along with prime mortgages), but the market is pricing in the sharpest recovery in history, along with profit margins getting back to historical levels within a sluggish but positive GDP growth.

Dead cat bounce: yet another statistically improbable result

Hussman as published another very interesting statistical data about the current bear trap:
This graph shows that the current rally is the biggest one in the recent history (past 100 years) and also the one driven by the smallest and decreasing volumes.

Apogee of exuberance, paroxysm of irrationality. Sign of a top?

The action on the stock market today seems to me like the apogee of exuberance and the paroxysm of irrationality: Freddie Mac and Fannie Mae are up between 40 to 50%.

While the fact that the Federal Reserve bought $5.6 billion of Fannie, Freddie and Federal Home Loan Bank debt is obviously bullish for these companies shares (free money given to any company increases its value), this reaction shows that people are now fully believe that the real estate bubble will reflate.

Too bad, because it won't.

The bad news ignored by the markets are numerous, but again, nothing in this rebound has to do with fundamentals. It is lead by mass hysteria.

I think we might have touched a top...

As Hussman wrote: As John Mauldin recently pointed out, a June survey of 1500 real-estate agents by Mortgage Finance found that only 36% of all existing home sales involved “non-distressed” properties, and of those, only 31% were described as unforced or optional, the remainder being sales prompted by personal financial difficulty such as unemployment or changes in family circumstances, but without a delinquent or foreclosed mortgage. As John wrote, “Think about that for a minute. Two-thirds of home sales are either foreclosures or banks taking a loss on the mortgage. And only a third of the remaining one-third – roughly 10% of overall sales – comes from something we could call a normal selling process.”

What kind of recovery is the market pricing -or- just how much is the market overvalued?

Here are some very reasonable comments made by John Hussman on their weekly market update:

[...]
The U.S. economy lost a quarter of a million jobs in July. Meanwhile, over 400,000 workers abandoned the labor force (and are therefore no longer counted among the unemployed), which prompted a slight decline in the unemployment rate despite the job losses. In the context of an economy still strained by high levels of consumer debt and still record delinquency and foreclosure rates, labor market conditions are still troublesome. Still, the pace of job losses and new unemployment claims has clearly softened from the pace we observed early in the year.
[...]
Moreover, it might be enticing to look at a chart of the S&P 500 and envision a quick return to 2007 highs and beyond, but it is important to recognize that those highs were based on profit margins about 50% above historical norms, combined with an elevated P/E multiple of about 19 against those earnings. Even if the economy is poised for a sustained recovery here, the belief that those joint outliers will be quickly re-established goes against historical precedent.
[...]
Based on our standard methodology, which considers normalized earnings (not the far more depressed level of current earnings) the S&P 500 is now priced to deliver 10-year total returns in the area of 6.9% annually. This is a figure that has historically been associated with bull market peaks, including 1969 and 1987. In most instances, such valuations turned out badly in reasonably short order. It is, however, true that prospective returns were even worse prior to the 1929 crash, and during the bulk of the period since 1996, so there have been some historical periods where speculators have driven valuations to higher levels, and during these times, it has not been particularly effective to stand in front of speculators saying "no, stop, don't."

And just to show how irrational the market has become, and current fantasy world recovery it is expecting, they published this chart:

Bailout Tracker and Banks Capitalization Bargaining [updated]

I just came across these very interesting pages, from CNN and the WSJ.

The first one is a bailout tracker that tracks the amounts of money handed by the government in their desperate need to keep the status quo, save their friends and sponsors in private corporations and avoid the collapse of the current failures and the raise of the competent people. According to their work, already $10.5 trillion has been committed by the US Gov and the Fed and 2.6 already wasted... errr sorry I meant invested. Definitely worth having a look at the page.

• CNN Bailout Tracker

The second one is this report from the WSJ along with an interactive Flash application showing the current assets of banks. According to this report, the results from the "stress test" (that many called "cake walk") have been delayed because banks were negotiating (and finally obtaining) multi-billion reductions in their capital requirements. While this is all but surprising, the ground work done by the WSJ on their interactive work is really interesting and valuable and shows the extend of which US banks are undercapitalised and the financial system in the US still exposed to massive capital injections by the Government (and maybe by specially selected private investors who will obviously have their capital guaranteed and by the US Gov, allowing them to take no risk but get the full upside instead of the US citizens).

• WSJ Stress Test results and bank capitalisation (interactive app)

It's definitely worth reading the article as well. Here's the first 2 paragraphs:

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.
In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

John Hussman writes in his weekly letter:

The “stress test” procedure also conveniently excludes any potential mark-to-market losses during 2009 and 2010, as banks “were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (‘cash flow losses') rather than discounts related to mark-to-market values.”

Now, just think of this for a minute. Even if you assume that the “risk-weighted assets” of the banks are about two-thirds of their total assets (as the stress-test does), we're still looking at $7.8 trillion in total assets at risk in these banks, and despite being on the edge of insolvency only weeks ago, we are asked to believe that they will need less than 1% of this amount – $74.6 billion – of additional capital even in a worst case scenario. How do the stress tests arrive at this conclusion?