The Toxic Asset Plan Is Fueling A Rally – But I Doubt We Will Breakout!

The market is reacting to news this morning and I wanted to get comments out early today. Last week, the market continued to move higher after establishing a 12-year low the prior week. Good fundamental news drove us to within striking distance of a major resistance level and quadruple witching fueled us the rest of the way. Two weeks ago, China announced that for the third straight month its PMI rose and that it was adding to its stimulus program. Copper prices rose to three month highs and bulls stepped in hoping that a rebound in China might stabilize global economic conditions. A few days later, Citigroup announced that it was profitable during the first two months of the year. All of the other major banks (and GE Capital) chimed in with similar comments. Bank stocks rallied and financials pushed the market higher. Over the weekend, we learned of the Treasury's new toxic asset plan. It is a multi-pronged approach that blends public and private investment. This is a very complex plan. To keep things simple, the government will bid for toxic assets alongside private investors. They will match private capital on a dollar for dollar basis. This part of the program will run into problems when the market is a mile wide. Private capital will not overpay for loans and simply having a higher bid from the government won't assure that a price for these assets can be reached. In the second part of the program, the government and private investors will purchase bank loans and the FDIC will offer guarantees to lenders who purchase these assets. The price tag to taxpayers could reach $1 trillion. Banks did not want to part with toxic assets because they felt that a government bid (in the form of a “bad bank”) would yield a higher price. They did not like the private capital bids and they did not want to realize huge losses. Now that they have help from the government, they still may not want to participate. New mark to market rule changes could give banks enough breathing room to hang onto these securities until conditions improve - they don't want to take their losses. Based on how banks respond to the new plan, we will find out how aggressively they wrote down assets. Banks that were conservative and took big unrealized losses will favor the plan. They might actually benefit from mark-ups as the assets fetch a higher price. Banks that overpriced their assets will hate the plan. Financial stocks are rallying right out of the gate today. To put the problem into perspective, Citigroup said that in the first two months this year it had an operating profit of $8.3 billion. That does not include any write-downs. They also have $350 billion worth of toxic assets and they owe taxpayers another $45 billion. Clearly, we are far from out of the woods. The spread between the borrowing rate and the lending rate is as wide as it has ever been and banks should be making great money. Unfortunately, it will take many years of profitability to offset losses of this magnitude. I'm glad that the Treasury is doing what it can to help in the toxic asset price discovery process, but I question the effectiveness of the plan. If the government and private capital are a mile apart on their bids, no transactions will occur. I question the government's ability to price these assets, but I’m sure private capital won’t overpay. After conducting a CEO witch hunt the last year, private capital might be hesitant to have the government as a partner. This is certainly a feel-good rally, but in reality we are just regaining some of the losses from last Thursday and Friday. In the chart you can see that multiple resistance levels are converging at SPY 81. The 50-day moving average, the downtrend line and horizontal resistance are all keeping a lid on this market. As I stated last week, I don't believe that a sustained rally will come from any "artificial" stimulus from the government. We need solid fundamental improvement in the way of increased economic activity, a drop in unemployment or improved earnings guidance for sustained rally. I believe this morning's rally will ultimately stall and the market will drift lower the remainder of the week. We are likely to test support at SPY 75 before next week's Unemployment Report. I do believe that the lows will hold and that we will make a higher low on the next pullback. That would be technically bullish and it would help us "mark time" at this level. Given time, the Fed's actions and the Treasury's initiatives will start to take root. When those signs appear, the market will stage a bona fide rally. Longer-term, I am still very bearish. The punch has just been served and the party is about to begin. It’s going to be a good one and it could last. The hangover won't hit us for many months and reality the “morning after” will be ugly. This extravaganza has to be paid for and interest rates will rise, inflation will spike in the dollar will get crushed. For today, the market has staged an early rally. The momentum favors the bulls and I doubt shorts will stand in the way. I feel that this rally will stall this week, but first I will make sure resistance at SPY 81 is intact. That level could be challenged today. I am eyeing up (not executing) call credit spreads on weak stocks that have rallied from deeply oversold conditions to a resistance level. I am making sure that the long-term downtrend is intact and that I have multiple resistance levels to protect my position.

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