Stress tests for banks over, stocks next?

The stress tests conducted by federal regulators on banks in the United States have been completed and the results gave the stock market little reason to stop its recent positive run. Still, neither the economy nor the stock market is necessarily out of the woods yet.

On May 7, the Federal Reserve announced that 10 of the 19 banks examined would need to raise US$75 billion by November based on stress tests conducted under the Supervisory Capital Assessment Program. This is less than what many analysts had feared.

The relatively benign conclusion of the stress tests comes in the midst of a stream of better-looking economic data and reinforces the view that the US economic outlook is improving. For example, on Friday, the Labor Department reported that the US economy lost 539,000 jobs in April, the lowest rate of job loss since October. In addition, the Institute for Supply Management's indices for manufacturing and non-manufacturing activities both increased in April.

Investors certainly appear to be happy with the results of the stress tests. Financial shares led US stocks up on Friday, the day after the announcement of the results. The Dow Jones Industrial Average closed at 8,574.65 for a 2.0 percent gain for the day and a 4.4 percent gain for the week. The Dow Jones is now down only 2.3 percent since the start of the year, helped by the hefty 31.0 percent rally since 9 March. The latter seems to suggest that investors are expecting something like a V-shaped recovery.

Not everyone is sanguine though.

In an article in the Wall Street Journal entitled "We Can't Subsidize the Banks Forever" on 5 May, Matthew Richardson and Nouriel Roubini, professors at New York University's Stern School of Business, wrote that the stress tests "will not mark the beginning of the end of the financial crisis" because the estimates of the losses on US loans and securities by the International Monetary Fund and RGE Monitor imply that "the financial system is currently near insolvency in the aggregate".

Furthermore, the so-called stress tests might not have accounted for a sufficiently adverse economic scenario. "For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' 'worst case' scenario of 7.9% for this same period," they wrote. "At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010."

Paul Krugman, who won the Nobel Prize for Economics last year, is also not optimistic. In his 7 May New York Times article "Stressing the Positive", he wrote that "the odds are that the financial system won’t function normally until the crucial players get much stronger financially than they are now". However, he thinks that the US government will not do anything dramatic to recapitalise the banks and will instead hope that the banks can earn their way back to health.

The risk is that this strategy "will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth".

Indeed, the experience from Japan shows us that the recent rally in the US stock market is not really unusual in the context of a secular bear market.

Ambrose Evans-Pritchard wrote an article for the Telegraph on 10 May, and his message is clear from the title, "Enjoy the rally while it lasts - but expect to take a sucker punch".

"Bear market rallies can be explosive," he wrote. "Japan had four violent spikes during its Lost Decade (33pc, 55pc, 44pc, and 79pc). Wall Street had seven during the Great Depression, lasting 40 days on average."

There is much debate over whether the US economy would fare as badly as Japan and experience its own "Lost Decade". The US does have one advantage over the latter that is not often mentioned: its demographics is not as unfavourable as Japan's was. Japan's population barely grew throughout the 1990s, a situation that was not conducive to economic growth.

Still, as the accompanying chart shows, even within the first three years of the bear market in Japan, the Nikkei 225 index experienced a wild ride. The fluctuations in the US stock market today have been sharper, especially in the past year or so. However, in terms of the magnitudes of the moves -- including that of the latest rally -- they have so far been comparable with Japan's in the early 1990s (for a chart comparing the present US bear market with that during the Great Depression, see "Bear market rallies").

So big stock market rallies are not proof of an impending recovery and the bank stress tests are not proof of a healthy financial system. The latest market rally may have been impressive but it remains vulnerable to an adverse turn in financial and economic conditions.

Stock market investors relieved over the bank stress test results may yet face more tests of their own in the market.