Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1.  Stress tests = a case in selective reality: Seven out of 91 Banks in the EU failed to measure up, according to officials. Markets around the world rallied in response, dampening the effect of 2nd-quarter earnings news (more on this below).  On the surface, the result of the stress tests appeared to be positive, but that facade covered a case of denial, in our opinion.  Holdings of sovereign debt, troubled or not, such as Greece, Hungary, Italy, Spain, and more, were essentially eliminated from the analysis.  All such bank holdings were allowed to be carried at maturity value, or “par,” instead of what should have often been considered junk value.

These tests were very similar to those conducted here in the U.S. not long ago under FAS 157, in which U.S. quasi-government debt (Fannie Mae & Freddie Mac) was allowed to be reclassified as “held to maturity,” and therefore carried on the books at par.  Of course, this reclassification and revaluation of faulty assets didn’t help Fannie’s and Freddie’s solvency from a cash-flow perspective.  Shares of both companies are now penny stocks at best.  By extension, we suspect the true condition of many these banks that hold faulty credits will also reflect a similar value before long.  Our bet is that “value” is somewhere slightly below par – at best.

The implications for ailing EU economies are still grim, regardless of this window-dressing effort, as sovereign debt interest expense still outpaces economic cash-flow generation.  Banks in Europe would agree.  With inter-bank lending rates hovering at all time highs (and going higher), it would seem that the stress tests didn’t do much to promote confidence within the financial community.

2.  We would say that the earnings season turned out as expected, with many companies able to beat the numbers, so to speak.  UPS, Caterpillar, AT&T, Intel, Apple, Microsoft, and Union Pacific all fared well – just to name a few.  Following the fairly impressive performance, one might think now would be a good time to ring the victory bell on the recovery.  However, it appears that even the market didn’t get very excited about the results.  The Dow and the S&P remained range-bound for the week.  Chairman Bernanke’s intention to keep rates where they are with the intention to “act” in case things get worse also didn’t help markets regain their previous speculative fervor.  So what is the market trying to tell us?

It’s our view that, within the last month or two of the quarter, things started to slide.  Homes sales, employment, and retail activity all headed south in June.  The main reason for this, we think, was the lack of stimulus.  Most Fed intervention and government tax credits (for housing and autos) came to a halt before the end of the quarter.

So a major question mark hangs over the market.  Can the U.S. economy grow – or even stabilize – without government intervention? We would say that the conclusion is obvious.  What’s more, it seems to be obvious enough that even our friends at CNBC spent most of the week arguing about what weapons the Fed has left at its disposal to turn things around.  To be sure, we believe it’s a problem worth discussing, but let’s not forget the real issue.  If we can’t grow or proceed without stimulus, what impact will this dependency have on our currency, our bond market, and ultimately on our economy?  These are parts of the equation that are not so obvious to the folks on television, but we would say that the writing is on the wall.

Have a great weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO