Despite recent weakness, the stock market remains in a rising trend, continuing the rally that started in March of this year. Given the strength of the rally during the past seven months, we might conclude that the government has been successful in efforts to avert disaster and transition the economy toward recovery. Economic statistics have been improving gradually as well. As we look to forecast the future of the economy and stock market, it is instructive to look back at the government bailout activities that led us to our current situation.

First, credit where credit is due. Given the scale of economic catastrophe, the Bush and Obama administration each took strong actions to maintain the integrity of global economic order. However, we are left with a central controversy regarding government bailout policy: whether large companies should more frequently be allowed to fail, and what are the implications of moral hazard when the government does step in.

Any evaluation of the bailouts and moral hazard must consider the result when the government allowed Lehman’s failure. Frontline did an excellent documentary on the crisis, Inside the Meltdown, which specifically looks at Hank Paulson’s thought processes leading to his decision regarding Lehman. Of course, a much bigger shoe dropped almost immediately afterward, and to some degree as a consequence, when AIG required an $85 billion rescue. Given the consequences, Paulson’s decision appears to have been a critical error.

Of course, sometimes a situation can be so dire, there really are no good solutions, only those that are the least bad. Even so, there is much to criticize in the government’s bailout policies to date. Activities at both the Treasury and Federal Reserve have been characterized by secrecy and backroom deals, conflicts of interest, and a failure to act in the interest of the taxpayer. The bailout of AIG is a case in point, as it funneled enormous sums to AIG’s counterparties, including both American and foreign banks. As Zero Hedge reported in March:

AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

Rep. Darrell Issa recently followed up with the New York Fed president, requesting AIG bailout disclosure.

As you know, in late 2008 American International Group (“AIG”) was attempting to negotiate a haircut for banks that held $62 billion in credit default swaps (“CDS”) from AIG. AIG was reportedly seeking to persuade the banks to accept haircuts of as much as 40 cents on the dollar in order to retire these CDS contracts.

On September 16, 2008, the FRBNY extended AIG an $85 billion line of credit,
effectively nationalizing it. According to news reports, late in the week of November 3, then-FRBNY President Timothy Geithner, along with the U.S. Department of the Treasury and the Federal Reserve Board in Washington, took over negotiations with AIG’s counterparties.

News reports indicate that Mr. Geithner’s team circulated a draft term sheet to set the terms under which AIG would settle its CDS obligations, including a blank space in which the haircut for creditors was to have been inserted. However, the haircut provision was reportedly crossed out and, after less than a week of secret negotiations between the FRBNY and the banks, FRBNY ordered AIG to pay its creditors at par – 100 cents on the dollar – not 60 cents as AIG had been attempting to negotiate.

Thus, behind closed doors and with no approval from Congress, the FRBNY may have added an additional $13 billion of debt on the backs of taxpayers.

These allegations, if true, amount to nothing less than a backdoor bailout of AIG’s creditors, including Goldman Sachs, Merrill Lynch, Société Générale and Deutsche Bank.

The lack of transparency and accountability in this transaction is disturbing enough. However, there is evidence that this $13 billion expenditure was entirely unnecessary. According to Janet Tavakoli of Tavakoli Structured Finance, “There’s no way they should have paid at par. AIG was basically bankrupt.”

The AIG scenario is typical of the government’s approach to the financial crisis: pass enormous quantities of taxpayer dollars to Wall Street (and banks abroad) through numerous creative means, including overpaying for assets. At the same time, hold nobody responsible for fraudulent activities, and avoid any meaningful reforms of the financial system that would help avoid a repeat of the crisis down the road. Rinse and repeat.

So, we seem to have avoided a catastrophe, at least for now. Yet we have seen an unprecedented transfer of wealth from Main Street to Wall Street, and somehow Goldman Sachs seems to have emerged stronger than ever. In an article for The Atlantic earlier this year, former IMF Chief Economist Simon Johnson recognizes the consistent patterns of financial crises, and worries that elite business interests have been directing policy. Looking back at his IMF days, he asserts that the political environment is central to whether a country in crisis is prepared for recovery. “Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks.” His experiences with developing economies provide striking parallels with the current global economic situation. As he says, “Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.”

The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Johnson goes on to discuss the revolving door between Wall Street and Washington, and the cultural pull that Wall Street exerts, influencing beliefs and policy.

Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here. In September 2008, Henry Paulson asked Congress for $700 billion to buy toxic assets from banks, with no strings attached and no judicial review of his purchase decisions. Many observers suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands—indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved.

Instead, the money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves. As the crisis has deepened and financial institutions have needed more help, the government has gotten more and more creative in figuring out ways to provide banks with subsidies that are too complex for the general public to understand.

… In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign.

Boris Fyodorov, the late finance minister of Russia, struggled for much of the past 20 years against oligarchs, corruption, and abuse of authority in all its forms. He liked to say that confusion and chaos were very much in the interests of the powerful—letting them take things, legally and illegally, with impunity. When inflation is high, who can say what a piece of property is really worth? When the credit system is supported by byzantine government arrangements and backroom deals, how do you know that you aren’t being fleeced?

Defenders of bailout policy will say that banks needed to be recapitalized, and these solutions were preferable to outright nationalization. But it is important to ask who’s interests are being represented as Wall Street insiders funnel massive taxpayer dollars to Wall Street megacorporations, which then turn around and use a healthy chunk of that money to lobby congress to avoid accountability and reform.

Economist, and former savings and loan regulator, William Black discusses moral hazard, and shortcomings of Geithner’s prescriptions:

If cheaters prosper, cheaters will dominate. It is like Gresham’s law: Bad money drives out the good. Well, bad behavior drives out good behavior, without good enforcement.

[Geithner's] plan essentially perpetuates zombie banks by mispricing toxic assets that were mispriced to the borrower and mispriced by the lender, and which only served the unfaithful lending agent.

We already know from the real costs — through the cleanups of IndyMac, Bear Stearns, and Lehman — that the losses will be roughly 50 to 80 cents on the dollar. The last thing we need is a further drain on our resources and subsidies by promoting this toxic-asset market. By promoting this notion of too-big-to-fail, we are allowing a pernicious influence to remain in Washington. The truth has a resonance to it. The folks know they are being lied to.

I keep asking myself, what would we do in other avenues of life? What if every time we had a plane crash we said: ‘It might be divisive to investigate. We want to be forward-looking.’ Nobody would fly. It would be a disaster.

We know that with planes, every time there is an accident, we look intensively, without the interference of politics. That is why we have such a safe industry.

Many will consider these points to be superfluous, considering the rallying stock market and apparently improving global economy. And perhaps this point of view will be validated by a continuing recovery. Personally, I think the US government simply kicked the problem down the road. It is still not clear that the credit crisis has passed. Neither bank nor REITs are required to mark-to-market, which leaves us with big question marks regarding toxic assets still in the system. In the end, it is impossible to gauge the success of bailout programs so soon after their implementation. The economy will tell the tale over time.

As we get into the heart of earnings season, investors will be watching the quarterly results in order to predict the market’s reaction, both short- and long-term. Earnings reports help us gauge the health of individual companies, as well as the broader macroeconomic trends across industry sectors. At the same time, it is important to note that stock price action will often move seemingly at odds with earnings results. This because, at least in the short term, markets do not trade on valuation alone. Moreover, valuation itself is a tricky game.

Henry Blodget explained some of the difficulties inherent to valuation in a 2004 article:

A share of stock is, in theory, worth the “present value of future cash flows” attributable to the share. (In practice, a share is worth what someone will pay for it, but leave that aside for a moment.) Given the confidence with which some commentators cite the theory, a casual observer might assume that the “present value of future cash flows” is an indisputable number, akin to a price tag on a can of soup. In reality, however, it is not a number but an argument, and, in most cases, it is a surprisingly imprecise argument, with a wide range of reasonable conclusions.

Blodget goes on to discuss the complexity of evaluating future cash flow given the uncertainties of the broader economic environment, future earnings, and, particularly, interest rates. As he says,”Over the long haul, thankfully, valuation does matter: The market is not random, stock prices do tend to regress to long-term means, and long-term investors are better off buying when stocks are cheap. As discussed in a previous piece, however, the “long term” is long (decades, not years), and valuation is not a particularly helpful prediction tool over timeframes of three months to a couple of years (not worthless—just not particularly helpful).”

In this light, we can consider the prior two quarters of earnings results, post meltdown, that led to continuation of our remarkable rally. At no time since the financial crisis began have company earnings been particularly good. In fact, across the board, both revenue and earnings have been down drastically. Remaining profits often have been the result of cost-cutting, or in the case of the larger banks, profits from trading with taxpayer dollars. Moreover, when it comes to banks and REITs, financial results have not been marked-to-market. Therefore there are certainly enormous unreported liabilities throughout the system. As in many billions of dollars worth. The media has generally reported the sustained rally as being due to improving economic conditions. Perhaps to a degree this is the case. At the same time, it is equally likely that we have rallied due to the massive liquidity injected through bailouts, quantitative easing, and other government activities. Disaster was averted. Yet it is unclear that anything has truly been fixed. On the contrary, we have seen a massive wealth transfer from US taxpayers to Wall Street, in a desperate attempt to solve an overleveraging problem by simply taking on more debt. Our “jobless recovery” rests on very shaky foundations indeed. Most likely it simply sits atop a newly-formed asset bubble.

This week Doug Kass wrote up an excellent analysis of the current season’s earnings, drawing the following conclusions:

1. The third-quarter beats were overhyped as they are the outgrowth from lowered guidance.

2. If one divides the third-quarter earnings reports by end-market categories, differentiating between the beneficiaries of restocking and those companies that are closer to the end markets and consumption, it leads to two different pictures as to the health of corporate earnings.

3. If end demand doesn’t pick up (and pick up quickly), the 2010 earnings outlook for many industries (such as semiconductors and other beneficiaries of restocking) will be in jeopardy, as will be the now ambitious consensus for S&P 500 earnings of over $70 a share next year.

So what is an investor, or trader, to do in such an environment? For now, the market continues to go up. I remain very cautiously net long in my portfolio, with an emphasis on stocks in the following sectors: energy (especially clean energy), Brazil, China, and select technology stocks. In my view the pickings are getting slimmer, and other signs indicate we may be nearing the a market top. Investors should note in particular the inverse directional relationship between stock market and the dollar. Talk is increasing in Forex circles that the dollar is due for a trend change. Moreover, other countries may soon follow Brazil’s lead in making policy changes to prevent overvaluation of their currency with respect to the dollar. The world does not want an overly weak dollar. With countries vying to devalue their currencies, and with an appreciating dollar, risk appetite is likely to abate, and stock markets globally could lose momentum quickly.

In other words, if you are a trader, the trend is still up, for now. If you are a long-term investor, tread with caution, whatever the earnings reports may say to you.

I’ll end with one recommendation. Apple (AAPL) reported earnings this week, and broke to new highs on very heavy volume. This company is a superstar. If you are investing for the short- or long-term, you can’t go wrong here.