Reading the most recent bank related headlines is reminiscent of a love sick young lad plucking one rose pedal at a time wondering if, “she loves me or she loves me not…” The financial news is in constant flux every day and one day the media seems to believe, “the rescue plan will work” another day it’s, “the rescue plan won’t work.”

A Mixed Bag

Just last week, Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC) and Goldman Sachs (NYSE: GS) reported better than expected earnings giving investors a glimpse of hope. Yesterday, Morgan Stanley (NYSE: MS) reported weaker than expected earnings and announced that its dividend will be cut from 27 cents to 5 cents per share.

Accordingly, the two major ETFs, tracking the above and many other financial stocks, the Financial Select Sector SPDRs (NYSEArca: XLF) and SPDR KBW Bank (NYSEArca: KBE) have been all over the board.

Earlier in the week, Treasury Secretary Geithner conveyed the sentiment that America’s banks are still broken, despite the bailout infusions. Right now, the market is not giving us a clear indication of how the recently announced bank rescue plans will fair. But don’t despair; the results will be forthcoming soon enough.

More Money for Banks

Next in line is the much anticipated stress test. The Fed is scheduled to detail the methodology behind the stress test this Friday and release the actual results on May 4th. As part of the stress test, officially called the Capital Assistance Program (CAP), the government will look at the balance sheets of struggling institutions and evaluate how much capital the company will need under various circumstances in the future.

The CAP builds on the existing Capital Purchase Program (CPP) which has already boosted banks balance sheets by over $200 billion in bailout funds used toward preferred share capital injections. The stress test (along with the potential for many more, untold billions of dollars) is to include the largest 19 financial institutions with assets in excess of $100 billion. If you are not confused yet, don’t worry, there is more to come.

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Of course, the list of banks in question is top secret. However, based on publicly available information, we have compiled a list of what could be among the 19 largest financial institutions to participate: JP Morgan Chase (NYSE: JPM), Citigroup (NYSE: C), Bank of America, Well Fargo, Goldman Sachs, Morgan Stanley, MetLife (NYSE: MET), PNC Financial Services (NYSE: PNC), U.S. Bancorp, Bank of New York Mellon (NYSE: BK), GMAC, Sun Trust, State Street (NYSE: STT), Capital One, BB&T, Regions Financial, American Express (NYSE: AXP), Fifth Third Bank, KeyCorp.

A Not So Stressful Stress Test

The idea behind the stress test is to find out how banks would fair in the worst possible economic situation. The worst case scenario however, is about as rosy as Moody’s credit rating on pre-bailout AIG (NYSE: AIG) and Lehman Brothers. The underlying assumptions of the worst case scenario are as follows: Economic contraction of 3.3% in 2009 with flat growth in 2010. Unemployment will reach 8.9% this year and 10.3% in 2010. An additional 22% drop in housing prices.

The government’s worst case scenario is just a tad more pessimistic than the average forecast given by economists and we know how far off economists forecasts were over the past two years.

Even though the stock market has been wearing its poker face over the past couple of weeks, not letting investors know (yet) how it will react to the bank (and economy) rescue plan, we can take a strong clue from how the market reacted to the past two major bailout programs, TARP and TALF ($700 and $789 billion).

Even before the first bailout was approved, the ETF Profit Strategy Newsletter outlined five flaws and explained why that (and all subsequent bailouts) will fail. As it turned out, the S&P 500 (NYSEArca: SPY) dropped between 20% and 40% following the announcements of TARP and TALF.

Monty Python would be Proud

You might argue that TAPR and TALF were bailouts where the money went directly to the banks, but the CAP and Public Private Investment Program (PPIP) are not. Unfortunately this is not true. The PPIP, which is designed to help banks unload some $1 trillion of toxic mortgages, is just another bailout in disguise.

Under the PPIP, private investors will be able to control the purchased pool of toxic assets (under the program they are called “legacy assets”) with an equity stake of only about 7%. The Treasury will match the private investor’s contribution. The difference, over 85% of the total, is financed via a non-recourse FDIC loan. Non-recourse means that the private investor is not liable for a decline of the underlying toxic assets, which is certain to happen.

By the end of 2008, the FDIC was nearly broke with only $18 billion left in its war chest. Where did the FDIC get the money from? Under the pretense of needing more money to protect consumer deposits, the FDIC was granted a $500 billion loan from the Federal Treasury. The $500 billion initially allocated to protect CDs is not being used to inject banks with more money.

Even though not as apparent, the PPIP is just another conduit to funnel hundreds of billions of dollars to ailing financial institutions. Monty Python would be proud of the government’s roundabout.

The PPIP has many other unjust and unwelcome side effects all of which are likely to be covered up by the current rally, which the ETF Profit Strategy Newsletter predicted already months ago. The January issue foretold that the stock market would bottom below 6,700 followed by the biggest rally seen since the October 2007 all-time highs.

Optimism about future prospects visible towards the end of this current rally however, should be succeeded by skepticism which will ultimately uncover the short comings of the bank rescue attempts.

Side effects aside, one of the main problems is that the bank rescue plan does not address the real issue. The government is under the misconception the reluctance to lend money by banks is the root of the problem.

For once, banks are actually doing the right thing because there simply is a very small pool of qualified borrowers still remaining. What benefit is there in creating more toxic loans? The bank rescue plan does not address how to shore up the middle class’ credit worthiness and thereby curtail defaulting loans.

The Key Question

How will failing bailout and rescue attempts affect the stock market?

Estimates concerning to actual total losses financial institutions will have to absorb are inaccurate and so are stock market forecasts based upon the government’s flawed projected degree of success or failure. The AP reports that losses could total $2.7 trillion. With nearly $50 trillion of credit default swaps still outstanding, we believe the total losses will be significantly higher.

Projected losses, projected earnings, projected growth ... they are just that – "projected." Projected forecasts will have to be adjusted to the actual numbers eventually and who cares about forecasts that need to be adjusted?

An analysis of historic stock market bottoms provides REAL numbers and REAL targets. A study of dividend yields and P/E ratios for example shows that the stock market does not bottom unless dividend yields and P/E ratios reach a certain level – it’s that simple.

Furthermore, the Dow Jones (NYSEArca: DIA) measured in inflated U.S. dollars does not provide a true and reliable picture. A look at the Dow measured in the only true currency – Gold (NYSEArca: GLD) – provides a clear and irrevocable point of reference. In fact, the Dow measured in gold has already mapped the course which the dollar inflated Dow will soon follow.

A detailed explanation of the governments house of card (bank rescue plans), dividend yields, P/E ratios, the Dow in gold along with specific target levels for an ultimate bottom and corresponding ETF profit strategies is available via the ETF Profit Strategy Newsletter.