Are we there yet? No road trip is complete without this innocent question coming from our little back-seat warriors.

As of late, investors – feeling they’ve lost their position in the driver’s seat – are asking: Are the banks healthy yet? Is the worst over?

What do you tell a little kid who’s itching to get out of the car even though the destination is still hours away? You tell them it’s just a little while longer and invent some car-games to distract the little mind.

On a much grander scale, that’s what the bank stress test and corresponding results are designed to do for investors.

The stress test results were released on Thursday, and what’s previously only been available via well engineered leaks is now official. “Some of the largest banks are stable. The financial system, like the overall economy, is healing but net yet healed,” reports the Associated Press.

10 of the 19 largest banks need a total of about $75 billion in new capital to withstand a worsening economic recession. Compared to a few trillion dollars already committed to propping up financial conglomerates, $75 billion indeed does not seem like much.

Among the 10 banks needing to raise more capital are Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC), Morgan Stanley (NYSE: MS) and Citigroup (NYSE: C).

According to the stress test, Bank of America needs the biggest boost ($35 billion). BofA’s CEO Ken Lewis, a counterintuitive chap, is in denial and feels comfortable with the bank’s current capital position.

Fortunately for many banks, the stress test is a turn-key program and comes with a built in option to “cheat” the government's own requirements (more about that in a moment).

The performance of bank stocks has been all across the board since the March lows. Fifth Third Bancorp. shares are up 141% while Citigroup gained only 15%.

Investors and traders looking to capitalize on a composite move in financials may want to look at financial sector ETFs rather than trying to pick a winner.

The Financial Select Sector SPDRs (NYSEArca: XLF), SPDR KB BANK ETF (NYSEArca: KBE), iShares Dow Jones US Financial Sector ETF (NYSEArca: IYF) and Vanguard Financial ETF (NYSEArca: VFH) offer exposure to a broad basket of financial stocks.

All of the above have outperformed the S&P 500 (NYSEArca: SPY) and Dow Jones (NYSEArca: DIA) by a large margin over the past eight weeks.

The Ultra Financial ProShares (NYSEArca: UYG) and Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS) provide double and triple leveraged performance linked to the financial sector.

For naysayers, the Short Financial ProShares (NYSEArca: SEF), UltraShort Financial ProShares (NYSEArca: SKF) and Direxion Daily Financial Bear 3x Shares (NYSEArca: FAZ) are short ETFs with 1x, 2x, and 3x leveraged.

Underneath the surface

There is no shortage of financial ETF choices but the key question is whether the stress test results will sink or propel stocks. Will the “worst case scenario” for banks ever materialize or is the worst over?

Back in October 2008, on the same day the first bailout was approved, the ETF Profit Strategy Newsletter considered financials to be a downward spiral with no stop-loss provision and outlined why the bailout will fail. In October and once again in the beginning of January, the newsletter recommended to load up on short ETFs and short financial ETFs.

Has the outlook changed? There are three components to the forecast for financials:

1) The validity of the stress test and actions to be taken;
2) General stock market valuations to determine the long-term outlook;
3) Investor sentiment to determine the short-term outlook.

1) The validity of the stress test and actions to be taken

Let’s get back to the “Are we there yet?” question. The worst case scenario test conducted by the government compares to telling a little kid “just 10 more minutes” when in reality you are still an hour away. The worst case scenario test compares to stock market valuations around Dow 6,000 (Dow 6,440 was the March low). If the Dow Jones drops below its March lows, the stress test scenario becomes nearly obsolete.

Banks can increase their capital in three ways: A) Raise money from the private sector B) Sell assets or C) Go back to the government for help. Going back to the government for help might be as easy as converting preferred shares – which the Treasury already owns – into common shares.

To do that, a new instrument has been created, the “mandatory convertible preferred share.” This provision would allow for preferred shares to be converted into common shares. Without actually increasing the capital, this conversion still counts towards building the capital buffers required by the Fed and technically fulfills the requirements to protect against the worst case scenario.

You may not be surprised to hear that Citibank has already announced that it will convert an extra $5.5 billion of preferred shares into common stock to shore up its balance sheet. Those intricate technicalities may go unnoticed as long as stocks continue to rally. A drop towards the worst case scenario levels however, will make the capital shortfall all too clear.

2) General stock market valuations to determine the long-term outlook

Wall Street bases their forecasts on news and news-worthy events such as the stress test results. Granted, over the short-term, seemingly monumental pieces of news may affect the market’s performance for a day or two.

A look at the big picture however, reveals that news-based predictions are no more than water under the bridge. In fact, news in general tends to be good at the top and bad at the bottom. If your investment decisions are news-based, chances are your portfolio is racking up losses.

The only true indicators for the market are signals originating from the market. Such signals include P/E ratios and dividend yields. A study of historic market bottoms shows that the stock market does not bottom unless P/E ratios and dividend yields reach certain levels.

Just as water doesn’t melt until the temperature moves above 32 degrees, the stock market does not bottom unless P/E ratios and dividend yields clock in at certain levels (more about that in a moment).

3) Investor sentiment to determine the short-term outlook

As mentioned above, the stress test results will have the same effects on investors as made-up car games for kids. They keep the moral positive.

Ironically, positive or optimistic investor sentiment reaches a climax right before the market tops. Think for a moment how good investors felt about the market in the summer of 2007, right before the market reached its all-time high, and in January 2009, right before the Dow Jones dropped 2,700 points.

The ETF Profit Strategy Newsletter referred to this phenomenon on December 15th when it warned that “optimistic sentiment, which should be more visible above Dow 9,000, will give way to new lows.”

It looks like this rally still has room to grow, especially if small corrections continue to temporarily “cool” investor optimism. Nevertheless, investors (individuals and institutions) have become significantly more bullish since the March lows which indicates that this rally’s exhaustion point is approaching.

How far will this rally go? Where is the ultimate market bottom? The March issue of the ETF Profit Strategy Newsletter contains an in depth analysis of the above mentioned indicators (P/E ratios, dividend yields and more) along with target levels for the end of this rally and the ultimate market bottom.

Are we there yet? Unfortunately, NO. To be prepared for this unique trip, an understanding of the road ahead and the final destination is priceless.