One of the most amazing and wholesome attributes of little children is their ability to forgive and forget. A small “bribe” in the form of candy or ice cream and even the worst faux pas is forgotten. In general, this adaptability can be beneficial for all involved for minor infractions.

As it turns out, investors are very forgetful when it comes to Wall Street’s shenanigans as well. This, however, may not prove beneficial for investors. What are we talking about?

Not too long ago, major Wall Street firms were accused of taking taxpayer’s money – given in the form of bailouts – to fix, or cover up, their own escapades. After a 50%+ slide in the Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC), and Nasdaq (Nasdaq: ^IXIC) from October 2007 through March 2009, all parties – or at least the parties being milked for money – had enough and wanted to make sure the bleeding in banks and other financial institutions would be stopped.

This led to the creation of the bank stress test. The purpose of this “rigorous” assessment was to project different financial scenarios and make sure that the banks were sufficiently capitalized to survive another wave of defaulting toxic assets, without having to tap into the tax-pool.

The bank stress test reviewed

The bank stress test was hyped up to be a big deal and go a long way in shoring up banks’ collective balance sheets. Below is a quick synapses (quoted from the June issue of the ETF Profit Strategy Newsletter). Take a look and judge the effectiveness for yourself.

According to Wall Street Journal reports, the initial results showed that the 19 banks, deemed “too big to fail”, would face a total of $599 billion in losses over the next two years under the government’s worst-case scenario. What is the worst-case scenario?

The proposed worst-case scenario was about as rosy as Moody’s credit rating on the pre-bailout AIG. The parameters are as follows: An economic contraction of 3.3% in 2009, with flat growth in 2010. Unemployment would reach 8.9% this year and 10.3% next year. A 22% drop in housing prices.

At the time of the release in May 2009, the worst-case scenario projections were just a tad worse than the average forecasts given by economists. We now have the luxury of evaluating economists’ forecasts more fully.

Hardly an economist saw the post-2007 market meltdown. Contrary to the trend of the time, the ETF Profit Strategy Newsletter marked the financial sector on a “downward spiral with no stop-loss provision” before the financial sector unraveled. From September 2008 to March 2009, financial stocks dropped 75% on average.

In March, after two failed bailouts, Wall Street was mired in self-pity over the hole it dug. Fears about another Great Depression were running rampant. At exactly that time, on March 2nd, even before the government announced its $1.2 trillion bond buy-back program and the Public Private Investment Program (PPIP), the ETF Profit Strategy Newsletter issued a Trend Change Alert with a clear buy signal.

Clean slate or cover up?

Sure enough, the market rallied and it rallied big; over 65% thus far. This rally soothed investors as sweet candy would a child’s wounded psyche. In fact, most investors are so excited about the recent gains that they have forgotten to ask probing questions such as: Why did stocks rally? How high can the market go? Were the root problems actually fixed?

What would you do if you discovered a dry rot or mildew problem in your house? Would you replace and repair the infected area, or whitewash and cover it up? Let’s see what the banks did with their problem.

As mentioned above, the initial capital deficit was estimated to be $599 billion. Since the banks felt this estimate was too high, the government was kind enough to reduce the official shortfall to $75 billion.

The banks had three choices to raise the additional capital: 1) Raise money from the private sector 2) Sell assets 3) Go back to the government trough. Choices no. 1 and 2 are pretty straight forward, but choice no. 3 includes a “Monty Python like twist.”

Financially engineered safety

For the sake of time, we can’t offer a full description of option no. 3 (the full version is available in the June ETF Profit Strategy Newsletter, page 2), but essentially, with some clever financial engineering, banks were able to shift existing assets from one section of the balance sheet to another, which technically improved the Tangible Common Equity (TCE), a measure of a bank’s ability to absorb losses.

Back to square one

The big story on Monday (11-23-09) was that sales of existing homes jumped 10% in October to the highest level since February 2007. This is good headline news, but fails to excite savvy investors willing to dig deeper.

Many, if not most, of those sales are forced sales, foreclosures or short sales. Institutional investors often buy real estate properties in bulk. 50,000 – 100,000 properties are often bundled into one transaction.

Median home prices are still dropping. According to an Associated Press report from 11-10-2009, the national median home price clocked in at $177,900, or 11% below the third quarter last year.

The credit worthiness of the U. S. consumer has gotten so bad that the private sector (aka banks) has virtually stopped lending. The value of loans held by the largest banks (the same banks that received bailout funds) fell for an eighth consecutive month in September, according to the Treasury Department.

What do the banks know that we don’t? If it wasn’t for government agencies, mortgage lending would be at a stand-still. But lending at all cost is not the solution either. The Federal Housing Administration (FHA) reported that foreclosures on price mortgage and home loans rose to a three-decade high driven by the biggest job losses since the Great Depression.

About 17% of FHA borrowers are at least one payment behind. Even though the FHA’s capital ratio has fallen to 0.53%, the FHA still claims its financial condition is solid. That sounds familiar, up until the government bailout, Fannie Mae and Freddie Mac claimed the same thing.

Worst-case scenario is here, now!

The lynch pin for falling real estate prices, rising toxic asset, and a struggling economy is unemployment. An unemployed worker is unlikely to pay his mortgage and/or buoy consumer spending.

The Bureau of Labor Statistics (BLS) publishes a number of different unemployment numbers. The one captured by the headlines is the best-case scenario, currently 10.2%. The true reflection of the unemployment picture, however, is the U-6 unemployment number which is currently at 17.5% (see chart below, courtesy of the BLS).

Not only is the U-6 unemployment at an all-time high, the number of hours worked is at an all-time low, while the number of jobless workers unemployed for 26 weeks or more has also soared to never before seen highs.

Unemployment was one of the parameters used to determine the worst-case scenario for the bank stress test. Under the worst-case assumption, unemployment (U-3 which is currently 10.2%) was not to exceed 8.9% in 2009 and 10.3% in 2010. Wow! For more details on the U-3, U-4, U-5 and U-6 unemployment numbers and other statistics, refer to the December issue of the ETF Profit Strategy Newsletter.

What does this all mean?

We asked earlier, what do banks know that we don’t? It seems like not only banks know they are in trouble, but even investors are starting to catch on to the fact that banks and other financial institutions are on shaky ground.

As the broad Dow Jones (NYSEArca: DIA), S&P 500 (NYSEArca: SPY) and Nasdaq (Nasdaq: QQQQ) have rallied to new highs just recently, the following bank and financial ETFs have not. In fact, some are still trading around 10% below their recovery highs reached 6 – 10 weeks ago.

Financial Select Sector SPDRs (NYSEArca: XLF), SPDRs KBW Bank ETF (NYSEArca: KBE), SPDR KBW Regional Bank ETF (NYSEArca: KRE), iShares Dow Jones US Regional Banks (NYSEArca: IAT), PowerShares Dynamic Banking Portfolios (NYSEArca: PJB), Vanguard Financial ETF (NYSEArca: VFH), iShares Dow Jones US Financial Sector (NYSEArca: IYF), PowerShares Dynamic Financials Portfolio (NYSEArca: PFI) and others.

As long as the broad market keeps moving up, the weakness of the financial sector will remain covered. But we’ve seen how relentless the news reports will be once the media smells blood. All kinds of indiscretions, at even the highest level, were openly discussed in the early parts of 2009.

Bear markets – the best auditor

Falling prices are the best auditor. Falling prices mixed with the unsettling news they uncover are a recipe for disaster.

The current rally is giving investors a chance to replenish their portfolio. It’s up to each of us individually whether we will repeat the same mistakes made in 2007, or in September 2008. The ETF Profit Strategy Newsletter includes a detailed short, mid, and long-term forecast along with target levels for the end of this rally and the ultimate market bottom.

Sometimes, forgetting isn’t such a good thing. But if that’s the route you prefer to go, enjoy the “candy” while it lasts.