“When in doubt, issue a bailout” seems to be the strategy global leaders trust to fix economic problems. They’ve gone from bailing out corporations, to bailing out entire governments. If bailouts don’t do the trick, they resort to stress tests.

On May 10, the European Union created a $1 trillion package to save the euro. This didn’t appease investors much as the S&P dropped up to 13%, thereafter, the SPDR Euro STOXX 50 ETF (NYSEArca: FEZ), Vanguard European ETF (NYSEArca: VGK) and iShares S&P European 350 (NYSEArca: IEV) tumbled as much as 16%, and many predicted the extinction of the euro currency.

Something else was needed to shore up investor confidence in an entire continent’s financial system. “Bank stress test” became the magic phrase. Nothing calms fear like a stress test that’s labeled as rigorous.

The stress test raises a few very obvious questions:
1) Will it work?
2) Why was it needed in addition to a $1 trillion aid package?
3) Is the stress test just a gimmick to appease investors?

The stress test is conducted by the London-based Committee of European Banking Supervisors (CEBS). Ironically, the test has ignored the majority of banks’ holdings of sovereign debt.

Sovereign debt concerns by the so-called PIGS countries (Portugal, Italy, Greece, and Spain) triggered the latest wave of financial problems. Ignoring sovereign debt in the Euro stress test would be like ignoring toxic real estate assets in the U.S.

10% Good – 90% Bad

According to a Morgan Stanley survey, European banks hold about 90% of their Greek government bonds in their banking books and 10% in their trading books. The bonds in the banking book are generally held until maturity, the bonds in the trading book are traded more frequently.

According to a document obtained by Bloomberg, the stress test assumes a loss of 23.1% on Greek debt, 14% on Portuguese bonds, 12.3% on Spanish debt, 4.7% on German debt, 10% on U.K. debt, and 5.9% on French debt.

However, the stress test only looks at the bonds held in banks’ trading books, which account for a mere 10% of Greek bond holdings. Can that be called a stress test?

Nouriel Roubini says that “the assumptions made about economic growth, about sovereign risk are not realistic enough.” The fact that only seven banks failed the test with a combined shortfall of $4.5 billion confirms the lax nature of the test.

Publicity Stunt

Have you ever heard the expression “happy wife, happy life?” The same is true when it comes to investing; “happy investors, happy stock market.” Of course, too much happiness on Wall Street general turns into a correction of some sort (such as in April 2010).

But European leaders recognized that a scared investor is bad for business. Priority number one was to appease investors, just as a casino would want to win back a disgruntled whale (Whale is casino slang for gamblers who can lose millions, also considered high rollers).

Stress tests on Wall Street (or the European equivalent) work like free penthouse suites, show tickets, and dinners in Las Vegas. They win investors back and make them feel comfy and cozy.

However, the stress test is very much a timing issue. A whale will quickly become disenchanted if the losses continue to pile up, just as investors will similarly leave the table when the stock market (NYSEArca: VTI) refrains from going up.

All About Timing

A recent Associated Press report suggested that the U.S. bank stress test was one of the causes of the magic March 2009 – April 2010 rally. However, as the chart below shows, by the time the test results were announced, the S&P (NYSEArca: SPY) had already rallied 39%.

To many this came as a surprise, but not to subscribers of the ETF Profit Strategy Newsletter. On March 2, 2009, the newsletter sent out a Trend Change Alert and recommended to close all previously bought short positions and buy long and leveraged long ETFs to profit from a rally that may carry as high as 10,000 for the Dow (DJI: ^DJI) and 1,000 for the S&P (SNP: ^GSPC).

As we know today, the rally carried even further, dwarfing a forecast that seemed outrageous initially. Because this rally kept going and lifted stocks from banking (NYSEArca: KBE), regional banking (NYSEArca: KRE), large financial corporations (NYSEArca: XLF), technology (NYSEArca: XLK), and pretty much every other sector, the stress test was believed to have been successful.

The U.S. Bank Stress Test – A Nice Facade

A closer look under the hood of the U.S. bank stress test, however, shows that there’s not much substance behind the facade either. It was determined that the 19 tested U.S. banks need to increase their balance sheets by $75 billion to meet the conditions of what’s termed the “worst case scenario.”

To a large extent, the $75 billion of additional capital was financially engineered. Banks didn’t have to actually raise $75 billion. They were able to change the label of some of their assets on their balance sheets. The government supported this practice via mandatory convertible preferred shares (detailed analysis in May 2009 issue of the ETF Profit Strategy Newsletter).

The stock market did the rest. Rising stocks increased the shares value of the actual banks and the stock portfolio they owned. In addition, the banks’ trading desks raked in record profits courtesy of a relentless rally. But most importantly, rising prices combined with the comfy cozy feeling surrounding the stress test kept investors happy.

As the chart above shows, the timing for the U.S. bank stress test was nothing short of perfect. Unfortunately, the same can’t be said of the first $700 billion bailout which sunk stocks (NYSEArca: TWM).

About Timing

The tricky thing about timing is timing. It’s tough to time the market, and as the chart shows, the timing for the Euro stress test looks already off. Unlike the U.S. stress test, which surfaced after a historic 54% decline; the Euro stress test appeared after a historic 83% rally. After an 83% rally, the upside potential is limited to say the least.

One lesson to be learned is that the market does what the market wants to do. Savvy investors don’t attempt to interpret how government decisions affect the market; they go straight to the source and analyze the market itself. The government will have to adapt to the market, not vice versa.

The ETF Profit Strategy Newsletter analyzes the market from all angles; technicals, candle formations, fundaments, valuations, sentiment gauges, and a fair shot of plain common sense. This approach cuts out all the confusing noise coming from Wall Street and focuses on what’s important – what the market tells us.