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Bailout Doesn't Offer Market Clear Direction

The $700 billion bailout proposed by Treasury Secretary Henry Paulson could have a major impact on the stock and bond markets. Its unprecedented size and scope make it difficult to predict how. Frank Curzio breaks down the market action in The Real Story video above.

Investors on Monday began to digest some unfortunate news: Despite the Treasury's proposed $700 billion Wall Street bailout, the hefty price tag does not guarantee a clear direction for either the bond or the equities market.

The Treasury has outlined a plan to issue up to $700 billion worth of new debt to finance the purchase of troubled loans from U.S. banks. But many questions remain about the bailout, which has no historical parallel in size or scope, and whose details have not yet been fully hammered out.

The stock market moved quickly back to panic from relief on Monday, with the

Dow Jones Industrial Average

giving up nearly half the gains it had recorded since the Treasury's plan first surfaced. Treasury yields have swung wildly since the plan was announced, as investors considered several issues, including basic supply and demand fundamentals and the rising -- albeit still highly unlikely -- chance of T-bill default.

A huge amount of government bonds will be auctioned in coming months to support the bailout plan, as well as the earlier recues of

Fannie Mae



Freddie Mac



American International Group


. The flood of issuances, along with the government's moves to take on the banking industry's riskiest assets, could drive yields higher. On the other hand, if the year-long flight to safety and predictions of further economic strife are any indication, robust demand may keep rates relatively low.

James Glassman, senior economist at JPMorgan Chase predicts there will be no material effect on the Treasury market.

"If the market thought the government would not be able to pay back its debts, it would show up in rates," says Glassman. "These are risk-free assets and they're backed by the good faith of the government, which will never default on its debt. The Treasury secretary would rather go to jail than to make that happen."

Still, Tony Crescenzi, chief bond market strategist at Miller Tabak + Co., notes that credit spreads have widened sharply, with the market pricing in far more risk for U.S. government and agency debt. Another "key gauge," he says, is the dollar's value, which dropped sharply against the euro, pound and yen on Monday. But looking ahead, Crescenzi says the bailout plan will ultimately help investors of all stripes.

"In general, I see tighter credit spreads, higher Treasury yields, and higher equities prices as time goes on," he says. "It will take time, though, as there will remain lingering anxieties evident in the pricing of risk assets such as corporate equities and corporate bonds, reflecting uncertainties about the economy and the impact of the government bailout."

Many investors still consider Treasuries to be the safest investment, especially in light of how far-flung economic problems have become. Europe, Russia and Asia have been struggling with issues that stem from the U.S. crisis, and are faring worse in certain respects. With a volatile market for equities, commodities and foreign exchange, Treasuries may prove to be the best bet.

"Investors are going to take their money out of riskier assets and put it into the Treasury," says Vinny Catalano, chief investment strategist at Blue Marble Research. "There's a belief at the end of the day that the U.S. government is still going to be standing and those assets are safer than everything else."

In theory, the government's plan to buy up mortgage securities will also help the financial market, by putting an official price tag on mortgage-backed assets. The range of prices for securities backed by the riskiest subprime mortgages on the ABX Index, currently varies from 5 cents to 10 cents on the dollar, according to Tim Backshall, chief strategist at Credit Derivatives Research. Alt-A mortgages, which are less risky, vary from 10 cents to 20 cents on the dollar, while the best, prime loans are valued at 51 cents to 95 cents on the dollar.

Some financial firms will inevitably lose out on overvalued assets, but ultimately, taxpayers may not be on the hook for anything and may even profit from the bailout plan. The government has a much longer time horizon to sell troubled assets at a fair price -- one that it will set.

"It has luxuries that private owners just don't have," notes John Rekenthaler, vice president of research at Morningstar. "It won't have to mark to market or raise capital."

Rekenthaler's research of past financial crises finds varying results for portfolios -- whether all-stock or bond-balanced. For instance, it took the market three years to post significant gains after the savings and loan crisis of the 1980s, but the dot-com crash took at least five years. In most cases, the balanced portfolio outperformed the one that held only stocks.

When it comes to buying up riskier assets, Ronald Albahary, head of strategic investment solutions, North America at Schroders, is working to determine the midpoint of the current downturn to begin reweighting portfolios.

"We're trying to tune out some of the day-to-day market noise that occurs and focus on what our long-term economic and market models are telling us," says Albahary. Still, "it is very hard to predict what's going to happen. What's going on now is kind of unprecedented."

Backshall says all types of investments may suffer until several economic headwinds facing the consumer improve. Otherwise, rising unemployment, stagnant wages, high inflation and the degradation of household wealth will continue to push up foreclosure rates or cause defaults on other types of loans, from cars to college educations.

The government plan is "by no means a sufficient solution to start a new bull run," says Backshall. "Ultimately, the market needs the greatest of all healers -- time -- to do its thing."