Credit Update: Neither a Borrower nor a Lender Be

The stress test results have come and gone. Now it's time to refocus on the economy and the markets. In the past nine weeks, neither much-feared earnings, stress test leaks nor swine flu could keep the market down. The view among the big traders I talk to is that the rally is overdone. Of course, they have been saying that for a month and have been wrong.

Here's what we know: the risk of financial system failure and economic free-fall has faded. That does not mean that there won't be bumps along the way -- there will. But we have backed away from that scary abyss and now turn our attention to the more mundane question: what kind of recovery is in store?

We know that it's imperative for credit markets to improve before a true recovery takes hold. On that front, there has been an improvement in lending spreads. The TED spread, which is the difference between 3-month Libor and the 3-month Treasury bill, has narrowed dramatically. On March 3, the TED was at 110 bps. Today it has dropped to 78 bps, which is great, but still well over the ten-year average of 55 bps.

This week, Libor fell below one percent for the first time since the summer of 2007, the beginning of when banks started hoarding cash, prompting the credit crisis. LIBOR peaked at over 4.8 percent in October 2008 before easing to current levels.

TED and Libor tell one part of the story, but not the whole shebang. Bank lending to companies has fallen dramatically and just yesterday, the Fed's release on consumer credit indicates that the problem is as much about the lack of consumer borrowing as it is about bank lending.

Consumer credit decreased at an annual rate of two percent in Q1, while revolving credit decreased at a whopping 6.5 percent annual rate. It only took an 18-month beating to get American consumers to stop borrowing! As a result, banks are lending far less than they were last Fall. The 19 "stress test" financial institutions made or refinanced a total of $226.3 billion in loans during October. In February, that figure had fallen to $174.2 billion.

OK, so where does that leave us? We know that the recent economic data has improved and for that, we are grateful. But with borrowing down so much, it's worth considering whether the current earnings forecasts are a bit too rosy.

The stock market will be the ultimate arbiter. The old sayings -- "Don't fight the tape...The Trend is Your Friend" -- notwithstanding, investors will need proof that earnings projections for the next two years validate the current valuation of stocks.