No stress about stress tests

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It might be a challenge for investors to take the Federal Reserve's stress tests on U.S. financial firms seriously. After all, the U.S. economy has been on an impressive winning streak in recent weeks – retail sales are humming, payrolls are growing and initial jobless claims are shrinking – while major stock market indexes have been exploring new multi-year highs.

Who can possibly envision another financial shock? That's the Fed's job: Under its stress tests, it looked at the ability of financial firms to withstand a spike in the unemployment rate to 13 per cent (up from the current 8.3 per cent), equity prices getting cut in half and the already depressed housing market getting hit by another 21 per cent tumble in house prices.

These might have been realistic threats as recently as last fall, when investors fretted over the possibility of the euro blowing up and the economic repercussions sweeping through Wall Street, triggering another global financial crisis. But now? You do get the feeling that threats have subsided to the point where investors see the threat of a financial crisis as distant – perhaps even hypothetical.

This seems to be the reaction in the market, so far at least, to the release of the Federal Reserve's stress tests on Tuesday after markets closed – two days ahead of schedule because of a couple of leaks. The upside to the stress tests is being celebrated; the downside is being ignored.

That is, just about all bank stocks surged on Tuesday after JPMorgan Chase & Co. said it had passed the stress tests, giving it the freedom to return money to shareholders in the form of a dividend hike. It announced such a hike immediately, boosting the share price by more than 6 per cent. You can't blame investors for assuming that other dividend hikes and share buybacks are on the way, from other firms.

However, while 15 of the 19 firms subjected to the tests passed, some obviously didn't – and what's interesting is that the failures aren't being punished harshly in premarket activity on Wednesday morning.

Citigroup is the highest profile bank among the failures: The Fed deemed that its Tier 1 capital ratio would fall to 4.9 per cent under a worst-case scenario, which is below the 5 per cent threshold necessary for a passing grade and suggests that investors won't be seeing any boost in dividends or buybacks. The reaction? The shares were down 4.2 per cent in premarket activity, which isn't bad at all when you consider that the shares rose 6.3 per cent on Tuesday on a false belief that the bank had passed its tests.

Perhaps investors are shrugging off the tests as being unrealistic in today's upbeat environment. We'll see how long this confidence lasts.

"Overall, we can't complain that these tests weren't rigorous enough and it's good to know that most banks would at least survive another global financial meltdown," said Paul Ashworth, chief U.S. economist at Capital Economics, in a note. "Nevertheless, this doesn't mean that the U.S. economy would be unaffected by a meltdown in Europe."

Or maybe investors are looking at the bigger picture here. Fifteen of the 19 banks passed the stress tests: As Meatloaf sang, "Two out of three ain't bad" – and a 79 per cent pass rate is even better.