Stock prices in New York skyrocketed this week and U.S. stock indexes are now about 20% higher than when the market hit bottom on March 9. Unprecedented measures to expand credit are one cause of this powerful recovery. The Fed is buying long-term Treasury bonds, increasing purchases of asset-backed securities and other credit instruments, and taking other actions. Investors were also happy to hear the U.S. government’s plan to buy as much as $1 trillion of toxic assets.

There are three key aspects of this plan: (1) the participation of private-sector investors with the backing of Fed loans will provide more funds to buy these assets; (2) the government (using the FDIC and bailout fund under the Economic Stabilization Act) will cover losses; and (3) prices will be determined by auctions. Since the government has limited the downside risk, many private-sector investors are likely to purchase toxic assets.

This massive program to buy toxic assets will not succeed unless the prices of these assets climb. There are two viewpoints regarding the probable direction of these prices. One is that current prices of toxic assets are far too low because financial markets have broken down. Once the markets return to normal, prices of these assets will increase sharply. The other viewpoint is that today’s low prices are justified because markets are factoring in the possibility of a severe economic downturn on the scale of a depression. I subscribe to the first view. Market prices have dropped too far. Once a correction occurs, I think we will see a positive cycle that starts with higher capital at financial institutions and leads to a resumption in lending and a recovery in real demand. This process is very likely to produce a V-shaped rebound in both market prices and the economy, both of which are extremely depressed. Of course, the pessimists have a completely different view of this matter.

Pessimists have been emboldened by the accuracy of their gloomy forecasts thus far as the financial crisis unfolded. They are convinced that the crisis originated with the mistaken economic structure of the past (the U.S. reliance on debt for economic growth and the reliance of the world on U.S. economic growth). Since the problem is structural in nature, the pessimists believe that monetary easing, fiscal stimulus and bank baling out programs are nothing more than cosmetic solutions. This leads to the conclusion that government initiatives provide no reason to be confident about the outlook.

Optimists also recognize that many excesses, including excessive debt and the housing bubble are one cause of crisis. This stance is based on the belief that the financial crisis is not linked to the structure of economic growth in the past. Instead, optimists think the crisis was caused by defects in the financial system. In particular, the causes were unbridled greed and an automatic instability amplification mechanism that exaggerated the downturn in financial markets. People who embrace this position believe that a V-shaped recovery will begin once capital markets are functioning again and an upward correction in prices occurs. Prices on stock and credit markets will rise first. Next, the real economy will begin to improve. This optimistic outlook for the economy is still alive and well.

Last 5 posts by José Pérez

• Investment and Trading Books - March 2nd, 2010
• Why You Shouldn’t Be an Investment Banker - February 27th, 2010
• Top International Business Schools - February 25th, 2010
• Hedge Fund Interviews - February 24th, 2010
• A Day in the Life of an Investment Research Associate - February 22nd, 2010