News a week ago Friday that a bailout plan was in the works that would allow the government to take the toxic mortgage assets off the balance sheets of financial companies was met with a great sense of relief by the markets.  It was hoped that a solution would bailout the financial system's problems, which is housing and mortgage-related assets clogging up bank balance sheets, freezing all types of lending.  However it didn't take long, for those good feelings to disappear as no consensus among politicians could be reached. 

Last week the NASDAQ slid 4%, the Dow dropped 2.2%, and the S&P 500 fell 3.3%.  Most of the economic news was negative.  Sales of existing homes fell 2.2% to an annual rate of 4.91 million, according to the National Association of Realtors. While the median sales price of an existing home fell 9.5% versus year ago. Unsold inventory fell to 10.4 months in August, mostly because discouraged sellers are taking their homes off the market.  New home sales dropped 12% to an annual rate of 460,000. Durable Goods orders fell 4.5% in August.

This will be a September to remember. The month has been one of the most amazingly bad months for the credit markets in history, starting with the effective nationalization of Fannie Mae (NYSE: FNM [1]) and Freddie Mac (NYSE: FRE [2]), the bankruptcies of both Lehman Brothers and Washington Mutual, and the $85 billion Federal loan to AIG. The credit markets have not witnessed a month like this since 1990 when the Savings & Loan crisis and the Resolution Trust Corporation (RTC) version 1 was set up by the Federal government.

The overriding force propping the market up right now is the prospect of a Wall Street rescue.  Treasury Secretary Hank Paulsen was quoted this week as saying "I have never thought intervention was good.  It is necessary right now."

Details on this $700 billion portion of the overall government bailout are as follows:  The cost to taxpayer could be nil.  It all depends on what price the government buys these assets from the banks.  How much further housing drops.  And finally what price the government eventually gets when they sell off these assets in the future.

Why is this necessary?  Hank Paulsen and Ben Bernanke believe that there could be a domino effect to the entire lending market.  They feel the connection between financial markets functioning and economic activity will continue until policymakers and central bankers unfreeze the US financial system, which is in effect "locked up" due to the toxic mortgage paper.

Will it really work?  It will not necessarily stop housing prices from falling further or avoid a US recession.  It will relieve the markets of some major immediate issues like a complete stoppage of corporate lending, which could have some unintended consequences such as the failure of our entire financial system.  So near term it helps.  Long term, it still may not be enough.  Which just goes to show how bad things have really gotten with our ultra leveraged financial system.

The failure of Washington Mutual (NYSE: WM [3]) the largest bank failure in U.S. history, ten times the size of our previous largest bank failure ever in Indy Mac Bank, demonstrates the severity of our problems.  If not for JP Morgan (NYSE: JPM [4]) stepping in to buy their assets quickly, and hope for a bailout package from Congress - Friday's market action would have been much more severe!

The WaMu fiasco once again demonstrates the need for investors to use stop losses.  Back in 1986 WaMu traded at $2 per share. It took about 22 years for WM to get to $46 per share.  It became the largest Savings and Loan in the US and a trusted "feel good" name on Main Street.  They issued about one third of all home loans in California over the last 10 years.  Then the housing problems started and it took WaMu only 2 years to erase all of those gains back to $2 per share.  Once the stock hit $2, in a matter of days it was taken over virtually wiping out all shareholder equity - effectively zero!  What a waste, unless you trailed the gains up over the years with stop losses.  A stop loss is a sell order below the market price to act as a safety net, to avoid disaster.

The market technically looks positive and is working on a follow through day up from last Thursday's gain.  A fundamental vote of confidence that lent support to the market last week was news that Warren Buffet's Berkshire Hathaway (BRK.A) would buy $5 billion of a new Goldman Sachs (NYSE: GS [5]) perpetual preferred stock and would acquire warrants that enabled it to buy $5 billion more worth of the bank holding company's common stock in the future.  You and I can't get that deal - Warren buys companies - we invest in stocks and bonds of those companies - there is a distinct difference.  But it is a positive indication for the markets when the world's most renown fundamental analysis guy is buying in here!

Next week look for the market to rally on news of a government sponsored rescue plan.  If that does not happen I think we will drop at least 1000 points on the Dow - but I believe that some form bailout plan will be passed and we will avoid disaster yet again. 

Next week the key economic data release will be Friday's report on the labor market. Nonfarm payrolls have declined every month so far in 2008 and the unemployment rate has surged. I expect the labor market weakness to continue; a loss of another 100,000 jobs is expected.   We also get releases on Consumer Confidence and The Chicago Purchasing Managers Index on Tuesday, both are expected to decline.  The European Central Bank meets Thursday and is likely to leave interest rates unchanged.  The economy will continue to slow as it will take some time to feel the benefits of the bailout even if it were to happen quickly.  Like a steamer ship on the ocean, it will not turn around on a dime. 

The markets on the other hand could start a nice rally.  We are working our way towards the traditionally best investment months of the year November, December, and January.  Potentially the election results may provide hope for the future as well.  Time will tell.  Pay attention to risk management and rely on thorough research. Invest for the long term but manage risk for today's market - it's what you keep that counts!  Use stop losses.