Stock Market Double Dip Probability - Leverage, the US, & China

I have been cautioning investors about this overvalued stock market and the low volume continuation of the March rally with its recent meaningless sideways correction and current feeble attempted rally.  I have been particularly concerned that the weak US dollar and current US low interest rates have created an asset bubble in the US stock market which has been purposefully used to assist banks in issuing new debt and stock in order to recapitalize.  Additionally, there have been close correlations between the weak dollar and the upward movement of the stock market as a risk investment and carry trade.

If you read the post below in detail with all its links you can see the multiple foundations for a recurrence of the financial crisis.  Other commentators and economists are positing similar concerns for a variety of reasons.  Even Paul Krugman has finally voiced the possibility of a double dip if unemployment is not quickly and effectively corrected.  James Gagnon in an article which has attracted posts by Tom Duy, Brad Delong, and others has entered the fray with the assertion that the the Fed's monetary easing policy needs to be continued but used to create jobs.  While one might argue over the use of monetary easing policies to combat unemployment, his argument is essentially that the data indicates the economy is too weak, particularly with high continued unemployment, to not require a second, more effective stimulus.  In fact there are commentators and members of Congress talking about using the returned TARP monies to provide small business loans to create new businesses and to provide the credit small businesses need to operate and hire.

Given the Fed's use of unemployment to hold inflation down and its obvious policy, despite its public positions, to decrease lending and contract credit, I do not see anyone but large banks continuing to get low cost money while they build their cash reserves and fail to lend.  The failure of Congress to pass credit card usury laws and to allow the time for banks to jack their interest rates up, without respect to credit worthiness, in the interim (Citi says it wants to lend but it is changing credit card rates to 29.99% on consumers with high credit scores) as they also continue the arbitrary reduction in credit limits.  Is Citi's policy, which is 37% government owned, a silent acknowledgment that banks make more money driving an account holder into bankruptcy rather than placing them in a closed account fixed interest loan they could pay?  It is as if we are being conditioned to ask why waste government money on consumers by creating jobs and providing them the means to start spending again?  We are even being told saving is bad.

In fact China's savings are increasing substantially faster than those of the US.  But economists expect increased spending to fuel recovery.  It does not appear that the Fed or Treasury have a recovery plan which includes the American middle class.  However, a strong argument is being made by a variety of economist's that the excessive use of leverage is leading us right back to another financial crisis, that the US is following the example of Japan in the 1990's, and that China is not that fall behind. There are economic indicators adding emphasis to the possibility that China is tied to the global financial system and on the road to following the financial policies of the developed world in favoring its financial elite and it is creating tension between its coastal financial elite and the interior masses in China.  In fact, we are being told that the middle class is growing in China at the same time the financial elite are consolidating power in China.  There is no decoupling.

For months I have cautioned my radio show listeners that a double dip is a significant possibility, but you never fight the market.  For over a year, I have said the current stimulus is ineffective and if there is no significant improvement in unemployment by the 2nd Quarter of 2010, it will be a very long haul.  Unemployment figures today are being trumpeted as huge improvement, but if you look at the data in the BLS release, you will see that the figures are the result of people no longer in the labor force and the continuation of the collection errors in the Birth/Death Model which continues to show job growth and which is on track to be corrected in February for an overestimate of jobs filled of approximately 824,000+.

I read John Hussman's weekly commentary religiously, because his viewpoint is based on fundamental and technical analysis.  Obviously, he has been too conservative this year, but that does not negate the correctness of his interpretation of the market data and the failure of the market to reflect the fundamentals and the technical divergences.  As of this last Monday, he has moved his conservative hedge mutual funds out of TIPS, because their yields are too low.  His post last Monday said, "Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them."  He goes on, "In part, the market's increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation."  He believes the market is 40% overvalued using both a q and CAPE analysis and said, "In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action."

He said an 80% probability of a second market plunge.  The problem is when and it is only a probability not an actuality.  What we saw today was an irrational upward movement in the market that quickly met resistance.  In fact, on December 2nd, Afraid to Trade posted charts showing the choppy boundary ranged S&P (SPY) with gaps from November to that date which would indicate that there is a Failed Breakout or Bull Trap.  Bull Traps can be the precursor of a sharp downside move.

If the Fed and Treasury are merely maintaining the financial status quo and using the credit contraction, unemployment, weak dollar, and low US interest rates to grow the stock market as a risk asset bubble in order to allow the systemically dangerous to re-capitalize while they grow even larger and the American middle class dwindles as unworthy of protection, why should there not be a double dip?  After all what is good for Goldman Sachs is good for America; they are just "doing God's work" to quote the CEO of Goldman Sachs.

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