Source - http://www.onlineinvestingai.com

The chart above is of the economic investment cycle. The blue is the stock market and the yellow is the economy.

This chart shows us what we should already know, that the stock market is forward looking and typically bottoms or peaks out 6 months to a year after the economy.

More importantly, this chart also shows us that bull markets are formed on the back of a healthy financial and transportation sector.

In other words, to see if this is a sucker’s rally or not, we have to see the financial sector bottom out and move higher.

This makes sense. Money is the lifeblood of the economy. If banks aren’t lending it, then the economy can’t expand.

Today, the big question is whether banks are seeing a sustainable turnaround. Wells Fargo announced a $3.3 billion profit and Goldman Sachs made over $1 billion.

But the problem with banks isn’t their ability to make profits in a low interest-rate environment. The problem is the valuation of the mortgage-related assets these banks have on their balance sheet. Banks are basing their leverage on the value of these assets.

If these asset values decline, then banks must write those assets down and raise more funds or deleverage to meet capital requirements.

In other words, earnings or not, banks still have more to do in order to be considered “healthy”. That means this current rally should be one for the “suckers”

That’s the natural pattern that most recessions follow. However, this has been a pretty unnatural recession, with a number of highly artificial actions undertaken to fight it, meaning we must plan for the possibility that it won’t be a “U” pattern, but will instead follow a less-frequently seen pattern.

When you think about it, the alphabet presents a number of fun shapes, patterns or trajectories that an economic cycle might follow. There’s a slightly slanting J – a shallow downturn followed by an energetic, near-vertical upswing. There’s an L – a descent into the recessionary pit, followed by a total refusal to recover – kind of like an accident victim who flat lines on the way to the emergency room. There’s an O, round and round in circles, never going anywhere – you can think of that as being the typical pre-industry economy, without significant technological change.

When the Roman Empire collapses or the Industrial Revolution happens, you get a (possibly upside-down) Q, in which the economy escapes from the static O, to move down or up in the Q’s tiny tail. There’s an R – round in circles for a time, followed by a sharp descent into the economic mire: That’s static – albeit cyclical – economy, where some environmental disaster hits, causing output to tank.

There’s both the U and the V – the latter being an economic cycle where a slump is immediately followed by a sharp rebound, with no period of depressed activity at the bottom.

And of course there’s the W, the classic “double-dip” recession, like the one the United States experienced in 1979-82. W-shaped recessions can be further divided into two types: There’s the “lazy W,” in which the second downturn is worse than the first; and there’s the “energetic W,” in which a deep recession is followed by a shallower one that is barely a blip in a strong recovery.

The recession of 1979-82 was a slightly lazy W, whereas the 1929-41 Depression-era downturn can be thought of as a very deep energetic W, in which the second dip (1937-38) was still part of the same overall economic event, but was much shallower than the first.

Had the United States been on a gold standard with an administration determined to maintain budget discipline, the current unpleasantness – which started with a major banking crisis – would probably have followed a V-shaped trajectory. The banking crisis would have caused output to descend rapidly to a considerable depth. But once a bottom was reached, the U.S. economy would have recovered almost immediately, showing a period of extra-rapid growth as output returned to a normal trajectory.

That’s how it worked in pre-Keynesian gold standard days, when governments and business followed the downturn advice of onetime U.S. Treasury Secretary Andrew Mellon, who said it was wise to “liquidate everything.” The economy might descend to an unpleasant depth, but once it turned, the forces that would fuel the recovery were very strong. Thus, the recoveries after the recessions of 1893-96 and 1920-21 were both exceptionally vigorous by modern standards.

Most modern recessions are U-shaped, rather than V-shaped. When a recession hits, governments run budget deficits while central banks lower interest rates and allow the money supply to expand. That limits the depth of the downturn, but it also reduces the speed of the recovery, since the natural stimulus from a smaller downturn is weaker, while the government stimulus wears off after a while. That’s what we got in 1991 and 2001; in the latter case, the U.S. government stimulus, both monetary and fiscal, was very strong indeed, so the recession was extremely shallow, but recovery was exceptionally slow.

In 1979-82, we had a W-shaped recession. The first leg was caused primarily by U.S. Federal Reserve Chairman Paul A. Volcker’s now-famous attack on inflation, in which he boosted interest rates well above their normal level, and choked off economic activity. That caused the first dip, which was ended by monetary relaxation. However, monetary policy was tightened again in late 1980, so we got a second dip, which was not balanced by the usual fiscal stimulus, and so proved to be quite deep. Being deep, the second half of the W was followed by a strong recovery from 1983.

This time around, both the initial banking crisis and the fiscal and monetary stimuli have been exceptionally strong. That raises the possibility of a W-shaped double-dip recession. Initially, the stimulus may act like a shot of adrenalin, causing the downturn to abort and be succeeded by what seems like recovery. However, the stimulus must inevitably be temporary, and will produce both extra-rapid money supply growth and an extra-deep budget deficit. That is likely to lead to a second downward leg, this time accompanied by unpleasant inflation, as the “hangover” from the excessive stimulus is felt.

Even more unpleasantly, we could see an L shape – “Bloody L,” if you’ll allow me to use a British Cockney phrase, reflecting the unpleasantness of the outcome. That would result in a situation in which the ultra-low interest rates left in place too long fuel inflation, while out-of-control public spending produces deficits that permanently dampen growth, so recovery never really arrives at all.

That can happen: Japan in the 1990s had an L-shaped economic downturn, although with zero growth rather than a prolonged recession. More ominously, Argentina after 1945 transitioned quite quickly from a rapidly growing, buoyant economy into a global basket case, with occasional bursts of hyperinflation. That’s the worst-case scenario for the United States. It’s not likely, but neither is it impossible.

So what are we most likely to see? The factors causing short-term strength are currently powerful. The collapse in oil prices has caused retail sales to be considerably less weak than expected, stronger consumer confidence and leading indicators both point to an approaching economic bottom, and the stock market is up more than 10% from its November low.

Instead of a “worst” down quarter, the first half of 2009 may see a period of unexpected strength, with cheap mortgage money producing an apparent bottom in the housing market, a bottoming out and initial recovery in U.S. gross domestic product (GDP), and an additional bounce in U.S. stock prices.

Don’t be fooled if this happens (though by all means try and make a buck or two out of the short-term stock market bounce). The Obama “stimulus package” and massive federal government slush funds will exact a price – in the second and probably deeper leg of a lengthy lazy W recession – the much-feared “double-dip” downturn.
Source: What Shape Will the U.S. Recession Take: U, W or ‘Bloody L?’

This from The Daily Reckoning:

Occasionally I hear the odd guest on CNBC or Bloomberg Radio who lays blame for the crisis in exactly the right place – the Federal Reserve System in the U.S….or central banking more broadly.

These extremely influential institutions ostensibly exist to regulate prices, employment and interest rates by way of control over the money supply. They do this by inflating bank reserve credit, on which the banks can pyramid, thus essentially abrogating the role of interest rate determination by the market.

That is, the central bank tries to determine interest rates as far as it can. The rationale for this policy is to attain full employment and price stability, and to otherwise manage economic affairs.

Any economist whose lenses aren’t blurred by the fatal errors of the neo-classical doctrines is immediately capable of spotting the problem with that policy foundation. Unemployment could scarcely exist on a free market, where the government did not interfere with the price of labor. Just like shortages of goods cannot really exist in a market where their price is free to adjust to the reality of existing conditions, there can be no excess labor unless the government intervenes to artificially boost its price. It’s the same principle. It is a simple economic fact – free of political considerations. Labor is an economic good primarily because it is scarce.

Moreover, whether we are talking about labor legislation or the central bank trying to manage growth, prices and interest rates, it amounts to economic management, even planning.

The apparent effect of the policy is to bring about a boom in investment and consumption… the building up of bubble companies and uneconomic enterprises relying on the continued increases in the selling prices of the goods they deal in – be it widgets, homes or securities.

These price increases are afforded by regular money debasement, which is one of the economic consequences of an increase in the supply of money in particular. So it is illusory.

In reality, as Rothbard points out, the boom “is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit’s tampering with the free market”.

So this policy, and the booms it engenders, crowds out real savings (by pushing rates below market), and investment comes to rely on the continued “stimulus” of money creation or from borrowing overseas.

Ultimately, it further lays the seeds of its own demise because the process invariably arrives at a point at which the central bank must desist if it does not want to prompt a run of confidence in its notes, leading to hyperinflation.

This is why we say the policy is “unsustainable.”

Thus it tries to withdraw the stimulus or “tighten” money and credit – explaining that the overheated economy might produce inflation. The error in its thinking is that it is managing a delicate balance between price stability and growth…that it checks market failures, and can know the unknowable (the future).

In fact, almost all economists would agree, it cannot produce growth. It’s like the analogy of pushing on a string.

The Fed’s policy can only increase employment by decreasing the relative cost of labor through inflation (the expansion of money supply relative to demand). And as one of the largest of interventions conducted by government policy, it only produces more instability – i.e. the boom-bust cycle as well as interest rate and foreign exchange volatility eventually.

Technically, tampering with the rate of interest produces disequilibrium as a mismatch between consumer preferences and producers’ investment plans – during the boom phases. Effectively, it taxes long run growth, and is but a massive redistribution of wealth from savers to borrowers and speculators.

The bust, which often begins with the onset of a financial crisis, brings much pain, and threatens job losses on a wide-scale. But this is because the artificially low rate of interest produced by the previous policy, which could not be sustained, produced waste, a “cluster of error” as Rothbard called it. This “malinvestment” or uneconomic activity is essentially exposed as the subsidy is withdrawn.

In his book, America’s Great Depression, Rothbard posits the error in Marx’s reasoning,

“In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.”

What you see then is basically the widespread failure of parasitic enterprises that could not survive on their own – without the handouts and support of the central bank. This is the empirical evidence that should indict any inflation policy. But, the bust still merely represents a return to natural market ratios.

“The ‘depression’ is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments” (Rothbard)

It follows then, that “Attempts to interfere with free and flexible prices, wage and interest rates prevent recovery and prolong the depression period” (Mises Made Easier)

Efforts to stabilize the bust with even more inflation effectively prevent the liquidation of uneconomic enterprises necessary to return the economy to equilibrium, where markets reflect actual conditions.

Now, I’m not a policy maker. I don’t want to suggest the best way to fix the world or argue why these theories are true. My chief concern is the future. And the evidence that most people would side with Marx on this (over Mises et al) is all I need to predict more inflation, war and higher gold prices.

Joe Public can’t for the life of him figure out why it matters if interest rates are 1.5% or 1%.

He cannot connect the escalating price at the pump to the process of money creation required to bring about such a modest change in the interest rate. The tech bust was the fault of irrational speculators, and greedy investment bankers. The housing bust is blamed on Wall Street’s larceny, his mortgage and real estate brokers, or the thrust toward deregulation. The painful increase in commodity prices is caused by too much growth. The growing trade deficit is caused by new competition from foreign countries. And so on.

For, Joe takes his cue not from Mises, but from the media and political classes under heavy influence by the progressive institutions.

Political leaders in Europe, meanwhile, are taking full advantage of Joe to wage a new war on capitalism from the left on grounds that American style capitalism is in dire need of more regulation.

This is the great evil of the inflation policy.

It is insidious. The great economists have all recognized this truth. It only produces the opposite of what it claims to accomplish. It also funds the growth of government and anti-capitalist sentiment, and other confused ideas that may lead, ultimately, to the general disintegration in the division of labor, the fabric of society. It promotes moral degradation and corruption, conflict, and finances wars. It is 80% of what’s wrong with the world.

But for the most part, the voices of reason that point to this cause are trampled over by the rhetoric of the larger political class, which fear mongers people into clamoring for more money and credit.

This truth is evident in the Fed’s actions. It has abandoned any remnants of conservatism, as have the other central banks worldwide. The helicopter blades are in full swing. So any enthusiasm about the world having reached this place where it is ready to turn a new leaf must be tempered by this fact.

The voices of reason, though on the beltway, are still only voices in the wilderness.

This alone suggests we are going to continue to see more inflation, taxes and government. The scary part is that this process is accelerating.

The next bubble may well be in gold.

Source: Voices of Reason Still in the Wilderness