Asked about the rally on Wall Street, Barron’s latest Roundtable Panel had various views about how far and how fast it would take us. But all were sure of one thing: the worst is over. We will not go below the lows set this past March.

This recovery is for real, they believe… and so is the bull market on Wall Street.

Investors believe it too. Analysts believe it. Economists believe it.

And why not? The ‘Committee to Save the World,’ part II, is on the job. And here are two of the three committee members writing in the Washington Post. “We have nothing to fear but fear itself,” they would have written. But that line had already been taken:

“Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.

“By restoring the public’s trust in our financial system, the administration’s reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses.”

Get it, dear reader? The slump has nothing to do with bad investments and bad businesses… or with too much debt… or with too many producers making too much stuff for too many people who can’t pay for it. Instead, it’s all in our heads! And if we can make some ‘reforms’ that cause the public to think everything is all right, well… heck… everything WILL be all right.

Except that it’s not all right. You can pull as much wool over the public’s eyes all you want, GM still won’t be a going concern. Nor will any of the other problems go away. And until those problems are worked out, there won’t be enough earnings and savings to push the economy forward. As for the feds’ confidence tricks, they only make the situation worse. If the public spends more money… it just goes even deeper in debt! Our old friend Rick Ackerman has no more faith in this recovery than we do. It’s “just like the recovery of ’31,” he says. Of course, as regular DR sufferers know, there was no recovery in ’31. Instead, it was a head-fake upwards, followed by a major drive to the bottom in ’32. The ’29 crash was just the beginning. The Dow reached its peak of 381 in September ’29. It crashed in October… but then bounced back for the following 5 months. By April 17th the bounce was exhausted at Dow 294. Then, too, people thought the ‘worst was over’ and that the initiatives of the Hoover administration had put the economy back on track for growth and prosperity. But then stocks headed down again and the economy sank. On July 8th, 1932, the Dow hit 41 – its low for the Great Depression.

Why won’t history repeat itself? The run-up in debt in the ’90 to ’07 period exceeded even the debt build-up of the ‘20s. Many other features are similar too – a huge expansion of global trade… new inventions… suburbs… financial innovation. Why would it be different this time? “Because the government has taken aggressive action to correct the problem!”

That’s what most people think. But here’s what Rick has to say about the feds’ rescue: “Bailing out the economy and the banking system has been such a brazenly corrupt, mendacious and, ultimately, doomed enterprise that one could almost forget for a moment how very clever the perpetrators are. If we needed proof that these guys are the slickest behind-the-scenes spin doctors around, consider the following two headlines that ran on successive days atop the Wall Street Journal’s front page. “Rate Rise Clouds Recovery” was the grim news that greeted us last Thursday, on day one. The article described how, despite the Federal Reserve’s explicit strategy of buying as much Treasury paper as it takes to hold market rates down, particularly in the mortgage sector, rates are rising anyway, and steeply. In fact, 30-year fixeds climbed to 5.79% from 5.00% just two weeks earlier, suggesting that market demand for mortgage paper is drying up despite the Fed’s strategy of direct monetization of Treasury debt (a.k.a. “quantitative easing”).

But get this: On day two, as if to reassure us that Treasury’s borrowing is well under control despite the fact that the opposite is true, the spinmeisters co-opted the Journal’s front page with this well timed policy leak: “Fed to Keep Lid on Bond Buys”. Are we actually being asked to believe that, absent the acceleration of direct purchases of Treasury paper by the central bank, demand from other sources will suffice to keep rates from rising further?”

Yesterday, we saw a chart that showed the effectiveness of the Fed’s efforts. When the Fed intervenes to buy Treasuries, yields tend to go down – that’s the whole idea. Low yields help people borrow… and pay their debts.

But the chart clearly shows that each subsequent intervention has less effect. This is very bad news… though just what you’d expect. It’s why a little bit of monetary inflation has a tendency to become a lot of consumer price inflation. On a more philosophical note, it is how people get trapped into doing things they really don’t want to do – because the alternative is even worse.

Here’s the dilemma. The feds buy US bonds to keep interest rates down. If they don’t buy them, the government’s huge demand for credit drive up yields: greater supply of bonds leads to lower prices (higher yields). But if they do buy them, investors begin to fear inflation. Then, they sell bonds… driving up yields: less demand leads to lower prices (higher yields).

That’s why the Fed is talking about keeping a “lid on bond buys.” It’s expected to reassure investors.

So far, everyone seems to be playing the part he has been given. In today’s news is word that the Japanese and Russians are hundred percent behind the dollar and US bonds. The Japanese even say their faith is “unshakeable.”

These comments helped send bonds back up… after yields on the 10-year note had reached 4% last week.

But do you believe them? C’mon, dear reader, you know better than that. The Japanese and Russians have two of the biggest piles of US bonds in the world. Only China has more. What would you say if you owned $800 billion of bonds? Wouldn’t you tell the world what a great investment they were… and then sell them quietly, when no one was looking?

Most likely, the feds will be forced to do what they don’t want to do. They’ll have to buy bonds to keep rates down. Then, they’ll have to buy more… because others will be selling them. Finally, they’ll have to monetize a huge percentage of them… ultimately causing inflation rates to soar.

When and how that will happen is the financial drama that will occupy these daily reckonings for many months to come.

And a thought or two…

*** “Man lives in closet in Delray Beach,” was a headline that caught our eye. We wondered what sort of man would live in a closet. But there was the photo – he looked like a very ordinary man.

Indeed, he seemed proud of what he had achieved. Downsizing is in style; he is a trendsetter.

Beneath the big financial headlines, there’s a huge aesthetic change taking place in America. Small is becoming fashionable. Less is becoming more. Ostentation… big spending… and luxury are out. Charm, making do and innovation are in.

Pick up a copy of “Cottage Living” magazine and you’ll see what we mean. A couple of years ago it was the “wow factor” that sold houses. Clients were meant to drive up to a façade that looked vaguely impressive… like a bank with a bad architect. They walked into an entry way and saw a huge hall with a chandelier hanging on a chain. The more expensive McMansions had sweeping marble staircases. “Wow,” prospective buyers were supposed to say… reaching for their checkbooks.

Now, the McMansions are hard to sell. Cottages are more popular. They tend to be plain and uninteresting when they are purchased. But now people are taking pride in making them nice places to live – with shutters… larger windows… fireplaces… reading nooks, and so forth. They’re using imagination and elbow grease instead of credit cards.

People are downsizing – slimming away the unwanted, trimming off the unnecessary, and skimming off the best of what remains. They are making – or trying to make – their lives more manageable, more affordable, and more secure.

In a way, this is ‘back to the ‘70s,’ when wood stoves became popular ways to heat a house. Wood stoves practically disappeared in the ‘90s. But they’re back. And so are back-yard gardens… bicycles… chickens… canning… saving and many other things our grandparents took for granted.

Source: Things Our Grandparents Took for Granted

Now that it’s here, we turn our attention to trying to discern, “How bad can it get?” and “How long can it last?”

While such questions can never be answered with anything approaching absolute certainty, there are methods that can be used to assess what may lurk over the horizon. With that goal in mind, this article focuses on – and then expands upon – the recent work of two economists who painstakingly analyzed a substantial number of previous banking and currency crises in an attempt to derive potentially useful lessons. I have then taken their data and applied them to the current circumstances to see where we are, relative to those other experiences.

The Data

The data are from a study called “The Aftermath of Financial Crises” by Carmen M. Reinhart of University of Maryland and Kenneth S. Rogoff of Harvard University. In their study, the authors summarize the results of a broad sampling of banking crises, with between 13 to 22 crises analyzed for each of the variables.

The Reinhart/Rogoff study is based, in turn, on data extracted from an even more comprehensive study of events in 66 countries, titled “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” by the same authors.

I’ve summarized the findings from the latest study in the table below:

The economic measures in the left column show how far the U.S. situation has deteriorated so far. The next columns show the average historical deterioration and the worst case of the crisis analyzed.

I then applied these data to calculate the levels that the U.S. could reach if it followed the path of the historical examples. The projected level is based on the measure analyzed, either from the peak prior to the downturn (e.g., the S&P 500) or from the bottom prior to the downturn (e.g., the lows in unemployment). Thus, as you can see in the table here, the S&P 500 has already dropped from its October 2007 peak of 1565 down to 766. If this crisis were to end up being only “average,” then it would drop to 690.

If, however, the worst case of a 90% drop were to occur, as it did in Iceland last year, then the S&P 500 would trade down to the shocking level of 157. For further reference, if the current crisis were to cause the stock market to fall as sharply as in the Great Depression, the S&P would touch 469.

Duration of Crisis

As you can see in the summary table below, it took 3.4 years, on average, for the stock market to fall from the peak to the bottom. In the worst case, it took five years. With the recent peak in the S&P 500 occurring in October 2007 – just one and a half years ago – the crisis is likely to have some time to go before reaching even an average duration. More specifically, if this crisis turns out to be just “average,” we would not expect to see the low before the first quarter of 2011.

Crisis Horizon: Some Conclusions

The global economic situation continues to deteriorate on all fronts (see charts below).

Housing Prices Can Take Years to Decline	U.S. Federal Debt Is Likely to Jump from Crisis
Unemployment Could Jump over the Decade

Housing prices are down 28% from their bubble peak in 2006 but still have a ways down to go to get back to their pre-bubble levels. Even an average downturn will mean that housing remains a problem for several more years. Unless, of course, the government steps in to stave off those resets… a “solution” that carries with it a separate set of problems, making things worse. We continue to expect very serious problems in the commercial real estate sector.

The stock market is approaching a 50% decline, the average of what has been observed in past crises. Further slowing in U.S. corporate activities and profits means additional increases in unemployment, establishing a negative feedback loop that pushes corporate profits – and stock prices – even lower.

The only growth trend at this point is in government bailouts, which are in high gear, indicating we’ll experience the serious growth of outstanding debt seen in other crises. The elevated levels of government borrowing required to fund that spending are absorbing all available credit from foreigners, directly competing with business in need of the new financing that will be required to expand the economy. The combination of declining business activity, coupled with declining levels of household income, will result in declining tax revenues, increasing the budget deficit beyond the size of the new bailout programs. State and municipal governments across the nation are already being confronted with large shortfalls in their budgets, shortfalls that will only widen as the crisis worsens.

The combined business slowing and jobs contraction assure that the GDP will decline. Components of GDP having to do with necessities like food and shelter will continue to bump along regardless of the economic conditions, but the lack of growth in GDP could extend for years as it did in Japan and as it did after the 1929 stock crash.

Inflation/Deflation

Given that we are currently in a deflationary phase, it is easy to dismiss the case for inflation – and many do. We think that is a mistake. Even a summary tabulation of the unprecedented increases in government debt at this relatively early stage in the crisis make a compelling case for higher inflation, if for no other reason than that it shows clear intent on the part of the government to spend “whatever it takes” to offset the deflationary forces now stalking the land.

The research paints a dismal story of years of economic stagnation. In our view, the trend is now firmly established for dollar debasement, a debasement that will eventually overwhelm the deflationary pressures from collapsing asset values. Therefore, don’t listen to the happy faces on CNBC spouting off, for the umpteenth time since this crisis began, that now is the time to jump back in and buy stocks. It isn’t.

Be extremely skeptical when you hear some pundit pronouncing that this piece of short-term good news or another is an “all clear” signal. Until we start seeing a systematic improvement in the economic fundamentals – for example, an upward movement in consumer confidence – the only signal the economy will be hearing is that of a runaway train coming straight at it.

The numbers paint a dark picture… but it is in crises like today’s where unusually good opportunities arise for investors. Take our investors, for example, who made money shorting financials over the last year. The Casey Report focuses on recognizing and analyzing market trends way ahead of the investing crowd – a strategy that has already provided its subscribers with up to four-digit returns. The latest edition includes an update on the analysis you’ve read above. Try it risk-free for 3 full months, with our 100% money-back guarantee: click here to learn more.

Source: Bad, Worse, or Worst?