At least the Europeans are owning up to the fact; in the U.S. investors are still pretending that the emperor’s new clothes are real. The pan-European Dow Jones Stoxx 600 index is down 1.2%, down the second day in four.

Shanghai stocks have also taken a bath. They’ve suffered their worst fall since November. This time, the worry is that the Chinese government will tighten its loosey-goosey monetary policy. According to MarketWatch, “The Shanghai Composite Index dropped 5.8% to 2,830.63, closing below the 3,000-point level for the first time since the end of June.”

Japanese shares are also down, despite recent data showing that the Japanese economy expanded during the second quarter. Japan’s Nikkei 225 Average fell 2.2% in today’s trading in Tokyo, after ending at its highest level since October on Friday.

Is this tidal wave of losses and bad news going to hit US shores? It wouldn’t surprise us in the least, dear reader. We’ve been calling the end of this sucker’s rally for months now – sooner or later we’ve got to be right! Our bet is it won’t survive September.

As we pointed out in last Tuesday’s Notes, options traders are now betting that the VIX – the widely watched volatility index – will spike 13% over the next five weeks – the biggest spread since August 2008… just before the S&P 500 saw its worst two-month plunge in 21 years.

But it’s just a hunch… Anything could happen in the Twilight Zone economy. Every time we look at the US stock market shooting higher we’re reminded of horror-movie zombies clambering out of their graves and shuffling around in search of human flesh.

We think the analogy is apt. According to the tenets of voodoo, where the zombie myth originated, a “bokor” (an African or Haitian sorcerer) can revive people from death and take control of them.

In the case of the US stock market, the bokor is none other than Ben Bernanke; the magic reviving ingredient, of course, is the excess liquidity he’s pumping into the economy.

As we pointed out on Wednesday, a study by Deutsche Bank economist Sebastian Becker shows that excess liquidity – measured as a rising stock of money to GDP – is now being created in the US, British, Japanese, Canadian and euro zone economies faster than in the late 1990s stock-market bubble and the subsequent housing boom.

The more we think about the zombie analogy, the more we like it. We recall the work of Harvard ethnobotanist Wade Davis, author of The Serpent and the Rainbow.

It’s a spooky tale, but in 1982 Davis traveled to Haiti on the trail of real-life zombies. He made the controversial claim that Haitian bokors turned living people into zombies by administering two special powders into the bloodstream. This from Wikipedia:

The first, coup de poudre (French: ‘powder strike’), includes tetrodotoxin (TTX), the poison found in the pufferfish. The second powder is composed of dissociatives such as datura. Together, these powders were said to induce a death-like state in which the victim’s will would be entirely subject to that of the bokor.

In our view, Mr Market is in a “death-like state” right now. All that excess liquidity is fuzzing up his brain, and he can’t help but shuffle along thanks to the twin “coup de poudres” of monetary and fiscal stimulus.

How else do you explain investors’ brain dead belief that we’re back in a secular bull market? As Gluskin Sheff’s David Rosenberg pointed out last week:

With every 1 in 8 Americans with a mortgage either in arrears or in the foreclosure process; 1 in 4 homeowners “upside down” on their mortgage; 1 in 6 either unemployed or underemployed; and 1 in every 7 housing unit in the United States sitting vacant right now, it will be interesting to see exactly what sort of recovery we end up with.

In among the “green shoots” there’s still plenty of really ugly data emerging. US foreclosure data for July has hit a record of 360,149. That’s up 7% month-on-month and up a truly shocking 32% year-on-year.

US July retail sales news was almost as bad. Last month’s sales were expected to rise by 0.8% month-on-month. Instead, they came in at -0.1%. The problem is July was supposed to be a positive month because of the feds’ “cash for clunkers” program.

Then you’ve got corporate revenues. Pick up a newspaper and you’d be forgiven for thinking that corporate revenues are up. But the reality is that earnings are beating estimates thanks to cost-cutting, not top-line revenue growth.

The truth is corporate revenues were down -10% in the second quarter. When the market started its recovery in 2003, revenues are up 13% in the first quarter. And they continued to rise into the bull run that followed.

Still, 27 out of 47 economists surveyed recently by the Wall Street Journal say the recession has ended. Problem is they’re probably the same 27 economists who thought the US economy wasn’t in trouble following the August 2007 subprime collapse!

Here’s what the mainstream either doesn’t know or doesn’t want to let on it knows. On average unemployment rises for five years following a financial crisis. That means another 2.5 years of rising jobless rates and contracting consumer spending.

But that’s not what really scares us, dear reader. Downturns are to be expected; the economy is cyclical after all. What scares us is the black magic being used by the feds to ‘fix’ things – the economic voodoo of the government’s printing presses. This from underground investor Porter Stansberry in today’s DailyWealth:

There is no way for an economy to outrun a printing press. The Fed has the power to create an unlimited amount of money or credit and the power to inject that money into the economy in any way it sees fit.

Let’s look at the numbers. Let’s assume the total collateral damage of the banking crisis turns out to be $5 trillion. Yes, that’s a huge hit – roughly half the output of our economy each year. It’s the equivalent of sending every American household a bill for $50,000 – due immediately. However, in less than a year, the Feds have already created nearly $4 trillion in new money and credit. The hole in the system has already been plugged. It only took a few months.

The fight between inflation and deflation is over. Deflation was knocked out in the first round.

The big risk is what happens next. Having turned on the presses to save the day, who will have the political clout and the desire to shut them off? Barack Obama’s budget calls for annual deficits in excess of $1 trillion for the next eight years. Thus, by the end of this year, not only will all of the damage from the mortgage collapse ($5 trillion) be replaced by new money and credit, there will be significant inflationary pressures in the economy.

The good news in our economy this year, so soon after such a major collapse, means we will certainly have a massive inflation during 2010 and 2011. There’s no such thing as a free ride. Bailing out the banks will carry a heavy price for anyone who doesn’t have the resources or the knowledge to escape the dollar.

What should investors do to protect themselves? That’s the easy part. According to Porter the best way to survive and prosper in the coming inflation is to own plenty of gold bullion and “assets that will run higher in an inflationary environment, like transportation and energy assets.” Porter also recommends owning some good farmland.

Here at Notes, we think it’s a lot more practical, however, to own a good quality agriculture fund. We like PowerShares DB Agriculture Fund (NYSE: DBA).

All we know, dear reader, is that following great crashes we get great bear market rallies. And these euphoric rushes of blood to the head have a nasty habit of suckering overoptimistic investors. As resource investing legend Doug Casey put it in yesterday’s Casey’s Daily Dispatch, there were eight such rallies during the Great Depression. These rallies lasted an average of 11.3 weeks, during which time the average increase was 52.6%.

Simple math will tell you that this rally has lasted almost twice as long as the average bear market rally during the Great Depression.

Doug reckons what he calls the “wonder rally” on Wall Street won’t survive the September. He points out that options traders are now betting that the VIX – the volatility index – will increase 13% in the next five weeks, according to data compiled by Bloomberg.

That’s the biggest spread since August 2008 – just before the S&P 500 saw its worst two-month plunge in 21 years. See, these two indexes – the VIX and the S&P 500 – have moved in opposite direction 81% of the time over the last five years.

As Doug says, however, it’s critical that underground investors keep an open mind regarding equities right now. The reason is simple. The government is pumping phenomenal amounts of funny money into the economy. And equities are extremely sensitive to this kind of fiscal policy (more sensitive, that is, than the wider economy, which tends to react slower to stimulus).

This is a big wild card. And in our humble opinion it’s a big reason behind why stocks are doing so well right now. Long suffering readers will recall that here at Notes we believe traders and investors are betting on the government’s ability to backstop the market rather than on the market itself.  There is also a strong likelihood that Washington’s fiscal and monetary stimulus will trigger an inflationary cycle, which would also benefit stocks in the short-term.

Common sense isn’t exactly fashionable these days. But take a moment to think about just how extraordinary a 49% rally stocks is over just five months. As our favorite underground analyst, David Rosenberg, points out, this is “unprecedented back to the 1930s.”

In the last cycle, it didn’t happen until February 2004 – 18 months into that bull phase where again there was tremendous policy stimulus and an oversold low to climb out of. In addition, household credit was expanding rapidly. Even coming into what was a secular bull market in 1982, it took a good seven months to rally 49% – and that was with the benefit of a V-shaped economic recovery. Going back to 1950, it has taken an average of around 18 months for the market to rebound 49% from a recession trough, not five months as has been the case thus far.

That stocks have climbed out of their recent recession trough over three times as fast as after the average recession sets serious alarm bells ringing here at Notes HQ. As we’ve said before, if you have money in stocks right now, you better be sure that money is nimble.

Then a second news alert hit my inbox. The Fed had just lowered the discount rate from 3.5 percent to 3.25 percent. Was the Fed trying to calm the market? You bet they were. When news of BSC being sold at such a discount hit the street, futures dropped as much as 38 points. After the Fed announcement, they were down only 22 points.

You never know when the market will make an unexpected major move, up or down. That’s why I recommend being somewhat balanced between bullish and bearish positions. It is also the reason why you should take profits off the table on portions of your trades. If you take, say, a 50 percent profit on a third of your position, you will have limited your potential loss without limiting your gain if the stock continues to rise.

Though it was Sunday night and the equity markets were closed, the news was coming fast and furious and money was being made and lost. Bear Stearns dropped from $30 to $3.18 in one move. There was nothing traders could do unless they were trading futures, because S&P futures markets open at 5:30 p.m. Eastern Time on Sundays. Equity traders and options traders had to wait until Monday’s opening bell to know their fate. But those who had balance in their portfolios and had been managing their trades with partial closeouts didn’t have much to worry about.

Remember the phone call that Gordon Gekko makes to Bud Fox in the movie Wall Street that starts out with “Money never sleeps, Buddy Boy.” No kidding.

[Ed. Note: Rick Pendergraft is a professional trader and market analyst. In Rick’s new investment service, he reveals how you can make hundreds - even thousands - of dollars just by playing a simple game of "guess the pattern." Learn more here.]