Yesterday we suggested that the investors should not underestimate the power of the central bankers and politicians. We also said that the Pavlovian dogs like Zero Hedge or Mish will have to wait longer for the collapse of the world. 

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As the days of summer draw to a close, we are filled again with uncertainty about the future. The scares of 2008 have not been erased from the minds of the investors and we are constantly looking over our shoulder to watch out for the double dip recession. But 2011 is not 2008. The central bankers have learned their lesson or so you would think. Perhaps they are better prepared in terms of addressing the crisis, but they still do not understand how to solve the crisis on a permanent basis. Much of the crises of 2011 are actually fiscal crisis and credit crisis. To solve a fiscal crisis with a monetary tool is not only ineffective, but a waste.

The threats facing the world economy today are ironically the things which were responsible for the progress for much of last 40 years. The globalization of trade and interdependent nature of the economies. The Keynesian theory of growth followed by the world governments, which depend on debt to deliver prosperity. The desire of the politicians to hang on to power by providing or promising to provide everything to everyone. And of course, the growing power and greed of the “Bankers” to manipulate the political class and engage in excessive speculation.

In the USA, from the period of dot com bust, till date, the political class and their henchmen in the Fed, have created bubble after bubble by borrowing and injecting liquidity in the system. There was no job growth, no real income growth, only an illusion of prosperity, created by simply inflating asset prices. Stock markets went up and up, house prices went higher forever, fooling the mass that they are far wealthier and they need not save or produce anything. Only one country in the western world has bucked this trend. That country is Germany. But there also they were fooled by megalomaniac politicians, notable among them Mr. Helmut Kohl. Helmut Kohl, a post world war 2 politician, who grew up in the guilt of wars, wanted to become a world statesman and thus pushed for the creation of a unified Europe and Euro. While Euro has helped German export machinery to a great extent, it has also tied Germany to other profligate countries in Europe and its periphery that do not have the fiscal or work ethics of Germany.

So in 2011, we are faced with two headwinds not one. The economic powerhouse of the USA is slowly turning to recession again and Sovereign defaults in Europe is a real possibility and banking crisis in those “soon to default” countries is going to explode sooner than expected.

For all the news of BIRC countries who will take us to economic salvation, these countries cannot even save themselves, let alone the world. China and India are just other developing countries, who will soon turn to emergency market from emerging market, when the markets in the USA and Europe dries up and protective barriers start to come up. Make no mistake, politicians will install protectionism to appease their vote bank and the globalization that we know will be a thing of the past. When the unemployment rate hits past 10%, who do you think the politicians will blame for the loss of jobs? They won’t take any blame themselves. They will sure find scapegoats and the easy ones that too.

Anyway, let’s just look at the real GDP figures of USA.

The 1^st revision of the 2^nd Quarter GDP figure stands at barely 1%. So year on year we are below 1.5% and the 3^rd quarter is not going to be pretty either.  Normally, consumers get the feel of economy better and earlier than the sale-side economists in the big banks. So the following chart says.

The GDP and Consumer sentiment have mostly walked together. So what can we expect here? GDP following the sentiment or sentiment climbing up?

And then we have glorious politics. The presidential election of the USA in 2012. With the bitter partisan divide that we have seen so far, the slash and burn method employed by the Republicans, and their pledge to make Obama one term president, we can be sure that they will do anything to turn the voters away from the incumbent president. What better way than to sabotage the economy.  Historically, the 3^rd year of the presidential cycle is the best in terms of stock market returns and the 4^th year is the worst.  You can read it here; http://alphaim.net/research/Pres_Cycle/index.html

When we combine all these three, we can be almost certain that a recession is in the cards by 2012. Stocks typically go down 40% or more in a recession but this one is going to be a depression, not just our garden variety of recession. In addition to the negative economic growth in the USA, we are going to have sovereign default in Europe and possibly a banking collapse there as well. (More on that,later) All these toxic combinations will lead to massive balance sheet contraction and we are looking at an uncharted territory 12 months down the line. In short term, I think we might still re-test the lows of August or might even go below it, before the Fed is forced to tip its hand with more liquidity. If that happens, it will consistent with the script of 3^rd year cycle and also the fact that when January of a 3^rd year of a presidential cycle has been positive, 90% of the time, the stock markets in that year has ended in positive territory as well.  

That is another reason, I am not expecting the bottom to fall of yet, but we are not far off from the cliff either.

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China is a success story told many times over. It’s economic miracle has been the stuff of folklore. There are investors out there who think that China will keep growing forever. The commodity speculators love China. Be it oil price or copper, any spike in price in any commodity is attributed to the insatiable demand from China. But behind the obvious, there is another story. For those who are willing to question the fairy tale story, it is time to short China.

Let us start by looking at the socio-economic model of China. The communist party of China has ruled the country with iron hand for over from 1949. The political elite of China want to avoid any social unrest and upheaval at any cost. They have an unenviable task.  They have to provide enough work, food and shelter to the millions of ordinary Chinese. Being a command economy means there is no free market. The local purchasing power is insignificant compared to the western world. In order to create work and alleviate poverty, the leadership decided to take the route of growth by export.

Today China is the manufacturing powerhouse of the world and the single biggest factor in the growth has been low labour cost. Companies from all over the world shifted their production base to China to take advantage of the cheap labour. With the result, western civilization lost jobs. But most of the wages that a Chinese worker gets is at a level that is just sufficient for survival. Millions of rural poor migrate to bigger coastal cities in search of work and live in deplorable conditions. The worst part of the deal is that the companies that produce goods for the world do so at a very low level of margin, average 4% to remain competitive. And now every country is trying to grow out of poverty through export. Irony is, not every country can be net exporter, and someone has to be net importer as well. And consumers in western civilization do not have the capacity anymore.

China imports all the raw materials from other countries, iron ore from Australia, Energy from Middle East, and Machinery from Germany and produce goods to export. When the world demand for the cheap Chinese goods plummet, as it will with the slowdown of the global economy, what will happen to the export oriented growth model?

After 2008, China decided to kick start its economy through construction. And they found it is the easiest way to keep people employed while projecting a growth of GDP. But creating assets which does not give income does not actually create sustainable growth. When, not if, the world economy slows down in the coming months and years, the available capital to continue such useless construction projects will come to a halt. Already millions of homes and cities are lying vacant across China. As if the sub-prime housing crisis is being played all over again in China, but with a much greater scale.

Over the last 40 years, there has been a growing middle class in China who are well educated and are demanding. Since the currency is pegged to US dollar, the QE in the USA is exporting inflation to China in the form of higher food cost. And unlike in America, food cost constitutes over 40% of the average household expenditure in China. So inflation is rising in China and China is now battling hard to control the price rise. This is causing huge social unrest and the Communist Party if uneasy about it. As a result, we are seeing a slow rise in the value of Chinese Yuan vis-à-vis US$. But this cuts both ways. While a rising Yuan will help reduce the cost of imported foods, it will reduce the profit margin of the exports and make them uncompetitive. More so in today’s week demand situation where the exporters do not have the leverage of negotiating higher prices.

There are talks about the huge Chinese holding of US debt and the threat they possess to US Economy. Actually it is the other way round. China has no option but to invest in US treasury and if they don’t, they would not be able to keep their currency down and be totally uncompetitive. If they want to sell the massive holding of the US Treasury bonds, they would push the prices down and lose money.  So again, China is caught in a no win situation there. With the money fleeing Europe, there is no shortage of demand of US Treasury, at least for now. So US do not need China, as much as China needs US.

The demographics are another factor to be worried about China. With one child policy strictly followed by the party for so long, the average age of the population is growing and the country is graying. Moreover, because Chinese parents prefer boys to girls, there have been systemic abortions of girl fetus on a large scale for a very long period of time. With the result, the ratio of man and woman has been totally skewed. In some places there is one woman for every two men and poor migrant workers cannot get wife for the love of their life.

Central command always fails. The asset allocation in central command economy is not based on efficient use but what the part leaders think best. And few people cannot decide what is best for millions. Corruption is rampant and so are the red gift bags. Even the death penalty does not deter the local authorities much. The end result is something other than desired.

The bubble is about to burst along with the global debt deleveraging and the popping  sound will be heard loud, far and wide for many years to come.

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Who are our real masters?

I think there are 1200-1300 of them all over the world and their names can be found here

They and the businesses they control are the true masters of the universe. Every politician in every country is at their service. Why do you think the members of Congress are exempt from the insider trading laws? Is it because of the special relationship the politicians have with these masters?  If we could follow the portfolio of the US Congressmen/women we would retire rich.

Given the above, how do you think the politicians will react to the current crisis? Bear in mind, this crisis is just the continuation of the crisis of 2008 which never went away. Here, we have a president who came to power on the promise of change and changed nothing. He has a war chest of $80 million for the coming election and most of this money came from Wall St. On the other side we have Tea Partiers who have been brainwashed to protect the interest of the rich by refusing to tax them and we also have union freeloaders who suck the system dry.

In a normal world, economy should drive the stock market. But 30 years of bull market have changed the character of the country. Now it is the stock market which drives the economy and the economic policies. Remember during the debt debate, both the Democratic president and Republican speaker would invoke the stock market for speedy resolution.  All the actions for solving the crisis of 2008 have been centered on saving the stock market, Wall St. and “Too Big to Fail Banks”. That is where the masters of the universe keep their wealth. Uncle Ben created QE1, QE light and QE2 just to restore the wealth of the masters which eroded during the 2008 banking crisis. And you thought he wanted to create employment! Silly you.

So now we see that the politicians and central bankers of the world are holding emergency meeting over the week-end to solve the looming crisis. And they will do the only thing they know. Pump in more liquidity in the system.  They mistake this credit crisis as liquidity crisis. But when one continue with the same mistake for three years, it is not a mistake any more.  It is a way of life for them.

Do whatever they may; the response to these emergency measures is getting smaller and weaker. Like in Japan, where debt is 200% of its GDP, the debts of America and Europe have socialized the losses and created Zombie banks. And at some point all the kings’ men won’t be able to put “humpty dumpty”  back together again.

As I said on 4^th of August, the politicians will not give up without a fight. So we see the fight started. Between Fed and ECB they will introduce some sort of liquidity measures, which will keep the money flowing in the stock market. Short term, we might see a vicious rally. Let me again show you the  SPX weekly chart.

Like in 2008, SPX made the first touch of the 80DMA on the weekly chart.  So the next move should be upward and possibly a new high. Sounds ridiculous today, but it is a possibility.  I do not think a bear market will start on such high negative sentiments. There has to be euphoria before the plunge.  A speculative market top is formed when everyone who can be sucked in has been sucked in. And it is a stock market driven by speculation not by fundamentals.

The debt deleveraging has started and it is going to be a long process.  Rest assured that the bear market is also going to be long and vicious. I do not think it will be one straight line down. It will be more of Chinese torture, 30% down followed by a 20% rally, untill such time all the excess has been cleansed out of the system. The central bankers will fight back hard and when everything fails the politicians will create war to divert attention from their failure. That has been the d history of mankind and there is no reason to think that it will be otherwise now. The military industrial complex is there for a reason.

The next three weeks are going to be interesting to say the least. Last week’s sell-off was a complete insider job in a completely rigged market because they knew about the coming downgrade. If my thinking is correct and a deal between FED and ECB and world politicians are done over the weekend, we will see dollar weakening and stocks rallying. Gold will reach new heights. That will be an opportunity to go short 200 %.

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For over 200 years, America has been the place which draws the best and the brightest from all over the world. It is the place where dreams come true.  

In his definition of the American Dream, James Truslow Adams said in 1931, "life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement" regardless of social class or circumstances of birth. 

Let me quote from Wikipedia: “The idea of the American Dream is rooted in the United States Declaration of Independence which proclaims that "all men are created equal" and that they are "endowed by their Creator with certain inalienable Rights" including "Life, Liberty and the pursuit of Happiness." “

Such noble words!  “Life, Liberty and Happiness”. Is there anything else in life? Yet, we now find that our dreams for a better life, a better future for the next generations are being increasingly threatened.  The middle class, which forms the back bone of the American Society, is being squeezed like never before. Somewhere along the line, the dream has been robbed by the Grinch. The Grinch exists on both sides of the aisle. Today the top 0.01% of the population control over 70% of the wealth.

 The last ten years have been exceptionally bad. We waged wars which were not needed, gave money to the super rich under political patronage, and even when the Oligarchy bought the country down to the ground with its financial frauds, we socialized the losses while privatizing the profits.

 
Three years after the financial tsunami, not a single person has been punished. Those responsible for the messes are bigger than before. They wrote a 2000 page law which promised much, but delivered little. One year after the Dodd-Frank Act, we still have no consumer protection as promised and only a handful watered down laws have been written so far which are totally ineffective.  We put lipstick on the pig and made it beautiful. Grinch has really robbed our dream.  

The giant Ponzi scheme that is being played on us is now reaching its end game. The illusion of prosperity cannot be carried on much more. The growth built up on borrowed money is collapsing like a house of cards. Look at the dark clouds on the horizon.

•           The socialist economies of the Europe has almost but collapsed. The unemployment is Spain is almost 40%.

•           Growth is negative in Italy, Greece, Ireland, Portugal, Spain, UK.

•           Banks in Italy, Spain as well as France are dead men walking. With the slightest weakness in the global financial system, banks in these countries will be denied further liquidity, so necessary to keep them alive.

•           Japan has been in depression for decades now with little sign of any life in the economy and with a debt to GDP ratio of over 200%.

•           GDP growth is now officially 1.3% in the USA and 0.3% in Canada.

•           Much closer to the shore, shipping container traffic is slowing, rather, decreasing alarmingly.

•           The growth in China since 2008 is purely construction driven, with very little domestic consumption growth. This is another Ponzi scheme that is about to collapse soon, bringing the commodity sector down with it.

•           The ports in China, the export powerhouse of the world, are seeing their total numbers falling dramatically.

•           There is no job growth in the USA nor there any real income growth for the last decade. The consumer spending which constitute 70% of the economy is unsustainable when the QE is taken out of the system.

•           The major shock is going to come from the Balance Sheet Contraction at a global level. Here in the USA, just the residential housing sector has lost well over $ seven trillion value from its peak. Add to that useless MBS that the financial institutions hold, trillions of dollars of derivatives based on such valueless properties, and we just sitting on a ticking time bomb.

•           The frauds in the financial sector continue and more than ever, Government is now a part of that fraud, aimed to keep the status-quo going.

•           Since 2008, over $ two trillion has been pumped in the system, to give the wealth effect based on the misguided trickle-down theory. All it has done is to increase the debt to more dangerous level, where the law of diminishing return is now in play. It has merely helped keep the big banks alive yet reducing the market value of assets in their books. If the banks follow the proper accounting principles, and start marking their assets to the market, instead of fantasy, each one of them will be bankrupt. Yet, today they are pillars of our financial system.

•           We have not touched the Geo-political tensions that are smoldering in different parts of the world. Bombing of Iran by Israel is a real possibility. The unrest in MENA region is going on and Syria is about to explode soon. China is having serious tension with its neighbor in the south sea region. In South East Asia, Pakistan is an unstable country with nuclear capability and the fountain head of global terrorism. Pakistan with its proxy Muslim fundamentalist military dictatorship is hell bent on destroying Non-Muslim democratic India. India and China are having issues with water. Drinking water is going to be a major flash point and potential conflict point in the future.

These  list can go on and on. But there is no way the western civilization can continue to enjoy the lifestyle of the last 40 years. The payback time is here and now.

The debt drama is just a diversion from the real challenges. I never doubted for a second that America will raise its debt ceiling. Each politician owes his/her position to some special interest groups. Do you ever think GS or JPM would allow the USA to default now? After-all even the most power-full politician in Washington has just one head on shoulder. This drama was just to scare the general population to sell cheap. The next chapter will be euphoria. The Boyzs who control the markets, know that the end is near. They now need to make one last effort to suck as much money out of the ordinary Americans and their retirement funds and savings.

It is a monkey business alright. If SPX can fall 50 points in three days, it can also go up 100 points in six days. Do not be surprised to see the markets making new highs in August. But that will not be the beginning of a new bull market. Rather, it will be the beginning of the end. Hope you have not sold out in this panic. Sell when the market is experiencing an out of the body high and be prepared for the next storm. It is coming. 

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