The Many Faces of an Economic Correction

Dow down 39 yesterday. Gold plus $2. And the noose tightens on Bernanke's neck.

As of this writing, Wall Street is still in bull mode. Can you make money by joining it? Maybe. Is it worth it? Probably not.

If you do decide to play the game...just be sure you remember what game you're playing. This is a Great Correction. Over time, prices are going to work their way down until the Dow has dropped below its March 2009 low.

And we're not alone in this view. Here is Albert Edwards at Société Générale:

My views on the outlook could not be clearer. They may be wrong, but at least they are clear. We still call for sub-2% 10y bond yields and equities below March 2009 lows.

I have for a very long time likened events now unfolding with what we saw in Japan a decade ago. Of course there are some major differences, but one can still draw clear parallels to see how extreme equity overvaluations unwind in a post-credit bubble world.

Edwards then goes on to make an important point. As we keep saying, this is not a recovery. Instead, we'll have on-again, off-again periods of recession, deflation, growth and apparent prosperity. Some of these movements will be sustained and important. But investors beware: don't forget; we are in a Great Correction, not a recovery. Edwards:

...there are huge returns to be made in equities from participating in short-lived cyclical rallies like the one we have just seen. The Nikkei regularly used to enjoy 40-50% rallies as policy stimulus drove pronounced cyclical upturns in both GDP and profits. You had to remember however that you were still in a structural bear market and you had to get out when the cycle began to top out. A downturn in the leading indicators proved to be a very useful sell signal for equity investors.

Here's a contrarian indicator: investors are more bullish than they've been in two years. Bloomberg is on the case:

Investors are exiting bearish bets on global equities, pushing bullish wagers on stocks to a two-year high versus short sales, according to Data Explorers.

The firm's long-short ratio has risen to 9.5, having surged from 5.75 in September 2008 when Lehman Brothers Holdings Inc.'s collapse intensified the financial crisis, the London- and New York-based securities-research company said. The reading is the highest of the data that goes as far back as July 2008.

While investors are bullish, consumers are bearish. Small wonder the consumer is feeling blue. Corporate profits are up to a record of about 8% of revenues. But business achieves these numbers not by increasing sales and payrolls, but by cutting costs - usually labor costs. This leaves the poor consumer with less money to spend. This from The New York Times:

...the Conference Board said its index of consumer confidence slipped to 50.4 in July, down from a revised 54.3 in June.

"Despite better-than-expected earnings reports, especially last week, unfortunately the economic data continue to be weaker than expectations," said Conrad F. DeQuadros, and economist with RDQ Economics. With consumer spending accounting for about 70 percent of the overall economy, analysts closely watch the moods swings of Americans as guideposts to the recovery.

Analysts said that many Americans were worried about the weak labor market. In its survey of 5,000 households, the Conference Board found that the percentage of consumers who said jobs were difficult to obtain increased to 45.8 percent in July, from 43.5 percent in June.

And our report continues...

Here's the latest from The Telegraph:

Drip after drip of deflation data... Today's release on manufacturing activity by the Richmond Fed is pretty ghastly, as you would expect given that the effects of fiscal stimulus are now wearing off at an accelerating pace - before the happy handover to the private sector is safely consummated - and given that the structural East-West imbalances that lay behind the global crisis are getting worse again... This follows yesterday's horrendous fall in the Texas business activity index from the Dallas Fed, which fell from -4 in June to -21 in July. "Thirty-one percent of firms reported a worsening of activity, up from 22 percent in June," said the bank. Texas New Orders were -9.6 in July, -8.2 in June, and +15.8 in May. Capacity Utilization was -0.6 in July, +2.7 in June, and +18.7 in May. This of course is why Fed chair Ben Bernanke has been giving strong hints of QE2 (helicopters again) if necessary.

Here is where it gets so interesting we can barely sit still. Ben Bernanke is threatening to drop money from helicopters (quantitative easing). In a better world, a banker who threatened to inflate the currency would be punished immediately. People would take him at his word. They would dump his paper money immediately. The price of it would drop. He'd be forced to protect it.

But this time it really is different. As Ben Bernanke himself put it, even the "credible threat" of monetary inflation by the central bank should be enough to cause people to want to spend paper money rather than save it. Thus, Bernanke promised, he can always speed up the velocity of money and thereby bring about a boom, of sorts, simply by threatening to drop money from helicopters.

But lately he threatens. And still the dollar holds firm. Why? Because the threat is not credible.

Oh what a wicked twist of fate. What has this world come to when a central banker cannot roll the currency markets and whack speculators?

Usually, central bankers are careful to give the impression that they will protect their currencies. Even while they are actually undermining them with monetary inflation. Investors catch on after they've been shellacked a couple times. Then, the central banker loses credibility and the currency falls.

But this time, Ben Bernanke actually wants investors to believe he WILL undermine the dollar. He wants to stimulate spending and investing by encouraging people to get rid of greenbacks rather than save them. But people don't believe him.

Inflation is only really a threat, we conclude, when central bankers are pretending to prevent it...not when they're trying to cause it.

But why won't Ben Bernanke drop money from helicopters? Because he's got a rope around his neck...and it's getting tighter. As long the US can finance its deficits at low interest rates, he can't move. It's uncomfortable, but it's a damned sight better than hanging. More on this as we figure it out.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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