It is unclear how well the balance sheets of the remaining Wall Street bastions stand up to scrutiny when interest rates are raised, mark to market accounting resumed and all the fanciful Fed’s creations (like Primary Dealer Credit Facility, Commercial Paper Funding Facility, Term Asset-Backed Securities Loan Facility, Term Securities Lending Facility Options Program, etc) are withdrawn.

Ben Bernanke is reluctant to raise low interest rates but he has been quick to toast his “success” in saving America and the world from financial meltdown. Bernanke said: “History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers responded with speed and force to arrest a rapidly deteriorating and dangerous situation.”

While Ben Bernanke’s resolve in throwing money from his helicopter is impressive, history will remember him fondly not for the amount of dollars he can print in record time nor his financial creativity but rather the exquisite timing of his exit strategies. Liquidity injections canot continue indefinitely without leading to massive asset bubbles. The Fed will have to pull the trigger (I hope sooner rather than later) and that will lead to a shakeout for equities, commodities and dollar short-sellers.

Harsh facts are never appreciated when everybody is having fun at the party. Lest I keep repeating the same old bleak story and being deemed as a gate-crasher or scare-monger, I have refrained from posting too often in this blog. But it will be remiss of me not to mention that this rampant bullishness prevading the stock market is raising alarm bells.

Today, we are, at best, peering into a nascent economic recovery but Dow Jones Industrial Average have already crossed 10,000 (about 30% off the all time high of 14,198 in October 2007) when peak euphoria reigns amongst investors. If that is not getting ahead of ourselves, I don’t know what is.

Bank of America gave us a measure of reality by reporting a $1 billion loss, its fifth straight quarterly loss. To be sure, the financial sector is still in murky waters. What has changed over the last year is not the debt crisis but rather a reshuffling of cards. Instead of transferring risks to unknowing investors through securitized debts, the US government has been forced to gobble these toxic assets and shoulder immense financial risk.

The solvency of major financial institutions has come at the expense of insolvency to the US government. If financial institutions get into trouble again, what are the odds of the US government mustering another rescue when its credit is hanging in the air? Can the Federal Reserve double money supply as coolly it did over the last year? Will taxpayers, consumers and investors not bat an eyelid as their purchasing power and dollar denominated assets go into the dumps?

Knowing that the next financial crisis could require as much, if not, more resources to resolve, and the Federal Reserve could be found sorely lacking by then as the dollar loses its status as the world’s reserve currency, it is rather baffling that financial institutions are still resisting reforms to get their house in order. Perhaps it is inevitable that this unregulated financial system, as we know it today, has to crash into oblivion and be rebuilt from the ground up again.

I have nothing against attractive remuneration for top performers. You can’t fault traders who netted, say, $1 billion and they lay claim to 50% of profits while the owners and creditors who came up with the capital get the rest. However, when the traders lose $3 billion the following year and even compromised the company’s financial position, they lose nothing except their bonuses or jobs while shareholders, bondholders and even taxpayers have to step in to pick up the tab. Capitalism is not about privatising rewards while socialising the risks, but apparently the rules of the games can be changed.

Dollar Crisis And Commodities Boom?

Reckless money printing by the Federal Reserve has devalued the dollar, and we can expect a dollar crisis to play out within the next decade. Already, murmurs of discontent are getting louder amongst key players.

Rumors are rife that a meeting among Arab States, China, Russia, and France hopes for a discontinuation of oil trading in U.S. dollars. In the short term though, the dollar could strengthen as the stock market experience a major setback but its demise is inevitable if federal debts continue to pile up and the US economy weakens.

Currently, the US government is not in a hurry to defend the dollar. Without turning off the printing presses and reining in excess liquidity, Timothy Geither has only paid lip service to the notion that that America supports a strong US dollar. Exporting nations in Asia are left with little choice but to implement currency intervention, in light of narrowing US trade deficit which signals a rebound in US exports.

The dollar crisis has lent weight to investors like Jim Rogers who believe that commodities is the best place to be. I don’t doubt his words as supply and demand support his judgment. In fact, crude oil could very well run out in a generation’s time. If oil continues its uptrend, other commodities (food, metals, etc) are bound to follow.

But until the global economy gets back on a firm footing, any commoditiy boom is far-fetched. China, in its bid to sustain 8% economic growth for “social stability,” may well have decoupled from the deflationary environment in the US. China’s voracious domestic consumption is looking very promising, just over their eight day National Day holidays, retail sales of consumer goods surged 570 billion yuan, up 18% compared to last year.

But it is impossible for the Chinese to pick up all the slack in global consumption. Thus, while a collapse in commodities is unlikely, prices may fall from current levels and stay low for a while. That will actually benefit a weak US economy which is 70% dependent on consumption.

Printing more money which results in inflation and then runaway prices of oil and food is self-defeating. Raising interest rates will cause a sell-off in commodities which is a boon for consumers and businesses rather than a stock market rally fuelled by speculation and greed.

For those who are thinking of using commodities as an inflation hedge, it is also not a wise idea. Fortunes can be made or lost on a wrong bet, even for seasoned investors who study technicals and fundamentals closely.

A Global Double Dip Recession

Another rapid slump in global economy is far from impossible. Double dip recession could arise from sky-high public debts or another financial crisis sparked by delinquency in prime mortgage loans, risky commercial sector or derivatives. Geopolitical rivalries in the Middle East and Noth Korea also threaten stability. And not to forget trade conflicts which could result in protectionism or rather beggar thy neighbor policies.

If the global economy slids back again, a fresh round of stimulus packages could be harder to coordinate in the face of precarious budget deficits and debts. This could be the start of a multi-year recession, lasting at least 3 - 5 years.

America is moving in a similar trajectory as Japan when they lost their way after a housing bubble burst in the ’90s and bad loans overwhelmed their financial system. Till today, Japan has not really emerged from its lost decade. It is too early to say if Ben Bernanke has steered America away from the crippling deflation which plagued Japan or banished the ghost of the Great Depression.

Despite the stock market rally, consumer spending has not picked up. Equities may have enriched a select few but Americans are still struggling with job losses and lower income. In August, it was reported that consumer debt declined a further $12 billion, marking the seventh month of debt contraction in a row.

Since the credit crisis struck, consumers have reduced their debt by a record $113 billion (excluding mortgages). Either Americans are tired of using credit for discretionary spending or the credit crunch has not really abated as banks remain fearful of making loans.

Not surprisingly, US retail sales fell in September after the Cash for Clunkers program ended. Hopes are now on the fourth quarter where the retail industry brings in the bulk of its profit but I am keeping my fingers crossed as record unemployment will dampen holiday sales.

Dark Clouds Behind Singapore’s Economy Recovery

Singapore was the first Asian nation to announce a recession but its economy has rebounded with an 14.9% expansion (following the 22% growth in the second quarter), prompting the government to raise its full-year economic outlook. Being an export oriented nation, our modest recovery bodes well for the health of most Asian economies.

Nevertheless, MAS has kept its monetary policy steady, being cautious about the sustainability of this recovery. If private consumption in the developed nations do not increase when effects of stimulus programs wear off, we have to brace ourselves for a W-shaped recovery.

There is no doubt that things are picking up but it is too early to pop the champagne. In fact, I believe next year will be similarly, if not, more challenging. The sole pillar of our economy during this harsh recession was the construction industry which attained double digits growth while other sectors languished.

However, this sector is losing some steam. As it is, construction dipped by 0.6% while manufacturing and services were up 35% and 9.5% respectively. There could be more contraction to come. Due to lacklustre interest from buyers in 2008, many developers were vexed by their inventories and were on the verge of selling at greatly discounted prices. Interest in bidding for new plots of land was scant. Fortunately, demand for mass market residential properties spiked in recent months. 

Construction companies will feel the brunt of this “quiet” period next year, just when most of their existing projects are completed. Competition for new projects, especially from the private sector, will be keener, driving down prices. We can expect fewer companies reporting fat profits and there could even be a weeding out of the weak players which will increase unemployment figures.

The integrated resorts (two biggest construction projects in Singapore) are scheduled for completion by mid 2010. Whether new public projects can absorb all the resources being freed up remains to be seen. The “idle” situation may persist for a while as private developers are still building their land banks and the planning and approval process takes time. Hopefully, by then, other sectors of the economy will have firmed up sufficiently.

In view of the challenging times ahead, I believe the stock market is too optimistic with its valuations of 15-25 times earnings. Stocks have rallied aggressively since March. Most of them are trading above their 200-day moving average and with no sign of slowing down. In this kind of bullish environment, fundamental analysis seems really foolish. A monkey, with no baggge of knowing how bad things really are, could have made huge profits just by throwing darts in the dark. 

It is at moments like these when rational investors are blinded by greed and let their guard down. If you are seduced by lucrative gains made from stock market speculation, count yourself in good company.

Sir Issac Newton, a man renowned for his achievements in the field of physics, was left in financial ruin when he succumbed to the South Sea bubble. In 1720, the South Sea Company’s shares soared before plummeting and becoming worthless. It has no viable business but it was able to issue shares due to insatiable demand from investors, aided by rumors and speculation.

We should not forget that in the short term, the stock market behaves like a voting machine, swayed by emotions and fuelled by momentum, but in the long term, it is a weighing machine. Fundamentals have to come into play but of course, the million dollar question is when. Unfortunately, nobody can time the market accurately.

The bullish momentum may not exhaust itself just yet as there are no shortage of investors coming round to the idea that “this time, it is different,” so more cash is expected to flow into the stock market. It is getting close to a final hurrah though.

Rather than being obsessed with calling a market top, we should just maintain a neutral stance and stay vested, or for the risk averse, take profits off the table (which I have done progressively since August). By divesting all our stock holdings, we may miss out on more upside. I am not keen to buy more stocks but if you want to do so, remember to keep your stop losses tight and never maximise your leverage.

Green shoots have “blossomed” but it is during such exuberant times that we have to be cautious. Of late, I noticed that the debate has intensified on whether the stock market has topped or will continue to break-out. In the last week of August, there are days when the stock market came under furious selling pressure at the open, only to end in positive region by aggressive buying towards the end of trading sessions.

Clearly, there are manipulative forces at play, aided by a media which put a positive spin on any economic news. As they say, less bad is the new good. But the rally will not work without greater fools hopping on the bandwagon. What eager retail investors see is the stock market advancing each day, thus they are happy to stay vested and let their profits ride.

If the Federal Reserve hikes interest rates and stops creating money from thin air tomorrow, the party will be over but since that is not likely to happen and the US stock market is buoyed by so much liquidity, I wouldn’t be surprised that there is more upside to this rally.

However, given that September is historically the worst month of the year and with some big boys getting uneasy, selling pressure could escalate in the coming weeks as they unload their huge inventories of stocks.

Already, interest in US stocks is waning. Last week, trading was dominated by a few counters, namely the notorious gang of nationalized financial institutions (Fannie Mae, Citigroup, AIG, and Freddie Mac). If the top traded stocks are discounted, market volume is pretty thin which doesn’t make a convincing case for the stock market rally to continue.

In Singapore, penny stocks came into focus while blue chips fail to break out from the highs set in late July and are mostly undergoing consolidation. While some penny stocks warrant a long-overdue value discovery due to their low P/E ratios, I am surprised that investors are jumping headlong into stocks which are struggling with dismal operating cash flows and refinancing woes.

Of greater concern is the Shanghai Composite Index. It was quick to awaken from its slumber back when the world were still skeptical of the first sightings of green shoots. However, the behavior of the index has been anything but robust in August, tumbling 22% after registering seven consecutive monthly gains. On Monday, the index plummeted 6.7% to a three-month closing low and its second-biggest monthly loss in 15 years.

China policymakers have warned that unprecedented lending aimed at fighting off the economic downturn could be withdrawn and have signaled its worry about overcapacity in the steel and cement industry. According to the latest Reuters poll, Chinese fund managers have reduced their allocation to equities for the first time in six months.

This is a clear sign that investors sentiment are weakened by concerns over shrinking liquidity. Demand for stocks also declined as investors grew jittery over sky-high valuations which stood at odds to corporate earnings and dividend yield. The further stocks rises, the more unbalanced the Chinese stock market as it pulls away from fundamentals. In addition, a boom in initial public offerings has also mopped up much liquidity in the system.

Residential Properties Overheating Again

Many people are still struggling with defaults and foreclosures but there are no shortage of new investors willing to take a bite of this fruit and see for themselves if the pain of foreclosures is real. The moribund property sector is back in business. In fact, it is in rip-roaring form. 

In some locations, China property values already rival Hongkong, Singapore and US in terms of cost per square meter but the per capita income of China workers is about US$6000, lowest among its counterparts. If speculation is not curbed, affordability and valuation may be skewed dangerously. 

Though the Chinese governmnet is intent on achieving 8% economic growth to maintain internal stability and investors’ confidence, a housing bust will derail their plans and possibly spark mass civil unrest. I believe they are right in restricting loans from being funneled into the property and share markets but trying to stay on top of the bubbly situation is tricky, without damaging any nascent recovery.

In Singapore, crowds are thronging sales room, queuing up overnight, handing over blank cheques, all in the hope of snapping up residential properties (see here and here). The price for some of these condominums, in sub-urban locations and on 99 year leasehold, is not cheap, to say the least. Yet, the projects were launched to great fanfare and selling like hotcakes.

Wasn’t it only in February that developers were worried about mass defaults and banks making huge provisions for non-performing loans? I doubt if such interest is sustainable. Currently, rental yields are not impressive and unlikely to improve with more supply entering the market. Unemployment figures, though not getting worse, are not pretty either.

At this frenzied rate, I believe there could be another bust in the housing sector by 2011 or 2012 and this could be the real bottom when people swear off investment in housing for a long time. For developers and the construction industry, this is bad news but something which has to be expected as part of a business cycle.

Banks who hold mortgages will also be in trouble if the economy nosedives again and jobless rate spikes. The problem with banks is that when times are good, they are extremely flexible and generous with their loans, so long as they can get a bigger piece of the action. Customers, for better or worse, are spoilt for choice, thanks to their financial engineering.

I have nothing against financial engineering. Given that individual consumers have different financial goals and background, tailoring loan packages according to their needs is supposed to be a boon. However, the US housing crisis has taught us that financial engineering is not as helpful as it seems. Unless you know what you are getting into, plain vanilla fixed mortgages is still the best option.

At the height of the housing boom, a lot of subprime debtors were sweet-talked into taking on loans with adjustable rate mortgages so that they can buy bigger houses which are beyond their affordability level. Some even went for negative amortization (ie, they pay less than interest only on housing-backed debt) and the result is that every month, their amount of debt increases despite making payments. Not surprisingly, foreclosures have exploded in states like California and Florida where such loans are concentrated.

Economic Recovery Without US Consumers?

We have been drilled often by media reports that the worst is now behind us. There are broad signs of stabilization and emerging growth but is it time to pop the champagne? Can we expect the same heady, export-led growth, prior to the 2006 subprime crisis?

You know, those groovy days where American consumers spend beyond their means? During those reckless decades, American consumers expend whatever avenues of credit available to them -  refinancing their homes, maxing out credit cards, taking loans for vehicles, second homes, and education.

The US government and export oriented markets will like to see American consumers get back to their old spending habits but the deleveraging process is far from over. Banks are still expecting over-extended Americans to pay down existing debts first before lending more money. You can’t blame the banks, when they are in trouble, they become cautious and avoid lending money, regardless of your credit history.

Unless wages increase or the government takes on more debts to issue stimulus packages, there are not much discretionary cash for consumers. The US government is making some headway in stoking the spending psyche of Americans through programs like Cash for Clunkers and cash for refrigerators but it is unclear how much of a multiplier effect they have on the economy. 

I doubt Americans are in a hurry to take on more credit for spending purposes. Frugality is the new order. Savings have risen and and consumer spending patterns are changing. This could have adverse impact on the US economy which is 70% driven by consumer spending. 

Worsening Credit Of US Government

84 US banks have already failed in 2009. If the 1980s savings and loans crisis is any indication, this is only the tip of the iceberg. There is also a strong suspicion that the Federal Reserve is still propping up some of the too-big-to-fail US banks, without which a catasphore could wreck the financial markets again. The Fed is fighting tooth and nail against full disclosure of its dealings but it is clear that financial institutions are not out of the woods.

In order to rescue the financial markets, the US government has put its credit on the line by bailing out shaky institutions and offering guarantees on deposits and loans. Obama has also revealed that America is likely to increase its debts by $9 trillion in the next ten years. Add this figure to the existing $12 trillion of federal debts, that is more than $20 trillion.

Assuming an interest rate of 5%, that is about $1 trillion which has to be allocated in the budget to pay creditors yearly. Where is Uncle Sam going to get the bulk of this money except to turn to its printing press? And we are not even thinking about other liabilities in its social security and health care.

Is there a point where the party stops and nothing works anymore? Very likely yes. The Federal Reserve cannot cause the market to rise indefinitely by printing money at will. Its status as the global reserve currency is at stake after abusing it for so long.

It is a matter of time before we experience another major recession because the key lessons from this financial crisis were forgotten easily and people are back to their greedy speculative ways. But the next time round, the Federal Reserve may find its hands tied, with very few options available. 

The financial market may not respond as positively to a deeply insolvent America issuing another $700 billion TARP fund or its wafer-thin guarantee of deposits for the next crisis. If the situation spirals out of control, there could be bank runs, bank holidays or even total economic shutdown till everything is sorted out, which means that a lot of what we own is at risk of becoming irrelevant in a new world order.

As a lot of economic activities and assets are denominated in US dollars, the problem arising from this battered reserve currency is not confined to America alone. Clearly, there are some tough monetary issues which have to resolved during calmer moments.

I believe the stock market is likely to dip again before embarking on another bull run but don’t try timing the market as it is a matter of luck and has little to do with superior foresight. Instead of being obsessed with selling at the peak and buying right at the trough, we should adjust our portfolio allocation at this point of time and not be overly exposed to stocks.

Whether the stock market or property market advances further or dramatically declines, having a healthy cash hoard gives us the flexibility to buy on the dips and not rush into panic decisions.

More importantly, China declared its intent to rein in the flood of new bank loans to the tune of Rmb7,370bn (more than twice the amount lent last year), many of which appear to be speculative in nature.

Recently, Chinese regulators ordered banks to ensure the record number of new loans are funnelled into the real economy and not to inflate asset bubbles in the equity or real estate markets. Banks must now monitor how their loans are spent and that has temporarily stopped the red-hot Shanghai stock market in its track.

Over in Europe, economic conditions are looking more promising but they are not out of the woods yet. German industrial production fell 0.1% as compared to an estimated increase of 0.5%. The UK economy has a smaller contraction for the second quarter but weaknesses persist in the financial and business services sector.

The Bank of England’s decision to increase the size of its asset purchase program shows that the UK financial system is still suffering from deleveraging and a deluge of toxic assets. Compared to leading US financial institutions which are sheltered by the Federal Reserve, European banks have more dark days ahead.

Don’t expect them to report blow-out earnings on the scale of Goldman Sachs. In fact, Royal Bank of Scotland just reported huge losses of 1.04 billion pounds, despite revenue increasing 58%. The loss was mainly due to an increase in bad debts to 7.5 billion pounds.

Meanwhile, the European Central Bank has provided about $600 billion financing to the banking system as it foresaw a credit crunch in the fall and may be taking advantage of this bullish period to create a buffer against a possible funding shortfall.

As for the US stock market, it closed on a high last week after rebounding from early weaknesses due to an optimistic report by the US Labor Department. Unemployment rate slipped lower to 9.4% from the forecast 9.6%. Nevertheless, jobless claims increased which means jobs remain scarce and businesses are not expanding as fast as the heady stock market suggests.

The better than expected US jobs data is likely to reinforce the view that the economy is stabilizing after a generational financial crisis. Some economists have even suggested that the economy will rebound strongly in the third quarter, with a surge in vehicle production. However, any fledging recovery could still be threatened by strong economic headwinds.

The latest Federal Reserve credit report revealed a drop for the fifth straight month. Banks’ restrictive lending, unemployment, stagnant wages and falling home values resulted in reluctance of households to borrow money for spending. With debt weary US consumers (which accounts for 70% US GDP), the US economy and export markets will not be in a hurry to rush into a V-shaped recovery even as the recession eases.

It is hard to say if the US economy has recovered or just a mirage caused by Quantitative Easing but there is little doubt green shoots have come at the expense of the federal balance sheet which was compromised by unprecedented debts. The US government is determined to keep its financial system from failing, ease the credit cruch and prevent deflation. It has turned to printing money furiously which has tarnished much of the US dollar’s safe haven status.

The massive money created out of thin air has caused consternation amongst foreign creditors and investors. Their lack of participation in US Treasury auctions will result in higher cost of borrowing (higher yields and lower prices of bonds), and that leaves the Fed with little choice but to monetize its own debt, with further dire implications on the US dollar.

In the past, China depends heavily on US export market and has a keen interest to prevent its currency from appreciating. They do so by purchasing and propping the price of US denominated assets.

But with America in doldrums, China has to implement its own stimulus package to offset the weak export market and maintain an 8% growth through public infrastructure spending, investment and consumer spending. As inflationary pressures build up, a stronger yuan may be a more useful weapon for the central bank. There is little incentive to continue bolstering the US dollar.

As the US dollar risk losing its function as a store of value, investors may consider a diversified approach to sitting on cash. Gold has intrinsic value that cannot be created at will and is a prized asset for those who lost their confidence in fiat currencies.

I believe gold is an important component in our portfolio mainly for insurance against inflation rather than capital gain. Stocks have got ahead of themselves and most coporate earnings are barely satisfactory. I will certainly not add on to positions at such valuations. Even if the stock market collapses, we should only play with money we can afford to lose.

Investing in the stock market is a venture that is skewed against retail investors and one has to be avoid excessive leverage in chasing profits as market directions can turn on a dime. Retail investors are helpless against financial institutions equipped with state of the art technology and algorithms which allow them to see what cards market participants are playing in split seconds. This will allow the big banks to front run customers and skim profits from every trade.

Goldman Sachs just brought criminal charges against one of their programmers for stealing a software program that allowed them to front-run their own customers. In their criminal complaint, they said the software would allow someone to manipulate the stock market.

Now, isn’t this admission very disturbing? If you are considering cashing out your retirement nest, maxing out your margin account or taking out home equity loans to invest in the stock market, you could get burned very badly.

It is a matter of time that the rampant bullishness in stock markets ends. There are other dark clouds over the horizon which do not square with the possibility of a V-shaped economic recovery. CIT, the troubled commerical lender that serves small and midsize retailers and manufacturers, is still struggling to survive and if it does file for bankruptcy, the impact on US businesses could be severe.

Confidence could take a further hit as California IOUs don’t seem to be working very well. The state may have a budget now but any hopes of redeeming the IOUs is far away. Already, some contractors have sued California for paying in IOUs. Said William M. Audet, lawyer for the plaintiff, “The state is forcing people to accept these pieces of paper and pay taxes on them. Small businesses are closing, and more will close by the time the state redeems these warrants.”

Also, problems in the financial system remain hidden. Derivatives, all $600 trillion of them, show that there are far more debt in the world than assets to cover it. To reduce them into something more manageable could wreck havoc once again on financial markets. While derivatives are zero-sum games which does not benefit the economy in terms of tangible production, they do serve a purpose in risk management.

Derivatives are necessary for businesses which need to hedge against risks like interest rates or foreign exchange losses but there are investors who indulge in such contracts for the purpose which can only be best described as gambling. Such investors play with money they don’t have and since most derivatives are written over the counter without checks and supervision, you have to depend on the good faith and credit of the counterparty which in some cases, contain dubious risk profiles.

It is clear that the unravelling of derivatives will have severe implications on the stock market but nobody seem interested in implementing a framework to safely regulate such activities. Maybe we should just wait for the whole thing to blow up before taking action.

Another factor which will impact economic recovery is rising crude oil prices. As the global economy recovers, demand of crude oil will increase exponentially even as supply is depleted irreversibly. Crude oil may face downward pressure as rumors surfaced that the Federal Trade Commission would impose fines on market abuse.

This will prevent excess speculation but the fact remains that we are approaching or have passed peak oil. Market forces will drive oil prices beyond the average consumers’ affordability levels, long before the last drop of oil is exhausted.

We can expect oil prices to eat into the profits of businesses and discretionary income of consumers, jeopardising the prospects of a V-shaped economic recovery. Perhaps some economic activities will be forced into a standstill or rendered redundant when oil reaches $300 or more per barrel.

As for residential properties, they are enjoying a new lease of life (long queues, blank checks and scruffles in show rooms), I doubt they are sustainable. The stimulatory effects and loose monetary policies have propped prices for properties but they are not accurate reflections of demand, affordability or a lack of good properties. In fact, the supply chain is strong as there are many deferred projects waiting to be launched.

In conclusion, I am keeping my fingers crossed on a sustainable recovery in the economy. The rampant bullishness was able to cover some horrific earnings but the likelihood of another crash is quite high. In fact, I would not be surprised to see stocks drastically correct by October.

The inspector general for the $700 billion TARP scheme tallied about 50 initiatives set up by the Bush/Obama administrations and the Federal Reserve and came to the conclusion that “the US government’s maximum exposure to financial institutions since 2007 could total nearly $24 trillion, or about $80,000 for every American.”

Sheesh… for those who have a million dollars or more in their bank accounts, $80,000 to save the financial markets is chump change but for most blue collar workers, that could very well be their net worth.

To be sure, the $24 trillion is the gross and not net exposure. Most likely, the full amount will not be used. But the astronomical amount of money at stake makes the effort of most Americans who have turned to frugality and saving money seem insignificant.

Anyway back to the stock market. After seven consecutive sessions of gains, market sentiment has turned slightly cautious. Technically, the averages show that stocks are overbought, which increases the risk factor but because they have broken out above early June highs, the upward momentum is not likely to fizzle out immediately.

Indeed, the stock market rally has fooled many investors with its longevity and I am glad that I did not sell off all my stocks. Blow-out earnings from leading banks (Goldman Sachs and JP Morgan) renewed market optimism and reversed a bearish head and shoulders pattern.

Strong profits from the financial sector are actually not surprising considering the low interest rates (effectively 0%), mark to market accounting thrown aside, and the value at risk for trading activities soaring to record levels. In addition, low earnings forecasts across the board make it easier to surpass expectations.

Investors were further emboldened after a temporary reprieve for CIT from bankruptcy and a string of better-than-expected corporate earnings filtered in. Nevertheless, the euphoria for commodities and equities might prove to be transitory. Thus, I am not keen to add to my positions amid increased appetite for speculation.

Due to weak consumers’ demand, it is still highly suspect if earnings from the real economy can consistently outperform expectations in the months ahead. Before the financial crisis, most individuals and businesses stretched their budgets and leveraged to the hilt. Well, it finally hit home that nobody get rich by spending beyond their means.

The years of easy credit is unsustainable and most likely over. If Americans are squirreling money away for a rainy day, then the only hope for the global economy to power ahead lies with emerging markets.

A case in point is the booming Chinese market. China reported an impressive 7.9% growth in their economy in the 2nd quarter while the U.S. and Europe remain mired in recession. China’s 4 trillion-yuan ($585 billion) stimulus package has worked like a charm - domestic consumption and infrastructure works have more than compensated for the decline in exports.

We are also told that China’s stockpile of currency rose by a record $178 billion in the second quarter. The US definitely need China’s continued support to fund unprecedented amounts of debts. In a further show of strength, China has overtook Japan as the world’s second-largest stock market by value for the first time in 18 months. Slowly but surely, Japan’s large but ailing economy is losing its influence.

At the moment, I am sticking to my view that the stock market rally is overdone and there is a good chance of buying on the dips again. We have come a long way from the March lows when stocks fell far below their peak, and a stock market rally is justified by long-term fundamentals. As more disbelievers wade in to capture a piece of action before they miss out on more profits, the stock market rally stretched into months.

However, the recent rally has priced in very rosy earnings for many sectors in anticipation of a full-fledged recovery. Such optimism will allow bears to force the stock market lower in the later part of 2009 when the outlook for earnings in the real economy turns bleak or more time bombs in the commercial and prime mortgages explode.

Instead of a lengthy consolidation, the stock market has broken its previous resistance aggressively. Though investors are now behaving like sex-starved addicts in a harem and are ready to invest at any hint of positive news, do not forget that market sentiment can turn on a dime. The result is that there are air pockets instead of firm support at the bottom, and that makes a major correction inevitable. 

Some experts have postulated that we are entering a 20-year bear market, with rallies occurring intermittently and the worse is yet to come. We are now a few weeks away from challenging the record “longest” stock market rally of 155 days which happen in November 1929. The drastic stock market correction and prolonged economic malaise thereafter is something which I do not hope for, but nevertheless a distinct possiblity.

A major correction will really test investors’ resolve. After experiencing these bear traps a few times and the stocks retreat to unprecedented lows, investors will give up stocks altogether. Judging from the buoyant mood in the stock market. we are not at the depressed level yet.

So far, we have seen complex toxic financial instruments, frauds, Ponzi schemes and creative accounting come out of the woodwork. Usually, the greater the deception, the more severe will be the depression. We can heave a sigh of relief if most ills in the financial system has surfaced already. Unfortunately, that is a tough guess.

As for the housing sector, there is a renewed spat of buying. It is true that houses are much cheaper than in 2007 but they are not necessarily more affordable. The falling prices is a reaction to lower income and employment. Credit has also dried up as mortgage lenders become more cautious about whom they lent money.

Another property bubble could be brewing. Speculators are hanging on to the common refrain that “houses always go up in price” and are rushing to snap up new offerings. Prices may have stabilized currently but not bottomed yet. Thus, hopes for huge capital gains may not be realistic.

That is not to say we should shun properties. If you intend to stay in your house, then it is a good place to park your surplus cash. A house offers you a roof over your head and is a very durable asset (which cost money to maintain). When you take on a 30 year fixed rate loan, chances are that you are paying off the loan with cheaper dollars as inflation rears its ugly head. But if you are seeking investment grade properties, they will probably not appear in another 2-3 years time.

Because of the liquidity being pumped into the financial system by the Federal Reserve, nobody in his right mind will sit fully on cash and let inflation eat into their wealth. It is difficult to know how much further this rally will last. Is it exhausted already or the start of another massive bull run?

The bulls feel that “prosperity is around the corner” and that this recession, like others since World War II, will end as soon as the stock market, as a leading indicator, recovers and people start spending again.

I am inclined towards the view that things are picking up but the possiblity of another major correction is never far from my mind. On the technical side, there is room for huge rallies, but there is also room for plenty of misery.

The key is not to be overexposed to the stock market and stay nimble as the opportunities that present themselves may not follow traditional recovery patterns. Stocks could be depressed further or languish for years, so if you see the need to take profits off the table, then just do it.

While there will be quarters of positive economic growth ahead and the recession could even be declared officially over in the coming months, the radical economic reorganization that is slated by policy makers or will be forced upon by circumstances will change the macro economic landscape as we know it.

Not surprisingly, a cautious mood has descended on investors as they await the next major move in the stock market. During this lacklustre period (a good excuse for not updating this blog), what gives for July? For one thing, there is the hugely anticipated second quarter earnings reports which will either lend credence to green shoots theory or spark a fresh round of selling as optimism is shown to have overtaken reality by a mile.

Most Asian stocks fell over the week. Hongkong has a turbulent session as financial and property stocks declined but it clawed its way back to end a 3 day losing streak. Japan, the world’s second largest economy by GDP, is a really sad story as its “lost decade” is now well into its 19th year. To add to its woes, it suffered its first trade deficit in 28 years.

This is expected since Japan cannot export what the world won’t buy (especially America) and an appreciating yen doesn’t help its exports. Domestic consumption is also fragile, with its aging population, low birth rates and a struggling workforce. Currently, manufacturing sentiment is on the mend but still fared worse than expected. In fact, Japan’s manufacturers plan to trim capital expenditures by a record 24.3% for this fiscal year, exceeding estimates of 13.2%.

I don’t harbor hopes of Japan leading the world out of this Great Recession. If it can get its house in order, and not be the first to declare a Depression, it is already an achievement. On the other hand, China has the potential to eclipse Japan as Asia’s economic powerhouse in the next decade. The Shanghai Composite Index is on a roll, finishing up at a 13-month high.

China turned in a good manufacturing report and its PMI boosted confidence, rising to 53.2 in June (from 53.1 in May), above the watershed mark of 50 for a fourth month in a row. Clearly, its stimulus which amounts to 20% of their GDP is working.

However, it is debateable if the high asset prices are sustainable when much of the world is still in a slumber. Even if the Chinese recovery story (propelled by domestic consumption) is compelling, irrational exuberance is a threat as investors are buying into stocks regardless of valuations.

As for the developed world, it presented little cheer for investors. Europe is hit hard by the highest jobless rate since the EU was formed 16 years ago. 9.5% of the citizens are unemployed in May (up from 9.3% in April). That is 15 million unproductive people depending on handouts, and unemployment is not expected to peak until 2010 when it reaches 11.5%.

US jobless rates were equally awful. Non-Farm Payrolls fell 467,000, much worse than the expected 350,000 job losses. Unemployment climbs to 9.5% from 9.4% last month. So much for green shoots when unemployment rate is still increasing. The global economy will take months, if not years, to recover which makes the run-up in oil prices all the more baffling.

Since March, oil prices have doubled as investors plumped for oil, not only to hedge against inflation but also to profit from the contango trade. But oil prices will face strong resistance from poor demand, especially when workers and the unemployed drive less and buy fewer goods while factories shut down, saving on electricity.

For the time being, inflation is kept at bay despite a ferentic printing press in America to fund stimulus and bailout packages, but I am cherishing the effects of deflation because in 2-3 years time, we will be begging for falling prices.

In the past year alone, US ramped up its money supply by $1 trillion which is likely to cause about 50% hike in prices as the money trickles down the food chain. This staggering amount, expected to be replicated for several years as bailout, spending and payment obligations pile up, will lead to hyperinflation and weaken the investment of foreign creditors.

The reserve currency status of the US Dollar is at risk. In good times, the US can deflate its debts by paying back money with lower purchasing power but with its economy in distress (insolvent households, banks and corporations), investors are not biting the bait anymore.

Calls for a replacement grow louder every day but this is no conspiracy, just simple economics at play. The situation today is markedly different as compared to 1948 when Americas was in ascendancy as the world’s biggest creditor and manufacturer and the owner of the largest gold hoard.

The US dollar was as good as gold, backed by a stable government, competitive economy and powerful military. Right now, save for a military which stills evokes fear and respect, its economy is in tatters and the government debt load is insurmountable.

It is entirely possible that under the astronomical Quantitative Easing policy, the US will suffer a double whammy of higher inflation without any improvement in its economy. Handing out the pork barrel to zombie banks and corporations means mistakes and weakness are not flushed out of the system. This is not the scary part, if you consider the multitude of bailouts awaiting the US government.

Indeed, the hat-in-hand circus is just getting started. The inability of individual states to meet their operating expenditures - at last count, 29 states anticipate budget deficits in 2011, will limit the Federal Reserve’s ammunition to cope with further shocks in the financial system. All it is needed is a precedent to set off a wave of state bailouts.

California is already making tough decisions, shutting down the civil service for three days and issuing IOUs. Other states may not have the luxury of borrowing and have to raise taxes, draw on reserves or depend on the federal government to prevent humanitarian disasters and economic standstill.

Yet, there are more bailouts to come. With more people jobless (on average for 6 months or more), America may have to bailout state trusts which pay unemployment benefits. Resources in unemployment funding are running low and may be insufficient to handle the next massive, post-holiday wave of layoffs.

And with just about everybody receiving some pork, you can’t leave a housing bailout out of the picture, nor a bailout of the pension benefit plans when employers go under. These are popular policies which directly affect the people on the ground and it is hard to say no, not when you have already bailed out greedy and irresponsible executives on Wall Street, compromised the federal budget and yet ignored hardworking Americans who are displaced from their jobs.

It is hard for the US government to put a stop to all these nonsense. Each bailout increases the pressure to fund the next one and the result is everyone ends up poorer. Noah’s ark can only accommodate so many living beings, trying to rescue everybody means you sink the ship. And this is what you get when the currency is debased. If the US Dollar is forsaken tomorrow, a significant devaluation will occur, followed by a huge loss in US denominated wealth.

China, Russia and India are now striking out similar paths to ween off their dependency on the dollar. At the very least, they are more concerned with their own domestic market than to think about funding America’s deficits.

The Chinese will not aggressively undermine the US dollar to protect their colossal foreign reserves in Treasury bonds but they are not standing still to witness the debauchery of the dollar via trillions of dollars in new debt. They will rather stake their claim on commodities by investing in mining companies and importing materials.

All the bailouts and lack of foreign participation will only force further monetization of Treasury debts but this is a dangerous and unsustainable path. Confidence in US dollar will return only if the monumental debts are whittled down or the money are channeled into productive economic activity instead of sheer speculation. But when nobody seems to be in the least interested in where or how the money is being used, you do have to wonder if Obama’s vision of change is for the better or worse.

With all the money printing to save America’s hide and destroying everybody’s wealth, what is an investor to do? Putting our cash under the mattress without any returns and assuming the same inflation from 1988 to 2008, our purchasing power could be halved in this 30 year period. If you factor in hyperinflation, then we could be left with a serious retirement crisis using that approach.

We definitely have to put our money to use. Inaction is not an option. To invest safely, it is important to do a thorough analysis of earnings report and a good measure of common sense. But the macro picture will affect us despite our best efforts to protect our money.

What I see right now is not a pretty sight. Like it or not, the fiscal malaise in America is also the world’s problem. That is, until a new global order is established. But that could mean everybody starts off afresh and nobody knows who owes what to anybody anymore. Is it good or bad, I do not know.

At the moment, I am staying off equities as trading in this bearish market calls for nimbleness and is a different ball game to the easy money during the bullish period from March to June. The risk return is not appealing but staying out entirely is not wise either as we could miss out on profits from sudden run-ups as well as steady dividends.

I have taken some profits off the table and my portfolio allocation stands at about 40% stocks, 15% gold and 45% cash. As I will investing more of my income into gold, I expect the percentage of equities in my portfolio to decline further in the coming months.

The precious metals sector is still in a favorable technical and fundamental situation, despite summer doldrums and the gold sale by IMF. I can’t say the same for commodities which have been driven up stockpiling in China and speculation by hedge funds. A correction is imminent once China feels it has enough commodities.

I expect more US bailouts to dampen market sentiment. Investors can choose to scale in progressively on the dips or just sit on cash. If there is no major correction, I will like the stock market to consolidate further as it accumulates energy for a sustained run. The longer idle cash sits, the stronger will be the pent-up demand when the market resumes its bullish direction.