Remember when Bush senior was running for President against Clinton (Mr.) and, in order to emphasize what was the most important issue in the campaign, the Clinton supporters used the phrase "It's the Economy, Stupid", to make sure the voters didn't lose their focus?  We will use a similar phrase, "it's the housing market, stupid", in order to make sure you understand what we consider to be the most important issue for the U.S. economy and stock market.  If the housing market continues declining as we expect, the enormous loss of wealth will affect individual consumption, the economy, corporate earnings, and the stock market. 

To put this in perspective, you have to understand that the total value of the housing market was close to $21 trillion in 2006.  It got to that level by almost doubling from 2000 to 2006 by misleading lending (bordering on fraudulent), way too easy monetary policy, and major over-building relative to job growth and incomes.  We have been convinced for some time that the housing market value would decline by at least 20% and could decline by over 35%.  So far it has declined by about 16% meaning that over $3 trillion was extracted from the U.S. consumers' net worth.  If the housing market declines in value by over 30% the extraction of the U.S. consumer's net worth would be over $6 trillion.  And this is on top of household's being overburdened with debt of close to $14 trillion!

If that were not enough, the rising prices of energy and food will clearly have a very adverse effect on the spending binge of the U.S. consumer, who has propelled not just the U.S. economy but the entire global economy.  It is clear that the consumer "hit the wall" earlier this year and the latest auto statistics in May are a good example-Ford -19%, Chrysler -28%, GM -30%.  

The bulls have been claiming that all they really need is for the U.S. dollar to rise.  This will trigger the energy prices to decline followed by the other dollar based commodities.  When commodities break the inflationary problem will ease and the stock market will do very well.

For a short period of time on Tuesday the bulls thought they had a major break through as Ben Bernanke gave a speech in the morning where he discussed the dollar at length.  He talked about "monitoring" the dollar and said things like he was "attentive" to the dollar movements.  In the past he never would talk about the dollar, but instead, made sure everyone understood that the dollar policy was under the auspices of the Treasury Department and Paulson.  Bernanke now seems to be more interested in a "strong dollar" policy.  Paulson, who claimed to advocate and support a strong dollar, never actually instituted aggressive dollar policies. 

After the speech, the dollar rallied, commodities broke down, and the stock market rallied as the bulls have been predicting.  The rally continued with little volume until it ran out of steam and dropped sharply without any news.  We think the market broke because the bull's case of the dollar rising, commodities breaking, and a strong stock market is flawed.  The flaw is the fact that housing problems (it always comes back to housing) have already spilled over to the consumer and the only thing keeping the economy slightly positive is exports, which have been driven by a weak dollar.  What happens if or when Bernanke raises interest rates to support the dollar and is successful?  We think the economy goes into the tank.

We will do a "special report" next week to answer the question raised in the last "special report", "How We Got into This Mess", titled "How to get Out of this Mess".