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  Posted on: Thursday, July 31, 2008
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Still in Rally Phase between Concern and Fear & Capitulation
Budget Deficit is very much Understated

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We remain in the rally phase in the stock market between the "Concern" stage and the "Fear & Capitulation" stage.  As we stated last week, this phase could take us as high as 1360 or possibly to last week's high of 1291.  We believe the main thing to concentrate  on is that the bear market is not over and will probably not end until the S&P 500 breaks down below the lows set in 2002 and 2003 just under 800.  We know this sounds outrageous, especially when the market rallies are so powerful, but the problems we have discussed in these comments many times in the past are not even close to being resolved.  The main problem is the fact that home prices have not declined nearly enough to get back to the normal relationships between price and incomes and price to rents.  To get there the prices have to decline about 25%-30%.  This is likely to lead to further foreclosures and additional write-downs on mortgage-related securities, not to mention the damage inflicted on the economy.  We also believe that the commercial side of real estate will get much worse later this year and next year.


The real GDP in the second quarter was reported today and was somewhat less than the expectations at 1.9% vs. the estimate of 2.2%.  The main impetus to the report was net exports which added a stunning 2.4%.  We wonder what all of these economist that think the Fed should raise interest rates to support a stronger dollar believe would happen to our exports if the dollar is strong.  We believe the economies of almost all our trading partners will be so weak that instead of wanting stronger currencies they will instead compete to keep their currencies as low as possible.


Other releases today were jobless claims rising 44,000 to a 5 year high of 448,000, but most of this was due to the emergency unemployment compensation program being implemented.  The news from abroad continues to show weakness as the UK house price index declined again, PAC RIM leading indicators fell, and Japan's wages dropped 0.6% in June.  And Australian retail sales fell the most in six years.



The White House budget director, Jim Nussle, predicted Monday that the federal budget deficit for 2009 would be $482 billion.  This was a major turnaround from 3 years of surpluses prior to President Bush taking office in 2001. Mr. Nussle also predicted that the deficit would more than double in the current fiscal year to $389 billion from $162 billion in 2007 before rising up to the $482 billion deficit in 2009. 


Mr. Nussle stated that the 2009 deficit does not reflect the full cost of military operations in Iraq and Afghanistan or the potential cost of another economic stimulus package.  It also does not include the possibility of a recession in the forecast, let alone a severe recession we expect.  In fact, it was just six months ago that Mr. Bush and Mr. Nussle predicted a budget deficit for 2009 of $408 billion or $74 billion less than this week's prediction. The reason for the change was due to the economy growing more slowly.  Their more recent estimate was based on real economic growth of 1.6% this year compared to an estimate of economic growth of 2.7% in February.  The estimate of growth for 2009 was also lowered to 2.2% from a 3% estimate in February. 


Another reason for the increase in the shortfall in 2009 is due to spending increases in some domestic programs like veterans' medical care. This was precisely the reason that Joe Stiglitz and Linda Bilmes wrote the book "The Three Trillion Dollar War".  They wanted to point out just how costly this war in Iraq is to the American public.  Remember, the administration and Rumsfeld claimed that the war would "only cost about $50 billion".  They tried to save money and stay within the $50 billion budget by not spending the appropriate amount on body armor and armor for military vehicles, and now the ratio of wounded to fatalities is 5 times greater than in previous wars.  This war could cost a lot more than $3 trillion if we decide to stay for a few more years.  Why aren't we asking our leaders just what constitutes "winning the war" in order for us to pull out our courageous service men, who are stretched to the limit, while the rest of us are sacrificing nothing.  How do we go into a war like this without raising taxes to pay for it and instead lower taxes mainly for the wealthy?    


The just retired Controller General, David Walker, has been touring the country to warn about the exploding budget deficits that are already built in and will soon be "out of control" unless we change our polices.  He states, "the government has been spending way too much, promising way to much, charging it to our nations credit cards, and are leaving it to our children and grand children to pay for it."  He believes the Social Security problem is major, but that the Medicare problem is 5 times worse.  These problems have become even more serious now that the "Baby Boomers" have just started retiring and the addition of the drug Medicare program.  We will not have enough wage earners working hard enough or long enough to pay for the promises made to our retirees.


The problem will get even worse if the foreigners eventually refuse to finance much of the debt we have to issue to finance the shortfalls.  This debt has just recently skyrocketed to over $9 trillion and will continue to grow at an accelerating pace.  Japan and China together hold over $1 trillion of our treasury securities and we have to hope they stay content holding U.S. dollars. Domestically, if the recent government bail outs of financial institutions continue, and the paper they are taking on in these alphabet soup auctions become even more toxic, the deficits will further skyrocket.   


There sure doesn't seem to be easy solutions to these problems, but let's start by making most Americans realize the box we are in presently and only vote for politicians that also understand them.  Comstock doesn't see how we can avoid doubling the 2009 budget deficit again in 2010 if the recession we foresee comes to pass, and the 2009 deficit will also surpass this latest forecast by the administration. All of this, of course, would be extremely negative for our economy and stock market.

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