Five years ago on the eve of another of the Fed's annual financial symposiums at Jackson Hole, we wrote the following"

"Since 1999 when the financial bubble was in full bloom (due in large part to the Fed) we have been saying that the central bank faced a dilemma with limited choices----none of them good.  They could either kill the bubble, let the economy and markets take a hit and come out of it ready to resume healthy growth----or they could keep extending the bubble for a while longer with far worse consequences down the road.  The Fed, under Greenspan, chose the latter course, resulting in a dangerous housing bubble following the financial bubble of the late 1990s.  This is evident in the fragile economic unbalanced recovery, the massive trade deficit, low consumer savings rate and record household debt.  The standard measures of the economy indicate to many that Greenspan has won his bet, and the Jackson Hole symposium will probably be full of praise for his long tenure.  We hope that they are right, but we believe that the final word on Greenspan's reign as Fed Chairman is not yet written, and history may not view him kindly."

Now, five years later another Jackson Hole symposium will attempt to find solutions to the economic mess that partially resulted from the Fed's reckless actions.  The problem is that an already sub-par recovery (if we can even call it that) is giving signs of petering out even after all the massive stimulus programs provided by the Fed, the Administration and Congress.  Sales of existing and new homes have dropped to new lows while consumers beset by high unemployment, minimal wage increases, near-record debt and limited access to credit are reluctant to spend.  At the same time the inventory replenishment that was one of the few contributors to growth is now winding down and yesterday's report indicated that core capital goods orders declined by 8% in July.

With the recognition that economic growth is showing signs of coming to a halt, the talk has turned to the possibility of more quantitative easing or QE2.  The problem, though, is that after TARP, the stimulus plan, Fed purchases of $1.7 trillion of government securities and near-zero interest rates, there is little more the Fed can do that they haven't already done.  At this point the Fed cannot use monetary policy to force companies, banks and consumers to take credit that they do not want to use.  In economic literature, this situation is known as a "liquidity trap", a phrase you will probably hear a lot in coming months. 

The dilemma is well presented in today's Wall Street Journal op-ed column by Alan Blinder, a Princeton economist and former Fed member, who is certainly not a perma-bear.  The article, called "The Fed is Running Out of Ammo", outlines three options for the Fed-----expanding the Fed's balance further, changing the "extended period" language in the Fed's statement or lowering the interest rate on bank reserves.  He then demonstrates that each one of these options has either negative political consequences, economic drawbacks or limited effectiveness.  He concludes by saying that if the economy doesn't pick up, it's time to use even this "weak ammunition", although he obviously doesn't think it would be of much help.

In sum we believe that all of the options with regard to economic policy are negative, a point being gradually recognized by the stock market.  The S&P 500 peaked exactly three months ago on April 26^th.  Yesterday it found support at about 1040 for the third time, although it has temporarily dipped to 1010 on July 1^st.  In our view both of these support lines will be pierced and the market is likely to decline significantly from there.

It becomes clearer every day that the economy is headed for a renewed recession or a recovery so slow it will seem like one.  Initial unemployment claims climbed to 500,000 last week for the first time since November while the Philadelphia Fed index dropped below the zero line for the first time since July 2009.  This follows a pattern of generally softening economic data over the last two or three months.

 As we have long expected, the economy is tracing out a trajectory typical of a balance sheet induced recession rather than the garden-variety inventory recessions typical of the period since the end of World War ll.  In a balance sheet recession the dire effects of debt deleveraging overwhelm the efforts of the government to stimulate the economy as is happening now, and the economy undergoes a lengthy period of deflation,  sub-par recoveries and frequent slowdowns as the U.S. experienced during the 1930s and Japan over the last 20 years.

While the massive stimulative measures undertaken by the Fed, Congress and the White House have succeeded in averting a financial collapse, they are being more than offset by the deleveraging now taking place.  The effects of inventory replenishment are winding down without any other major drivers to sustain growth.  Typically a new economic expansion is led by inventories, consumer spending, employment, housing and readily available credit.  This time only inventories have performed their usual function, meaning that the economy has been acting on only one of five cylinders.

The Fed has already used all of its conventional weapons and will undoubtedly resort to untried unconventional measures with unknown outcomes and the possibility of unintended consequences.  The most likely measures will probably be further large purchases of Treasury securities and mortgage bonds together with a ceiling on Treasury bond yields as outlined in Chairman Bernanke's famous 2002 speech that earned him the nickname "Helicopter Ben".  This is commonly referred to as quantitative easing or QE2.  We doubt, however, that this will have any more effect than QE1 as it would be more than offset by debt deleveraging in the private sector.

We also believe that the market is currently too complacent about the global economy.  China is attempting to prevent a bubble by engineering a soft landing that will at best result in a substantial slowing of imports, and at worst a full-fledged recession as often happens when governments aim for soft landings.  Japan, too, is undergoing renewed economic weakness following two decades of deflation and minimal growth.  Europe is going through a short period of temporary calm after the EU and the IMF threw a lifeline to the struggling southern tier.  However, the authorities have failed to deal with the underlying structural debt problems that will continue to be a major problem while the austerity measures that that are being implemented will be a major drag on the various economies.

For example the German magazine, Der Spiegel points out that the austerity measures applauded by the EU are already having dire effects on the Greek economy.  The Greek government has reduced its budget deficit by an astounding 39.7% and spending by 10%.  This has had a drastic effect on income, consumption, employment and bankruptcies, leading to a "mixture of fear, hopelessness and anger".  According to the article another wave of layoffs is likely in the fall and this could have "extreme social consequences."  Such an outcome could come as a severe shock to a U.S. market that has factored in a quieter Europe.

In sum, we believe that the market is still discounting a continued U.S. recovery as well as a supportive global economy.  In the current climate such hopes are likely to be disappointing and corporate earnings estimates for 2010 and 2011 will probably be revised down sharply.  The market peaked in late April and is now trending down amid a lot of volatility.

The Fed tried to thread a needle and ended up satisfying nobody.  They confirmed to all the doubters that the economy was indeed weak and that they really couldn't do much about it without resorting to completely untried and unorthodox measures with unpredictable results.  To all intents and purposes the Fed showed to all that the emperor has no clothes.  The $200 billion in proposed Treasury bond purchases only compensates for the coming rollover of mortgage bonds, and, in any event, is dwarfed by the measures previously taken with little effect on the economy, although it did succeed in averting a financial meltdown.

The market has suddenly awakened to the fact that the economy is tanking and that the Fed has used all of its conventional ammunition.  Interest rates are near zero, the budget deficit is 10% of GDP and the Fed's balance sheet has tripled to $2.3 trillion.  After some $700 billion of TARP funds, $1.7 trillion of Fed purchases of mortgages and Treasuries, untold billions of dollars of guarantees, the auto industry bailout, cash for clunkers, home purchase credits and mortgage workout programs, the economy still cannot stand on its own.

Aside from the Fed's tentative move, new reports released this week convinced even most of the doubters that the economy has weakened considerably and that the outlook ahead is for more softness at a minimum and, potentially, a renewed (or continued?) recession.  For a long time it seemed as if we were the only ones talking about deflation, and suddenly it has virtually become the conventional wisdom  After a big June increase in the trade deficit and a slowing increase in inventories, most economists have reduced their second quarter GDP growth estimate to a range of 1%-1.5%, compared to the previously reported 2.7%.  Taken together with a sharp rise in unemployment claims, the disappointing payroll employment number, a continually declining housing market, tepid consumer spending and yet another gloomy report from the small business survey, the economic outlook going into the third quarter does not look promising.

Anyone looking for help from the global economy has to be disappointed as well.  European industrial production dropped in June and the Bank of England reduced its forecast for economic growth.  The ECB warned that much of the European recovery over the last year was due to one-off factors such as the rebuilding of inventories and government measures that are now expiring. Now the austerity measures that are being put into place are likely to result in slower growth or recession.  In addition new concerns about the peripheral EU nations have begun to emerge once again after being papered over in recent months. Greece's growth weakened even more than expected.  Ireland's interest rate has almost doubled in three weeks.  According to the Financial Times, the so-called Euribor-Eonia spread, a measure of banking sector risk, rose to its highest level since last September.   The cost of insuring against default by European banks has also climbed.  At the same time, Chinese imports dropped 5.6% in July while the government reported slower growth in production and retail sales.

As we have pointed out numerous times, the reason for the U.S. and global economic malaise is the enormous overhang of debt that is in the process of being deleveraged.  Efforts to cure the debt problem by attempting to add even more debt are doomed to fail as various sectors of the economy are either attempting to reduce debt or are not good credit risks.  This is a typical pattern after recessions that are caused by a credit crisis. 

The stock market peaked on April 26^th at 1219 on the S&P 500 and declined to 1010 by July 1^st.  The rally to 1129 since then has now abruptly ended, leaving previously bullish traders trapped.  We believe that their efforts to get out of their bullish positions will drive the market lower.  Furthermore since consensus economists were only recently looking for 2.5%-to-3% growth in the second half, earnings estimates will have to be revised down for this period and probably 2011 as well.  It's also likely that corporations will be issuing a lot more earnings warnings during the current quarter, and that Cisco's disappointment will not be a one-off event.  Near-term S&P 500 support at 1088 has already been violated and 1010 is next.  In our view an eventual test of the March 2009 lows is a distinct possibility.

 We have maintained all along that the statistical economic recovery would lose momentum after the effects of the stimulus and inventory replenishment wore off, and the recent data are confirming our view.  Moreover there are no drivers to sustain the recovery or prevent deflation without additional drastic measures with an uncertain outcome.  The likelihood therefore is either extremely slow growth or the feared double-dip.

The Fed and the administration will attempt to use everything in their arsenal to turn things around, but have used up all of their conventional ammunition and would have to resort to non-traditional methods that have never been tried before.  Obviously, the results of these further potential interventions would be highly uncertain as to impact, timing and unintended consequences.  The authorities would therefore be hesitant to move before they are more confident that the current pause is the precursor to a new economic downturn.

Not only is the statistical recovery faltering, but it was never that robust to begin with.  Real GDP growth in the last four quarters has averaged only 3.5%, a paltry rate compared with the first four quarters of growth in prior recessions.  Furthermore, real final sales over this period averaged a meager 1.4%, only 40% of the total.  It is therefore clear that inventory replenishment accounted for 60% of the growth in GDP over the last four quarters, and this should wind down with the declining economic momentum.

New economic expansions following recessions are usually powered by four major factors: the end of inventory drawdowns, a robust rebound in housing, renewed substantial growth in consumer spending and a significant increase in employment. That is usually followed by a handoff to other sectors with a resulting positive feedback loop that sustains the recovery for a lengthy period.  In the current anemic recovery only the inventory factor has contributed anything significant while housing, consumer spending and employment remain weak.  Therefore the handoff is unlikely to happen and the desired positive feedback loop will not take place.

As it soon becomes obvious that the current loss of economic momentum is more than just a pause in an ongoing recovery, we believe that the market will break down from its current S&P 500 trading range between 1217 and 1010 and test the March 2009 lows.  Major bear markets tend to bottom at P/Es of ten or less smoothed long-term reported earnings, and we think this one will be no exception.  As we previously pointed out, the market has sold at P/Es of ten or under trendline earnings in 17 of the last 60 years indicating it is not an unusual occurrence.