"It seems nothing can keep a bad market down," we opined last week, adding, "If this bounce goes much higher, we're going to have to review the laws of financial gravity."

Just when we were on the verge of losing faith in those immutable laws...the market put them to the test for us, leaping off a cliff with barely a cocktail umbrella to slow its fall. The Dow Jones Industrial Average plummeted more than 4% during the past five trading days. The broader S&P 500 index faired even worse. That's the thing about the laws of physics - they don't require any faith. They are testable. They care not for wish thinking and make believe, dot.gov statistic padding. Central planners can fluff their partly fraudulent, wholly misleading GDP figures all they like...the truth always comes out in the end.

Unfortunately for investors (and ill-equipped base-jumpers), it's not the fall that kills; it's what's at the bottom.

Readers will observe that one week does not a bear market make. But we are not one week into a bear market. Depending on the metric with which one chooses to define "bear market," we are anywhere from two to ten years deep, arguably longer. Stocks, for instance, have handed investors negative returns over the past decade...and that's in nominal terms. Allowing for inflation - which has cost the once-almighty greenback about one-third of its value since the turn of the century - results are far more depressing.

Home prices too have slid into the red during the last ten years, as has total employment when measured as a percentage of the workforce.

Worse still, the closer one looks at the rotten unemployment situation, the more alarming the situation appears.

• 
  "One out of every 25 people in the American work force has been out of work for six months or longer. That's a good 60% worse than the previous record set during the early-'80s 'double dip' recession."
  
  Curiously, most investors still seek shelter from the unfolding crisis in the currency of the world's largest debtor. Stranger still, they shun gold, the safe haven investment that don't owe nobody nuthin'. Our favorite yellow metal slid all the way down to the $1,090s per ounce last week as the greenback rallied on "safe haven" buying (though it has rebounded $10 per ounce as we write this morning, suggesting at least some support at these levels).
  
  Short-term trends notwithstanding, unquestioning confidence in the dollar is not like an immovable law of physics. Quite the reverse, in fact. On a long enough time line, entropy wins over all matter. As the greenback hurtles through space, wasting heat along the way, its value continues to erode. Assisted by proposals to raise the national debt ceiling (the latest of which would boost it to $1.9 trillion) and record monthly Treasury auctions to keep the whole show financed, this trend toward eventual currency disintegration ought to increase in both speed and severity.
  
  In the end, a dollar will still buy a dollar...but a dollar's worth of anything else, including gold, will be more or less microscopic.
  
  
  For Americans concerned about where their country is heading, Mr. Walker's insights provide an invaluable reference point.

The Scary Budget Numbers
By David Walker
New York, New York

The recession and attendant financial shock appear to be easing as I write this. But in Washington, financial imprudence is part of the fabric of government. You can see that in a single document that gets updated every year: the US budget. In putting together the budget, the president and Congress set our national priorities and allocate resources among them. The results have been pretty consistent. Over the forty years ending in 2008, revenues have averaged about 18.3 percent of our economy and spending has averaged over 20.6 percent, resulting in an average deficit of about 2.4 percent.

But that gap began to widen under Bush 43, who cut taxes while starting two wars, bolstering homeland security, adding an expensive prescription drug benefit to Medicare, and increasing other spending. In 2007, the federal deficit stood at $161 billion, or 1.2 percent of our economy. In 2008 it was $455 billion, or 3.2 percent. In 2009, figuring in the billions spent to pull our economy out of recession and on various bailout efforts, the deficit rocketed to about $1.42 trillion, 9.9 percent of our economy.

In Washington, they speak of our "fiscal exposure" - the sum of all the benefits, programs, debt payments, and other expenses that will cost us big bucks in the future whether or not we want to cut spending. The term I've used for all of that is our "federal financial hole." In the first eight years of this century it has grown from $20.4 trillion to $56.4 trillion - a 176 percent increase.

Maybe you have a few bills - mortgage payment, auto loan, cable TV, phone - deducted automatically from your checking account. How would you feel if those expenses had risen 176 percent in eight years while your income remained steady?

The hole is getting deeper because we are doing little to bring our income into line with our spending. And until now I haven't even talked about the interest payments on our federal debt. Suppose our government fails to increase federal revenues above the current rate. Based on the GAO's latest long-range alternative budget simulation, within about twelve years, our interest payments will become the largest single expenditure in the federal budget. By 2040, all of our federal tax revenues will add up to enough to cover only our two biggest expenses: interest on our debt and Medicare and Medicaid. Everything else - Social Security, defense, education, road building, you name it - will fail to be funded.

As you know, benefits payments are the biggest chunk of the government's massive obligation. Since the 1960s, the growth of these mandatory payments has overtaken what we spend on defense as a share of our national output - and what we spend on everything else in our federal budget, from law enforcement to border protection, children's programs to national parks, highways to foreign aid.

Although defense has declined dramatically as a percentage of the overall federal budget over the past forty years, we have actually increased total defense spending. In recent years, we have added resources to fight terrorism abroad. That means that other discretionary programs are much more susceptible to cutting. These include education, research, transportation, infrastructure, and other programs that, if properly designed and effectively executed, can promote economic growth and development. How will squeezing those areas serve to keep America great?

All of this puts us in a major-league quandary. Our nation has to bring what we earn into line with what we spend at a time when our spending literally is out of control. One option - cutting investments in America's future in order to finance our large and growing mandatory spending programs - is another way of cheating the next generation. Unfortunately, today we are both cutting our investments in the future and handing our descendants a mountain of debt. That is a double whammy for young people and the unborn. It's not just irresponsible, it's immoral and downright un-American.

In the meantime, be sure to tune in next Monday when we bring you Part II of Mr. Walker's series on fiscal responsibility.

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And now over to Bill Bonner, who has today's reckoning from Paris, France...

Is this it? Is this the beginning of the end?

In the beginning there was the word. And the word was 'subprime.' When investors spoke the word in 2007, markets quaked. By the autumn of 2008, Lehman Bros. had gone broke and stocks were falling all over the globe.

The end of the beginning came on March 9th, 2009. Stocks had lost about half of their value...a loss of about $25 trillion, worldwide. The first stage was over.

The next stage was the rebound...the bounce. It boosted stock prices everywhere - particularly in the emerging markets. Worldwide, stocks recovered about half of what they had lost in the first stage.

Now, we are either near the end of the middle stage or at the beginning of the final stage. Last week, it looked like the final stage had begun. The Dow fell 4 out of 5 sessions...with a big drop on Friday, of 216 points.

Fear is back. Oil is trading under $75. Gold dropped $13 on Friday. Proportionally, gold lost less than stocks. At least a few smart investors see gold as a refuge, rather than a threat.

Commentators are providing plenty of 'reasons' for the wobbles on Wall Street. The Chinese are tightening credit. Obama is getting tough on the banks. Take your pick. But the noise coming from the financial media merely provides a way for investors to understand what is going on without really understanding at all. On the surface, markets react to the news. But their primary direction is determined by deeper currents.

Obama is losing the confidence of the nation. His health care reform plan is a rat's nest of corruption and confusion. His handling of the wars against the Iraqis and the Afghans is a disgraceful mixture of claptrap and cupidity. And his treatment of the banks is one half publicity stunt and the other half relatively unimportant.

Too bad. He seems like a likeable fellow. He just didn't realize that he came into the presidency on the downside of the credit cycle. Fish gotta swim. Birds gotta fly. And credit cycles gotta correct. That's why the stock market - at present - is unfinished business. It is a work in progress. A bear market began at the beginning of the '00s. It was held off by a final, reckless increase in cash and credit from the feds, following the pseudo recession of 2001. Then, after a spectacular bubble in the financial industry and in residential real estate, the bear market resumed in 2007. In 2009, stock prices reached a temporary bottom and bounced. And now the end stage for the bear market may be beginning.

None of this is Obama's fault. He didn't create the credit bubble. And he can't be faulted for not fixing it. It's not a fixable thing; at least, not by politicians. Markets have to do their work. They have to take prices down to levels where it makes sense - considering the risk of loss - to buy assets again. They have to get rid of the mistakes. They need to punish stupid...arrogant...and imprudent investors. They need to move money from weak hands to strong ones. All of that takes time. Offering the market more phony money only blurs the picture...making the decisions more difficult.

You can't really fault Mr. Obama for doing the silly things he has done, either. He's been too busy to think deeply about how an economy works. That's why he has advisors. Unfortunately, his financial team is made up of mostly jackasses, fools and opportunists - such as Larry Summers, Ben Bernanke and Tim Geithner, not necessarily in that order.

Only "Tall Paul" Volcker has any clue what is going on. To his credit, he's made some brave critiques of the banking industry. He's probably giving Mr. Obama some decent advice, here and there.

But what can he say? Obama is president of all the Americans. He needs to "do something" to make the pain go away. His party is counting on it. The voters demand it.

Mr. Volcker knows you can't really make the pain of a correction go away. It has to run its course. It has to do its job. All you can do is to try to control the banks so it doesn't cost so much to bail them out.

Mr. Volcker may also realize that feds are only making things worse - with their bailouts, deficits, subsidies, and boondoggle spending. But so what? Fish gotta swim, remember. Democratic governments gotta play to the voters. And the voters want solutions! They want leadership! They'd rather have a bunkum, harmful solution than no solution at all.

And that's what they've got.

And more thoughts...

Maybe this is the next leg down. Maybe it isn't. In either case, we don't want to be holding a lot of stocks and real estate when we find out.

If we're right about the depression/deleveraging...

And if we're right about the bear market...

You're probably going to see stocks lose another half of their value. Remember, a correction is equal and opposite to the deception that preceded it. That deception is almost a hundred years old...and has added trillions of (largely fictitious) dollars to the nation's wealth. An Everest of mistakes has been made. Can all this deception be corrected in 2 years...with the feds fighting every inch of the way? Can problems caused by too much credit be cured by more credit? Can a generation's worth of mistakes be hidden under the carpet of bailouts? Can the boondoggles be washed away by more boondoggles?

"They do one dumb thing," said our gardener, speaking of the feds. "Then they do two dumb things so they don't have to admit they did something dumb in the first place."

"The whole idea that you can cure financial problems by offering people money that doesn't exist is preposterous," adds colleague Simone Wapler.

Governments have been up to this trick for a long time - but especially since the world went on the paper money standard in 1971. Where Americans had a dollar worth a dollar in 1913, today they have a dollar worth 3 cents. What happened to the other 97 cents? Where did it go?

We don't know. But we'll take a guess - it went to the place where the feds keep all that money they don't have.

Hey, we're not the only ones who think Japanese stocks may be a good buy. Bloomberg reports:

Jan. 25 (Bloomberg) - Not even the slowest economic growth in the industrialized world or deflation can keep Byron Wien, David Herro and John Alkire away from Japanese equities.

Wien, the Blackstone Group LP adviser who predicted last year's rallies in stocks and oil, says Japan shares are his favorites. Harris Associates LP's Herro, Morningstar Inc.'s international manager of the decade, says stocks at the cheapest ever relative to assets will gain even if the economy stagnates. Alkire of Morgan Stanley Asset & Investment Management is betting low debt levels will spur an advance that beats the US.

Japan, the world's second-biggest equity market, is up 3.7 percent this year as measured by the Topix index, the most among the world's 10 largest economies. Overseas investors pumped almost $13 billion into Japan during the two weeks ended Jan. 15, the most since 2004. Companies trade for an average 1.2 times book value, almost half the valuation for the Standard & Poor's 500 Index, according to data compiled by Bloomberg.

"My best investment idea is Japan," said Wien, 76, a former market strategist at Morgan Stanley and at hedge fund Pequot Capital Management Inc. who predicted the end of the technology bubble in 2000. "The Japanese market looks relatively attractive assuming the earnings come through, which I think they will."

Wien, Herro and Alkire's predictions are based on valuations instead of economic prospects. Wien favors export-related companies, technology makers, and drug and cosmetics suppliers. Gauges of automakers and electronics companies in the Topix have climbed 11 percent and 6.2 percent, respectively, in the past three months, more than the broader index's 4.3 percent advance.

"Japan is extremely cheap on fundamentals," said Herro, the chief investment officer for international equities at Harris, with $55 billion in assets. "When you combine the two concepts of low price and high quality to get a value proposition, especially if we see a movement towards more sustainable operating profitability by corporate Japan, this could be one of the best-performing markets over the next couple of years."

Regards,

Bill Bonner,
for The Daily Reckoning

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