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Financial Disconnect

Despite last week's confusing employment data, the increasing threat of another decline in home values, political uncertainty in Egypt and the broader Middle East, and sharp pullbacks in some emerging markets such as Brazil, US stock markets continued to rise. It sometimes seems that Wall Street exists in a bubble that is well-insulated from the rough and tumble of the outside world. But, in what may be a harbinger that America's era of prosperity is winding down, the hallowed New York Stock Exchange, long the epicenter of American economic might, is expected to be bought by Germany's Deutsche Boerse. When the king is so unceremoniously uncrowned, it won't be long before investors notice how shabbily dressed he really is.

Earlier this month, the Bureau of Labor Statistics revealed that the unemployment rate had fallen from 9.4 percent to 9.0 percent. Many in the financial media seized on the report and bundled it together with recently released data on improved consumer sentiment as great news for the economy. However, the report only showed 36,000 new jobs created, far less that the 146,000 that economists estimate need to be created to bring down unemployment significantly. Regardless, US stock markets continued to rise.

One must remember that the unemployment figure excludes those who have given up looking for jobs altogether. The percentage of Americans who have jobs continues to shrink. By factoring back in those who have left the work force over the last few years, many economists have concluded that the real unemployment rate is closer to 20 percent.

The housing market also shows fresh signs of enduring stress. Based on a report released last week, using data as of November 2010, nearly one third of US houses are now worth less than the amount owed on their underlying mortgages. Not surprisingly, given this harrowing statistic, defaults continue to rise. The price of the average house is now at a ten-year low and still falling.

In view of this evidence of increased unemployment and continued erosion in the housing sector, it is hard to see any likely recovery in consumer demand in the short term. Without such a rise, it is hard to justify any short-term run up in consumer sentiment and stock prices. But both have done just that. From my perspective, this represents a major financial disconnect.

Serving under former Fed Chairman Greenspan, Ben Bernanke helped to engineer the largest asset boom in history. The natural result was the credit crunch of 2008, from which we now are still trying to recover. However, Bernanke has been unwilling to accept continued recession. Clearly, he is determined to stimulate the economy, not by encouraging consumer demand, but by inflation.

The stimulus packages and quantitative easing programs have created a massive injection of liquidity. Furthermore, the Fed's manipulation of interest rates has pushed investors into riskier assets, such as equities and commodities, and out of relatively secure investments, such as bank deposits and bonds. This abundance of cheap money is creating an artificial asset boom, and it is the main reason why equity prices have risen.

Meanwhile, the political problems in Egypt have caused smaller investors to temporarily fear political risks in emerging markets, despite their having better fundamentals than the US. I expect this dynamic to quickly reverse as the protests settle in Cairo.

In short, the continued rise in US equities appears to be stimulated not by sustainable US consumer demand, but by cheap government-supplied liquidity, and a temporary diversion away from emerging markets. This qualifies more as a splash than a wave. The tide is still drawing capital to the developing world.

The big question investors should ask themselves is: for how long can the rise in US stock prices continue when consumers are still faced with stagnant employment and falling house prices?

The printing of fiat money is likely to be able to sustain a false economic recovery for some time. But, eventually, the cost will be a rapid erosion of the value of the US dollar - not just in real terms, but also against almost every other foreign currency. Despite possible short-term corrections, gold and silver holdings are likely best to shield investors from the perils that lie ahead.

 


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