Source: Green Faucet

The new narrative forming among the Goldilocks crowd is that US economic supremacy reigns once again, as manifest in a reawakened "King Dollar". The US dollar will continue to strengthen, commodity prices will plummet, and the stock market can only rally from here since all of the bad news has already been discounted. The Global Goldilocks view is that the rest of the world slows just enough to dampen commodity pressures and prices, but the world does not slow too much to wreck the American economy. The dollar strengthens resulting in capital flows into the US. And voila-- we have a return to the glory days of the 1990s.

As I have written countless time in the past, unwarranted optimism is a necessary human trait-it allows us to persevere through tough times when alternatives may be dire. This characteristic, however, is treacherous when it comes to investing in bear markets. As Nobel Laureate Joseph Stiglitz said in CNBC's Squawk Box last Friday American investors are afflicted with "wishful thinking". We have a "built in bias for excess optimism." This occurred in the 2001-2002 bear market. The only thing different this time is that this decline is going to be much worse. We are going to have the bear market we should have add earlier in the decade. Because we didn't, it is going to be much more painful having it now. We are finally going to have the purging of the excesses for all of the debt we racked up and all of the stupid leveraged over-valued securitized products we created.

The dollar is strengthening because the US is leading the economies of other countries over a cliff. Both in terms of easy monetary policies and the continued vendor financing arrangement where we buy their goods financed by their buying our treasuries and keeping our interest rates artificially low. Their currencies are now reflecting their deteriorating fundamentals. To be sure, the long commodities/ short US dollar trade was very crowded and is also playing a part as it unwinds. Marc Faber, author of the GloomBoomDoom Report, identifies what is really going on:

I need to make one more comment with respect to oil prices and commodities. It is not a strong US dollar that will lead to declining oil prices, as some commentators argue. What will bring about lower oil prices is a collapse of consumer spending in the US and elsewhere in the world. If US consumption collapses, the US trade and current account deficit will be halved and will lead to a drying up of global liquidity. I have discussed this relationship many times in the past and have clearly shown the relationship between the growth rate in Foreign Official US Dollar Reserves and the US dollar. Declining US consumption will be positive for the US dollar and will certainly bring down commodity prices because of lower demand (at least temporarily). But if you really think that such an outcome will be good for stocks, then dream on!

Meredith Whitney, the Oppenheimer banking sector analyst who dared to separate herself from the comfort of her community herd and boldly predicted the financial disaster a year ago, thinks that, according to a Fortune article where she is the feature cover story, investors should still avoid banking stocks because they will be forced to report even bigger credit losses in the future. The article reads, "Whitney is convinced the economy is about to slip into an ‘early 1980s style' recession that will devastate the 10% of the population that became overextended during the housing boom."

Now who do you trust? Someone who has been dead on in predicting this mess from the beginning, or someone from the pack of pathological pollayanas who mindlessly continues to call one false bottom after the other? You know who I'm talking about. Whitney warns, "What's ahead is much more severe than what we've seen so far." Furthermore, according to Whitney, the banks need to more drastically reduce headcount (from a reduction of 7% so far to 25%--see my commentary "Escape From New York") and "get real" about how their valuing their mortgage-related debt. Banks are only under-estimating housing price declines. They see drops limited to 20-25% where Whitney sees declines around 40%.

If all of that weren't enough, the coup de grace for the consumer is a new credit law (well-intentioned as it may be) that will go into effect this fall that will, as the Fortune article citing Whitney's view writes, "force banks to reduce the amount of credit they extend to consumers." This of course will force consumers to cut back even further on spending. Whitney says that this is "basically going to amount to a pay cut for the average American consumer."

Highly-respected historian and author Niall Ferguson wrote an editorial in Friday's Financial Times titled "How a locals squall might become a global tempest" where he posited a confluence of economic conditions could portend a "real perfect storm [that] may still lie ahead." He writes that 1970s stagflation might be preferable to what might be forming on the horizon:

One year after the onset of the financial crisis we are still calling the "credit crunch", could we be witnessing a similar catastrophic convergence, as the slow-moving hurricane of a US banking crisis hits first a commodity price rise and then a global slowdown?...The question is whether or not this American hurricane is about to run into two other macroeconomic weather systems. Up until now the global impact of the crisis has been limited. Indeed, strong global growth has been the main reason the US recession did not start sooner. With the dollar weakened as an indirect consequence of the Fed's open-handed lending policy, US exports have surged.

This is where Global Goldilocks fantasy falls apart. The world economy may not be too hot; but is almost certainly is shaping up to be too cold. Of course the perma-bulls will never acknowledge this. And anything is possible. A continuation of dollar strengthening could take the it back to the 80-level, a level of support which held until earlier this year since they began the trade-weighted index almost three decades ago. And, given, the interventions and machinations of our compromised policy-makers, anything is possible. Problem is the system is becoming a joke of sorts, where participants need to increasingly "factor in" actions make exchanges less and less of a free market. Such actions were once viewed as bold and celebrated for avoiding to systemic collapse. For all their hubris, they succeeded in creating excess money and moral hazard, and the false expectation that catastrophe could always be avoided if the monkeys were clever enough to prevent the meltdown. Fannie Mae says that "the worst housing slump since the Great Depression is deepening" and our financial market policy heroes are able to engineer a stock market rally that possibly takes us to new highs with all of the bullish pundits going through all their charting contortions to show us how the rally is justified.

This might happen, but it will be unsustainable and result in an even more painful disaster. It baffles me how financial professionals can continue to take markets seriously after the SEC, the Treasury, and the Fed's ad hoc, ‘fly-by-the-seat-your-pants', ‘make ‘em up as you go' interventionist actions are all that have stood between propping up markets and systemic collapse. They don't care as long as it appears to work. This is the danger of placing your trust in a performance-based system rather than one that is process-based. And this is what happens when you are continually forced to treat the symptoms of the disease rather than the disease itself (excess debt and money). And each time the treatment is a little more unconventional and extreme as the symptoms become ever harder to treat. Just once they are going to reach for a rabbit and they are going to find nothing at the bottom of the hat.

Along these lines Doug Noland, who writes a weekly column for The Prudent Bear, observes in his latest piece ("Burst Bubble: Energy or Speculator"):

Recent extreme global market volatility is part and parcel to the Heightened Monetary Disorder I have been addressing for months now. The Massive Global Pool of Speculative Finance has Run Amuck. The bulls will celebrate the rally, yet markets this unstable are prone to "melt-ups" that lead to breakdowns... Yet if the key dynamic is instead a Bursting Leveraged Speculating Community Bubble, entirely different dynamics are now in play. Enormous short positions have built up, the vast majority as part of "market neutral," "quant" and myriad risk hedging strategies. If today's dislocation develops into a significant unwind of these positions, the market immediately then becomes vulnerable to a disorderly "melt-up" followed almost inevitably by a sharp reversal and disorderly decline. The unwind of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis.

My question for the bulls is can you not admit that our financial market system has been irreparably harmed and that it is only a matter of time before a real crisis occurs? But I suppose you will accept such market interventions as long as you are chasing the Global Goldilocks economic fantasy.