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Experimental stimulus is not the solution for what ails the U.S. economy. But such is the environment that we have been operating under over the last several years since the outbreak of the financial crisis. Both fiscal and monetary policymakers have been digging deep into their stash of resources in a seemingly never ending attempt to try and make all of the fundamental problems simply disappear like a really bad trip. But nothing has really been fixed on this endless high. Instead, all that has been achieved is a sluggish, unsteady recovery with capital markets that have been distorted beyond all recognition and a fresh new set of structural problems to go along with the old. And no matter how hard policymakers push, an endless stream of stimulus and spending is unlikely to lead us on healthy trip to a new American dream. Instead, it will likely leave investment markets with an even greater mess and a longer road to true recovery.

"We had two bags of grass, seventy-five pellets of mescaline, five sheets of high powered blotter acid, a salt shaker half full of cocaine, and a whole galaxy of multi-colored uppers, downers, screamers, laughers . . . and also a quart of tequila, a quart of rum, a case of Budweiser, a pint of raw ether and two dozen amyls. Not that we needed all that for the trip, but once you get locked into a serious drug collection, the tendency is to push it as far as you can."

-Hunter S. Thompson, Fear and Loathing In Las Vegas

Monetary policymakers remain among the most addicted to the idea that endless stimulus is the solution to the problem. The rate of economic growth is starting to slow? Commit to ZIRP even longer. The threat of crisis is rising in Europe? Pump the system full of liquidity. The stock market moves sharply lower for a few weeks? Engage in more long-term asset purchases.

The inclination by central banks including the Federal Reserve to try and keep the global economy and its participants continuously sedated is likely being done with the best of intentions, but is also likely to prove most counterproductive in the end. This is true for two reasons. First, it prevents both the public and private sector from being forced to face up to the problems that caused the original crisis. Second, it adds significantly to the risks the market will be forced to navigate as it moves into the future.

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To this second point, the Fed's actions since the outbreak of the financial crisis are purely experimental. At the dawn of the crisis dating back to the summer of 2007, the total assets on the Fed's balance sheet stood at $867 billion. Today, it stands at $3.013 trillion and rising. By the end of this year, it will almost certainly be pushing past $4 trillion. In short, a single individual at the Federal Reserve along with his rotating board of 11 other members, some of which pointedly disagree with him but typically get in line for sake of solidarity, will have nearly quintupled the supply of U.S. dollars in the financial system over the course of just six years.

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Policymakers have been equally experimental on the fiscal policy side. At the dawn of the financial crisis, the Federal debt stood at $9 trillion and the largest budget deficit in history was just over $400 billion in 2004. But in the five calendar years since the outbreak of the financial crisis, the Federal debt has ballooned by 78% to $16 trillion and the federal budget deficit has been in excess of $1 trillion for each of last four years. In other words, we have had budget deficits that have been 2.5 to 3.5 times larger than the previously largest budget deficit in history in each of the last four years. Despite this fact, policymakers in Washington on both sides of the aisle squirm with discomfort at the idea of any substantial spending cuts. For example, a great deal is made about sequestration, which would lower the deficit by a mere $100 billion. What about the other $900 billion plus, which is still more than 2 times the previously largest budget deficit in history? While economic growth and additional tax revenues might help close the gap, it should be noted that raising taxes now will only constrain already slow economic growth even more going forward, which could ultimately result in even lower tax revenues down the road anyway. Such is the policy hangover in Washington.

What will the long-term implications of such policy excess be in the future? Sure, we all feel fine today with the stock market making a quick move back to its previous all time peaks reached twice before in 2000 and 2007. And I'm guessing both Timothy Leary and Hunter S. Thompson also felt quite all right if not downright giddy at times in the midst of their grand experimentations. But what will be the after effects of these actions down the road? After all, quantitative easing was a proven solution prior to its current implementation. Instead, it is effectively a hypothesis that is being tested real-time with the global economy and its financial markets as its grand laboratory for its experimental QE drugs. As a result, we have no idea what the long-term side effects will be. All we know is that it is a vastly different approach than what was being applied during the Great Depression. While the results from QE1 certainly appear promising, the impact from the rest may prove dubious at best and destructive at worst in the end. Only time will tell. But what we do know is that trillion dollar deficits on the fiscal side are unsustainable. And we have to look no further than Europe to witness the long-term consequences of ignoring reality and instead relying on continued policy hallucinogens and experimentation.

"He who makes a beast of himself gets rid of the pain of being a man"

-Samuel Johnson

The compulsion of policymakers to push as far as they can has transformed capital markets into a beast that seemingly feels no pain. And the succor is particularly profound in the U.S. stock market. Although it continues to drift dreamily toward its previous all-time highs, the fundamental backdrop does not support such a move in any meaningful way, particularly at these price levels. Given this widening disconnect, markets will eventually be forced to come down from their high at some point in the future. And the longer and more profound the trip, the more agonizing the subsequent detoxification is likely to be.

A look back on economic and financial conditions over the last year highlights the lack of fundamental support behind the markets.

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First, economic growth is becoming increasingly uneven. After the U.S. economy initially stabilized in 2010 at a growth rate that was still sub-par for an economic recovery, it has become increasingly sluggish and patchy in the two calendar years since. In other words, instead of the U.S. economy accelerating its way out of the recession, it has languished. And growth conditions outside of the U.S. have been notably worse in certain circumstances. This has been particularly true of Europe, which officially plunged back into recession in recent quarters. Thus, despite the chorus of excitement about the improving outlook, the economic environment has in reality become increasingly challenging as we move into the New Year.

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Such continued economic sluggishness is problematic for financial markets given that such growth is the lifeblood for corporate revenues and earnings. And we have seen the direct impact of the persistently disjointed economy over the past year. Revenue growth for those companies that make up the S&P 500 has slowed on a year-over-year basis to a near halt in recent quarters, dropping from over 10% a year ago to just over 1% today. While revenue growth is projected to pick up somewhat as the numbers come in for the final quarter of 2012, the rate is still likely to be lukewarm at best. As would be expected in an environment where revenue growth is decelerating and input costs are rising, the impact on earnings has been more profound. Earnings growth on an as-reported basis for companies in the S&P 500 have declined on a year-over-year basis in three out of the past four quarters. This includes a -6% drop in the most recently reported quarter in 2012 Q3.

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All else equal, a climate of flattening revenue growth and declining earnings growth is poor for profit margins. Put simply, when the numerator is shrinking and the denominator is essentially staying the same, the overall number is set to decline. This is particularly true at a time when corporate profit margins are already hovering at historical peaks at over +2 standard deviations above their historical average, as it suggests that corporations have little scope, if any, to cut costs or increase operational efficiencies any further than they already have.

Such conditions marked by flat revenue growth, declining earnings and the potential for shrinking profit margins all would typically bode ill for stock prices. Yet stock prices exploded higher by double digits on the S&P 500 in 2012, and they are off to a rousing start so far in 2013. As a result, virtually all of the stock market gains last year came as a result of valuation expansion, which is supported by the fact that the trailing 12-month price-to-earnings ratio on the S&P 500 jumped from 14.4 at the end of 2011 to 17.0 today. In other words, investors became hopped up to pay more for stocks over time when they were effectively becoming worth less over the same time period. Sounds like a long strange trip indeed. So what gives?

The first important point to note is that all else is not held equal when dealing with an economy or market, as numerous forces are all moving at once at any given point in time. And such forces may cause corporate operational results to remain stronger than would be expected and for far longer than might be anticipated. Leading among these is the continued massive fiscal budget deficits that have led to meaningful support to profits and margins over the last few years. Another important factor has been the perpetually low interest rates brought on by the Fed and other global central banks, which have not only helped keep borrowing costs low, but has provided a flood of liquidity into the financial system much of which eventually finds its way into inflating asset prices in global capital markets. Thus, the steady rush of fiscal and monetary stimulants over the last several years have provided a distorted perception that things are much better than they actually are.

But perhaps the market continues to ignore the current realities driven by the optimism that we are finally on the cusp of things getting truly better for the global economy in the future. This is certainly a reasonable idea at first glance. After all, economic numbers have recently been coming in fairly strong and forecasting outfits like Standard & Poor's are projecting a dramatic reversal in trend and sharp profit recovery in the year ahead. But what exactly is going to inspire such a reversal? Furthermore, if much of the progress we have seen to this point has been the product of a stimulant induced illusion, what happens when the high wears off and the policy narcotics simply start to run out? For just as the excesses of recreational drugs eventually wear the user out, so too are we seeing similar cracks behind the increasingly grand facade of today's global marketplace.

"Beware of enthusiasm and of love, both are temporary and quick to sway."

-Hunter S. Thompson, Fear and Loathing In Las Vegas

If the market is advancing based on the optimism for the future, the headwinds to such a rosy outcome are considerable to say the least.

European policy leaders are already celebrating a fix to their problems, but what has structurally changed other than some renewed hope inspired by nothing more than policy promises? Recent history has shown that the next round of crisis on the continent often erupts when policymakers fall back into complacency.

Optimism is building behind the U.S. economy, but what exactly is going to inspire U.S. businesses and consumers to spend more in 2013 when their incomes are stagnant, their costs are rising, their taxes are going up, and the path forward remains just as cloudy and uncertain as before, all at a time when fiscal policymakers are actively trying to figure out ways to spend less to shrink their budget deficits? Instead of spending more, it is certainly possible that they all might end up spending less in such an environment.

What are the chances of another unexpected geopolitical event breaking out along the way? Needless to say, the danger levels are certainly running high and rising seemingly by the day in certain corners of the world.

And what if those pushing the policy sedatives the most are incorrectly focused on wage inflation and are caught flat-footed by a sharp outbreak in asset inflation? After all, both demand-pull and cost-push inflation can be brought on not only by an increase in wage rates but also by increases in the money supply and in price levels across the rest of the world. It won't take long for a spike in gasoline prices past $5.00 or $6.00 per gallon, or milk for that matter, before the general public will become restless, particularly if economic growth remains tepid or worse.

These unanswered questions are just a few of the many risks that could cause economic and corporate earnings growth to fall well short of expectations. But looking at the quarterly earnings projections for the S&P 500 in the coming quarters, it is clear that a great deal of optimism, if not more, is already priced into the markets. Thus, in a normal environment, the risks to the downside would greatly outweigh the potential to the upside at current prices.

Of course, it seems that nothing else matters as long as investment markets can stay high on the daily drip of monetary stimulus. But for how long remains to be seen. And once the drip finally is forced to stop, the subsequent cleansing for financial markets may be ugly.

"So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark-that place where the wave finally broke and rolled back."

-Hunter S. Thompson, Fear and Loathing In Las Vegas

We are now five years later from the moment when the stock market last reached its high-water mark on October 9, 2007 at 1576 on the S&P 500. And following years of pushing the policy drug collection to unprecedented extremes, we find ourselves nearing the top of the steep hill where we can look west on the price chart and see that place once again where the wave finally broke and rolled back on the markets. Will we come tumbling back down once again as a new unsettling reality finally sets in? Or will the policy excesses of the past several years ultimately propel the economy and its markets to finally break out and realize a real American dream recovery? Only time will tell, but it promises to remain a wild ride along the way and one that remains likely to end badly.

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One is best to keep their head about themselves in the current market by remaining hedged in their investment portfolio. Investors certainly stand to benefit by going on the ride at least for now with full on risk exposures including stocks and other correlated assets. Leading among these are U.S. mid-cap stocks (NYSEARCA:MDY), emerging market stocks (NYSEARCA:EEM) including locations like China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ), commodities stocks such as BHP Billiton (NYSE:BHP) and Potash Corporation (NYSE:POT) and high yield bonds (NYSEARCA:HYG). But knowing that this market can turn on a dime and unwind into a nasty trip - stocks have turned in sudden sharp declines ranging from -10% to -25% in a matter of weeks even in the midst of the policy stimulus induced haze - it is worthwhile to carry protection in the form of securities that can rise whether the markets are stoned or sober. These include U.S. TIPS (NYSEARCA:TIP), National Municipal Bonds (NYSEARCA:MUB), High Yield Municipal Bonds (NYSEARCA:HYD) and Build America Bonds (NYSEARCA:BAB). But favored above all else remains the security of gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV). For if the monetary policy party rolls on, the precious metals should benefit. And if the whole experience turns ugly and global markets start to riot against its debt and currencies, these same precious metals should prove an invaluable safe haven. While owning the physical is ideal, securities such as the Central GoldTrust (NYSEMKT:GTU), the Central Fund of Canada (NYSEMKT:CEF) and the Sprott Physical Silver Trust (NYSEARCA:PSLV) are ideal selections for a securities portfolio to establish and maintain such exposures.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: Fear And Loathing On Wall Street