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Since the last week of June, the stock market has whipsawed in a tight range. Gone is the hot-headed exuberance but neither has a drastic correction materialize. Some bulls are still holding the fort amid a thin market volume, but deciphering market sentiment is difficult as false signals can be easily generated by a few market participants.

Not surprisingly, a cautious mood has descended on investors as they await the next major move in the stock market. During this lacklustre period (a good excuse for not updating this blog), what gives for July? For one thing, there is the hugely anticipated second quarter earnings reports which will either lend credence to green shoots theory or spark a fresh round of selling as optimism is shown to have overtaken reality by a mile.

Most Asian stocks fell over the week. Hong Kong has a turbulent session as financial and property stocks declined but it clawed its way back to end a 3 day losing streak. Japan, the world’s second largest economy by GDP, is a really sad story as its “lost decade” is now well into its 19th year. To add to its woes, it suffered its first trade deficit in 28 years.

This is expected since Japan cannot export what the world won’t buy (especially America) and an appreciating yen doesn’t help its exports. Domestic consumption is also fragile, with its aging population, low birth rates and a struggling workforce. Currently, manufacturing sentiment is on the mend but still fared worse than expected. In fact, Japan’s manufacturers plan to trim capital expenditures by a record 24.3% for this fiscal year, exceeding estimates of 13.2%.

I don’t harbor hopes of Japan leading the world out of this Great Recession. If it can get its house in order, and not be the first to declare a Depression, it is already an achievement. On the other hand, China has the potential to eclipse Japan as Asia’s economic powerhouse in the next decade. The Shanghai Composite Index is on a roll, finishing up at a 13-month high.

China turned in a good manufacturing report and its PMI boosted confidence, rising to 53.2 in June (from 53.1 in May), above the watershed mark of 50 for a fourth month in a row. Clearly, its stimulus which amounts to 20% of their GDP is working.

However, it is debateable if the high asset prices are sustainable when much of the world is still in a slumber. Even if the Chinese recovery story (propelled by domestic consumption) is compelling, irrational exuberance is a threat as investors are buying into stocks regardless of valuations.

As for the developed world, it presented little cheer for investors. Europe is hit hard by the highest jobless rate since the EU was formed 16 years ago. 9.5% of the citizens are unemployed in May (up from 9.3% in April). That is 15 million unproductive people depending on handouts, and unemployment is not expected to peak until 2010 when it reaches 11.5%.

US jobless rates were equally awful. Non-Farm Payrolls fell 467,000, much worse than the expected 350,000 job losses. Unemployment climbs to 9.5% from 9.4% last month. So much for green shoots when unemployment rate is still increasing. The global economy will take months, if not years, to recover which makes the run-up in oil prices all the more baffling.

Since March, oil prices have doubled as investors plumped for oil, not only to hedge against inflation but also to profit from the contango trade. But oil prices will face strong resistance from poor demand, especially when workers and the unemployed drive less and buy fewer goods while factories shut down, saving on electricity.

For the time being, inflation is kept at bay despite a frantic printing press in America to fund stimulus and bailout packages, but I am cherishing the effects of deflation because in 2-3 years time, we will be begging for falling prices.

In the past year alone, US ramped up its money supply by $1 trillion which is likely to cause about 50% hike in prices as the money trickles down the food chain. This staggering amount, expected to be replicated for several years as bailout, spending and payment obligations pile up, will lead to hyperinflation and weaken the investment of foreign creditors.

The reserve currency status of the US Dollar is at risk. In good times, the US can deflate its debts by paying back money with lower purchasing power but with its economy in distress (insolvent households, banks and corporations), investors are not biting the bait anymore.

Calls for a replacement grow louder every day but this is no conspiracy, just simple economics at play. The situation today is markedly different as compared to 1948 when Americas was in ascendancy as the world’s biggest creditor and manufacturer and the owner of the largest gold hoard.

The US dollar was as good as gold, backed by a stable government, competitive economy and powerful military. Right now, save for a military which stills evokes fear and respect, its economy is in tatters and the government debt load is insurmountable.

It is entirely possible that under the astronomical Quantitative Easing policy, the US will suffer a double whammy of higher inflation without any improvement in its economy. Handing out the pork barrel to zombie banks and corporations means mistakes and weakness are not flushed out of the system. This is not the scary part, if you consider the multitude of bailouts awaiting the US government.

Indeed, the hat-in-hand circus is just getting started. The inability of individual states to meet their operating expenditures - at last count, 29 states anticipate budget deficits in 2011, will limit the Federal Reserve’s ammunition to cope with further shocks in the financial system. All it is needed is a precedent to set off a wave of state bailouts.

California is already making tough decisions, shutting down the civil service for three days and issuing IOUs. Other states may not have the luxury of borrowing and have to raise taxes, draw on reserves or depend on the federal government to prevent humanitarian disasters and economic standstill.

Yet, there are more bailouts to come. With more people jobless (on average for 6 months or more), America may have to bailout state trusts which pay unemployment benefits. Resources in unemployment funding are running low and may be insufficient to handle the next massive, post-holiday wave of layoffs.

And with just about everybody receiving some pork, you can’t leave a housing bailout out of the picture, nor a bailout of the pension benefit plans when employers go under. These are popular policies which directly affect the people on the ground and it is hard to say no, not when you have already bailed out greedy and irresponsible executives on Wall Street, compromised the federal budget and yet ignored hardworking Americans who are displaced from their jobs.

It is hard for the US government to put a stop to all these nonsense. Each bailout increases the pressure to fund the next one and the result is everyone ends up poorer. Noah’s ark can only accommodate so many living beings, trying to rescue everybody means you sink the ship. And this is what you get when the currency is debased. If the US Dollar is forsaken tomorrow, a significant devaluation will occur, followed by a huge loss in US denominated wealth.

China, Russia and India are now striking out similar paths to ween off their dependency on the dollar. At the very least, they are more concerned with their own domestic market than to think about funding America’s deficits.

The Chinese will not aggressively undermine the US dollar to protect their colossal foreign reserves in Treasury bonds but they are not standing still to witness the debauchery of the dollar via trillions of dollars in new debt. They will rather stake their claim on commodities by investing in mining companies and importing materials.

All the bailouts and lack of foreign participation will only force further monetization of Treasury debts but this is a dangerous and unsustainable path. Confidence in US dollar will return only if the monumental debts are whittled down or the money are channeled into productive economic activity instead of sheer speculation. But when nobody seems to be in the least interested in where or how the money is being used, you do have to wonder if Obama’s vision of change is for the better or worse.

With all the money printing to save America’s hide and destroying everybody’s wealth, what is an investor to do? Putting our cash under the mattress without any returns and assuming the same inflation from 1988 to 2008, our purchasing power could be halved in this 30 year period. If you factor in hyperinflation, then we could be left with a serious retirement crisis using that approach.

We definitely have to put our money to use. Inaction is not an option. To invest safely, it is important to do a thorough analysis of earnings report and a good measure of common sense. But the macro picture will affect us despite our best efforts to protect our money.

What I see right now is not a pretty sight. Like it or not, the fiscal malaise in America is also the world’s problem. That is, until a new global order is established. But that could mean everybody starts off afresh and nobody knows who owes what to anybody anymore. Is it good or bad, I do not know.

At the moment, I am staying off equities as trading in this bearish market calls for nimbleness and is a different ball game to the easy money during the bullish period from March to June. The risk return is not appealing but staying out entirely is not wise either as we could miss out on profits from sudden run-ups as well as steady dividends.

I have taken some profits off the table and my portfolio allocation stands at about 40% stocks, 15% gold and 45% cash. As I will investing more of my income into gold, I expect the percentage of equities in my portfolio to decline further in the coming months.

The precious metals sector is still in a favorable technical and fundamental situation, despite summer doldrums and the gold sale by IMF. I can’t say the same for commodities which have been driven up stockpiling in China and speculation by hedge funds. A correction is imminent once China feels it has enough commodities.

I expect more US bailouts to dampen market sentiment. Investors can choose to scale in progressively on the dips or just sit on cash. If there is no major correction, I will like the stock market to consolidate further as it accumulates energy for a sustained run. The longer idle cash sits, the stronger will be the pent-up demand when the market resumes its bullish direction.

Source: The U.S. Bailout Circus Is Just Getting Started