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Underlying economic reality remains much weaker than Fed projections. As actual economic conditions gain broader recognition, market sentiment should shift quickly towards no imminent end to QE3, and then to expansion of QE3. The markets and the Fed are stuck with underlying economic reality, and, eventually, they will have to recognize same. Business activity remains in continued and deepening trouble, and the Federal Reserve-despite currency-market platitudes to the contrary-is locked into quantitative easing by persistent problems now well beyond its control. -John Williams

Final GDP for Q1 was revised down to 1.78% (annualized) from a previously estimated 2.4%. While I don't have the records to verify that this is the largest downward revision in the history of the data series, I can't recall ever seeing one even close to this size. A look beneath the cover of the headline report reveals GDP component revisions that point to a broad, severe contraction in economic activity.

It has been my view for quite some time that the economy has been a lot weaker than is suggested by the headline economic indicators reported on a weekly basis. But Wednesday's final Q1 GDP revision was a shock to me, both because of its magnitude and because of the implications of the size of this downward revision. The latter being that it confirms my belief that the next policy move by the Fed would be a further expansion of monetary stimulus rather than a "taper."

For reference, here's the news release PDF from the Bureau of Economic Analysis (BEA): Q1 GDP - Final Revision. The largest impact on the overall revised number was the downward revision to consumer spending on services to 1.7% from 3.1%, reflecting a decline in "spendable" income. Real Final Sales were revised from 1.75% to 1.2%. And speaking of per capita disposable income, adjusted for inflation it fell at a 9.21% annualized rate, the biggest drop since Q3 2008. This is a huge collapse in income, which will put heavy brakes on the housing market and the overall economy.

As for other revisions with highly bearish implications:

  • Consumer spending was revised lower to 2.6% from 3.4%. Keep in mind that consumption represents roughly 70% of GDP.
  • Business Fixed Investment (MUTF:CAPEX) was revised to 3% from 4.1%
  • Imports declined more than expected (although for some reason this has a slight positive impact on GDP), further reflecting a weakening consumer
  • Profits after tax with inventory and capital consumption adjustments decreased $17.5 billion in Q1

Just as significant in terms of showing contraction in the economy as the big decline in income and big revision in consumption is the fact that GDP was only 1.2% annualized if you strip out the growth in inventories. In other words, the inventory-build during Q1 was responsible for 33% of the final GDP. Assuming income and consumption continue to contract, it appears that inventory stocking in anticipation of a better economy is a bad bet and it will be offset by lower production in coming quarters.

More significantly, if you take the 1.2% ex-inventory build number and strip out the deflator used by the Government of 1.3%, on a real GDP basis the economy actually contracted in Q1. This assumes the deflator used by the BEA is accurate. I believe inflation is running at a higher level, which means real GDP is even more negative.

Now, the implications of all this are interesting to discuss. To begin with, when the FOMC announced that the outlook for the economy was positive, the variables it used in its econometric models were overestimating the strength of the underlying economy - quite substantially for some variables.

Furthermore, the CBO announced in early May its estimate of a full-year budget deficit of $642 billion. This was just plain wrong, especially considering that through the end of May, with four months left in the Government's fiscal year, the actual deficit was $627 billion. Given the numbers released in the GDP revision and the trends in incomes, consumption and corporate profits, tax revenues are going to fall far short of the numbers used in May by the CBO and the actual Government budget deficit will likely come in at or over $1 trillion.

The Fed is currently buying about 75% of all new Treasuries issued. The Government - short of finding some questionable accounting gimmicks that involve borrowing money from Federal pension plans like they have in the past - will have to issue more paper to fund this larger-than-expected deficit. The only way I can see the larger deficit being financed is through even more money printing and Treasury buying by the Fed (some may prefer to refer to this as "expansion of the Fed's balance sheet" or "QE"). I also believe that the Fed will likely expand its basket of QE purchases into more "unconventional" collateral such as corporate and municipal bonds. Recall that back in the spring of 2008, Bernanke testified in front of Congress that the Fed was considering some "unconventional" ideas to stimulate the economy. We will soon see how he defines "unconventional."

With the economy likely on a negative path, I believe the stock market is set up for a lot more downside. A little over three weeks ago I published an article in which I suggested that the SPX may be about to fall hard. The SPX closed at 1631 that day (June 4). Twenty days later it had fallen through its 50-day moving average and closed at 1573 (June 24). It has since bounced toward a possible retest of the 50 dma, after which I believe it will be at risk for even more severe downside.

If you agree with my analysis and want to express a bearish view before the Fed admits it has to increase QE, I like playing the leveraged inverse SPX ETFs for this purpose. SDS is 2x inverse the return on the S&P 500 and SPXS is 3x inverse the SPX. Both are trading at or near their all-time lows. If you like this call and you really want to leverage your bet, both trusts have liquid options, which trade. The call options will have most of the downside volatility premium removed from the price because of the mostly one-way move higher in the stock market. I like buying volatility when it's priced cheap. I also believe that gold, silver and the mining stocks have corrected to levels that will look extraordinarily low 12 months from now. I like AGQ (2x silver ETF) and long-term call options on both [[GLD] and GDXJ for the precious metals play. I also love some individual junior mining stock plays that I'll write about over the summer.

Disclosure: I am long SPXS, AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The fund I manage is long physical gold, silver and mining stocks

Source: The Economy Is Quickly Headed South - QE4 To Follow