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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... - John Williams, Shadowstats.com

The underlying, "grass roots" economy has been deteriorating for quite some time after the initial boost it received from the trillion-plus dollars injected into the system back in late 2008/early 2009 in response to the near-collapse of the financial system. I have been reviewing the indicators I monitor, which suggest the economy has been weaker than reported by the mainstream media, including my recent analysis of the First-Quarter GDP.

Last week and yesterday we got to see economic data released, which further confirms my view. In fact, based on yesterday's retail sales report for June, plunging mortgage applications and a couple other key indicators I'll review below, we can conclude that the economy is currently in contraction on a real, inflation-adjusted basis and it's safe to speculate that the Fed will be forced into increasing QE rather than tapering. I also believe that those long the stock market should exit those positions and either go short or move into the safe-haven of gold.

Retail sales for June were reported yesterday by the Census Bureau (pdf) and came in at a disappointing .4% vs. the .8% expected. April to May retail sales were revised lower from the initial report from .6% to .5%. Excluding auto and gasoline sales, sales for June actually declined .1%. Even more interesting, subtracting June's CPI of .5% (reported today, Tuesday) from the nominal June retail sales number implies that on a real basis (nominal growth minus inflation) total retail sales for June declined. This data point is consistent with my view that real GDP is currently tracking at a negative growth rate.

In addition to retail sales, and in a troubling sign for the housing market, last week's weekly Mortgage Bankers Association index of mortgage applications declined, with purchase applications declining 3%. Mortgage purchase applications have now declined eight out of the last nine weeks. Even worse, mortgage applications are falling at the fastest rate in over three years, with the index back to 2006 levels: Mortgage Applications graph. This is a very bad omen for the economy, as over two-thirds of the real economic growth in Q1 2013 had been attributed to housing market activity (source: Haver analytics).

In addition to housing and retail sales, the ISN Non-Manufacturing Survey was released July 3 (this represents the services segment of the economy). The index level came in a 52.2, well below an expected 54.4. More troubling was the decline in key sub-indexes, such as Business Activity at -4.8%, new orders at -5.2% and new export orders at -2.5%. In other words, the service side of the economy is slowing down and the forward expectation based on the decline in new orders is negative.

Finally, in more evidence that confirms my bearish outlook on the economy, UPS reported its 2nd quarter results on Friday (July 12), badly missing its expected numbers and warning about forward estimates based on a weak economy. If the parcel package delivery business is experiencing contraction, it reflects an overall state of contraction in both corporate and consumer spending.

Furthermore, several Wall Street banks have slashed their 2nd-Quarter GDP estimates including Goldman Sachs, which reduced its estimate yesterday (Monday, July 15) to just .8%. Note that based on the annualized CPI of 1.5% released earlier today, this implies that on a real, inflation-adjusted basis the economy slipped into recession in Q2.

Based on the analysis presented above, it is my view that the U.S. economy is headed south. In addition, I believe that as the housing market falls off and general consumption - based on the trend of a decline in real disposable income - continues to slow down, the U.S. economy will plunge into a serious recession.

If I'm right, this reality is not even remotely being reflected by the direction and level of the major stock market indices (Dow, S&P 500). The fact of the matter is that the stock market has been rising on declining volume, which is technically bearish. In other words, I see significant downside risk to the stock market right now. The best way to play this scenario is to either short the SPY (S&P 500 SPDR) or buy one-month puts on it. The SPY was around 135 back in November 2012, just before QE3 was rolled out. I think a good bet is to buy the SPY September 155 puts if you can get them under a $1. If the SPY retraces just half the move it made from last November, the puts will be a home run.

If you don't want to speculate on the direction of the stock market, now is a great time to take advantage of the correction in the precious metals market by buying physical gold and silver. I prefer U.S.-minted 1 oz. gold and silver eagles.

The only caveat to my stock market view is if the Fed surprises us with a move to increase QE in September. By then it should be obvious to all that the economy is in big trouble. If the Fed actually bumps up QE, your gold and silver purchases will do very well.

Disclosure: I am short SPY. 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 and silver.

Source: The Economy Is Contracting: Real GDP Is Now Likely Negative And No Taper Coming