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Well, much to the chagrin of the Bernanke bull crowd, stocks are finally starting to price in the fundamentals. On September 16 in an article dealing with QE3 and the "liquidity trap," I wrote the following:

There is no rational justification for stocks adding on to a 37% gain in a year. Even if one sees the Fed policy as positive the market has already discounted the perceived success of the policy.

As it turns out we put in the high for the S&P 500 on September 14, one day after QE 3 was announced. Since then we have pulled back 3%. The verdict isn't in yet but I am betting it will be soon as the downside momentum accelerates.

So how far will the pullback be - 5%, 10%, 20%? If you buy into the idea that Ben Bernanke and the Federal Reserve can effectively pull off a corner on US equities, you will probably come to the conclusion that the worst case scenario is a pullback to the September lows around 1400 - about a 5% correction.

Those with less optimism might conclude that the pullback will test the 2012 low at 1266 - a 13% pullback. Or maybe we end up testing the 2011 low of 1074 - a 27% pullback. There are even some that think we will end up testing the 2009 low of 666 - a 54% pullback.

At the risk of raising the ire of those in the "Feds got our back" camp, I am on record as one of the more pessimistic prognosticators. No doubt any call is somewhat subjective but I think there is a solid case to be made for why we will once again penetrate the 2011 lows and very possibly make a good run at the 2009 lows.

There is no answer to the fiscal cliff

Can we sift through the rubble of pundit and political commentary and identify honest, forthright perspectives in this day of global fear and uncertainty? Decades of fiscal abuse have brought us to the edge of this cliff. We will continue to talk about it but we will not hear anyone offer a palatable solution because there is not one.

Do we extend tax cuts and continue with entitlement spending? If we do that we add another $1 trillion to the deficit next year. Do we go ahead and attack the deficit with the tax hikes and spending cuts? If we do that we contract GDP by roughly $600 billion - about 3.5% of GDP.

Is either of these solutions a real solution at all? The answer must be no - at least not in the short term. Yet one thing is certain - we will do something or we will do nothing and either way we have some real problems to deal with.

If we tackle deficit spending as virtually everyone says we must, then we go over the fiscal cliff and into recession. Consider that we are currently at 1.3% GDP. A 3.5% contraction in GDP puts us negative 2.3%. That is a recession.

If we continue on the current path we will shift more public money into the coffers of US companies at the expense of the taxpayer. Here is what has happened. In an effort to forestall a recession and a deflationary spiral we have borrowed massive sums of money and fed that money back into the system via entitlements.

In so doing, those who are on the unemployment rolls have continued to remain in the consumption pool. In other words, we borrowed about $6 trillion and injected it back into the economy, the result being a relatively stable GDP. At the same time US corporations have undergone massive cost cutting measures (layoffs) to insure high corporate profits.

Our government's efforts to prevent recession and economic contraction have worked until now to keep us out of a recession but the sad truth is that those who we tried to benefit are not the ones we really did benefit. The only real beneficiaries of this fiscal policy have been major US companies whose coffers are jammed full of cash today.

Decades of fiscal abuse have brought us to the edge

The reason no viable solution is being offered is that we have no viable solution - at least one that avoids a recession. America and much of the rest of the world has effectively mortgaged their future and we have finally come to the day of reckoning.

It is hard to say we haven't tried to fix things. We did have a plan for avoiding the fiscal cliff and setting the country on a growth path. The Federal Reserve has done all it could to stimulate growth and employment with every tool at their disposal. Unfortunately their plan has failed.

Economics is a social science in that those in charge of monetary policy attempt to predict the public's reaction to certain policy actions and then implement those actions that they deem appropriate. In the case at hand the American people did not react the right way - at least from the Federal Reserve's perspective.

Keynes said it best:

.. if Investment exceeds Saving, there will be inflation. If Saving exceeds Investment there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving. This runs contrary to the prevailing wisdom, which says that thrift is required in hard times. In Keynes' words, 'For the engine which drives Enterprise is not Thrift, but Profit.

The Federal Reserve has tried everything they can try to get the public to spend. The public's response is the opposite of what the Fed had hoped for. The public - and that includes individuals and companies in this case - has elected to save and not spend.

The truth is without an increase in jobs we are not going to see GDP growth. The idea that companies will hire if only the uncertainty is removed from the equation is simply wrong. No company is going to hire unless the demand for their goods or services exceed that company's ability to meet the demand with their current staffing levels.

It is not likely that demand will increase if we attack deficit spending and high debt to GDP ratios with austerity measures. Yet, we must still attack the deficit. Virtually everyone who elects to weigh in on this knows that we cannot continue on the current path.

In retrospect, we should have stopped monetary policy with QE 1. It is hard to deny that QE 1 stopped a deflationary spiral and the resultant depression that would have followed. QE 1 gave us much needed time to re-capitalize banks and stabilize the economy. It was the right move and an effective one.

Additional QE and interest rate moves have probably been counterproductive. No doubt they were worth a try but the mere fact that they failed to alter the economic trajectory with increased employment and GDP growth leaves us in a worse place than we would have been had we simply allowed the deleveraging cycle to conclude on its own.

The fiscal cliff is not a doomsday scenario

What has occurred in the US and across the globe over the last few decades is a policy of easy money. We have mortgaged ourselves to the hilt relying on inflation to provide the necessary security for these overleveraged debts.

The banking crisis, spurred on by the housing bubble, finally brought us to our senses.

In an instant we found that the real estate used to secure these highly leveraged housing mortgages was no longer sufficient. The result was a crisis of systemic proportion.

Since then we have addressed most of the issues that threatened a systemic collapse. Today banks, corporations, small businesses and many individuals are much more sound than before the crisis. That said we still have a long way to go before we can say that the deleveraging cycle is fully complete.

We know the state of things in the eurozone. The 'haves' - led by Angela Merkel and the Germans - are forcing the 'have nots' to deal with deficit spending. It will be painful and economic contraction will certainly occur but it is the only alternative that promises an eventual end to the mess we find ourselves in today.

If the upcoming election in the US results in a Romney victory it is likely that the new administration will attack deficit spending and record debt with a vengeance as well. Romney is on record as strongly opposed to a continuation of the Bernanke monetary policies. He is also bent on attacking the deficit spending that has set up the fiscal cliff issues. Regardless of who wins in November we simply must abandon this charade of fiscal irresponsibility and the sooner the better.

Thankfully we have a period in our history that bears some similarity to our present situation and the solutions - painful as they were in the short run - launched one of the greatest periods of growth and prosperity in our history.

We need to pull a page from the Reagan/Volcker play book and raise interest rates and attack deficit spending with a vengeance. Restore strength to the US dollar and in the process flush out the remainder of the overleveraged. It will certainly fill the bankruptcy courts for a while but we are a different America than we were 4 years ago and we can stand the shock today.

It is time to forget pondering the fiscal cliff. We have no alternative but to jump. As I have said before, no recovery plan can work without the public's participation and our leaders - both on the fiscal and monetary front - are not creating an atmosphere of confidence.

If the early 80s are any indication of what we can expect, the chance is good that mid-way through the next presidential term we will have completed the deleveraging process and we can begin the climb back to a fiscally responsible country where our citizens are once again confident of their leadership. We are all ready to get bullish on America again but before we can do that we must deal with the deficits and the debts and the right approach is not to simply "kick the can down the road" any longer.

Disclosure: I am short a group of tech stocks, financial stocks and crude oil. 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.


Source: Dealing With The Fiscal Cliff