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Recession or Socialism, Pick a Poison

|Includes:DIA, DRV, DTO, SDS, SKF, SPY, SPY, USO, Financial Select Sector SPDR ETF (XLF)

 It’s becoming clearer by day that there is little sanity left in the realm that had once been hailed a “free market”. Traders suck up the “good news” of more QE from the Federal Reserve in the U.S., like a junky celebrating one more smack filled syringe he hopes will be soon smuggled into the rehab clinic by his big brother. How much longer can the lunacy persist?

Money Thrown at the Problem

Let’s review the facts, because it will have been two full years since Lehman in September and I think we all (myself included) need a bit of a reality check:

U.S. Treasury

- TARP = $700 billion USD to bail out the U.S. banking system through direct liquidity injections in U.S. banks

- 2009 Government Stimulus = $787 billion USD; Subsidized government and private sector jobs, subsidized state and local services, 14% invested in infrastructure.

- Unemployment Benefit Extensions = $120 billion USD; Eight (8) consecutive extensions of pay to unemployed.

U.S. Federal Reserve

- Total Long Term Treasury Debt Purchases (08/04/2010) = $753 billion USD; Fed bought 10+ year Treasury notes at auction to support demand for U.S. debt, taking rising pressure off of mortgage rates.

- Total Fannie & Freddie MBS Purchases (08/04/2010)  = $1.12 trillion USD; GSE Mortgage securitization  groups now state owned, as Fed swallows mortgages unfit to remain on GSE balance sheets.

- Federal Funds Rate target at 0.13%; historically unprecedented quantitative easing, which has allowed mortgage rates to ease below 5% on 30-yr fixed products.

When we add up the cash that has been dedicated to the sustainability of our financial market, and thus our economy, we see the following capital commitments:

Treasury = $1.6 trillion

The Fed = $1.87 trillion

America’s Future

It’s clear that if the Fed continues QE and the Treasury continues backing stimulus, the government will end up owning far more once private industries and the population will become dependent on anticompetitive subsidy rationing for survival. It’s been announced recently that over 4o million U.S. citizens are now on Food Stamps.

The other route suggests an imminent recession. Should the Fed and Treasury go the “austerity” path, as Europe has chosen with the leadership of Germany’s cost cutting plan, the most likely outcome would be a recession and repricing of all assets to actual market values.

The recession hurts more in the short term, but guarantees more robust long term growth, while the socialist-esque spending route will land us in an economic environment akin to somewhere in Western Europe.

Of course the Fed is attempting to eat the cake and have it too, by a little slight of hand trick where they announced a reverse repo of MBS on their balance sheet, once abducted from Fannie and Freddie, where they will take money out of the financial system by reselling MBS contracts into the market. However, we don’t know which MBS packages are being sold and which aren’t. Do you see Benny Boy selling bad debt back onto the market? We can assume that the fed is in essence serving as a purifier of bad debt, where they buy the toxic material sort out the rare gems, and sell the good stuff back to the private banks.

FOMC Tuesday

The Street is hesitantly expecting Bernanke to announce some kind of further quantitative easing, which would look something like a resumption to the old MBS purchase program from the GSE’s, which was ended in March. For the Fed to end a QE program in March and resume it in August is more than a bit frightening to this analyst. The Street, of course, is cheering the potential assistance.

If the FOMC Fed announcement tomorrow (Tuesday) includes specific promises of further QE we’ll see a short term rally. IF the FOMC continues to talk abut the economy’s “worse than anticipated” performance, but fails to outline any specific plan to stimulate through monetary policy, we will see as sell-off. In our view, any rally would be stopped cold at 1150 on the S&P 500, as a massive head and shoulders pattern comes to fruition.

Happy Hunting

Disclosure: Disclosure: Long SDS, Long VIX, Long GC (Gold Futures), Short XLF