The bond market dwarfs the size of the stock market. I know what some of my readers are thinking right now, “If I don’t invest in U.S. Treasuries, it doesn’t matter to me if they go up or down.” This is wrong.

The price direction of  U.S. Treasuries is based on interest rate expectations. If bonds are rising or decreasing in price, it means that future interest rates will either rise or fall. The entire economy is based on interest rates. Higher interest rates would be catastrophic for the stock market, real estate market, consumers, and businesses.

Right now, 10-year U.S. Treasuries are near their record low, yielding 2.28% this morning. Why so low? Because, on Tuesday, the Federal Reserve took the unusual step of saying it would keep short-term interest rates near zero into mid-2013.

The Fed cut short-term interest rates to between zero and 0.25% in December of 2008 and short-term rates have remained that low since. Now we are told that the Fed will hold rates at those levels for another two years.

But there is trouble in paradise…

Three of the 10 members of the Fed interest-rate-setting committee dissented from the decision to give specific dates on how long short-term rates would be held close to zero. The last time this many of the committee members dissented was almost 20 years ago.

There are two schools of thought on how this story will end.

One camp believes that the U.S. is entering the same type of phase Japan went through in the 1990s: a period of deflation, where interest rates remained low for more than a decade.

The second camp believes that the U.S. will need to raise interest rates, as its debt load increases and foreign countries balk at buying more U.S. Treasuries.

China—the biggest holder of U.S. Treasuries—and Russia have been blasting the U.S. for failing to rein in spending. We also have two other problems: the U.S. dollar has been falling like a stone against other world currencies and the Fed has been a major buyer of U.S. Treasuries. Some look at this as the government buying its own debt. How confusing is that?

I’m in the camp that believes a bubble is brewing in U.S. Treasuries. Just like a bubble happened in hi-tech in the late 1990s, just like the housing bubble that peaked in 2005, just like the stock market bubble that peaked in 2007.

Whenever the U.S. government auctions off U.S. Treasuries, the offering is oversubscribed. Investors are lining up to buy securities paying 2.28% that are issued by a country that is technically bankrupt. That story can’t have a good ending.

Michael’s Personal Notes:

There’s a tremendous amount of fear in the marketplace today. I’ve never really seen anything quite like it before. One would believe that it’s 2008 all over again. Hence my belief that the stock market will not just roll over and collapse at this point. The market rarely does what is expected of it.

A recent CNN/Opinion Research Corporation poll reported that 48% of Americans believe that another Great Depression is likely to start within the next 12 months. This is unheard of. If you asked people in 1930 if a depression was headed their way, they would not know what you were talking about. If history has taught us one thing, it’s that events happen when the great majority of people do not expect them to happen.

We even have France, the second largest economy in Europe, now under attack by the bond vigilantes. Rumors have it that France will lose its Triple-A credit rating, just like the U.S. recently did. Yes, things are very difficult in Europe. Unemployment is high; jobs are hard to come by. But I’m starting to get the feeling that the pessimists are painting the situation as worse than it really is.

Where the Market Stands: Where It’s Headed:

The Dow Jones Industrial Average opens this last trading day of the week down 3.8% for the year. Personally, I’m not letting the multi-100-point up and down days on the Dow Jones bother me. I recognize that a lot of it has to do with automated computer buying and selling.

I’m focusing on my long-term beliefs about the market. And those views have not changed. The first phase of the bear market brought stocks down to a 12-year low on March 9, 2009. From there, the second phase of the bear market took hold. And that’s where we have been for months.

The third phase of the bear market will have stocks fall below their March 9, 2009 low. It will present a once-in-a-generation buying opportunity for investors. However, I don’t believe the third phase of the bear market is ready to start quite yet. The bear hasn’t finished its job of luring more investors back in before it takes prices down again.

What He Said:

“A Stock Market’s Obituary: It is with great sadness that we announce the passing of the Dow Jones Industrial Average. After a strong and courageous battle, the Dow Jones fell victim to a credit crisis and finally succumbed on Friday, October 3, 2008, when it fell decisively below the mid-point between its 2002 low and its 2007 high.” Michael Lombardi, in PROFIT CONFIDENTIAL, October 6, 2008. From October 6, 2008, to November 27, 2008, the Dow Jones Industrial Average experienced one of its biggest two-month losses in history.

We have the PIGS (Portugal, Ireland, Greece, and Spain) battling with debt issues in Europe. Spain is not fully there yet, but may inevitably need to find money. These countries are referred to as the PIGS because of their need for financial help.

Stock markets are battling negative sentiment here. The situation was helped by the crisis in Europe, but my economic analysis is that you cannot blame the Europeans, as there is a financial mess of our own here.

The key stock indices are languishing below their respective 50-day moving average (MA) and 200-day MA. The near-term technical picture is bearish and is dangerous at this time without any base or support.

A debt resolution was approved by the Senate and White House. The deal calls for a $2.1-trillion increase in the debt ceiling to around $16.4 trillion, which will allow the country to pay its debt obligations and spend. First of all, this is just adding to a massive debt load. In return, there will be spending cuts of about $2.4 trillion; but over a 10-year period!

The debt increase is not what we needed, but was essential. The government will need to focus on the cost side and implement its own austerity programs with discipline in order to cut the deficit and begin to work to bring down the massive $14.6-trillion national debt. It’s scary looking at the debt load and watching the mounting interest payments.

And in a “what if” scenario, can you imagine the impact of higher interest rates? It would make interest payments much higher and make it that much more difficult to reduce the debt load.

The problem, as I have been saying, is that the U.S. economy is not faring well and is below President Obama’s hopeful expectations after spending nearly a trillion dollars in infrastructure spending along with QE2.

The sky is not falling yet, but may be pretty close to it.

Just take a look at the second-quarter GDP that came in at a meager 1.3%, well below the 1.7% estimate. In contrast, China is slowing, but is still growing at around nine percent!

And making matters worse was a downward revision in the previous first-quarter estimate to a dismal 0.4% from 1.9%.

JP Morgan downgraded its estimate for the Q3 GDP to 1.5% from 2.5%.

I doubt we will see another recession, but you cannot brush this off. The probability for another recession is below 50% in my view, but it is still a possibility.

Manufacturing numbers continue to show a stagnant economy. The ISM Index was flat at 50.9 in July, its lowest reading in years and well below the revised 54.0 in June. An ISM reading above 50.0 represents expansion, so the reading is a concern.

The ISM Services index was also weak and grew at its lowest rate in 17 months.

Factory orders also declined in June.

So the red flags are evident. It’s becoming clearer that the U.S. economy is at risk for another decline and possible recession if stalling continues and the jobs market fails to ignite.

With the higher debt ceiling, we may yet see QE3.

Stocks have declined for seven straight days to August 1, despite the debt resolution approved by the Senate and White House that’s waiting to be passed by the House of Reps. There was no doubt in my mind and the thinking of many others that it would be approved. Even so, the resolution does not mean Americais home-free. Actually, it’s more like we’re in the land of debt. The deal calls for a $2.1-trillion increase in the debt ceiling to around $16.4 trillion, which will allow the country to pay its debt obligations and spend.

But just the idea of adding to a massive debt load makes me shiver, thinking of the mounting interest and debt obligations. And, even worse; could you imagine the hardship when interest rates turn higher? It’s not going to be pretty and will continue to be a burden on the American taxpayer.

For the agreement to pass, both sides agreed to spending cuts of about $2.4 trillion. That is pretty good, but the fact that it will take 10 years is worrisome. The cuts are expected to come from defense and general cuts to programs and other current spending.

Right away, my economic analysis indicates a red flag. For the cuts and debt to be lower, everything must work out perfectly, but the reality is that there are glitches that will impact the process.

And don’t forget the debt issues in Europe that could worsen are still around.

The Obama administration and those following will continue to face many hardships. The government needs to increase the revenue side of the column in order to make its cuts less dampening on the wellness of the country’s citizens.

Major revenue consists of income taxes, but the current jobs market is weak. Watch for the key non-farm payrolls on Friday. After a disappointing June when the unemployment rate edged higher to 9.2% and a mere 18,000 jobs were generated, investors are anxious to see better numbers. Economists estimate that the unemployment rate will decline to 9.1%, with 78,000 new jobs created. Before the non-farm payrolls, watch for Challenger Job Cuts and ADP Employment Change on Wednesday.

The problem is that if the jobs readings disappoint, we could see more sellers run for the exits this week. HSBC Holdings plc (NYSE/HBC) just announced it would lay off 30,000 employees worldwide—not a good situation. Barclays PLC (NYSE/BCS) is joining in with the firings and is cutting 3,000 jobs. The cuts do not paint a rosy jobs picture.

Also troublesome is a decline in personal spending in June by 0.2% versus a 0.1% increase in May. This indicates a lack of confidence in the jobs market and economy. Moreover, personal incomes edged up a mere 0.1%, down from 0.2% in May. The combination of flat income and lower spending, along with the weak jobs market, will impact GDP growth.

And this will impact the economy and President Obama’s plans.

Please follow my story this morning.

Far away from North America, in Madrid, Spain, thousands of protestors are marching to protest high unemployment and poor government. They have marched for weeks.

The unemployment rate in Spain is 21%. According to The Associated Press, unemployment among those aged 16 to 29 in Spain stands at 35%. The thousands in the march are very well organized, accompanied by physiotherapists and masseurs (The Globe and Mail, 7/24/11).

Back to America…

On Thursday of this week, the U.S. may have its largest municipal bankruptcy ever in Jefferson County, Alabama. The county, with a population of 660,000, has struggled for three years under $3.0 billion of sewer bonds that have matured and that the municipality cannot repay. Creditors, led by JP Morgan Chase & Co., want their money. About 500 county employees are on unpaid leave.

The road from Madrid, Spain, to Birmingham, Alabama, is a long one. The problems in Greece, Portugal, Spain and Italy are mature and are only getting worse. How do citizens survive with 21% unemployment? 

In America, I believe our problems are only starting. Remember, the government and the Federal Reserve have done everything in their power to keep the economy going. We are starting to see stress on municipalities and states that cannot balance their books or repay their debt. 

Imagine the havoc that higher unemployment, a rapidly devaluing greenback, higher interest rates and higher inflation will play with municipalities and states? I really wouldn’t be surprised to see large, organized citizen protests become the new phenomenon in America in 2012.

Michael’s Personal Notes:

Wrong, wrong, wrong. They’ve called it all wrong.

The financial news sites this morning are reporting that gold is hitting a new record high on fears about the debt ceiling for the U.S.government not being raised. “Gold surges to record as U.S.debt impasse threatens default, AAA Rating,” is a headline that Bloomberg ran this morning (7/25/11).

In my humble opinion, gold is not rising in price because Congress will not raise the U.S.debt ceiling. It’s actually the opposite—gold is rising because the debt ceiling will be raised. And when it’s raised, the official U.S. debt will run up from its current $14.3 trillion to maybe $16.0, $17.0 or even $18.0 trillion.

That’s what gold is really worried about…spiraling national debt, which brings about a devaluation of the U.S. dollar and possibly inflation.

It’s a forgone conclusion that the U.S.debt ceiling will be raised. Politicians—both sides of the house—would not dare to have the U.S.default on its obligations.

Where the Market Stands; Where it’s Headed:

It’s more of the same for the market as far as I’m concerned. The assault toward Dow Jones 13,000 is on. The bear market’s last gasp will be bringing the Dow Jones into 13,000 territory, as it attempts to lure more investors back into stocks.

As the Dow Jones plows through 13,000, inexperienced reporters and analysts will tell us that the agreement between Obama and Congress to raise the debt ceiling is causing stocks to rise. Rubbish.

The higher the national debt, the greater the risk  for higher interest rates. We are near the end of a Phase II bear market.

The Dow Jones Industrial Average opens this last full week of the month up 9.5% for 2011.

What He Said:

“I personally expect the next couple of years to be terrible for U.S. housing sales, foreclosures and the construction market. These events will dampen the U.S economic picture significantly in the months ahead, leading to the recession I am predicting for the U.S.economy later this year.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2007. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.

Consumer confidence amongst Americans is nose-diving.

An important report just released by Thomson Reuters/University of Michiganknown as a preliminary index of consumer sentiment decreased in July to the lowest level since March 2009. The report is startling for several reasons, but this should not be news for my PROFIT CONFIDENTIAL readers.

If we go back to March of 2009, we remember it as the month the stock market hit a 12-year low. The Dow Jones Industrial Average fell from 14,164 in October of 2007 to 6,440 in March of 2009—a decline of 55%. People were running scared. It was the bottom of the credit freeze.

But why are consumers, who make up 70% of American GDP, so worried again? Several factors are coming into play.

Job growth isn’t happening. This is the sixth year that house prices will fall in the U.S.  People don’t understand theWashingtonshenanigans concerning the national debt ceiling crisis. Is it any wonder that the Commerce Department reported that Friday sales at U.S.retailers stagnated in June?

If American consumers are going back into hibernation now, what will they do when inflation really spikes, interest rates rise to offset rapid inflation, and housing prices fall further as rates for mortgages rise?

Rightfully so, the American consumer is starting to realize that the future really doesn’t look that bright for the economy.

Michael’s Personal Notes:

I’ve been warning about inflation picking up steam in 2011. Government statistics are starting to provide evidence of the heated inflation.

According to a Labor Department report from Friday, consumer prices in the U.S., excluding the volatile food and energy items, climbed 0.3% in June after rising 0.3% in May—the biggest back-to-back gain in three years.

Overall prices rose 3.6% for the 12-month period ended June 30, 2011.

Inflation running at 3.6% and the Fed not raising short-term interest rates? Think about this for a moment. If you buy a 10-year U.S. Treasury, you make three percent on your money. But with inflation at 3.6%, you are actually losing the purchasing value of your money, while paying income tax on your three-percent return.

Something’s not right in the marketplace. But, as always, a regression to the mean will adjust the imbalance. Long-term interest rates will rise.

Where the Market Stands; Where it’s Headed:

The Dow Jones Industrial Average opens this morning up 7.8% for 2011. The more time goes by in 2011, the more bearish I turn on the economy. There has been no real effort by politicians to slash spending, the Fed stands ready to unleash QE3 if the economy falters…the long-term effects of both are inflation and insurmountable sovereign debt problems.

But, in the meantime, in the immediate term, stocks can—and I believe they will—continue to move higher.

What He Said:

“Over-built, over-speculated, over-financed and overdone. This is the Florida real estate market right now. For those looking to buy for personal use or investment, hold off! The best deals are yet to come. I continue with my prediction that the hard landing in the U.S.housing market, which is now affecting lenders, will have significant negative effects on the U.S.economy.” Michael Lombardi in PROFIT CONFIDENTIAL, April 3, 2007, Michael started talking about and predicting the financial catastrophe we began experiencing in 2008 long before anyone else.

These are very trying and uncertain times for investors.

On the one hand, profits of public companies are rising sharply and short-term interest rates have been near zero for years. These are two very strong and positive forces for pushing stock prices higher.

The S&P 500 companies expect to report earnings this year 18% higher than 2010. The Fed may not raise short-term interest rates now until the spring of 2012—which will mark a historic 40-42 months that the Federal Funds Target Rate has been near zero. We have to go back to the 1940s to see a period when interest rates remained so low for so long.

On the other hand, investors are terribly worried about the economy. Small business is struggling, as the days of easy bank lending have disappeared, unemployment rate is rising, and the housing market is getting worse. About 8.7 million Americans lost their jobs in 2008 and 2009. In the past two years, we’ve recovered less than two million of those jobs.

Then there is the whole debt issue. The Federal Reserve made major purchases of U.S. Treasuries in 2010 and 2011. The last time this happened was during World War II. Back then, the U.S. needed money to fund the war. Today, it’s an economic war our government is fighting.

The fine-balance issue is: when will too much debt tip us over and make us no better than countries like Greece, Portugal, Spain and Italy who are all fighting sovereign debt issues?

When I look at all this, I think that stock prices will continue to rise in the immediate term, simply because corporate earnings are there and because monetary policy is so accommodative. But a little further out in 2011 and into 2012, if employment doesn’t improve drastically, the U.S. could face severe debt, inflation and currency problems.

Hence, I continue to be immediate-term bullish on stocks. But, short- to long-term, I’m very concerned about the U.S. economy.

Michael’s Personal Notes:

You know they’re getting desperate, when…

This morning news comes that Italy now requires short-sellers of Italian securities to divulge even their smallest positions. Unfortunately, for this economist, it’s too late.

On June 24, 2011, I predicted in PROFIT CONFIDENTIAL that Italy would be the next country to fall victim to the bond vigilantes. Events this weekend put Italy’s sovereign debt issues front and center in Europe. Trades in Italian bonds are tumbling. The stock prices of major Italian banks are falling quickly.

Austerity measures in Italy, I predict now, will be a bigger problem for Italians than it was for the Greeks. The Greek Prime Minister survived a confidence vote and got his government cuts through. Italian Prime Minister Silvio Berlusconi already leads a much divided government. Getting through government expense cuts in Italy will be very difficult because of its increasing political uncertainty.

Will the European Economic Community have enough money left for the inevitable bailout of Italy? Germany, when will you realize that joining the euro was a mistake and that you either need to pull out of the euro and go back to your own currency or demand that the weaker countries remove themselves from the euro?

Where the Market Stands: Where it’s Headed:

The Dow Jones Industrial Average opens this morning at 12,657, up 9.3% for 2011. This morning, there is downward pressure on the prices of U.S. bank stocks that have exposure to the mounting sovereign debt issues in Europe, specifically Italy right now.

I believe that this bear market rally still has life left…that it will continue to climb the “wall of worry”…that a shot at Dow Jones 13,000 is a real possibility.

What He Said:

“There is no mixed signal about this: foreclosures in the U.S. will continue to rise, the real estate market will get weaker, and the U.S. economy will get weaker. Smart investors should seriously consider unloading their stocks of consumer-products companies that produce nonessential goods.” Michael Lombardi in PROFIT CONFIDENTIAL, March 12, 2007. According to the Dow Jones Retail Index, retail stocks fell 42% from the spring of 2007 through November 2008.

I’ll try my best not to be sarcastic this morning…

But what happened to all theU.S.jobs we were promised were headed our way? The Labor Department reported this morning that only 18,000 new jobs were created in June 2011, the lowest monthly job growth in nine months. The median Bloomberg estimate called for 105,000 new jobs for June.

The unemployment rate; it’s going the wrong way, up this morning to 9.2%—the highest level in six months.

All those trillions spent to stimulate the economy, all those “too big to fail companies” that were bailed out. Did all that money really make a difference? Sure it did. It ballooned our national debt to $14.3 trillion. Now the Obama administration has new ammunition. It can go to Congress and say, “See, jobs are not being created; the economy is so fragile, we need to spend more money to stimulate it. Increase thatU.S.debt ceiling.”

It is just me, or is all this starting to sound more and more likeJapan1991-2000?

According to Canada’s Globe & Mail (7/8/11), theU.S. economy needs to add 125,000 to 150,000 jobs a month just to keep up with people entering the labor force for the first time. We are nowhere near that type of job growth.

What happens next? My thinking leans towards the Fed continuing to increase the money supply, keeping short-term interest rates artificially low, and coming up with a new version of QE2 (all which are inflationary measures). No wonder gold prices are jumping higher again this morning.

Why did I start today’s issue by saying, “I’ll try my best not to be sarcastic this morning?” Many economists believe that the way to solve our economic issues, the way to stimulate the economy, is to have the government throw taxpayers’ money at the problem.

From the early days of the credit crisis, I have been in that other group of economists; the minority that believe that economic contractions should follow their natural path, as economic expansions do—unabated by government intervention that eventually leaves its citizens with an overabundance of debt.

Let’s look at it this way. During the real estate and mortgage boom years of 2003 to 2006, did the government do anything to slow the boom down? No. It actually spurred the boom on by reducing interest rates to historical lows. Now that the economy has gone bust, we are throwing money (we don’t have) at the problem. It’s an ironic situation.

 Michael’s Personal Notes:

Talking about jobs…

Our neighbor to the north,Canada, a country with a population less than one-tenth of that of the U.S., reported this morning that it had created more jobs in June than the U.S.!

Canada created 28,400 new jobs in June (twice what analysts were expecting), pushing Canada’s unemployment rate down to 7.4%—the lowest jobless rate inCanada since 2009.

The Canadian dollar remains my favorite currency. I believe that, as the U.S. dollar continues to devaluate, the Canadian dollar will be a winner.

Where the Market Stands: Where it’s Headed:

We got to within 280 points of Dow Jones 13,000, and bang—the patheticU.S.job numbers report comes out, knocking stocks back down again.

In reality, the stock market could have taken it a lot worse today. Yes, it was a very poor June payroll growth number. Add that to continued woes inEuropethis morning with more pressure on the stock prices of Italian banks—and the market is taking the negative news in stride.

If this bear market was over, today’s bad economic news could have easily pushed the Dow Jones down 300 or 400 points. Hence my belief this is a stock market that very much wants to keep rising.

What He Said:

“There is no mixed signal about this: Foreclosures in the U.S.will continue to rise, the real estate market will get weaker, and the U.S.economy will get weaker. Smart investors should seriously consider unloading their stocks of consumer-products companies that produce nonessential goods.” Michael Lombardi, Profit Confidential, March 12, 2007. According to the Dow Jones Retail Index, retail stocks fell 42% from the spring of 2007 through November 2008.

Just imagine…

It’s 2012 and the world realizes the euro can’t make it as a currency. Greece, Portugal, Spain and Italy have all been repeatedly bailed out. Germany and France have had enough. They tell these weaker countries to get out of the euro or Germany or France will go it alone.

Meanwhile, in Canada, the air has finally been released from its overheated housing market and the economy is on shaky ground for the first time in almost 20 years. In the U.S., years of printing money are causing rapid inflation. Interest rates are rising, as investors want higher and higher returns from U.S. Treasuries. Debt has become a big problem for states and municipalities. The sovereign debt issues of Europe have crossed the Atlantic.

By late 2012/early 2013, countries around the world are in a race to devalue their currency. So they come up with any idea.

The central bankers of the G7, or maybe even the G20, meet to discuss an across-the-board devaluation of world currencies. But if massive currency devaluation is going to happen, what will be the reserve currency?

It can’t be gold, because there is not enough gold in the world to satisfy the reserve, even if the price is $3,000 by 2013. America joins China in making a new reserve currency composed of U.S. dollars and Chinese renminbi, 20% backed by gold.

Could this happen? Let’s put it this way: while I don’t have a crystal ball, I’ve seen stranger things happen. What I do know is that, sooner or later, something has to give with the euro and the greenback. That’s what the 10-year bull market in gold bullion has been telling those who listen.

Michael’s Personal Notes:

There is so much to say this morning, so much to write about. Fortunately, most of the action is happening outside the United States.

Moody’s Investors Service cut Portugal’s long-term government debt credit rating to junk status yesterday afternoon. Greece, Portugal, Spain, Italy…they are all in trouble. While just Greece and Portugal have “officially” had their credit ratings slashed, I predict Spain and Italy are next.

The entire euro region, except for Germany, is in trouble. And I don’t want my readers to underestimate how fast those troubles could spread to North America.

From the other side of the globe, this morning, we get the news that China has raised its benchmark interest rate for the third time this year, as inflation is accelerating at its

fastest pace in China since the summer of 2008. (So much for the naysayers who said China was a bubble about to collapse.)

In China, a one-year deposit with the People’s Bank of China pays 3.5%. In the U.S., a one-year T-bill pays about one-twentieth of that, 0.17%. You really need to ask why foreigners would buy U.S. Treasuries. The answer: I believe they are buying less and less of them.

Whenever we hear news of another euro country facing sovereign debt issues, we see investors in those countries run to U.S. bonds as a safe haven. Between those buyers and the Fed, the demand for U.S. Treasuries continues…that’s until the world wakes up to America’s own sovereign debt problems.

Where the Market Stands; Where it’s Headed:

On May 20, 2011, my lead article in PROFIT CONFIDENTIAL was “Dow Jones 13,000; Why It Will Become Reality.” I’m sticking by that prediction for these simple reasons:

Monetary policy remains very accommodative. I believe the government and the Fed remain ready to do whatever it takes to stimulate further should the economy lapse back into recession. Yes, the economy is in trouble, but corporate America continues to churn out profits. The number of stock advisors bullish on the market is relatively low—there isn’t a lot of optimism in the marketplace, which is good for stocks.

After a correction that took the Dow Jones from 12,876 on May 2 to 11,875 on June 15, I believe the bear market rally is set to give us a final blow on the upside.

Please, don’t get me wrong. My opinion is that we are fully entrenched in a bear market that has yet to enter the dreaded Phase III. But I see this bear market luring more investors back into stocks before taking their money away again.

The Dow Jones Industrial Average opens this morning at 12,569, up 8.6% for 2011 and only 430 points away from the 13,000 target I discussed above.

What He Said:

“Partying Like a Drunken Sailor: The party continues. Stocks are making new highs and people are spending like there is no tomorrow. Why? I really don’t know. Big (cap) stocks, they just continue going up. Wall Street bonuses are at record levels. Popular consumer goods are flying off the shelves. Designer clothes, fast and expensive cars, restaurants with one-hour waits…people are spending in America today at an unbelievable clip. 1932, 1933… who remembers those years? The depression of the 1930s was the biggest bust of modern history. 2005, 2006, 2007…welcome to the biggest boom of the same period. When will it all end? Soon, my dear reader. Soon.” Michael Lombardi in PROFIT CONFIDENTIAL, February 7, 2007. Michael started talking about and predicting the financial catastrophe we began experiencing in 2008 long before anyone else.

Back in 2005, a beautiful condo building was planned on Collins Avenue in North Miami. Very luxurious, each condo unit encompassed a full floor. All kinds of amenities were planned for this oceanfront building, including private elevators to each condo unit.

Construction started in early 2006 and, by 2007, construction was halted. When in Miami, I pass by this condo building on my morning walks/runs. For the past three years, all I saw was an unfinished building, construction crane projecting halfway through the unfinished structure. My wife used to call the unfinished structure the “Lonely Condo Building.”

This morning, I was pleased to see that construction at the building has recommenced. The bank that foreclosed on the original developer has sold the building to another condo builder, who is now forging ahead with completion.

A total of 48,000 condo units were built in a stretch east of highway I-95 from Miami to Palm Beach during the real estate boom years, which came to an abrupt halt in 2007. It was common to drive your car up Collins Avenue and see buildings popping up. A sign saying “Financing by Lehman” often appeared in front of many of these buildings. A couple of the seven Trump buildings built here are true architectural masterpieces.

If there was a real estate market that got hit hard after the bust of 2007, it was Miami. But things are slowly turning around.

Sales of existing home and condos in the Greater Miami area rose 71% in the first quarter of 2011 from the first quarter of 2010, according to the Miami Association of Realtors. Almost half of all transactions in the first quarter of 2011 were sales of bank-owned properties.

Who’s buying these condos? Fifty percent of all the sales of condo units over $500,000 are to Brazilians. The balance is to Canadians and Europeans. Americans account for only a small portion of the buyers, who are either paying full cash or are financing only half of their purchases.

Short-term, things look good in Miami. Long-term, I’m worried. Interest rates will eventually move up. Banks have slowed their pace of foreclosures. There are many more properties to come on the market, the question is when?

If you are looking to buy a condo in the Miami area for vacation use, price becomes a secondary consideration. If you are buying for investment, don’t expect a good return on investment for years to come.

Michael’s Personal Notes:

Two current trends I want my readers to be aware of:

After reaching a new record high of $1,552.50 an ounce on May 22, 2011, gold bullion prices have pulled back $50.00. A $50.00 pullback is nothing to be concerned about. If you look at the rising price trend of gold bullion since the $1,000-an-ounce level, the trend is a slow move up, a sharp pull back. This trend will continue and sharpen as the price of bullion continues to rise.

I see any weakness in the price of gold bullion as an opportunity to purchase the shares of the junior and senior gold-producing stocks.

In a mirror image of last summer, investors are running to U.S. Treasuries again. A short history: 10-year U.S. Treasuries fell to a yield of 2.4% in October of 2010. They then rose to a yield of 3.77% on February 9, 2011. Now, the yield is back down to 2.88%.

By the fall, we will be looking at higher yields on U.S. Treasuries; hence, I’m avoiding them. According to Bloomberg’s survey of 64 bond forecasters, the yield of the 10-year Treasury is expected to hit four percent by June of next year. I believe it will happen sooner.

Where the Market Stands; Where it’s Headed:

A bear market rally in stocks, although old and tired, continues to prevail. I expect another run-up in stock prices before Phase III of the bear market sets in.

What He Said:

“You’ve been reading my articles over the past few months and have seen how negative I’ve become on the U.S. economy. Particularly, I believe it’s the ramifications of the faltering housing sector that are being underestimated by economists. A recession doesn’t take much to happen. It’s disappointing that more hasn’t been written on the popular financial sites and in the newspapers about the real threat of a recession happening in 2007. I want my readers to be fully aware of my economic opinion: I wouldn’t be surprised to see the U.S. economy in a recession sometime in 2007. In fact, I expect it.” Michael Lombardi in PROFIT CONFIDENTIAL, November 13, 2006. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.

In January of this year, the Federal Reserve predicted that the U.S. economy would grow between 3.4% and 3.9% in 2011. In April, the Fed said it predicted that the economy would grow less, at between 3.1% and 3.3% this year. Yesterday, the Fed lowered its growth prediction for the U.S. for 2011 again, to between 2.7% and 2.9%.

Am I the only one that sees a trend here? A trend of continuously lowering our growth prospects for 2011?

Also yesterday, after a two-day Fed Open Market Committee meeting, we got more of the same: interest rates will remain low for an “extended period” of time, inflation pressures will subside, the unemployment rate is high, but should move lower later this year, and the Fed’s QE2 program will end in June as scheduled.

I’m a big fan of Fed Chairman Ben Bernanke. He’s done a masterful job of saving America from the Great Depression II. But maybe we should look at the situation today from a different angle.

Interest rates, as measured by the Federal Funds Rate, have been between 25 basis points and zero since December 2008. According to Bloomberg, interest-rate futures indicate only a 20% chance that the Fed will raise interest rates by March 2012!

Can interest rates really remain that low for that long without spurring inflation? And isn’t it worrisome that 31 months of record-low short-term interest rates have not spurred the economy?

We’re all entitled to an opinion, right? So here’s my two cents’ worth:

The growth forecast for the U.S. economy will need to be lowered again later this year. Inflation will surprise on the upside. The unemployment rate in the U.S. will be higher at year-end than it is today. Another form of stimulus similar to QE2 will be needed. Long-term interest rates will rise, too.

Where the Market Stands; Where it’s Headed:

A bear market rally in stocks that started on March 9, 2009 continues to prevail.

For the year, the Dow Jones Industrial Average is up 4.6%. Yes, the stock market has been higher (actually peaking on May 2, 2011), but we’ve recently undergone a small correction in a 27-month bear market rally…a healthy correction for stocks.

Some bullishness has been released from the air, stock values have been realigned, corporate profits are still strong, and monetary policy is still very expansive.

I continue to believe that stock prices will move higher before Phase Three of the bear market sets in.

What He Said:

The year “2000 was a turning point of consumer confidence in high-tech stocks; 2006 will be remembered as the turning point of consumer confidence in the housing market. That means more for-sale signs going up, longer time periods to sell homes, bloated for-sale inventory and eventually lower prices for homes. But this time, the turnaround in consumer confidence will have a bigger impact on the economy. Hold onto your seats, this is going to be a nail biter.” Michael Lombardi in PROFIT CONFIDENTIAL, August 24, 2006. Michael started talking about and predicting the financial catastrophe we began experiencing in 2008 long before anyone else.

They’re back…

After shying away from buying U.S. Treasuries, as the Federal Reserve was using its QE2 to do its own buying of government bonds, China increased its holdings of U.S. government debt for the first time in six months this April.

China holds about $1.149 trillion of long-term U.S. notes and bonds. Japan is the second largest holder of long-term U.S. debt, at just under $1.0 trillion dollars.

In total, foreign holdings of long-term U.S. Treasuries sit at $4.49 trillion (Source: Bloomberg).

Excuse my ponderings this morning…

While I don’t have a PhD in Economics, if I understand this right: foreigners own the majority of the U.S. debt. The Fed has been buying the same debt under its $600-billion QE2 program.

As we move from a national debt ceiling of $14.3 trillion to $17.0 trillion or $18.0 trillion, who will buy that extra debt? There seems to be only two buyers in the marketplace, foreigners and the Federal Reserve (the latter, only if it starts QE3).

At what point do China and Japan say, “Thank you, but we have enough U.S. debt on our books?” And who will ultimately be smarter? Will the U.S. succeed in keeping interest rates low, bringing in inflation and paying foreigners back with devalued U.S. dollars?

Or will China and Japan succeed in demanding higher interest rates on U.S. debt, while they debase the U.S. dollar as the world’s reserve currency?

In my view, the remainder of this decade will be a nail-biter…a real prelude to America’s future. And I wouldn’t want to miss it for anything.

If we go back through history, when we see countries in the past exposed to great dependence on foreign investment, the debtor nation has eventually faced sovereign debt problems and high inflation. Do we really think the U.S. will escape the same fate?

Michael’s Personal Notes:

Look at just how pathetic things have become in the housing market…

Sales of existing homes in the U.S. (re-sales) fell in May to their lowest level in six months. In May, 31% of all re-sales were “distressed” homes. In that same month, 30% of all re-sales were cash transactions. The median price of a resale home in the U.S. fell 4.6% from May 2010 to May 2011 (Source of all data: National Association of Realtors).

The banks have pulled the lending strings so tight that one out of three home purchases is in cash. (What a difference from 2006!) The government has not been successful at getting banks to increase lending in the housing sector. Too many distressed properties overhang the housing market.

How can the economy possibly recover under a scenario where the housing market still can’t find a bottom in its crash? Simply, a meaningful economic expansion cannot begin without a recovery in housing.

I’m sticking with my prediction of another 7.5% decline in the price of U.S. homes this year.

Where the Market Stands; Where it’s Headed:

Whenever I guide my readers through a difficult period in the market and we pull through, I feel very proud of our efforts. Let me explain.

From the period May 2, 2011 to June 15, 2011, the Dow Jones Industrial Average fell 1,001 points, or 7.7%. By June 15, exactly one week ago today, my indicators starting flashing that stocks were severely “oversold.”

On June 15, 2011, on these pages, my lead story was, “Stock Market Bounce Imminent as Bullish Sentiment Collapses.” Just this past Monday, my lead story was “Five Reasons Why Stocks Will Rise in the Immediate Term.” As cocky as it sounds, since June 15, the Dow Jones Industrial Average has gained 315 points, about 2.7%.

In this business, you can’t be too sure about yourself because that’s when the market slaps you in the face. Humbleness is one of the keys to success in the market.

By mid-June, the attitude towards stocks was getting too negative. Investors were pulling money out of mutual funds, stock and advisors were turning bearish en masse, but corporate earnings and monetary policy remained very favorable.

This bear market rally…it will exhaust itself soon. But it has yet to finish its business of luring more investors back into the stock market. Hence, I continue with my position that a bear market prevails for stocks.

What He Said:

“I see the coming recession being deep and difficult because U.S. consumers do not have the savings to spend their way out of the recession. The same thing happened in Japan. The Japan example proved that when consumer confidence is shattered, even zero percent interest won’t spur consumer spending. The same thing could happen here.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2006. Michael began talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.

Below I list five facts about the stock market, all very bullish cases for stock prices to rise in the immediate term.

According to Bloomberg’s survey of 9,000 stock analysts, the S&P 500 companies will earn 18% more in 2011 than they did in 2010. Despite this, the S&P is trading at 14.5 times last year’s earnings. Since 1991, the S&P has traded at an average of 20.5 times earnings.

Interest rates in the U.S. are not rising for the near future, as the unemployment rate remains high, the Fed is not pushing the inflation panic button yet, and the Fed is committed to a policy of monetary stimulus.

Stock prices have fallen 6.2% since May 2, 2011—and investors are in panic mode. While most investors have very short-term memories, I remember last year, in particular the period from April 2010 to the end of June 2010, when stock prices fell 16% and investors were panicking as well. Stocks subsequently rose 34% from the end of June 2010 to May 2011.

Investors pulled $5.46 billion out of stock mutual funds last week, according to the Investment Company Institute in Washington—the biggest withdrawal of money from stock mutual funds since the week ended December 8, 2010. From December 8, 2010 to May 2, 2011, stocks rose 12%.

The percentage of bullish stock advisors in the marketplace has fallen to a low not seen since September 2010 (Source: Investors Intelligence). The Dow Jones Industrial Average rose 22.6% from the beginning of September 2010 to May 2, 2011.

Michael’s Personal Notes:

Excellent story in this weekend’s New York Times on the backlog of residential home foreclosure cases across the country. The article refers to data from LPS Applied Analytics, which reports it would take “lenders 62 years at their current pace to repossess the 213,000 houses now in severe default or foreclosure” in New York State (New York Times, 6/19/11).

The article goes on to claim that millions in the U.S. are staying in their homes without making payments on their mortgages, as the foreclosure process grinds to a halt.

You may remember last fall’s controversy over banks foreclosing on homes without all the paperwork in order. This slowed the foreclosure process dramatically. Add to this a large number of homes still to be foreclosed on and the system is overwhelmed.

Do the banks really want more foreclosed homes on their books? I doubt it. It takes money to foreclose on a home and more money to sell it (real estate commissions, etc.). If I were a bank with tens of thousands of homes on my books, wouldn’t I want the people living in the homes to pay the utilities as opposed to my bank?

I’ve said this before: I have never seen the U.S. economy recover when the housing market hasn’t recovered with it. It will take another decade for any normality to return to the U.S. housing market. Hence, you can see why I’m so wary of the economic recovery and so concerned about a double-dip recession.

Where the Stands; Where it’s Headed:

My opinion remains unchanged: stocks are oversold. The bear market rally in stocks that started in March of 2009, although getting near its end, is still alive and well.

What He Said:

“I’m getting very worried about the state of the U.S. housing market and its ramifications on the economy. The U.S. could be headed for its first outright annual decline in home prices on record, adjusted for inflation. And I really believe this could be a catastrophe for the U.S. economy.” Michael Lombardi in PROFIT CONFIDENTIAL, August 2, 2006. Michael began talking about and predicting the financial catastrophe we started experiencing in 2008, long before anyone else.

The key to growing the economy is creating jobs to drive spending and economic growth. So far, the economic renewal has been decent with some encouraging developments in the critical jobs area. April saw the creation of 244,000 new jobs and was the third straight month in which over 200,000 jobs were created. However, May saw stocks decline, producing a dismal jobs report on Friday morning.

While I was sensing that there would be a lower reading based on a weak ADP jobs report, the creation of only 54,000 jobs in May was a massive disappointment. Economists were hoping for the generation of 169,000 new jobs, so the shortfall was significant. And, to make matters worse, the unemployment rate edged higher to 9.1%, above the estimate of 9.0%.

The jobs situation is even worse when you consider that the general consensus among economists is that the country would need to add 500,000 jobs monthly to make a dent in the unemployment rate and get it moving towards full employment at around six percent.

There are currently about 15 million Americans unemployed and looking for jobs while struggling to make ends meet. We are seeing record numbers at food banks across the nation. The government is positive that jobs are being generated, but tell that to those barely holding on. The problem is that there are only about 2.9 million available jobs. That is five unemployed workers competing for one job. You don’t have to do any complex economic analysis to figure out that this is a problem and needs to improve.

Jobs need to be continue to accelerate, especially given that the government has high hopes after spending hundreds of billions on infrastructure and incentives and, in the process, building a massive deficit and adding to the over $14.0 trillion in national debt.

Jobs drive confidence and this gives consumers a reason to spend, especially on non-essential goods and services.

Not only is the number of jobs created not sufficient, but also the quality of jobs is an issue that many in the government do not talk about. Many of the jobs created are more the lower-paying service or industrial jobs. The problem that this poses is that the lower incomes generally make for less spending and, hence, a longer road to a spending recovery.

In addition, weak jobs confidence will impact the demand for housing and big-ticket items. We continue to see a soft housing market with declining prices. Consumers are also not spending freely on durable goods, as they would in a healthy economy.

In all, we need to see more jobs and the quality of those created must improve. There are far too many previously employed professionals now working at menial jobs.

The May reading is a red flag and could signal less hiring due to a feeling among companies that the future economic growth may be slowing…and this is not good.

The government will need to think about its Quantitative Easing part three to try to drive the economy and jobs creation; otherwise, we could see that double-dip recession we’ve been talking about.

Dear reader, the sad truth is that while the media and government have been pumping us with good news about the recovering economy, we are inching closer and closer to falling back into recession.

If we look at Europe, analysts have cut corporate earnings forecasts by the most in two years. Inflation in the U.K. is running at 4.5% with core inflation running at the fastest pace in 14 years. But the economy in the U.K grew at only half-of-one percent in the first quarter.

Yesterday, the U.S. dollar rallied as concerns over European sovereign-debt issues arose again, especially for Greece. On Tuesday, Germany—what I call the “sole engine of Europe”—saw yields on its 10-year government bonds collapse to a four-month low. Why? Consumer confidence in Germany is now on the decline.

Back at home, the markets are ever so concerned with what will happen after the Fed’s QE2 ends in June. Short-term interest rates cannot rise, as our economy is so delicate it simply can’t deal with higher rates. Meanwhile, long-term interest rates have risen.

The housing market is a “damned if you, damned if you don’t” situation. After a 25- to 30-year down cycle in long-term interest rates, rising rates will negatively impact housing and construction (a true backbone of America) for many years. If we fall back into deflation, collapsing interest rates will not help housing.

Then, of course, we have the issue of too much debt in America. We are approaching a point where our debt-to-GDP ratio is close to what it was just after World War II. But after World War II, we had a great industrial revolution. What do we have today? The Internet and Hollywood?

After decades of leveraging up, no matter how much the government and Fed ease and support monetary system, the fact must be faced we have entered a future of deleveraging the excesses of the past.

Mervyn King, the Bank of England Governor, was quoted last Wednesday as saying his country faces “difficult times ahead…not just one year, but several years.” The sad truth is that his words can apply ever so dearly to us in here in America.

Michael’s Personal Notes:

In the early 1980s, IBM was deeply involved in the manufacturing of personal computers. It was in the hardware business back then. But IBM needed an operating system for its personal computers to work on. The rest is history. IBM hired Microsoft to put operating systems in its PC. A young Bill Gates eventually proved software is more valuable than hardware.

This week, for the first time in 15 years, the market capitalization of IBM, whose stock has been booming, surpassed the market capitalization of Microsoft, whose stock has been lagging. It took IBM 15 years to become more valuable than its one-time supplier.

The business lesson here? There is no force greater than an idea whose time has come. We can see this in these technology companies: Amazon, e-Bay, Apple, Facebook and now LinkedIn.

The life lesson? Aside from being in the right place at the right time, hard-working young people will never cease to amaze.

Where the Market Stands; Where it’s Headed:

Very surprised to see the number of stock advisors who have left the “bullish camp” and have moved into the “correction camp” (I follow the Investors Intelligence Advisor Sentiment gauge). Since the majority of advisors are usually wrong, I see the recent weakness in the bear-market rally simply as that: weakness in an aging bear market.

The Dow Jones Industrial Average opens this morning up a shrinking 6.7% for 2011. While I’m short- and long-term bearish on stocks, I believe the bear-market rally that started in March of 2009 has more life left.

What He Said:

“I’ve been pushing gold bullion and gold shares for over a year now. Bank in January 2002, I personally started buying gold shares.” Michael Lombardi in PROFIT CONFIDENTIAL, December 13, 2002. Gold bullion was trading at under $300.00 an ounce when Michael first started recommending gold-related investments. Michael has been a “bull” on gold since 2002 and has been recommending gold investments since.

On the continuing theme of dividend-paying large-cap companies, it’s pretty clear that institutional investors have been migrating towards these stocks because they don’t expect a lot of economic growth over the near term. In fact, we could get a major slowdown in the global economy in the near future as stimulus packages are withdrawn and higher commodity prices take their toll on demand.

The economic news lately reveals a mixed performance for industry and in the macroeconomic numbers like employment and housing prices. Institutional investors want dividends simply because they don’t expect much in the way of top-line growth. It’s the natural thing to do when interest rates are low, bonds aren’t attractive, and cash pays virtually nothing. Investors with money to spend have to put it somewhere to beat the rate of inflation and you can see the significant buying that’s been going on in dividend-paying large-caps.

I don’t necessarily see major trouble ahead for stocks given the current fundamentals, but it is difficult to imagine a major advance in share prices when there isn’t robust growth in the underlying economy. Instead of a well-deserved correction in share prices, it’s looking more to me like we’re in for a longer period of consolidation in the main stock market indices. There’s some waffling going on in capital markets, as investors don’t see a near-term trend. So, they buy yield if there’s nothing else going on.

As I’ve been writing for quite a while now, the price pullback in equities and particularly in commodities is a healthy development for the long-run outlook of capital markets. There was speculative excess in gold prices, silver prices and oil prices, and equities have been trending higher since last summer. A little breather, even if it takes a couple of quarters, isn’t as bad as a bubble that bursts.

Right now I don’t see a major need for equity investors to be making any new bold moves with new positions. There are always trades out there, but there isn’t much of a tailwind from the broader market. Investing in gold is a sectoral play that I continue to believe in for the next several years. The commodity price cycle is taking a break; it isn’t over.

As for the rest of the broader market, I’m still following the railroad stocks as my best indicator.

Looks like trouble in paradise…

We hear and read all kinds of reports telling us that the economy is improving, yet yesterday the Conference Board reported that its index of U.S. leading indicators fell in April for the first time after nine consecutive months of gains.

And the National Association of Realtors said that sales of existing U.S. homes “unexpectedly” fell in April. (Who are they kidding with the term “unexpectedly” in their release? Aside from millions of homes already foreclosed upon, over five million American homes are either in the foreclosure process right now or are at least 30 days late with their payments on their mortgages.)

On top of the above, the Federal Reserve Bank of Philadelphia reported last week that its general economic index fell last month and sits at its worst level since October 2010, about the same time the yields on U.S. 10-year treasuries started to rise.

Then comes the release of the Federal Reserve’s April 26 to 27 meeting minutes, in which we see that the majority of policy makers discussed how to unwind the Fed’s monetary stimulus.

The sequence of events consensus: stop reinvesting proceeds from maturing securities, then raise interest rates, and then sell assets. (By the end of next month, the Fed will be sitting with $2.6 trillion in securities on its books.) Great plan, but I don’t think they’ll be able to execute it for a while.

With the cracks in the economy I’ve listed above (leading indicators falling, home sales still falling, general economic index falling), the Fed can talk all it wants about unwinding its unprecedented monetary stimulus, but it likely wouldn’t be able to take any such action until 2012, unless inflation gets out of control.

I’m still in the camp that believes we’ll likely see a new version of the expiring QE2 before we see the Fed withdrawing monetary stimulus.

Where the Market Stands; Where it’s Headed:

Well, we’re in the home stretch. As we enter the final full trading week of the year, the bear is alive, well and looking forward to summer. But will the bear market make it through the summer? That is the real question.

The bear market rally that started in October 1934 lasted until August 1937—35 months—and took the Dow Jones Industrial Average from a level of 90 to 185, a gain of 106%.

The bear market rally that started in March 2009 has lasted 27 months so far and has resulted in the Dow Jones gaining 96%.

If the current bear market rally follows the same path as the bear market rally of 1934 to 1937, we have eight months left before the next phase of this bear market gets underway, which brings us to the end of December 2011. I have a feeling that this bear market will not make it that long.

What He Said:

“A Stock Market’s Obituary: It is with great sadness that we announce the passing of the Dow Jones Industrial Average. After a strong and courageous battle, the Dow Jones fell victim to a credit crisis and finally succumbed on Friday, October 3, 2008, when it fell decisively below the mid-point between its 2002 low and its 2007 high.” Michael Lombardi in PROFIT CONFIDENTIAL, October 6, 2008. From October 6, 2008, to November 27, 2008, the Dow Jones Industrial Average experienced one of its biggest two-month losses in history.

China is the second-largest economy in the world and is continuing to roll along at a nice pace. The International Monetary Fund (IMF) recently downgraded U.S. GDP growth to 2.3% this year from the previous 2.9% but concurrently raised China’s GDP growth to 9.9% this year—up from the previous 9.7%. This is why you need money in China.

The results reflect the significant growth difference between China and the U.S. and Europe. China is continuing to roll along at high speeds, but it must be controlled.

And while the growth is impressive, my economic analysis is simple: the superlative GDP growth is great, but the problem is the associated inflation that often surfaces as consumers spend more, and we know that spending is spreading like wildfire in China.

In April, the country’s consumer price index (CPI) was 5.3%—slightly lower than its March 32-month high of 5.4%, but still high by any standard. The CPI acts as a good way to gauge inflation. The average inflation rate in China from 1994 to 2010 was 4.3%, so there needs to be some work done here to relieve the inflationary pressures.

The reality is that prices continue to rise as consumers continue to spend, so we expect more tightening via either higher interest rates or higher bank-reserve requirements in China (or both).

Moreover a report that was just released indicates that real-estate values in China continue to rise in many of the tier-one and tier-two cities. This will force the government to look at further tightening, as some of the rise is due to speculative buying.

Interest rates continue to ratchet higher, and I expect the upward move to continue. The Chinese government has placed a cap on certain food products and subsidizing some of the poorer rural workers.

Traders in Asia are probably encouraged by the Chinese government’s battle against inflation and to control the rate of growth. China needs to make sure to keep its course and tackle inflation, since rising prices will hurt the majority of the 1.3 billion people living in China who are just trying to get by on a daily basis.

Chinese inflation is a real potential threat to growth and stability—not only in China, but globally with its trading partners. We could see higher-cost Chinese-made goods as prices rise, and this will drive up the prices of Chinese-made goods that are sold in the U.S.

Overall, China is on the right path toward developing into a rising world economic power, as well as a basin for incredible and sustained growth across many sectors, including industrial, mining, energy, services and technology. The reality is that if it is saleable and in demand, then you know that China will likely have a consumer market for it. China knows that, and so do many of the top multinational companies, including many in the U.S.

There’s quite a story going on between China and United States in respect to what each country believes the other should be doing with its interest rates, debt, and currency.

U.S. Treasury Secretary Timothy Geithner will be meeting this week with Chinese Vice Premier Wang Qishan. Here’s what the two want of each other…

Geithner will prompt China to raise interest rates to push up the yuan, which the U.S. says is kept artificially cheap. (You can see the U.S. argument easily. A higher priced yuan will make those Chinese goods more expensive to Americans.)

The Chinese, on the other hand, have been complaining that lax U.S. monetary policy and record U.S. annual budget deficits have lowered the value of the dollar, while spurring global inflation.

Bottom line: each country wants the other to have a stronger currency. If I had to pick a winner, the U.S. is the winner right now in the currency fight, but in the long term it will also be the loser.

China has raised interest rates four times since last October. One-year deposits in China yield an interest rate of 3.25%, while the one-year lending rate is 6.31%. Here in the U.S., a one-year T-bill continues to yield a pathetic 0.16%. If interest rates in the U.S. were what they are in China today, we would be facing deep economic problems again.

Yes, by keeping interest rates so low, running huge deficits and keeping the printing press running overtime, the U.S. has been able to emerge from the worst recession since the Great Depression.

However, the Chinese are right in that the existing U.S. monetary policy is causing inflationary pressures to rise worldwide. According to the Food and Agriculture Organization, a United Nations entity based in Rome, Italy, world food prices rose to a near record in April on soaring grain costs.

The U.S. is the winner today in the fight against the Chinese over currency valuation, but, as I say above, it will be the loser in the long term, as those short-term interest rates that are artificially low, huge deficits, and overtime money printing come back to haunt us in the form of a devalued currency and the rapid inflation that the Chinese are complaining about.

China sat on $1.15 trillion in U.S. Treasuries at end of February. A devaluing greenback and inflation are already paying havoc with the real return of U.S. Treasuries.

Michael’s Personal Notes:

Speaking of the “real return” of an investment, it has been months now that U.S. Treasuries have been delivering negative real rate returns.

A typical investor looking to park cash buys a U.S. Treasury yielding 1.86%. If we take an inflation rate of 2.7%, the investor is losing 84 basis points over a one-year period in inflation adjusted terms. If he or she held that T-bill for the full five-year maturity, the investor would lose 4.2% in the purchasing power of his or her money.

But we all know the inflation rate is much higher than the “official” rate we are given by the Commerce Department. The method by which the inflation rate is calculated in this country has not been significantly changed in decades.

The more the U.S. prints money, the more value our money is losing, and the less it is worth.

Where the Market Stands; Where it’s Headed:

It’s still “up, up and away” for this bear market rally. So far this year, the Dow Jones Industrial Average is up 9.2%. In total, since the bear market low in March of 2009, the Dow Jones Industrials has risen 96%. I’m looking for a gain of 100% to 110% from the March 2009 market low before this bear market rally finally calls it a day. Hence, the upside is about another 10%.

The bear market rally in stocks is alive and well.

What He Said:

“The Dow Jones Industrial Average, the S&P 500 and the other major stock market indices finished yesterday with the best two-day showing since 2002. I’m looking at the market rally of the past two days as a classic stock market bear trap. As the economy gets closer to contraction, 2008 will likely be a most challenging economic year for Americans.” Michael Lombardi in PROFIT CONFIDENTIAL, November 29, 2007. The Dow Jones Industrial peaked at 14,279 in October 2007. A “sucker’s” rally developed in November 2007, which Michael quickly classified as a bear trap for his readers. By mid-November 2008, the Dow Jones Industrial Average was at 8,726.

It will take a bit of good fortune, but I think the S&P 500 Index can achieve 1,500 this year. We’ll likely get a correction or some sort of prolonged consolidation in the not-too-distant future and, barring any unforeseen shocks to the system, the stock market should reaccelerate due to continued growth in corporate earnings.

We are seeing the market somewhat topping out at this time. Investors are greeting good earnings from brand-name companies with a little apathy. Of course, stock prices did already go up in anticipation for solid first-quarter numbers, so this is no surprise. The numbers from Merck & Co. Inc. (NYSE/MRK) and Caterpillar Inc. (NYSE/CAT) were excellent.

There are some headwinds that stocks will have to face this year, and the big one is inflation, which is happening all over the world. A little price inflation is good. A lot of price inflation is bad. Most definitely, the devaluation of the U.S. dollar to prop up the economy is a double-edged sword. While this does have direct stimulus benefits, it also contributes to inflation, as most global commodities like oil and gold are priced in U.S. dollars, thereby aiding the inflation contagion. While there’s no prospect for interest-rate hikes at this time, they are inevitable.

The current economic situation seems destined to produce a period of low, but steady growth over the next several years. While this isn’t what the market is used to, low and steady actually makes it easier for monetary policy to change in a manner that’s more helpful. When we get strong periods of growth, the Federal Reserve wants to ramp up interest rates. What we don’t need now is anything drastic that could kill off the current economic recovery.

The housing market continues to be a drag on the economy and investing in real estate isn’t likely to pay off anytime soon. There remains too much inventory for housing prices to accelerate in a meaningful way. The real estate market is still trying to balance itself out after its bubble burst.

The month of May has a tendency to be kind of slow for equity prices. With most companies reporting their first-quarter numbers in April, it isn’t surprising that stock market trading action may be lackluster this month.

I want to repeat a market view that I’ve had for a while. I do see the stock market able to tick higher later this year. I think it’s reasonable to expect a correction, perhaps soon. I also don’t think this is a market where investors need to be doing much that’s new. There’s no big rush to be investing in gold for example, even though the spot price of gold keeps hitting new records. The stock market has already done extremely well over the last eight months. Everything is due for a break.

For many years, the backbone of the U.S. economy has been the housing market. I’m not talking during the recent boom years in housing of 2003 to 2006; I’m talking way back. For those of us that lived through it, the housing boom of the late 1940s and early 1950s was a major contributor to U.S. economic growth after World War II.

The energy crisis of the 1970s, the high interest rates of the early 1980s…it seemed nothing stopped the housing machine. Millions of American people, from construction workers, to real estate agents, to mortgage brokers, were happily employed directly or indirectly by construction.

It was President Jimmy Carter’s Administration that started pushing for the dream every American could achieve: home ownership. The Bill Clinton team carried that torch.

Today, despite the most affordable housing market in a generation (when gauged against income), homebuilders are failing miserably at attracting buyers. According to the National Association of Realtors, the housing affordability index in the U.S. is at its highest level in four decades.

But why would Americans buy homes? According to data-compiler CoreLogic Inc., 11 million U.S. homes are worth less than their mortgage. Another two million homeowners have less than five percent equity in their homes…pay the real estate commissions and expenses on a sale and they’ll be underwater, too (the five-percent price decline I’m expecting this year in U.S. housing prices will definitely put them on the negative side).

Hence, we have about one-third of U.S. homes worth less than their mortgages. The median price of a U.S. home has fallen 32% from its 2006 level—the biggest five-year drop in history.

But, have no fear; the government is here.

Two government-created agencies, Freddie Mac and Fannie Mae, which either owned or guaranteed half of all U.S. home mortgages, failed during the credit crisis. The government took them over directly. Hence, our government owns or guarantees half of all U.S. residential mortgages. How ridiculous is that? Imagine how poor the housing market would be if the government was not involved in it.

I’ve lived through many booms and busts. I’ve never seen an economic recovery that did not include housing. With long-term interest rates rising, with such a large inventory of foreclosed homes, and with some many homes “underwater,” how can a real economic recovery happen? This is my point and this is one of many reasons why I’ve been calling it a bear market rally all along. 

Michael’s Personal Notes:

The more time that passes, the more I’m convinced that money in Washington is spent with little or no regard to our spiraling debt. It’s remarkable that Americans, as citizens, have not made the debt crisis a national issue.

Estimates I have seen on the Barack Obama Inauguration Day are in the $200-million range. Yes, $200 million of taxpayer money gone for a one-day event. For Libya, the Administration estimates that the cost has been about $600 million so far and is running another $40.0 million monthly. Back in 2008, the Washington Post pegged the cost of the Iraq war at $3.0 trillion. The Afghanistan war could be in the $500 billion to $1.0 trillion range.

Hence, when we hear that our deficit for the year will be $1.5 trillion to $1.6 trillion, we must remember that extraordinary events, like wars and sharply higher interest rates, are not included in the figures.

If the government does not exercise accountability, then the only way to finance its out-of-control debt is to issue more and more debt securities such as U.S. Treasuries. In light of a weakening U.S. dollar, foreigners might buy those securities if interest rates are attractive. The Fed might buy them, too, if it can print more money. The first evil—higher interest rates—chokes the economy. The second—printing more money—sets off inflation. We’re damned any way we look at it.

Where the Market Stands; Where it’s Headed:

Immediate-term, the bear market rally continues. I see five percent to 10% of upside potential from where the Dow Jones Industrials sits today. Short- to long-term, I’m decisively bearish.

After 30 years of falling long-term interest rates, the trend has reversed and we are at the beginning of a new cycle where interest rates will rise for years to come. With QE2 coming to an end, inflation rising, immense pressure on the greenback to devalue and still no real plan to cut government debt, the risks are aplenty.

What He Said:

“If the U.S. housing market continues to fall apart, like I predict it will, the stock prices of major American banks that lend money to consumers to buy homes will come under pressure—these are the bank stocks I wouldn’t own.” Michael Lombardi in PROFIT CONFIDENTIAL, May 2, 2007. From May 2007 to November 2008, the Dow Jones U.S. Bank Index of the world’s largest bank stocks was down 65%.