The recent few quarters of economic expansion are the result of enormous fiscal and monetary stimulus, without much 'intrinsic' private sector expansion at all. Now that inventories are replenished and the fiscal stimulus is tapering off, the underlying and still uncorrected fragility in the economy is likely to reassert itself for a time. While the Economic Cycle Research Institute has expressed increasing economic concerns, however, it has not yet warned conclusively of a double-dip.

There is a lot of apparent 'cash on the sidelines' because the government and many corporations have issued enormous quantities of new debt, often with short maturities, while other corporations have purchased it. It will remain on the sidelines until the debt is retired. The government debt has been issued to finance deficit spending. At the same time, a great deal of corporate debt has been issued over the past year apparently as a pre-emptive measure against the possibility of the capital markets freezing up again.

It is impossible to properly estimate long-term cash flows based on a single year of earnings. It is also impossible to properly value the stock market based on a single year of earnings. If you are not looking at a 'valuation' methodology accompanied by long-term, decade-by-decade evidence showing that the valuation method is actually correlated with subsequent market returns (particularly over a horizon of say, 7-10 years), then you are not looking at the sound valuation work of an investment professional.

Investors who will need to fund specific expenses within a short number of years - retirement needs, tuition, health care, home purchases etc. - should not be relying on a continued market advance. If your life plans would be significantly derailed by a major market decline, get out. In contrast, if you are pursuing a disciplined, long-term investment strategy, and you know from your own experience of the past decade that you are diversified enough to ride out periodic losses without abandoning that strategy, ignore my views (and those of everyone else) and stick to your discipline.

Investors who allow Wall Street to convince them that stocks are generationally cheap at current levels are like trout - biting down on the enticing but illusory bait of operating earnings, unaware of the hook buried inside. We should be skeptical about valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50 percent above their historical norms indefinitely. More sober and historically reliable measures of market valuation create a much more challenging picture.

The relative abundance of physical and educational capital has been a driver of U.S. prosperity for generations, and is the main reason why American workers earn more than their counterparts in the developing world. Neither advantage in capital, however, is intrinsic to American workers, and it will be impossible to prevent a long-term convergence of U.S. wages toward those of developing countries unless the U.S. efficiently allocates its resources to productive investment and educational quality.

Instead of directing savings toward investments in real, productive assets that we would observe as physical output, fixed capital, and equipment (and claims on those assets in the form of corporate stocks and bonds), our economy has been forced to choke down a massive issuance of government liabilities in order to bail out bad debt. For every dollar of debt that should have defaulted, we now have two dollars of debt outstanding: the original debt, and a newly issued government security. What appears to be 'sideline cash' is simply the evidence of past spending.

Warning: the US economy appears to be headed into a second round of decline. Looking at lessons learned across countries and centuries, Dr. John P. Hussman argues that that ?the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete.? The current argument that this outcome is ?unthinkable? is not evidence but rather reflects reliance upon incomplete data and narrow-minded perspectives.

If one thinks of the data as telling a story, the picture here would be a cliffhanger - where our hero dangles from a steep precipice, clutching a rock of uncertain strength, and the evidence is not clear about which outcome will prevail. One possible outcome is continuity, and the other is abrupt change. It's possible that things will resolve well, but we have to consider the possibility that they will not. Investors should make sure that a significant market decline would not derail their financial security or future plans, or cause them to abandon their discipline after the fact.

Wall Street seems to have no idea that every bit of growth we've observed over the past year can be traced to government deficit spending, with zero private sector expansion when those deficits are factored out. Unless the credit spreads, the S&P 500, or the yield curve reverse, a further decline in the Purchasing Managers Index to 54 or below would be sufficient to confirm a 'double-dip recession.' By itself, such a level might not be particularly troublesome. In concert with other evidence, however, it would be sufficient to complete the syndrome of risk factors.

The fundamental problem with the global economy today is that we have not accepted the word 'restructuring' into our dialogue. Instead, we have allowed our policymakers to borrow and print extraordinarily large band-aids to temporarily cover an open wound that will not heal until we close the gap. That gap is the difference between the face value of debt securities and the actual cash flows available to service them. The way to close the gap is to restructure the debt. This will require those who made the bad loans to accept the associated losses.

It's no longer reasonable to apply previous risk estimates even after we've observed a major disaster. Before the housing crisis, it might have been tempting to shrug off mortgage defaults as relatively isolated events, since the price of housing had generally experienced a long upward trend over time. Indeed, historically, sustained declines in home prices could be shown to be very low probability events. But as the bubble continued, investors made little attempt to assess the probability of a debt crisis.

In medicine, an Aunt Minnie is a particular set of symptoms that is distinctly characteristic of a specific disease, even if each of the individual symptoms might be fairly common. Last week, we observed an Aunt Minnie featuring a collapse in market internals that has historically been associated with sharply negative market implications. Historically, we can identify 19 instances in the past 50 years where the weekly data featured broadly negative internals, coupled with at least 3-to-1 negative breadth, and a leadership reversal.

Without a central taxing authority, the common European currency can only survive if participating countries strictly control their deficits. It should not be difficult to recognize that confidence in any currency is tied to confidence in the assets which stand behind it, and associated confidence in the restraint of fiscal and monetary authorities. The bureaucrats in both the U.S. and European central banks have chosen to betray that trust.

Despite the potential for a short burst of relief, the broader concern about deficits in the euro area make it unlikely that global investors will be appeased by a large bailout of Greece, or will go forward on the assumption that all is back to normal once that happens. Looking at the current state of the world economy, the underlying reality remains little changed: There is more debt outstanding than is capable of being properly serviced. Hussman also comments on overbought equity markets, and the current market climate.

Greece has insufficient economic growth, enormous deficits (nearly 14 percent of GDP), a heavy existing debt burden as a proportion of GDP (over 120 percent), accruing at high interest rates (about 8 percent), payable in a currency that it is unable to devalue. This creates a violation of what economists call the 'transversality' or 'no-Ponzi' condition. Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value.

The market is strenuously overvalued, faces a syndrome of overextended conditions that has historically proved hostile, and relies to an incredible extent on the absence of further credit strains. Accepting a greater level of market exposure will require, at minimum, that we clear the present syndrome of overvalued, overbought, overbullish, rising-yield conditions. The quickest way to a more constructive investment stance would be a meaningful improvement in valuations (which would most likely be associated initially with a deterioration in market action), and no further credit strains.

Overall, the current data presents at best a mixed picture of credit conditions. Investors should not be surprised by a significant second wave of credit strains. It seems unwise for investors to celebrate variations of a few basis points in delinquency rates, however. It seems equally unwise to celebrate 'favorable' bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately.

A year ago, the Financial Accounting Standards Board suspended rule 157, which had previously required banks to mark their assets to market value when preparing balance sheet reports. The basic argument was that fair values were not appropriate because there was 'no market' for troubled assets, which was false even at the time. This 'extend and pretend' policy has created a gap between the reported value of assets and the value they would have on the basis of reasonable cash flows over the course of their maturity.

Stock markets are overbought and overvalued, sentiment is too bullish, and yield trends are hostile. These high risk conditions tend to lead markets to successive but slight and marginal new highs. They also tend to invite nearly vertical drops of more than 10 percent over a period of weeks. The present conditions therefore recommend a defensive investment stance. The implied total return for the S&P 500 over the coming decade is just 5.7 percent annually, the lowest level observed in any period prior to the late 1990's met bubble.

Credit data suggests two distinct possibilities for the future direction of the economy. The most likely outcome is that we will see serious credit strains in the months ahead, adding to overextended market conditions, and creating a 'perfect storm' with a great deal of potential risk. Alternatively, if we do not encounter fresh credit strains in the coming months, a typical 'post-war' recovery may be on the horizon. Regardless of what lies ahead, current conditions recommend a defensive stance.

The U.S. financial system is one big Rube Goldberg machine that obligates the public to huge bailouts. Meanwhile, the Financial Accounting Standards Board continues to allow banks substantial direction in valuing their assets, which risks creating a zombie banking system by allowing a growing gap to emerge between stated asset values and the probable stream of cash flows from loans. The ability to obscure valuations appears to be a primary reason for the growing gap between delinquencies and foreclosures, as well as the reluctance of banks to modify mortgages.

The market's valuation looks overpriced based on widely tracked fundamentals. Price-to-normalized earnings, price-to-dividend multiples, price-to-book values and price-to-sales multiples all sit above long-term averages. Valuations based on forward operating earnings are also unfavorable. The long-term average P/E ratio based on forward operating earnings is about 12. The current multiple is 14.8, and this value assumes the continuation of near-record profit margins. Even a minor lowering of expected profits would cause the whole scale of the overvaluation to widen materially.

The recent credit crisis did not emerge as a surprise, but was the ordinary outcome of extraordinary recklessness. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns. Significant damage in the stock market often takes place during the "recognition phase" where the troubling reality departs from optimistic expectations. Fundamental measures suggest that markets are currently overvalued, and recommend a defensive position for assets.

If we are indeed at risk of a second wave of mortgage defaults and credit strains, it will first show up as a jump in 30-day mortgage delinquencies in data released over the next two to four months. A small initial round of resets, started in November 2009, is already in progress. A deleveraging cycle would likely establish a sequence of troughs, each at lower levels of valuation. It will still be possible, however, to trade within that range in proportion to expected stock returns. Fundamentals will take precedence over all other considerations.

The 4-week moving average for unemployment claims stands at 468,500. This suggests monthly payroll job losses of about 80,000. Census hiring should make a positive impact on short-term job growth. Debt burdens could produce credit strains if weak employment conditions continue. Hussman also comments on the current market climate for stocks and bonds.

John Hussman of Hussman Funds says the U.S. Treasury and the Federal Reserve circumvented the need for Congressional approval and engineered a tacit government bailout of Fannie Mae and Freddie Mac. More than 60 percent of the U.S. foreclosure market falls under the umbrella of these two government-sponsored enterprises. He also examines other factors affecting the current market climate.

Hussman notes that he foresaw the market decline in his comments a few weeks ago, and that it would be a mistake to attribute that decline to a single piece of news. His most significant concern is a ?significant second wave of defaults,? and he says those concerns (other than issues pertaining to Greece) have not been the focus of analysts? attention. Hussman believes the decline in the unemployment rate to 9.7% is an ?anomaly,? and expects unemployment to rise to 11-12%.

Hussman discusses the distortions in reported corporate earnings, arguing that the true measure of value is that used by Berkshire Hathaway: the growth in book value plus dividends. He concludes that, ?As is true for a variety of similar measures of normalized value, the valuation levels we observe today are comparable with the highest levels achieved in history, except for the bubble period since the mid-1990's.? He also discusses an op-ed piece by Volcker in yesterday?s NYT.

Hussman?s commentary falls into four sections: (1) an 8-step ?blueprint? for financial reform, in response to Obama?s proposed bank regulations; (2) a tongue-in-cheek plan for how to spend $1.5 trilli

It is in this context that we should consider inflation risks over the coming decade. At present, inflation risks are hardly considered to be problematic by Wall Street. From the standpoint of the nex