As we had suggested in recent weeks, a U.S. downgrade was going to likely be more negative for the equity market than Treasuries, and that is exactly how the week is starting off. The reason is that history shows that downgrades light a fire under policymakers and the belt-tightening budget cuts ensue, taking a big chunk out of demand growth and hence profits. It is not just the United States the problem of excessive debt is global, from China to Brazil to many parts of Europe. And lets not forget the Canadian consumer.

The U.S. consumer spending and income report for February was a bit of a mixed bag. First, personal income in the U.S. did eke out a 0.3% MoM gain in February, but it was below expected and failed to keep up with the rise in inflation, which are largely, but not exclusively, being driven by food and fuel prices (accounting for half the increase). The personal consumption expenditure (PCE) price deflator rose 0.4% MoM and as such real income - straight up, net of taxes and excluding personal transfers - fell 0.1% in the first contraction since last September.

A seven-quarter run of positive profit growth ? six were double-digits ? came to an end in the fourth quarter as pre-tax corporate profits in the U.S.A. sagged at a 10% annual rate (looking at corporate earnings before tax without inventory valuation and capital consumption adjustments). That was the first decline since the fourth quarter of 2008. The YoY growth rate is still healthy at +16% but off the boil, that is for sure.

A mini corrective phase in the equity market came and went. Investors have been groomed to buy the dip this cycle, and this is not just a mere observation. The flare-up in the Middle East, the tragic nuclear disaster in Japan, and not even a recent slate of poor U.S. economic data have put much of a dent in what is still an extremely positive sentiment readings. Bob Farrell?s Rule 9 seems to be facing a stiff headwind from the Fed?s overt policy stance on lifting valuation levels for risk assets. The bulls are fully in control and can now see new highs in sight for the major averages.

One of our favourite equity valuation metrics, the Shiller Cyclically Adjusted P/E ratio, continues to suggest that the equity market remains overvalued (the cyclically-adjusted P/E uses 10-year earnings to smooth out volatility). At 23.7x, it suggests an overvaluation of over 40% relative to historic norms (and in this case the data goes back to the late 1800s). Note that this indicator has been over 23x for three months in a row, something we haven?t seen since early 2008.

Within the space we do favour large-caps, strong balance sheets, high-quality, low P/E stocks, and commodities, especially energy. But among all the worries, we still see this as an overvalued market and we believe in buying low and selling high. We know that many pundits like to use short-term market measures of valuation using year-ahead or trailing earnings or cash flow, which at times seems a little disingenuous for an asset class that is inherently long-term in duration. Be that as it may, perhaps we can shed some light on why patience may still be virtuous here.

There are still many unknowns with regard to the global macro picture, but what we do know are the following 10 things: 1. There are more upside than downside risks to the oil price. 2. Japan was already the number-one importer of liquefied natural gas (LNG) and this status will be accentuated as replacements for a damaged nuclear grid is sought. 3. Nuclear energy development takes a near-term hit here by the politics of the Japanese crisis but not a permanent hit. 4. The aftershock in Japan will be related to contaminated food supply so we can expect to see more inflation on this score too.

Between the put-to-call ratio and the 40% share of stocks trading below their 50-day moving average, the U.S. stock market became hugely oversold. Plus we had the skew from the quadruple-witching session. And the cease-fire announced in Libya and the FX intervention to reverse the yen?s strength provided some fodder for the shorts to cover. But trend lines have been broken, portfolio managers have little cash to work, and according to a ML-BAC survey, we had a net 67% of global portfolio managers overweight equities against their position. Plus, the world is still a very uncertain place.

An object at rest will remain at rest unless acted on by an unbalanced force. An object in motion continues in motion with the same speed and in the same direction unless acted upon by an unbalanced force. This is otherwise known as Newton?s first law of motion. In market parlance, this implies that a trend remains in force until such time as an exogenous shock causes it to either stall or reverse. Economic, geopolitical, and natural disaster events aside, equity markets around the world have definitely broken their intermediate-term uptrend.

According to an RBC consumer outlook poll, one in three U.S. households is already ?significantly? cutting back on spending because of rising gasoline prices. And this was a survey taken at a time when the national average price at the pumps was around $3.20 per gallon ? wait and see what happens when it costs four bucks to fill up the tank ? that is the pain threshold for 41% of the consumer sector as per this poll.

The consensus is that the U.S. labor market is healing. That may well be the case but the slack in the job market remains huge allowing for a structural rise in the unemployment rate. Only 15% of the recession job losses have been recouped despite the fact that expansion has surpassed the downturn. The consensus is that the world economy has gotten used to high levels of oil prices so this latest run-up in crude poses little risk to the economic outlook. But it is change that matters to growth, not levels. As for the macro impact, do not understate the potential for economic contraction.

The reaction to the jobs report today is uniformly positive. I think a dose of reality is really needed here. It may as well come from this pen. Here is what I think is important: because of the winter storms, we really have to average out the past two months. While we are seeing positive job growth, it is not accelerating even though we are coming off the most intense impact of the fiscal and monetary easing that was unveiled late last year. We are disappointed with what is still a lackluster trend in net job creation, particularly in view of the peak stimulus we are currently experiencing.

?who picks up the slack if the Fed stops its bond-buying program?? The answer is hardly complicated since we have a template for this. It is a very simple guidepost. Last year, from April 23rd through to August 27th, the Fed allowed its balance sheet to shrink from $1.207 trillion to $1.057 trillion for a 12% contraction as QE1 drew to a close. Go back a year to the Federal Open Market Committee minutes and you will see a Federal Reserve consumed with forecasts of sustainable growth and exit strategy plans. A sizeable equity correction coupled with double-dip fears were nowhere to be found.

Only time will tell if yesterday?s market action was a true watershed. It was the first time since last July that the stock market was down on the first day of the month. Till yesterday, the opening days in January and February had already accounted for over half the year-to-date gains in the S&P 500. It was also the first time since the last leg of the bear market rally began six months ago that ?good? news failed to ignite equity prices. Yesterday we saw auto sales shoot up 6.7% to 13.4 million units, which was the best level since August 2009, and we also saw the ISM inch higher.

The good: The manufacturing data in the U.S. continues to improve, at least within the confines of the major diffusion indices. The bad: The U.S. income and spending numbers were hardly stellar. It remains to be seen how much of the weakness was weather-related, but consumer spending dipped 0.1% in January ? the first decline since Apr 2010. The fact is that consumers kept a lid on their spending even with the fiscal windfall in Jan, pushing the savings rate up to a four-month high of 5.8% from 5.4% in both Nov and Dec. The ugly: The housing sector remains in the dumpster.

The combination of sharply higher oil prices, the global food crisis, the accelerating geopolitical risks abroad, and the switch in the United States from fiscal stimulus to restraint ? all will serve to complicate the macro and market outlook further. Valuation may not be at an extreme, but most measures of market sentiment are. And some folks are beginning to notice that the wheels are starting to fall off the tracks.

Well, we used to say there were four key drivers: 1. Fundamentals; 2. Fund flows; 3. Technicals; 4. Valuation; Then we introduced another one last week: 5. The Fed?s balance sheet; Now that is not going to be included in any of the Graham & Dodd textbooks, that is for sure. But since Dr. Bernanke embarked on his non-traditional monetary maneuvers two years ago, there has been an 86% correlation between the S&P 500 and the movement in the Fed?s balance sheet. And now there is a sixth: 6. Corporate earnings surprises Yes, this works with a 90% historical accuracy rate.

First Tunisia. Then Egypt. And now Libya. What makes Libya different from a market?s perspective is that we are now talking about an oil exporter in the sudden grips of political upheaval. In this domino game, the next critical country we have to keep an eye on is Bahrain. The risk of further unrest is rising, especially with sectarian issues in full force in Bahrain. This means that oil prices at a minimum will retain a geopolitical risk premium. Bottom line: there is still more near-term upside potential than downside risk for the oil price (and most energy stocks).

The calendar of events that could create recurring bouts of market volatility is coming into closer view: February 25: Irish elections. Is a default coming? March 4: U.S. government shutdown; this is the date that the latest resolution expires. The hardliners in the GOP are digging in their heels over $60 billion of spending cuts. April 1: U.S. nonfarm payroll report for March. The jobless claims data suggest no improvement from poor February results. Then end of QE2 and the knowledge that movements in the Fed?s balance sheet in the last 14 months have had an 86% correlation with the S&P 500.

Well, if you haven?t yet heard, major budgetary restraint is coming our way in the second half of the year, and so we would recommend that you enjoy whatever fiscal and monetary juice there is left in the blender. There isn?t much that is for sure. The weekend newspapers were filled with reports of how the conservative wing of the Republican party have banded together to ensure that spending cuts will be in the offing. The state and local governments are already putting their restraint into gear.

The Treasury market retains a nice bid here and equities now look a bit wobbly or at least engaging in a pause. European bourses are in the red column for the most part and Asia was mixed with Japan, Hong Kong, and Korea posting gains but China and India were both clocked for a 0.9% and 1.6% loss, respectively. Even though China raised reserve requirements by a half-point again, the oil price is receiving support from concerns over the spread of social unrest in the Middle East towards Libya and Bahrain.

If there is anything to be worried about it is really that the equity market has easily climbed so many walls of worries. Is the outlook that much devoid of risks or do we have tremendous complacency on our hands? To be sure, the news is not all bad, though there are several caveats: Deere and Comcast beat their earnings estimates; The Fed lifted its real GDP forecast; The latest retail sales data were soft but there is momentum in the payroll-tax cut; etc.

At a time when bullish investor sentiment has soared to extreme levels, we can see some storm clouds coming. Yesterday?s market reaction to the +0.3% MoM print in U.S. retail sales attests to the view that a whole lot of growth is being priced in. Meanwhile, the real economic data are going to be deflated by a surging deflator ? U.S. import prices of food has risen at a 30% annual rate in the past three months and fuels by a whopping 60%. Looking for an asset class with possibly way too much risk priced in? Try muni bonds.

Inflation is priced into the market. This is not where the surprise will be and it is surprises that move markets. This is very good news for the bond market from a contrarian stand point. What isn?t being discounted is the degree of fiscal austerity that is coming down the pike, and likely sooner rather than later.

In an otherwise uneventful weekend, what did come out is that fiscal stimulus is about to turn towards restraint in a significant fashion. Even the White House recognizes the need for fiscal discipline and is on the precipice of unveiling a much more austere budget. And this will coincide with massive tax hikes and spending cuts at the lower levels of government too. The surgery is much more preferable now than becoming a banana republic down the road.The future of QE2 is looking more certain ? it will live to see June of this year but the chances of a QE3 are remote.

For 2011, not only do I still favor credit, especially the spread compression left in the high-yield space, but relative value portfolios, hybrids with a decent running yield and exposure to Canadian dollars. The resource sector is also attractive, especially oil, with a long-term view towards buying these companies on dips and not just for the commodity price uptrend. Corporate bonds, especially BB-rated product. Hedge funds, with low correlations with the direction of the market or the economy. And precious metals as a hedge against periodic bouts of currency and monetary instability.

Housing starts are at around 550k annualized units right now and household formation averages in the 1.1 to 1.2 million range. At what point do you think this dovetails and a housing recovery takes place? Great question. This is one overextended U.S. stock market, that is for sure. We have a dividend yield on the S&P 500 of 1.8% with a 10-year bond yield at 3.7%. The dividend yield, by the way, is where it was at the market peak in October 2007. The cyclically-adjusted P/E ratio on the S&P 500 is now 23.3x, where it was back in May 2008. At the lows, it was trading at 13.3x.

At the start of every year I remind myself that each individual year has its own story. For example, 2007 taught us that it never hurts to take profits after the market doubles and that if something is too good to be true (housing and credit bubble) it probably is. The 2008 lesson focused on capital preservation strategies and the urgency of managing downside risks. 2009 it was vital not to overstay a bearish stance in the face of massive fiscal and monetary stimulus. Last year?s lesson was how to handle the many post-stimulus market swings that are inherent in a post-bubble credit collapse.

Across many indicators, this goes down as a horrible recovery, especially in view of all the stimulus. Of course things look much better than they did in the ?double dip? risk days of last summer but absent the impact of the GDP deflator?s collapse and the decline in the savings rate, Q4 real GDP would have actually come in closer to +0.5% SAAR than the posted +3.2% print. We are hearing how great S&P 500 sales are doing so far for Q4 ? up 7.7% and beating estimates by the highest margin in 5 years. We scoured the data and found almost all the growth in sales is coming from outside the US.

The labor market in the US is not improving. Lost in the debate over the weather impact was the benchmark revision to 2010 ? overstated by 215k or 24%. The economy generated 909k jobs last year -insignificant considering that the population grew around 160k/month. The level of employment today is where it was in 2003. There have only been a handful of times in the past when both food and energy prices were rising so sharply in tandem. Since almost 25% of the CPI basket is in food and energy directly, it would seem logical to assume that we are going to get headline inflation in coming months.

It is next to impossible to make book on the January employment report. The data were not as weak as the disappointing headline would suggest, but there was nothing here to say that the U.S. labor market is progressing at anything close to resembling a normal post-recession recovery. The headline nonfarm payroll report came in light at +36k, well below consensus views of 146k and whispered numbers ahead of the report that were bordering +180k. Adjusting for our estimate of what the Bureau of Labor Statistics birth-death model artificially added, the headline would have been -52k!

Two weeks ago, Ben Bernanke congratulated himself on CNBC for helping to boost the Russell 2000 by 30%. More recently, the San Francisco Fed Reserve Bank published a report doing likewise, citing QE2 as a success because the inflation rate is currently a percentage point higher than it would have been absent the Fed intervention. Everyone should be made aware of the insanity of it all, and that preserving their capital and growing it slowly and prudently is a totally appropriate strategy for this radical money easing environment. This type of policy breeds speculative and dubious rallies.

I still consider this to be a bear market rally. With respect to the economy, the illusion of sustainable prosperity has done wonders for consumer spending in the U.S. The consumer has been an upside surprise and the ISM was a whopper too as these manufacturing indices have been in general around the globe. There are so many other headwinds out there. Dramatic cutbacks and tax hikes at the state and local government levels are in motion. Federal government austerity is next. The housing market has not yet stabilized.

No sooner did we run with a piece yesterday highlighting one of the critical downside macro risks to the year than the WSJ runs with Home Prices Sink Further ? its tracking of some 28 major markets shows each one of them suffering from YoY home price declines as of Q4. And, many cities are facing inventory backlogs of between 13 and 15 months? supply. It?s a mess, and will prove to be a deadweight drag on wealth, confidence, and spending.

The stock market headed into this post-Egypt action terribly overbought and a correction was overdue. It is incredibly ironic that 18 months ago, President Obama gave his first foreign policy speech at the University of Cairo (the Investor?s Business Daily dubs it the ?ill-conceived Muslim outreach speech? in today?s editorial), and now, Egypt is burning. Oil, gold and TIPS should be on anyone?s ?buy list? if the turmoil does spread within the Arab world.

The Q4 GDP data, while a tad light on the top line versus the consensus and whispered estimates of 4% did confirm that the spring and summer lull was just that, as opposed to the onset of a double-dip downturn. The 3.2% annualized real growth rate followed a 2.6% trend in Q3 and 1.7% in Q2. The configuration of the GDP report should help real GDP growth maintain its trend in the current quarter. The critical test will be the second quarter, when the incremental fiscal stimulus fades and the effects of higher food and energy prices depress the ?real? macro numbers.

Obama?s State of the Union: ?Two years after the worst recession most of us have ever known, the stock market has come roaring back. Corporate profits are up. The economy is growing again.? Herbert Hoover, 1930:?While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover.?

We will probably end up with a few years of stable to moderately deflating consumer prices once the effects of the latest commodity surge starts to fade. It appears that we are in the process of seeing another down-leg in national home prices. Equities are wildly overbought and may suffer the same fate before long, with all deference to the recent leg-up in valuations. The U.S. unemployment rate is unlikely to come down much, if at all, if real GDP growth does not accelerate beyond 3%. If it couldn?t do it in 2010, then we have no idea why it would be the case in 2011.

The unfunded liability that has to be closed at the lower levels of government is estimated to be $1 trillion and the combined deficit that has to be closed for this year is far higher than we initially thought at $135 billion. Second, there is reportedly talk in Congress of a broader bankruptcy bill that would give the states the power to adjust their pension obligations and rework union contracts. However, no bailouts are coming and the GOP is adamant about that. Staff cuts, service reductions, and tax hikes are coming in this critical 12% of the economy. Count on it.

Here's a list of ideas: An energy policy that truly removes U.S. dependence on foreign oil (shale case, coal, nuclear). A complete rewrite of the tax code that promotes savings, investment, and a revamp of the capital stock. A credible plan that reverses the runup in the debt to GDP ratio. A massive mortgage write-down by the banks. A creative strategy to put people to work instead of paying them to be idle ... and more

As they chase performance, retail investors plowed a hefty $6.54 billion into equity funds in the week of January 12. TD Ameritrade has reported that margin lending has soared 31% from year-ago levels. Uh oh. The one industry that is being hammered right now is the municipal bond fund space ? with net outflows last week of $2.37 billion, the tenth week in a row. While there is no doubt that we remain cautious on the equity market as an asset class, we like the large-cap, blue-chip, cash flow generators and reliable dividend payers.

In more than 20 months, the equity market has managed to turn in the same performance it took 60 months to achieve in the last bear market rally. Strip out the financials, and indeed, the entire equity market is now behaving as if the destruction of debt and household balance sheets either never happened or that the aftershocks are completely yesterday?s story. Governments around the world, especially in the U.S.A., have managed to convince nearly everyone that prosperity is here and will persist to perpetuity. But ? if it is too good to be true, it probably is. This is an illusion.

It is difficult to understand why it is that everyone is so whipped up about U.S. growth prospects. Even the latest set of data points has been less than exciting. Retail sales, payrolls, and consumer confidence have all been below expected and all of a sudden we see that jobless claims are moving back up. We have federal fiscal support, which at the margin is subsiding. And we have massive monetary support, and on this the Fed is going to be facing much more intense congressional scrutiny going forward. At the same time, about half of last year?s GDP growth was inventory accumulation.

This is just the fifth time in modern history that BOTH food and energy prices have risen at a double-digit annual rate for any length of time ? 1979, 1980, 1996, and 2008. At this rate, the energy bill is going to create a drag U.S. household spending power by $60 billion this year. Beneath the veneer of all the enthusiasm is the reality that real organic incomes are under pressure.

The question really today is still one of sustainability. If the Fed and our public officials were as comforted as the financial markets now seem to be over the sustainability of the recovery, then after a full year into it the central bank would not have embarked on another monetary experiment and the government would not have dipped into Social Security as a means to put more change in people?s pockets for spending purposes. Money, as an aside, that isn?t really ours.

While Bob Farrell?s rule number nine warns us to be wary of widespread consensus opinions, it may well turn out that all the bullish Wall Street analysts end up being correct that 2011 proves to be another wonderful year. But the one thing we can assure you, as was the case in 2010, is that it will not be a straight line up. In fact, we would argue that there are more headwinds, potholes, and event risks this year than there were last year.

Consider the charts below the equivalent of 10,000 words explaining why the U.S. post-bubble economic and financial backdrop is looking more and more like the Japanese experience of the past two-decades.

With inflation in China over 5%, Chinese policymakers are going to spend 2011 in restraint mode. Count on it. We are in the throes of a global currency war and late last week we saw Brazil move aggressively to rein in the real?s strength by imposing reserve requirements on domestic banks? foreign exchange positions. We have food prices surging and this is very likely going to cause social strife in the emerging market world - India, China and Indonesia come to mind. The Eurozone sovereign debt situation is looking increasingly tenuous.

While the details were obviously better than the headline, it would be a mistake to read much into the unexpected decline in the unemployment rate, which fell to 9.4% from 9.8% ? the lowest it has been since May 2009 (when the economy was still technically in recession) and the sharpest one-month decline since April 1998. While some of this ?decline? did indeed reflect the rebound in Household employment, it was largely due to the sharp decline in the labour force participation rate, which tumbled to a 27-year low of 64.3% in December from 64.5% in each of the prior two months.

Home price declines are an added significant risk to household wealth and spending. The Dallas Fed just published a report concluding that home prices have potential to decline more than 20% from here. Perhaps the banks can handle that, but the implications for the household wealth effect, consumer confidence and spending are hardly constructive.