A stressful weekend for the world’s bankers and politicians, followed by a sleepless Monday, and all with a single question rattling around in their heads: How can we fool them again?

For decades now the financial/public sector complex has been able to clean up its recurring messes — from Long Term Capital Management to the Asian Contagion to the tech crash to the housing bust — with credit. Just lower interest rates, shovel capital into the banks, and watch the hedge funds and CNBC eat it up. This has worked so well for so long that most of the people now running things seem to believe that it’s right, that easy money actually improves lives and greases the wheels of capitalism.

History will show, of course, that an unfettered printing press is actually economic heroin, inducing happy dreams at first but requiring ever higher doses until it finally kills its victim. Over the past three decades, the doses of debt have grown to near-fatal levels, leaving only the question of timing: when do we realize that not only have we been conned but that the con is over, and abandon, perhaps violently, the existing system?

Today could easily be that day. Interest rates are as low as they can go, debt is surreally high, and life is still getting worse. Government and the big banks seem to have fallen back on platitudes and finger pointing. Just today the president proclaimed that “The United States of America is now and always will be a triple-A credit!”

On the other hand, they’ve fooled us so many times, and so brazenly, that the possibility of one more for the road can’t be discounted. Here’s how the strategy is evolving:

Fed Expected To Try To Sooth Markets But Not Undertake New Quantitative Easing Tuesday

Federal Reserve policy-makers are likely to try for language assuaging financial markets Tuesday, but probably are not ready to embark upon a third round of quantitative easing, economists and market analysts say.

This is because fears of possible deflation are smaller than when the Fed last embarked upon quantitative easing, plus 10-year Treasury yields are already low.

The Federal Reserve has already embarked upon two rounds of quantitative easing, which is buying of long-term Treasury securities in an effort to push down market-set interest rates. “I don’t think the Fed is going to do anything dramatic, i.e., QE3,” said Greg Michalowski, chief currency analyst with FXDD.

“We’ve already had QE1 and QE2, and here we are today,” he said in reference to continued economic problems. “Participants who are looking for an actual QE3 announcement could be disappointed because the Fed has stated on a number of occasions now that it’s a really high bar in terms of implementing a QE3 program.”

Still, economists and analysts look for the Fed to acknowledge economic headwinds and craft some kind of communiqué that lets markets know the Fed is ready to help as necessary.

“There might be some type of change in the language that drives home the point they are committed to keeping interest rates very low for a significant period of time,” O’Hare said.

“One thing they might do is be a little more explicit in what they mean by extended period,” said Mike Moran, chief economist with Daiwa Capital Markets America. “For example, instead of just saying we intend to remain accommodative for an extended period, they might say we will remain accommodative until well into 2012, or something along those lines.”

Likewise, it’s possible the Fed may provide a more definite timeline on how long it will keep its balance sheet at elevated levels, said Robert Lynch, currency strategist with HSBC. “They are reinvesting interest in maturing debt, but they haven’t said how long they are going to continue to do that.”

Still another possibility, Moran said, is the Fed might opt to increase the length of the securities in its portfolio.

“They would not enlarge it by doing additional quantitative easing, but to try to lengthen its maturities, so that as securities mature, they would roll them into something longer term than what they had originally held and gradually increase the average maturity,” Moran said.

This might put some upward pressure on short-term yields, Moran said. “But long-term rates probably have more of an effect on the economy, therefore it would be a mild form of support for economic activity.”

The above is mostly speculation, of course, but it does seem reasonable that among the things we’ll be offered at Tuesday’s Fed meeting will be a promise of low interest rates pretty much forever, increased buying of long-term bonds to lower interest rates even further, and a statement of willingness to flood the banks with cash again if the bonus pool shrinks, er, if the economy keeps slowing.

None of these, of course, will make the junkie stop shaking. So the next dose — a towering QE3 — will come soon. But will it “work” again, buying the banks another year to drain the last few drops of wealth from the system? Or will the markets finally see through the monetary illusion and pour every last bit of free capital into hard assets and out of the US?

That US home prices are once again trending down is no secret. But just how bad things are likely to get is not yet well understood. Consider this from the Atlantic’s Daniel Indiviglio:

Chart of the Day: The Housing Market Is Worse Than You Think
Has the state of the housing market gotten better or worse since the first quarter of 2009? To answer this, you have to define what you mean by the state of the housing market. If you mean sales alone, then the state of the market hasn’t changed much: existing home sales are up a little from that time, while new home sales are down a bit. But assessing the inventory of defaulted, unsold homes in the market probably provides a better measure of health.

The following chart created by Laurie Goodman, a housing market expert at Amherst Securities, shows the ominous rise of shadow foreclosure inventory. It was part of a slide in a presentation she recently gave at an event last week at the American Enterprise Institute on how the Dodd-Frank financial regulation bill is stifling mortgage credit.

This chart answers the question: what’s happening to the homes of all those defaulted borrowers that we hear about? Many of those properties are a part of so-called shadow inventory. This is the sort of limbo between when a home’s loan defaults and when the property is put on the market for purchase.

The increase shown above is staggering. The shaded area shows mortgages more than 12 months delinquent or in foreclosure (darker blue) and those seized by the bank (lighter blue). The sum has risen from just below 2 million in early 2009 to 3.35 million in April 2011. That’s an increase of more than 67.5% over this period of about two years.

Also interesting: despite accumulating more defaulted properties, banks are very careful not to increase the number of loans sold very much. Loans sold has been very steady from 80,000 to 95,000 over this period. So recently prices have begun declining again even though the inventory for homes available for sale is being kept relatively low compared to the number that should actually be available to buyers.

`According to Goodman’s presentation, even though homes sold are only about 90,000 per month, inventory is growing by around 60,000 per month. So the homes sold each month would have to increase by two-thirds just to keep up with the growing inventory — not to begin to cut the 3.35 million homes in the shadows. To conjure up enough demand to meet 150,000 sales instead of just 90,000, home prices would almost certainly have to fall faster.

Wow. Housing is heading back into a depression even though banks are keeping millions of foreclosed houses off the market. Bank auditors won’t let them hold these depreciating assets indefinitely, so in the coming year the trend will reverse, as banks are forced to clear out their real estate. That’s a ton of new listings at a time when even current listings aren’t selling. So unless something radical happens (a government subsidy aimed directly at housing, for instance), the next leg down in prices should be epic.

This will cause consumers to spend less as their main investment turns out to be an even bigger loser than they currently fear. So a housing crash becomes a broader recession.

To my knowledge no one has tried to calculate what kinds of losses banks are sitting on. So let’s speculate that the average foreclosed house is worth $20,000 less than its mortgage (a conservative guess since most California houses are underwater by way more than that). 3.5 million times $20,000 blows a $70 billion hole in bank balance sheets that will have to come to light sometime soon.

Since the government’s reason for existing these days is to feed the banks, losses of this magnitude will pretty much guarantee a response. If QE3 hasn’t already happened, this will bring it on.

While we’re on the subject, consider the fact that pension funds are once again loading up on “alternative investments”, this time in the form of hedge funds:

Pensions Leap Back to Hedge Funds
Public pension plans are lifting hedge-fund investment, seeking to boost long-term returns despite losses suffered in some funds in the financial crisis.

Also, pension officials are using the historically strong returns of hedge funds to justify a rosier future outlook for their investment returns. By generating more gains from their investments, pension funds can avoid the politically unpalatable position of having to raise more money via higher taxes or bigger contributions from employees or reducing benefits for the current or future retirees.

The Fire & Police Pension Association of Colorado, which manages roughly $3.5 billion, now has 11% of its portfolio allocated to hedge funds after having no cash invested in these funds at the start of the year. “There has been some deserved criticism of hedge funds, but many hedge funds during the market downturn in 2008 did better than the S&P 500,” said Dan Slack, the chief executive of the system.

While pensions have been investing in private equity and what are called alternative investments for many years, hedge funds have represented a smaller part of their portfolio. The average hedge-fund allocation among public pensions has increased to 6.8% this year, from 6.5% for 2010 and 3.6% in 2007, according to data-tracker Preqin.

The number of public pension plans investing in hedge funds has leapt 50% since 2007 to about 300, according to Preqin. State pension systems had $63 billion invested in hedge funds as of their fiscal 2010 and are expected to invest another $20 billion in hedge funds in the next two years, according to a recent report by consultant Cliffwater.

In March, the New York City Police Pension Fund voted to invest in a firm that puts money into a variety of hedge funds, the first such move by the city’s pension funds, which manage $117 billion. In the past few months, two more New York City pensions made the same decision. Together the three funds invested $450 million with hedge-fund firm Permal Group.

It is a “first step into hedge funds,” said Larry Schloss, the New York City chief investment officer. He says he hopes the investment will help the city’s pension system avoid the “wild ride” it has taken in recent years. The system had $115 billion before market tumble in 2008, when it fell to $77 billion.

New Jersey’s State Investment Council, which sets investment policy for the state’s pension fund, voted last week to raise the target allocation for hedge funds to 10% from 6.7%, which would make hedge funds the $73 billion fund’s largest alternative investment asset.

Some thoughts:

• Once upon a time pension funds invested mostly in low risk-assets like bonds, because risk was unacceptable for money that had to be there. Pensions are legally binding promises made by governments to their workers, so non-payment isn’t an option; when a pension fund fails taxpayers are generally stuck with the bill.

• But with the US government keeping interest rates artificially low in order to ease its debt burden, the available returns on low-risk investments has fallen to a fraction of the rate that pension funds need to cover the promises made by government officials to buy union peace. So pension funds are “diversifying” into “alternative” investments like hedge funds that promise higher yields.

• This will work beautifully in the aggregate as long as the markets are generally moving up, i.e. as long as the “risk-on” trade is profitable. As soon as a slowing economy, the dissolution of the Eurozone, a Middle East crisis, or just a technical 20% correction sends capital scurrying away from high-risk strategies, hedge funds — and real estate and private equity and foreign growth stocks — will not only fail to generate the necessary 8% return; they’ll suffer losses, which will pull the entire pension fund complex into the red, moving them even further from their promised trajectory.

• Of course, the alternative is to load up on bonds and cash, which, with the dollar being depreciated at an accelerating rate, will probably be the worst possible investments going forward. So given the mess the US has made of its financial markets, maybe hedge funds are actually the lowest-risk alternative.

Sometimes the market makes it too easy. Check this out:

Desire for income drives high-yield bond ETFs’ popularity

BOSTON (MarketWatch) — Investors fed up with U.S. stocks’ negative returns over the past decade and paltry rates in today’s fixed-income markets are piling into exchange-traded funds that invest in high-yield corporate bonds.

“Where else can you get an 8% yield? The S&P 500 (MARKET:SPX) is flat over the last dozen years,” said Matt Hougan, head of ETF analytics at IndexUniverse. “I’m not surprised people are looking elsewhere on the capital spectrum.”

Still, investors need to be wary of the higher risk in “junk” bonds, which can manifest itself in big price swings relative to other categories of bonds. Structurally, Hougan noted the high-yield bond ETFs can trade at “significant premiums” to their net asset values. ETFs following less-liquid markets can see wider trading spreads.

Two high-yield ETFs with large asset bases — iShares iBoxx $ High Yield Corporate Bond Fund (CONSOLIDATED:HYG) and SPDR Barclays Capital High Yield Bond ETF (CONSOLIDATED:JNK) — both saw year-to-date inflows of more than $1.2 billion through July, according to data from the National Stock Exchange. More cash likely moved in the door this month amid a surge in bond issuance from corporate America.

The high-yield bond ETFs rallied in 2009 on easing economic and credit concerns, but are essentially treading water so far this year. The SPDR Barclays Capital High Yield Bond ETF gained 37.7% in 2009, according to investment researcher Morningstar Inc., as worries over defaults and bankruptcies eased. The fund lost 24.7% in 2008 as the credit storm raged. Both ETFs are currently yielding around 8%.

Hunting for income

With six-month certificate of deposit rates averaging less than 1% nationally according to BankRate.com, it’s no wonder many individuals are looking well beyond traditional savings accounts for income. The Federal Reserve has indicated it intends to keep short-term rates near zero to help stimulate the troubled economy and job market.

“The measly yields offered by the vast majority of fixed-income securities have forced investors to step up their hunt for current returns,” said Michael Johnston, senior analyst at ETF Database. “For many, that search has led to junk bonds.”

Although low rates have punished savers and investors approaching or in retirement who rely on income, they need to consider the risks of bond funds that are offering tempting yields, such those that invest in paper from companies that have lower credit ratings.

Investing in high-yield corporate bonds is “similar to investing in the equities of companies with highly leveraged balance sheets,” said Morningstar ETF analyst Timothy Strauts.

In his latest report on SPDR Barclays Capital High Yield Bond, he said the ETF “should be viewed as a satellite holding, and a risky one at that.” The fund takes an indexed approach with 166 holdings. The expense ratio is 0.4%, compared with 0.5% for iBoxx $ High Yield Corporate Bond Fund.

Some investors may be drawn to junk-bond ETFs because their yields are much higher than those offered by Treasury funds.

“With increased leverage comes the increased probability of default and bankruptcy,” says Morningstar’s Strauts. “In the grand scheme of things, risk equals return, and the ‘high’ yield of these bonds is designed to compensate investors for this risk.”

Recently, there are signs volatility in equity markets “has taken its toll on retail investor enthusiasm about high-yield bonds,” said Oleg Melentyev, credit strategist at Banc of America Securities LLC, in an Aug. 9 research note.

The strategist said inflows into the fund sector slowed to $50 million in the latest week, a “marked departure” from intakes of at least $500 million seen in each of the previous five weeks.

The volume of U.S. junk bonds has topped $155 billion this year and is on pace to break 2009′s record, The Wall Street Journal reported earlier this month.

Some thoughts:

• I used to be a junk bond analyst and learned from that experience that the math generally doesn’t work. Think about it. If you buy a junk bond at par and its price rises because the issuing company is doing well, they’ll call the bonds away from you. So your upside is limited to the coupon plus a modest take-out premium. But your downside risk if the company runs into trouble — as a big percentage of junk issuers do — is much higher, frequently 50% or more.  Even in good times these aren’t attractive odds.

• The default rate for junk bond issuers has been very low lately. This is always the case when money is easy, because even weak companies are able to avoid default by refinancing their loans. But when the economy turns down or interest rates rise you discover, as Warren Buffett likes to say, who’s been swimming naked. Typically the junk market has a lot of skinny-dippers.

• The whole sad story of junk bond ETFs is encapsulated in a quote early in the article: “Where else can you get an 8% yield?” It illustrates a point that tends to be missed by small investors who are induced by Wall Street to pile into risky instruments, which is that yield and return are two different things. A bond can yield 10% but return -10% if its price drops by 20%. So buying the highest yielding security is a fairly sure way to get a positive yield and a negative total return. The current generation of yield chasers will learn this lesson in 2011.

• Their tragedy is an opportunity for the rest of us, because junk-bond ETFs can be shorted like stocks. And as if they weren’t leveraged enough, these things have options! So short the ETFs, write covered puts on them to lower your cost basis, and wait for the market to show signs of cracking. Then close the covered puts and let your shorts ride. This is as close to a no-brainer as we’re going to get.

Pretend for a second that you recently retired with a decent amount of money in the bank, and all you have to do is generate a paltry 5% to live in comfort for the rest of your days. But lately that’s been easier said than done. Your money market fund yields less than 1%. Your bond funds are around 3% and your bank CDs are are down to half the rate of a couple of years ago. Stocks, meanwhile, are down over the past decade and way too volatile in any event. If you don’t find a way to generate that 5% you’ll have to start eating into capital, which screws up your plan, possibly leaving you with more life than money a decade hence.

Now pretend that you’re running a multi-billion dollar pension fund. You’ve promised the trustees a 7% return and they’ve calibrated contributions and payouts accordingly. But nothing in the investment-grade realm gets you anywhere near 7%. If you come up short, the plan’s recipients won’t get paid in a decade or – the ultimate horror – you’ll have to ask the folks paying in to contribute more, which means you’ll probably be scapegoated out of a job.

In either case, what do you do? Apparently you start buying junk bonds. According to Saturday’s Wall Street Journal, junk issuance is soaring as desperate investors snap up whatever paper promises to get them the yield they’ve come to depend on. Here’s an excerpt:

‘Junk’ Bonds Hit Record

U.S. companies issued risky “junk” bonds at a record clip this week, taking advantage of keen investor appetite for returns amid declining interest rates and tepid stock markets.

The borrowing binge comes as the Federal Reserve keeps interest rates near zero and yields on U.S. government debt are near record lows. Those low rates have spread across a variety of markets, making it cheaper for companies with low credit ratings to borrow from investors.

Corporate borrowers with less than investment-grade ratings sold $15.4 billion in junk bonds this week, a record total for a single week, according to data provider Dealogic. The month-to-date total, $21.1 billion, is especially high for August, typically a quiet month that has seen an average of just $6.5 billion in issuance over the past decade.

For the year, the volume of U.S. junk bonds has exceeded $155 billion, 80% higher than in the year-ago period and easily on pace to surpass the record $163.6 billion total for 2009.

Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds.

“Even though high-yield bond yields have come [down], versus other asset classes, they’re still comparatively attractive, especially when you consider the direction of default today,” says Darin Schmalz, a director in leveraged finance at Fitch Ratings. “When you take into account other investment options for investors, and a benign default rate, the high-yield asset class is still pretty attractive.”

In recent decades, following periods of economic slowdown, companies have tended to enjoy lower borrowing rates, which has helped credit markets recover and kept lower-rated companies afloat, says Christopher Garman, head of high-yield research firm Garman Research.

When the Fed keeps borrowing rates so low, “you see investors piling more into the high-yield market,” he says. “It becomes part of a virtuous cycle that allows lower-rated companies to refinance their liabilities.”

Companies are using most of the proceeds of the junk-bond offerings to refinance more expensive debt, or in some cases to pay special dividends to their private-equity owners. Many of the refinancings are for companies that took on massive debt over the last decade.

The refinancings, on the whole, are positive for the economy, because they help companies with too much debt avoid default or bankruptcy. But they do little to create new economic growth, and in some cases simply delay an inevitable reckoning.

Some thoughts:

• This is exactly what the government is hoping for in pushing yields down to zero. Forcing conservative investors to reach for yield saves the day in the short run by funneling extra liquidity to the sector of the economy that is most in danger of imploding. So the military industrial complex/welfare state lives to borrow and spend another day.

• One of the signs that a system headed for a crack-up is deteriorating credit quality. In other words, when low-quality entities are doing most of the borrowing, trouble will ensue. For more on this, look into the work of Hyman Minsky, an economist who seems to have understood today’s world pretty well.

• This quote deserves a closer look: “When you take into account other investment options for investors, and a benign default rate, the high-yield asset class is still pretty attractive.” The only possible response to this is that they really should make a financial history course mandatory for money managers. The fact is that in every bubble, default rates are nice and low when capital is flowing in and then spike when the money stops. Jeeze, it was just a few years ago that housing analysts were using the low default rate on mortgages and credit cards to dismiss the possibility of a housing bust.

• Obviously we’re once again solving a near-term problem by creating a much bigger one a few years down the road. What happens to retirees when their savings and pension funds are vaporized by the inevitable junk bond bust? More than likely they’ll panic and go to all cash, which will 1) crash the stock and bond markets, 2) leave them without enough income to meet their obligations, and 3) provoke another massive bailout at taxpayer expense. That is, unless the dollar tanks in the meantime, in which case it’s game over for everyone.

Remember the euro-zone crisis? Front page news for weeks, and then…nothing. Could they have found the secret formula for eliminating an overwhelming debt load without hyperinflation or depression?

Nah. They were just taking a break, and now they’re back. Greece’s economy is contracting and Spain’s regional governments are being shut out of the debt markets. And tonight the Wall Street Journal reports that Irish banks are getting a bailout:

ECB Buys Irish Government Bonds to Calm Market

The European Central Bank has bought short-dated Irish government bonds over the past 24 hours in a bid to calm rising market volatility stemming from concerns on the creditworthiness of Irish banks, two people familiar with the matter said.

The move, part of the ECB’s current program of bond purchases which it launched in May in a bid to stabilize euro-zone government bond markets, came after volatility rose sharply in short-term Irish government bonds amid low trading volumes, the people said.

The ECB declined to comment on the matter, but will announce the amount of bonds it bought this week on Monday.

The benchmark two-year Irish government bond, a 3.9% security maturing in May 2012, saw its bid price drop to a low of 100.795 on Thursday, down from 101.585 at Tuesday’s close, equating to a yield of 3.35%, up from 2.837% on Tuesday, according to TradeWeb data.

The bond’s yield, which represents the cost of borrowing for the Irish government, rose further in early trading Thursday to a high of 3.426% although it has since dropped to 3.216% in mid-morning dealings, the data show.

The market ruction was triggered partly by the Bank of Ireland’s announcement Wednesday that its underlying pretax loss nearly doubled in the first half of 2010 amid high loan impairment charges. On top of that, the European Commission has cleared the Irish government to inject another €10 billion ($12.89 billion) of capital into Anglo Irish Bank beyond the €14.3 billion already provided.

These events suggest the government will continue to have to bail out the country’s banks, pressuring public finances and denting the outlook for Irish government bonds.

Investors are particularly concerned about the ability of some Irish banks to raise new financing when their existing government-guaranteed debt issues mature in September. They are also worried about an auction on Tuesday next week of two bond issues due 2014 and 2020.

The Irish National Treasury Management Agency managed to sell €1 billion of two series of treasury bills, receiving total bids of €3.38 billion, or 3.4 times the amount on offer.

The two people, who are bank dealing sources, said the ECB started soliciting offers for short-dated Irish government bonds on Wednesday in a move designed to restore confidence in the market and a few trades were then executed by the ECB.

“Because the volumes in the market were very low, it was enough for them [the ECB], to a certain extent, to just ask dealers for prices to remind everybody that they would step in,” said one person. “However, there were some flows so the ECB has definitely bought some bonds.”

The annual cost of insuring €10 million of Irish debt rose around €12,000 on Thursday, hitting €282,000, up from around €200,000 at the start of the week. The cost of insuring a similar amount of bonds issued by Anglo Irish Bank and Allied Irish Banks PLC were both around €50,000 higher on the week at €532,000 and €425,000 respectively.

The risk premium that investors are demanding to hold Irish government bonds is “ridiculous,” said Patrick Honohan, Ireland’s central bank governor, in an interview with the Daily Telegraph newspaper, published on Thursday. They aren’t giving Ireland credit for cutting its budget deficit, he said.

The ECB has been reducing its bond purchases gradually in recent weeks. It said Monday that it bought only €9 million in the first week of August, down from €81 million the week before and €176 million the week before that.

This isn’t how it normally goes.

For the past couple of decades — that is, during the parabolic phase of the global credit bubble — the financial markets have responded to US Fed announcements of easier money like kids whose daddy has promised them a trip to Disneyland. The euphoria doesn’t always last, but the initial reaction is usually a credulous round of applause and reflexive buying of risk assets. Go back through the 2008-2009 bear market and you’ll see that even when the world seemed to be falling apart, a Bernanke speech or a discount rate cut was good for a quick pop in stock prices.

Which makes the past couple of days remarkable. The Fed promises more quantitative easing — this time via increased buying of US Treasuries — and instead of popping, the markets finish the day lower and open the following day down hard.

Could investors have finally figured out that they’re being played by the world’s monetary authorities, and that our growing mountain of debt makes a painless fix impossible? Maybe, but I’ll go out on a limb and say no. The problem with this latest stimulus program is that it isn’t seen as big enough to offset the slowdown that makes it necessary. The market is just waiting for the main course.

The scam that is fiat currency will continue as long as those currencies are in demand. While the US, Europe, and Japan can still borrow money, they’ll continue to do so, and continue to announce ever-larger stimulus programs aimed at counteracting the mass liquidation of private debt.

So there’s more coming. Much more. As the blog Pragmatic Capitalist explains, the “helicopter money” phase of hasn’t even started.

There is perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing. After all, it sounds so fancy, strange and complex. But in reality, it is quite a simple operation. JJ Lando, a bond trader at Goldman Sachs, has eloquently described QE:

“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”

Some investors prefer to call it “money printing” or “stimulative monetary policy”. Both are misleading and the latter is particularly misleading in the current market environment. First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy. The Fed simply electronically swaps an asset with the private sector. In most cases it swaps deposits with an interest bearing asset. They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe. It is merely an asset swap.

…No, no – Mr. Bernanke hasn’t failed. He just hasn’t tried hard enough….

Next year’s stimulus plan will feature a panicked federal government buying assets outright, for above-market prices, with newly created dollars. That’s when we find out just how gullible the financial markets really are.

In this week’s Credit Bubble Bulletin Prudent Bear’s Doug Noland makes a crucial point: It’s not inflation that the U.S. risks by issuing trillions of dollars of new debt, but “a crisis of confidence at the very heart of our monetary system.”

Exactly. If we keep this up the financial markets might abandon dollar-denominated assets, virtually overnight. And the only way to avoid this fate is to liquidate the debt and take the resulting pain. Here’s an excerpt:

And I find myself increasingly frustrated by the ongoing “inflation vs. deflation debate.”  With today’s low level of consumer price inflation, those arguing that deflationary forces are the paramount systemic risk now dominate policy dialogue.  Most tend to be inflationists.  Most argue for additional stimulus and see little risk in such activist policymaking.

I see risks altogether differently.  We are in the late-phase of a multi-decade historic Credit Bubble.  The greatest risk at this point is that massive issuance of non-productive governmental debt foments a crisis of confidence at the very heart of our monetary system.  The top priority must be to ensure that such a devastating outcome is avoided – and at significant unavoidable cost.  It is imperative that we as a nation come to the recognition that real financial and economic pain must be endured to protect the long-term viability of our monetary system.  The inflation rate is not the key issue.  And efforts to try to inflate our way out of structural debt problems are a lost cause.  We must instead move forcefully to rein in our deficits and avoid further debt monetization in order to protect the soundness of our money and Credit – or else risk a financial crash.

Most regrettably, Washington policymaking (fiscal and monetary) is on a trajectory that will inevitably destroy the creditworthiness of our nation’s vast liabilities. With ominous parallels to the mortgage/Wall Street finance Bubble, Federal Reserve policies have fostered Bubble dynamics throughout our Treasury, agency and debt markets, more generally.  Instead of market dynamics working to discipline Washington’s profligate debt expansion, Federal Reserve interventions ensure that a distorted marketplace again accommodates perilous Credit excess.  Our central bankers should heed Mr. Trichet’s warning.  Additional quantitative ease will only fuel the Bubble and risk calamity.

Normally, the consumer sentiment number that comes out each month seems like a piece of media fluff, far less substantial than, say, housing starts or the gold price. But today’s report is unusual enough to deserve a longer look. From MarketWatch:

Nothing happened, but the news was bad anyway

Commentary: Historic decline in sentiment comes almost without warning

WASHINGTON (MarketWatch) — It’s no secret that Americans are depressed. The economy is barely growing, job growth is anemic, raises are rare, house prices are falling, the stock market is down, and oil is spreading across the Gulf.

So, in one sense, it’s no surprise that the University of Michigan’s consumer sentiment index fell in July. See full story on the drop in consumer sentiment.

Markets Hub: Earnings euphoria fades

After an optimistic start to the week, stocks are deep in the red Friday as big name companies like Google, GE and Bank of America feed concerns about the pace of earnings growth. An undertone of discouraging U.S. economic data as well as the potential fallout from financial regulation is also weighing on stocks. Paul Vigna, George Stahl and Drew Dowell discuss.

But the magnitude of the drop — 9.5 points — was astonishing, and suggests that Americans may have hit some kind of breaking point.

The sentiment index doesn’t drop this much unless something really big shocks the economy and the national psyche. The shocking thing about this month’s decline is that nothing really shocking happened between June and July.

In the 32-year history of this survey, it’s fallen by 9.5 points or more on only six other occasions:

• October 2008: The month after Lehman Bros. collapsed;
• October 2005: The month after Hurricane Katrina hit;
• September 2001: The month terrorists attacked America;
• August 1990: The month Kuwait was invaded;
• March 1980: The month the stock market plunged and confirmed that the nation had entered a recession.Only once did the sentiment index fall so far without being accompanied by an event so big that it’s in the history books: December 1980.

In that month, much like today, Americans were anxious about the future of the economy, which had just emerged from a recession. They had elected a president who promised big changes, but the people weren’t quite sure what that meant, or whether the new policies would work. The market sold off. The economy dipped back into an extremely brutal recession soon thereafter.

History doesn’t repeat, of course. The drop in the sentiment index doesn’t mean a double-dip recession is in the cards, but it does mean consumers are fearful that everything is unraveling. They have no faith in government, or in business, or in the media, for that matter.

We could really use some good news right about now.

Some thoughts:

• The headline of the MarketWatch article is misleading. A lot is happening out there, most of it bad. Foreclosures are rising again, home sales are down (despite record low mortgage rates), empty commercial buildings are everywhere as video chains and other retailers close. And — the big one for readers of local papers — dozens of state and local governments are broke and threatening to lay off teachers, cops, and garbage collectors. The U.S. is rapidly becoming a Third World country, and people feel it even if they don’t always understand exactly how it’s happening.

• The designation of Americans as “consumers” still makes me uncomfortable. Why not compile sentiment stats for entrepreneurs or scientists or teachers or some other socially beneficial group, instead of putting shoppers at the center of the cultural/economic universe? Not that you’d get a positive reading from these other groups, but at least we’d be focusing on people who produce something of value.

So the real question isn’t why consumer sentiment is down, but why it was up in the first place.

When you run a website that contains Google ads you constantly have to watch out for penny stock hustlers promising ludicrous returns. They’re generally “pump and dump” operators who push up the price of thinly-traded stocks and then bail, leaving their hapless clients holding worthless paper. Dirtbags, in other words.

So it was with some interest that I heard of a young guy named Timothy Sykes who tracks the pumpers and shows clients how to bet against them. We did a quick Q&A last week; here’s an edited transcript:

Dollar Collapse: How did you figure out that penny stock scammers were easy targets, and how did you learn to prey on them?

Timothy Sykes: I actually made my first million buying the stocks they were pumping and only when that strategy stopped working did I get into short selling the same pattern on the way down…that’s the beauty of pump and dumps, you can either buy the pump or short sell the dump, or when you get good enough, trade the stocks both ways.

It’s far easier to buy on the way up, but after a decade of trading these shady stocks, I am really only comfortable betting on their inevitable failure as experience teaches me they all fail eventually. 

DC: Walk us through some of your biggest trades.

TS: When you make millions of dollars over the year by adding up tons of $5,000 and $10,000ish profits, there’s a lot of great trades to discuss, but I can think of two that really stand out, both are detailed in my book An American Hedge Fund.

Back in 2000, when I was a college freshman, the pumps were truly grand and I was on my way to earning $700,000 from my dorm room simply by buying microcap stocks when they broke out to new highs on strong volume. A simple technical pattern worked like a charm over and over and over and I wasn’t even very good at holding for more than 10-20% when in fact these stocks were spiking 50%+ within hours or days AFTER the technical breakouts occurred.

One such company was Illiinois Superconductor (ISCO at the time) which claimed to invent a product that would extend cell phone reception. The stock had tripled from $5 to $15 when they announced on a Friday morning press release they would be featured over the weekend on national news. The stock surged to the $17s in anticipation of great exposure and I bought 10,000 shares at $17, which was ¾ my net worth at the time, with the goal of selling into a Monday morning gap at $19, $20 or $21.

The news, using a very scientific approach, naively hyped this as the next Microsoft and I couldn’t wait to get out first thing Monday morning. I was using Scottrade back then and they didn’t have premarket trading so as the stock rose 19, 20, 21, 22, 23, I could do nothing but wait for the opening bell and when I finally got out at 9:40am (it took 10 minutes to execute since the trading volume was so overwhelming), I had sold my shares above $29 for a gain of $123,000. I celebrated by taking my entire dorm out to dinner that night. The best part was that I didn’t have to rush out as the stock nearly touched $40 the next day before gradually fading into oblivion as the product bombed.

So I was fortunate not to know about short selling then or else I would have surely been squeezed into bankruptcy before being proven right. But by 2004 I had learned how to short sell the very same pump and dump-type patterns and when the Asian tsunami hit in late 2004, I was ready to short any and all pumps and there were several.

I focused mainly on short selling a company called Taylor Devices Inc. (TAYD) as the stock had surged from $2 to $6 on rumors that Asian governments would use their earthquake absorption technology. I thought that preposterous given the company’s near-bankrupt state and shorted heavily in the $6s expecting to cover in the $4s. Unfortunately I learn the hard way that hype, like that with ISCO going to $40 before dropping back down to $15 within a week, can last longer than expected and I covered in the $7s and low $8s for a $180,000+ loss.

I know, I know, this is supposed to be great trades, but this was one of my best lessons and it got even better when I stuck to my guns and shorted again the next day in the high $8s and covered in the $6s for a gain of $250,000+ locking in total gain of $70,000, a horrible way to make that money, but a very decent haul for my small hedge fund at the time.

Now I have refined my strategy to focus more on paid-for stock promotion and I don’t go for home runs nor do I strike out so much, but it’s amazing that these patterns are still the exact same. I wish there was somebody like me teaching back when I first started as I would have enjoyed much greater success and not made so many bone headed trades!

DC: How do you short penny stocks? My broker won’t me let short anything under $5.

TS: This is the biggest obstacle to implementing my strategy and the problem is that most brokers out there absolutely stink for short selling penny stocks because they don’t want their customers partaking in such a “risky” strategy. That said, if you learn the rules I’ve learned the hard way over the years, the risk is lessened, so I use and recommend Thinkorswim, Sogotrade and Interactive Brokers. Sometimes all three brokers have shares to short, sometimes none of them do. Because I know the odds of successfully short selling a pumped up microcap or smallcap company if timed properly are around 80%, I try to reserve shares to short every day. I even came up with the term “ALFSS” which means Always Look For Shares to Short as it costs nothing but a few minutes to ask your broker if they can find shares to short each day.

DC: How do you track the pump-and-dump artists?

TS: I use several screens on StockFetcher.com and StockCharts.com and I also use great websites like StockPromoters.com and StockReads.com which spell out the compensation various promoters receive for their pumping these carcass companies, highlighting only the upside, and exaggerating as much possible, ignoring the reality that any company that is willing to pay six or even seven figures for stock promotion stinks more than cheese left out of the fridge for three weeks.

Over the years it gets easier to spot the hype and manipulation, which is why I want to get people started learning ASAP so they can become master detectives like me.

DC: Are the pumpers adapting to your strategies?

TS: No, lucky for me, penny stock CEOs and stock promoters are some of the absolute dumbest people you will never hope to meet, they are truly mental midgets. There was a CEO who had lost his medical license and in a blog post aimed at trying to discredit me, accidentally admitted to an SEC investigation just a few days before the SEC halted their stock!

I’ve seen companies that have recycled press releases from bankrupt companies while also copying that bankrupt company’s privacy policy for their website and forgetting to change the company name. SpongeTech insiders are out on $2 million bail and are alleged to have sold 2.5 billion shares thanks to the forging of legal documents signed by a fictitious lawyer and one of their “biggest customers” had the same fax number as SpongeTech executive! This niche is a comedy show and anyone with the slightest bit of intelligence has “an edge” to be able to turn the comedy into predictable profits.

The SEC has and will continue shutting down the most blatant frauds, but manipulation and pumping and dumping will always exist in some form or fashion. I will always be around to teach people to profit from it legally, by short selling these frauds and pumps and even buying them on the way up if you can be quick. Modifying a famous Jesse Livermore quote slightly “The frauds change, the players change, but Wall Street manipulation never changes.”

DC: What do you offer people who would like to try this themselves?

TS: I’ve created 10 comprehensive instructional DVD packages with over 100 hours of instructional content from the basics to advanced, the right and wrong trade setups & chart patterns, how I research and spot red flags and frauds, what data is important, etc. I also have 4 newsletters so everyone can follow along each day as I present potential trade candidates and share my real-time trade alerts.

But if I can teach people one thing, it’s to never trust anybody in finance so rather than just hearing me talk about my strategy, sign up to my free video lesson series so you can learn from the specific trades and patterns themselves.

Full disclosure: The above link is to an affiliate program that pays for referrals, so before buying a video or subscribing to a service do enough research to be sure you understand what you’re getting.