By Michael Pento

Watch out for that much promulgated market bottom! It may just be made of quicksand. Let me be as clear as I can about the current state of the U.S. economy. I want to keep it simple so you can avoid being caught up in the hype of pundits that are telling investors we are at or near a bottom in the equity market. The economy and the market will not make a recovery until the level of home inventories drops back to about a 6 month supply and home price to income ratios fall back to around 3:1. In spite of this, many of these so-called gurus have proclaimed the market's bottom ever since the first salvo of the credit crisis was sounded in July of 2007. That's when two Bear Stearns High-Grade Structured hedge funds went insolvent. However, that advice has caused you to lose money by chasing each and every false rally.

"The economy and the market will not make a recovery until the level of home inventories drops back to about a 6 month supply and home price to income ratios fall back to around 3:1."

The aftermath of the bursting of the real estate bubble left the U.S. economy with two paths to take. One was the free market approach, which was to let home values return to historical norms by allowing them to decline by about 25% on a national level. The other was to devalue the dollar relative to home prices (along with everything else) in an attempt to prevent the assets from falling to the point of engendering bank failures and a severe recession. The Fed, Treasury, Congress, and Administration have made it clear that they have chosen the latter approach.

This leaves us with the economic condition known as stagflation which investors must recognize in order to properly allocate their investments. The two clear ramifications of the above scenario and the reaction to it by the government are that inflation rates will continue to rise while G.D.P. growth remains well below trend-if not recessionary. The current environment of inflation will not end until the Fed is able to aggressively raise interest rates to eliminate the excess monetary creation of the last decade. However, trend economic growth cannot return until home inventories are absorbed and that will take an ever increasing amount of monetary stimulation. Helicopter Ben is far from being viewed as a hard money chairman in the manner of Paul Volker. What that means is that he will do everything in his power to avoid deflation of asset values. Any pull back in commodities should be viewed as a buying opportunity instead of the end of the bull market in hard assets that most are calling for.

Some two and a half years after the housing bubble burst we are still far away from an affordable real estate market. Home price to income ratios are about 20% above historic levels and inventories of unsold homes are about 80% above what a normal balance would be. When insurance and property taxes are added to the equation home affordability has changed little since 2006. This has real consequences for the banking sector whose market value will continue to erode in value until the real estate market heals. This in turn will depress the broader market averages whose values are being held hostage by the banking sector.

Adding to the pressure on real estate is the possible demise of the two G.S.E.'s, Fannie Mae (NYSE: FNM) and Freddie Mac, (NYSE: FRE) which the government has relied on to bail out the housing market. (Refer to: "What if the Lifeguard Can't Swim?") As I explained this week on Kudlow & Co., these two agencies were designed to take problem loans away from banks and put them on to their own balance sheets. This has the effect of freeing up capital and bailing out banks from their riskiest loans. These two companies together own or guarantee about $6 trillion of the $12 trillion home loan market. The problem with the G.S.E.'s was well capsulated by former St. Louis Fed President William Poole. In an interview on July 9th, Poole stated that "Congress ought to recognize that these firms are insolvent, that is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer." Unbelievably, the government's response to their insolvency has been to expand their loan limits and reduce capital requirements.

That which was once the purview of the black helicopter crowd is now in the vernacular. Talk of the bankruptcy of Fannie and Freddie is all over the news today. Investors who are buying into the strong dollar trade should ask themselves where the money is likely to come from in the event of a need to bailout these companies. The taxpayer will be on the hook and he will most likely pay with the most pernicious tax of all, the devaluation of the dollar. Do you really think it's a good time to sell your gold?