We are runing deficits in the 12-20% range currently. That is unsustainable and everyone knows that. However, the long-term picture isn’t any brighter. With medicare ballooning and baby boomers about to retire and get social security benefits, our entitlement system is about to collapse the economy. More entitlements for the elderly and a shrinking tax base does not bode well for the federal government’s fiscal health. While the government can raise taxes, it is hesitant to do so during a recession, and the amount of taxes they will raise will likely not be enough to cover the deficit.

Gambling on treasury bonds isn’t about what the government should do; it is about what the government will do. The Obama administration has made it crystal clear it will not raise taxes too much, even on higher earners (and raising taxes on them may very well not result in more revenue anyway). The Obama administration has made it clear it looks at the economy with rosy sunglasses and has exceedingly optimistic projections at every turn. It is simply putting its hands over its ears during this mess and saying “I can’t hear you!” when people talk about these long-term deficits because it believes we will have 4% growth in 2011, something we didn’t have even during the boom years, and certainly not something we will have during a more socialistic atmosphere.

Bondholders aren’t going to wait for the government to fix its mess. With the deficits rising, the government’s ability to repay, except through inflation, is questionable. Thus, the rise in interest rates.

The long bond is now over 4.5%, which is what the government targeted for 30 year mortgages. No bank is going to do a 4.5% mortgage when it can loan to the government at 5% and everyone knows that. But, the scary part is that if yields keep rising past 6% and closer to 10-12% in the Carter years, everything will slow to a miserable halt. We’ll have another depression caused by absolutely no credit being available (since it is all swallowed up by the government). Conversely, we’ll have inflation since the government will print some of the debt away. This would be a better scenario, and the one traders are viewing more likely.

In the short to middle run, I see the market going down, treasuries going down, and precious metals rising moderately. Once the Fed starts its ‘quantitative easing’ in full gear though, precious metals will go through the roof, stocks will go up moderately (or stay where they are), and inflation will be the name of the game.

However, to make money, it’s important to guess correctly how we’ll slow. If it’s deflation, with asset prices crumbling, shorting the market and buying government bonds is the way to go. This would be a repeat of what happened last fall, when the market crashed and the 30 year T-bill went below 3%.

Many don’t think it will be deflation, rather an inflationary depression. The reason for this is that that the government is hell bent on reflating the economy. It is taking on huge deficits…who will pay them? Scared investors like in the fall? That may have worked then, but how will it fund $2 trillion deficits going in the future? China/Japan have their own problems and we can’t rely on them. Thus, the T-bill should go up in yield (so shorting government bonds would be the play since you would be betting the government would have to pay a higher percentage than they would now to bond investors).

If this happens, the crowding out effect takes place. No small business can get a loan since a bank would rather loan money to the federal government at 10% than loan to a small business at 13%, and few small business can afford to pay that even. To stop this, the government may buy back its own bonds with money its printing, which would result in inflation. In this case, the bets are to short government bonds and buy commodities. Stocks in commodity companies would do well.

As you can see, they are very different playbooks. In pure deflation, you buy government bonds since you think the panic from investors will cause bond rates to go down. In inflation, you short them. In deflation, you sell commodities. Inflation, you buy them.

I’m bearish and lean towards inflation, but recognize I may very well be wrong and it could be deflation. I just don’t think the government will let a deflationary spiral take hold; it is too much in everyone’s interests for the pain to be felt through inflation than deflation.

Cramer is a very smart guy. There’s a bunch of people who knock him around the web. You have to remember he’s a TV personality and that he has to avoid saying anything that is too non-PC or give super direct advice, else his audience might over-react and not take into account their own financial situation.

He was very clear about taking 25% off the table before the October drop and even selling it all at Dow 10,000 if you needed the cash in the next five years. As of now, he remains fairly bearish long-term though he seems to think some sort of bounce is inevitable.

He recently said he thought the most bearish case scenario (which might also seem likely) has us at Dow 5300. I could see us dropping down to Dow 5500 and then having a sharp bounce back…perhaps all the way up to Dow 7500-8000 before dropping down to the 4000’s.

Even in the recession we are in, there are still bubbles around us. What if I told you that a company is making a lot of money off of a brand that is considered higher-end, the product costs almost twice as much as its rivals and its added features are not important to the vast majority of consumers, and that the company’s products are highly discretionary? You would think that company would be assigned a very low PE right now, with low earnings forecasts. Alas, Apple is defying this, even though it answers ‘yes’ to all of my questions.

Whether its the iPhone, Macs, or other Apple products, Apple is considered ‘high end.’ In particularly the case of computers (which are viewed as the engine of growth), Apple’s products are much more expensive than its peers. In the Mac’s case, there are no major advantages for owning a Mac for the common user (yes, Mac lovers hate mail me). An example is that my girlfriend would rather buy a $500 Acer than use my $2500 Powermac that I bought a couple years ago.

The main reason people started buying a lot of Macs- Apple is ‘cool.’ A good barometer for me for bubbles is what does my sister like (a spoiled older teenager) and what does my personal trainer like. Both were buying Macs near the end of last year…a little before the economy fell off the cliff. Given the economy’s in a spiral, people can’t afford to pay for ‘coolness’ much longer, especially with an extra $500 price tag.

The iPhone, while a very nice product, has problems too. The main one is that everyone already has an iPhone. Apple stock had a setback last year when it came out that iPod sales slackened since everyone and their dog already had an iPod. Same with the iPhone. There isn’t much more market left, and in the current environment, people aren’t going to be so quick to upgrade their cell phones unless they break, not just to get a new toy.

Apple is the ultimate bubble consumer discretionary, yet it trades at a fairly high multiple because of perceived growth. Past performance is does not always equate to future performance, whether its a mutual fund or a company. In the case of Apple, I call iBubble.

See ya at $40-$50 a share.

Obama decided to go even further than the statutory tax increases on people making $250k+ a year; he went after their deductions as well. The goal is to expand government at the expense of small business, not exactly a recipe for economic recovery.

My favorite is his decision to tax the worldwide profits of multi-nationals, even the ones made from their foreign subdivisions. This short-sighted grab at company’s profits will either help bankrupt some companies, and will push others to decide to just relocated outside of the US. All of this so he can give government employees a salary increase.

Increasing government and attacking business has been done before. It was tried in Cuba and the Soviet Union. Look where it got them.

That’s a drop of over 80% during a 20-year horizon, a sort-of epic downfall generally reserved for tulip speculation bubbles. The scary part though is that the current US economic situation, as well as direction of US government policy, greatly resembles that of Japan.

Japan did not have a Great Depression over the last 20 years. People aren’t eating out of miso soup kitchens and unemployment isn’t at 20%. However, they have had well over a decade of economic malaise. Years of virtually no economic growth, no mega contraction, but not growth either. The Japanse central bank has kept rates at near 0%, just like as our central bank is currently doing, but deflation is still an ongoing concern, just as it is in America.

The root of the Japanese economic mailase was a real estate bubble much like ours. In America, residential real estate prices ballooned out of control. In Japan, it was commercial real estate. The peak of Japan’s asset price bubble makes our look mild by comparison. At the peak of the bubble, it was estimated that the land beneath the Imperial Palace was worth more than the entire state of California!  Prices in Tokyo’s Ginza district were so high that it cost almost $90,000 per square foot.

Like our banks, Japanese banks provided easy credit which helped fuel this bubble and made many loans that would never be repaid. The Japanese government made efforts to stabilize the banks, but none were sweeping enough to fix the problem for quite some time. Japanese banks languished as ‘zombie’ banks, perpetually undercapitalized and had their lending ability impaired post-bubble. Sound familiar?

The Japanese government tried many stimulus plans similar to what the current Obama administration is doing. Japan embarked on rampant ‘pump priming’ spending, mainly building bridges and other construbtion projects, aimed at boosting demand. The result: a debt/GDP ratio among the highest of developed nations at 180% without a meaningful recovery. Obama’s stimulus plans mirrors the Japanese errors. We too are ramping up public debt to fuel wasteful projects. It’s estimated that our debt/GDP ratio will be at least 120% before this mess is over with.

Both Japan and America have the highest corporate taxes in the world, which stand just shy of 40% (when you factor in state corporate taxes as well). This will help stunt recovery, as some businesses move out of the country to stay competitive.

To combat its rising debt/GDP, Japan was forced to raise taxes in the mid 90’s to bring down the budget deficit. The Obama administration has stated it plans on doing the same. The Obama plan is to raise taxes on individuals making $250k+ or more a year (many of which are small business owners), as well as raising capital gains taxes. While these tax increases may be politically popular, they still have the same deleterious economic effects as well as  further pushing capital out of America.

Both America and Japan had epic asset bubbles, followed by a banking disaster, and inept government policy that wasted taxpayer money, raised taxes, and drastically inflated the country’s debt/GDP ratio. We already have seen what effect this had on Japanese equity prices over time. Long-run, there’s a good chance we may see Dow 4000 someday.

Comparing the collapse of our financial system to the collapse of the Soviety Union….doesn’t exactly inspire confidence that things can turn around.

That may be a good idea if your holding period is a couple of days, but it doesn’t work out well for long-term bets. Whether you are buying an ultra long or an ultra short, the mechanics of the leverage the ETF uses burns you long-term.

This is mainly due to the fact that the ETF doubles or triples the daily, not monthly or yearly index. Let’s see the effect of this. Suppose the S&P 500 makes the following moves over the course of 5 days (double move in paranthesis).

Day 1: +5% (+10%)

Day 2: -3% (-6%)

Day 3: +1% (+2%)

Day 4: -12% (-24%)

Day 5: +10% (+20%)

The standard S&P 500 would have moved -.4%, essentially unchanged. The math is 1.05*.97*1.01*.88*1.1.

The ultra’s math would be 1.1*.94*1.02*.76*1.2, resulting in a loss of 3.9%, well more than just double the loss of the S&P 500.

The ultra inverse’s math would be the flip of ultra long, so it would be .9*1.06*.98*1.24*.8, resulting in a loss of 7.3%. So even though the market went down a little, the ultra short managed to go down a lot! How did this happen?

It’s because of the mechanics of leverage and the fact that negative moves have more of an effect than positive moves. Think about it. If the S&P 500 goes down 50%, it then needs to double to just get back to even. The short ETF, even though it is betting against the market, still moves in the same way as the stock.

If you are bearish long-term, don’t buy SDS or BGZ and just hold. You can get burned during just a short market rally. If you’re a long-term bear, either short SSO or BGU (the ultra longs) or just short the SPY or individual stocks.