The U.S. economy clearly worsened over the past two weeks, and shows no sign of slowing its downside momentum.

Among the data points were terrible retail sales report and outlook from Best Buy (BBY), the bankruptcy of rival Circuit City (CC) and lousy same-store sales reports from JC Penney (JCP), Abercrombie & Fitch (ANF) and Pacific Sunwear (PSUN).

We also had reports of rising unemployment claims, another demand-related drop in the price of crude oil and a meeting of world leaders on the global financial crisis that failed to produce any meaningful progress.

Yet still there are bulls who believe that right now we are in the darkest hour for the economy, as tons of federal monetary and fiscal stimulus is about to kick in. The bulls think they can see around the corner, and that in the next few months the money pumped into the system will have stabilized banks to the point that they are willing lenders to businesses again. They think these loans will help businesses halt all their job-cutting and start expanding. They think this will boost investors’ mood just in time for a new fiscal stimulus package from the federal government that puts more money in consumers’ wallets that will not be saved, but rather spent. They think that new programs from the federal government to curb foreclosures will keep people in their homes, and this will stabilize prices.

Well, maybe they will be right. But the deck is stacked against this sunny scenario.

When I want to peer around the corner of the economy, I only trust one indicator: The Weekly Leading Index published by the Economic Cycle Research Institute.

I’ve been following this measure for 10 years and it does by far the best job at seeing what’s ahead for the economy. It saw the 2001 recession coming when it was not expected by the mainstream, as well as the recovery. And the WLI, which is published every week, is currently declining at its fastest rate in more than 35 years, with no indication of a turn ahead. It hasn’t even slowed down to stabilize yet.

The Weekly Leading Index is already well below the level of 1974, which was the worst recession in recent memory. Yet you would think that the current era would be so much better. Back in the mid-’70s, after all, America was experiencing an oil price shock and the Fed Funds target rate was 8.5% to 12%. Right now, oil prices are half what they were last year, and the Fed Funds rate is 1.5%.

The WLI only looks ahead six months, so it’s still possible that by May 2009 the economy will start to turn around. As soon as it turns, I will let you know. But for now, the WLI says anyone who believes that the economy is already at its its darkest hour right now is dreaming.

Financials Still Weakening Group by Group

The difference in my view vs. the consensus view primarily centers on the effects of deleveraging and the condition of banks and the banking system.

Financial stocks appeared to bottom in July as it appeared to many folks that the government would fight their problems with every means at their disposal. Banks then became overbought in late August even as commodity stocks fell.

Bank shares began to deteriorate again once investors came to believe that the system could not be stabilized by conventional means. After Lehman Brothers and AIG fell apart in September and October, the banks tried to come back on the heels of a new stimulus and federal rescue package known as TARP,  but they began to deteriorate again as it’s become clear that their losses are so big and so pernicious due to over-borrowing that they have a virtually infinite need for new capital.

Now the new phase of pain has come from the realization that auto finance is also in deep trouble and probably en route to zero; GE Capital is likely to need federal help, commercial property is still rolling over badly and likely still in the early innings.

So financials are currently cheap vs. their history, but they have also never been in worse shape in their history. If you believe their book value is still deteriorating, then their price/book values are not even as cheap as they were in 1990, which, trust me, was a much simpler time, with little by way of derivatives and greater strength in the bigger banks.

Presently financial stocks are only slightly cheap vs. their lowered growth prospects, their need to raise more capital and their prospective losses—which are orders of magnitude wore than their 1990s losses.

Furthermore, let’s face facts: There is not enough government capital to save everyone, and neither is there political will to save everyone. Expect the painful triage process to continue. During the Great Depression, most of the big banks were not as needy as the small ones. That’s not so in this cycle. So we can expect a lot more mergers and many more banks seeing their shareholder equity go to zero.

Insurers, Investment Managers and the UK

Insurance companies are cheaper than they’ve been in the past 35 years, but their problems are also worse than ever as they struggle to fulfill annuity contracts and worm out of their ownership of mortgage-backed securities and derivatives. Weaker companies like Genworth (GNW) are probably goners, but eventually the likes of MetLife (MET) and Allstate (ALL) will likely survive, while reinsurers, which really finance the industry, like Ace Ltd. (ACE) and Everest Re (RE), might actually be fine. Brokers like Brown & Brown (BRO) and AJ Gallagher (AJG) have an acute survival instinct and are likely to survive as well, since they don’t take capital risk.

Investment managers like T Rowe Price (TROW), Legg Mason (LM) and Janus Capital (JNS) face an uncertain future. Their price/earnings multiples are cheaper than in the last extreme trough in 1990, but their long-term growth prospects are growing less attractive and they face lawsuits from unsatisfied customers.
Possibly the worst financials around are in the United Kingdom, though, which I pointed out at the start of the year as well. Their earnings estimates are still very lofty compared to expectations in Europe and the United States, so banks like Barclays (BCS), which are already hammered, look like they can still suffer in the months ahead.

Narrowing down to look at individual U.S. banks here, it’s easy to see that Citigroup (C), Morgan Stanley (MS) and Goldman Sachs (GS) are in the sort of free fall right now that characterized the tailspins suffered by Lehman Brothers and Bear Stearns just before they augured into the ground. These three banks are almost certainly too big to fail, but they are also too big to rescue. The government may pump liquidity and capital into them long enough to sell more assets and make them small enough to make suitable merger partners.

We are likely moving toward a world where there will be two or three super-large banks like JP Morgan (JPM), Wells Fargo-Citigroup and US Bank-Morgan Stanley, and then maybe some new super-regionals like Zions-Fifth Third, and then some stronger, prudent mini-regionals like Bank of Hawaii-Washington Federal. 

In this scenario, a company like Goldman—which has lost its premier status as a specialist in derivatives that no one wants any longer, and in mergers that aren’t occurring, and in private equity that is melting—can lose an astonishing amount of value in a hurry, particularly if its top talent walks out the door.

Goldman could easily drop another $20-plus from its current $66 perch as fretful investors speculate on its weakened status. Keep in mind the lesson from Bear and Lehman, which is that once investors loses confidence in a bank, which has very few hard assets, it’s a slippery slope to the single digits.

No matter what happens on a big-picture scale, it is not surprising that all banks have become more fearful to lend at this stage, as they can’t afford more losses.

The same happened in the Depression despite government subsidies. Eventually I think we will all have to face a new world in which deleveraging means reduced bank lending, and both companies and individuals will have to make do with what they have for awhile. That’s a scenario in which asset values—i.e. stocks and bonds—would mostly stagnate or deteriorate, though it’s certainly possible for new groups of industries to emerge and show enough strength for us to invest in.

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This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights like this, visit www.InvestorPlace.com.