“It aint’ over ’til it’s over, and that ain’t now.”

I have used this expression too often in the past few months, a reaction to the
oversupply of market optimists who have abandoned reason and what they learned in
third-grade math.

So, why ain’t it over? Why is the economy going to be in worse shape than expected,
why are earnings worse than expected, and why is the market worse than expected?

Reason #1: The Housing Crisis Isn’t Over

Reason #1: The Housing Crisis Isn’t Over

The epicenter of everything — the credit crisis, financial crisis, economic crisis
and crisis of confidence — is housing. Not just bad mortgages but a continuing
fall in housing prices — already down 20% with another 15%-20% to go. Yup, it is
not close to being over – home sales continue to fall, inventories are equal to
more than a year of sales, and the vast majority of new mortgages being applied
for as interest rates fall are for refinancings. Speaking of mortgages here comes
the…

Reason #2: The Next Mortgage Tsunami

Reason #2: The Next Mortgage Tsunami

Subprime mortgage defaults peaked and will slowly begin to slide during the next
two years. But don’t smile — option ARMs and ALT-A mortgages are now beginning
to rise at a very rapid rate. According to analysts I follow, notably Ivy Zelman,
the next tsunami will be larger than the one we just went through. And the banks
are not currently valuing these mortgages as if they will default at this rate.
And, because we do not know what is really on bank balance sheets…

Reason #3: Credit Markets Remain Frozen

Reason #3: Credit Markets Remain Frozen

Yes, you may hear that the corporate bond market is breathing again and the exotic
“TED spread” — the difference between T-Bill and LIBOR rates — is shrinking, but
no one is lending money to anyone and confidence is non-existent.

This week the entire country of Spain — meaning Spanish national debt — was put
on credit watch due to deteriorating economic conditions. Remember, the Great Crash
and Depression (I am not forecasting either one, by the way) started at a medium-sized
bank in Austria, not on Wall Street or in London. Credit markets are not only frozen
because we don’t know what is on the banks’ balance sheets; they are frozen because
banks are repairing their own balance sheets by hoarding capital. Are the markets
wrong? Nope, the mess is growing…

Reason #4:The Banks Are Falling Apart

Reason #4: The Banks Are Falling Apart

They are a wreck and now the pieces are beginning to fly apart with Citigroup (C)
struggling the most and beginning to dismember itself. Meredith Whitney, the uber-analyst
right about everything in banking for more than two years, said there were $2.4
trillion in asset downgrades at the end of last year by the credit agencies, this
will whack the banks’ critical Tier One capital, and even if you forget earnings
problems, they will continue to have no money to lend, strangling both business
and another big factor in the economy…

Reason #5: The Consumer Has Stopped Spending

Reason #5: The Consumer Has Stopped Spending

The consumer spending component of the economy was 70% of GDP but it’s shrinking
fast and is not coming back to former levels — maybe ever.

Unemployment and fear of unemployment are killing spending. I believe we will see
double-digit unemployment before we see 5% again. as Another drag on spending is
a lack of credit as credit cards get pulled back, home equity lines are withdrawn
and people realize that buying the next piece of breakable stuff made in China may
not be the wisest thing to do with their money right now.

At the end of last year the U.S. savings rate went up for the first time since 1952,
and saving money does not repair economic damage — right now, it aggravates that
damage. How much damage? Well, the canary in the coal mine for the economy is business
capital spending and the canary that sings first is in this sector…

Reason #6: IT Spending Is Flat And Falling

Reason #6: IT Spending Is Flat And Falling

And, I might ask, what IT spending? According to our
ChangeWave Research surveys, spending is flat or falling. There are no gee-whiz
products to buy and install, the number of employees is shrinking, meaning there
are lots of extra computers and spare server capacity lying about. The number of
licensees for a software license is shrinking and so on. Worse, IT spending is contracting
even faster overseas, and these markets account for more than 50% of the revenue
for most big U.S. tech outfits. The only outfit buying more stuff is one we’re all
funding…

Reason #7: The Government is Grasping at Air

Reason #7: The Government is Grasping at Air

Yes, Uncle Sam is going to continue buying stuff and stimulizing (a new word for
the new economy) with money it prints, including the Fed. And — getting back to
pure Yogisms — it ain’t gonna work.

The net decline in wealth — including the stock market and housing and private
equity and such — plus the withdrawal of credit is $415 trillion or more. You think
$700 billion for concrete and a fat guy holding “Go Slow” sign is going to help?

Roosevelt calmed people by wasting a fortune in and on the Works Progress Administration
— great buildings, better murals, not a lot of long-term economic impact. We are
a bit too advanced for that kind of naïve reaction. Not to mention the government
is going to need many more trillions to fix the financial system. And that’s the
rub — even Uncle Sam cannot help too much, long term, as the world kicks its addiction
to excess credit and with that goes a big drop in fundamental demand, from the U.S.
to China.

So What is An Investor to Do?

So What is An Investor to Do?

First, do no harm before trying to make money — avoid long-only mutual funds and
avoid buying the indexes. Then, think about shorting the financials, the homebuilders
and selected retailers through options or an ETF.

Three Trades to Profit From the Current Mess

Three Trades to Profit From the Current Mess Trade #1:
Short the Financials

Trade the obvious -– buy puts, preferably LEAPs, on Citigroup (it is melting as
I write this), a pure play on a busted balance sheet or Capital One Financial
(
class=”getaquote”>COF), the leader and therefore the biggest
loser in the credit card market.

Or if you can handle very high risk and volatility, buy the double-inverse ETF (it
goes up twice as fast the Dow Jones Financial Index goes down), the SKF.

Trade #2: Short the Homebuilders

Trade #2: Short the Homebuilders

Ivy Zelman of Zelman & Associates — a great housing analyst and someone who has
called the crisis correctly — sees most homebuilders as fundamentally weak and
unsound because of the upcoming tsunami in foreclosures and defaults. I’ve written
about this before and it will likely be larger than the subprime meltdown.

Among the homebuilders, the weaker the balance sheet, the better an opportunity
for short side profits, so take a look at Hovnanian (
class=”getaquote”>HOV) or KB Homes (
class=”getaquote”>KBH) .

Trade #3: Short the Retailers