After a terrible 1990s (Bulls won 9 years to 1) the Bears scored a rare trifecta in 2000-02, with the New York stock market down in each of the three years. Since then, Bear life has been less satisfactory, but on the decade so far, counting 2006 as a Bull victory, the Bears lead 4-3 on the Dow Jones Index, the Bulls lead 4-3 on the Standard and Poors 500 Index (2005 was a split verdict.) Going into 2007, it’s about as even as it can be; will the Bears win the decade?

The markets certainly aren’t forecasting so. Implied volatility in the Chicago market for stock options futures is close to a record low, implying that investors have very little fear of a sharp market reversal, but expect instead the remarkably smooth of uptrend of the last few months to continue. Treasury bond yields have also trended down in the last few months, and Federal Funds futures are forecasting that the Fed will begin to cut rates in the second quarter of 2007. U.S. economic growth appears to be slowing, and there seem to be signs that the U.S. housing market is bottoming out. Meanwhile, Wall Street price-earnings ratios are moderate. So why should anything go wrong? Why can’t we expect a continuation of the moderate Bull wins that characterized the period since 1990, except for the brief interruptions of 1994 and 2000-02?

In the short term, maybe we can. Federal Reserve Chairman Ben Bernanke unquestionably favors a bit of inflation and a quiet life. For the next few months, he may get it. Notable in the hoop-la that greeted the news that November’s consumer price inflation was 0.0% was a lack of skepticism about the figures. The Cleveland Fed Median Consumer Price Index, announced later the same day, ticked up again to 3.7% year-on-year. This indicator, which the Cleveland Fed believes to be a better measure of “true” inflation than either the official or adjusted CPI, has been rising steadily from the middle 2s over the course of 2006.

Better hidden still was a BLS press release of November 14, announcing that “quality improvements” in 2007’s automobiles and light trucks over 2006 had caused the BLS to remove $150.91 from 2007’s car prices and $392.00 from light truck prices, to take effect in October’s PPI and November’s CPI. On closer inspection, most of the “quality improvements” consisted of federally mandated safety changes, warranty improvements and changes to audio equipment. In other words the “hedonic pricing” that since 1995 has suppressed reported price inflation through correcting artificially for increases in computing power that brought little net benefit, has now been extended to removing from the index federally mandated cost increases on automobiles. Since new and used vehicles represent 7.9% of the CPI, that 1+% cost removal is roughly 0.1% on the CPI in the month, or 1.2% at an annual rate from this source alone. The unexpectedly high Producer Price Index for November announced Tuesday indicated that November’s CPI was indeed an unduly massaged figure, and that inflation remains a real and present danger.

Nevertheless, that’s not what the market believes, and if Bernanke believes it, he’s hiding the fact very well. Consequently, we can expect no interest rate increases in the next few months, possibly even cuts, while long term bonds continue to trade at yields far below their equilibrium real level. While we have cheap money, and corporate earnings far above their normal level as a share of Gross Domestic Product, the stock market will remain elevated. In such an environment, hedge funds, private equity funds, mergers and evil shall continue to flourish as a green bay tree.

Since continued low real rates of interest will mean continued high economic activity worldwide, continually escalating commodity prices, and eventually a sharp increase in inflation that even the BLS can’t hide, this state of affairs won’t last forever. Once inflation has become apparent to all, bad debts in the housing market will sap confidence, interest rates and risk premiums will rise, several large hedge funds will collapse, the dollar will fall out of bed, corporate profits will drop or a combination of all five, and the stock market will react like Wile E. Coyote several seconds after he’s trotted over the edge of the cliff.

From then on, even evil and the Goldman Sachs bonus pool will have trouble surviving. Once confidence has been lost, the imbalances that have bedeviled the U.S. and world economies since 1996 will assert themselves. The dollar will fall far enough to reduce the U.S. payments deficit to a manageable level. Interest rates will rise far enough to give investors an adequate return above inflation, with a bit to spare in case the BLS is still fudging the figures. House prices will drop far enough that they become a screaming buy, even given the higher interest rates. The U.S. consumer will panic about his retirement and start saving 20% of his salary, as he should have done all along. Corporate profits will drop drastically, as interest rates rise, the dollar drops, consumer spending collapses and the government frantically raises taxes in an attempt to bring the budget closer to balance.

Internationally, increasing risk premiums will adversely affect many emerging markets, particularly those with large debts. Currently, emerging market risk premiums on debt are at an all-time low, at only 1.72% above U.S. Treasuries of the same maturity on the Morgan Stanley International Index. That’s insane. Not only are investors being paid insufficiently for taking very substantial emerging market risks in places such as Latin America (default) or Thailand (exchange controls, political instability and government ineptitude), but they could generally get better returns on stocks in the same emerging markets, or indeed in sounder ones such as Taiwan and Singapore, where there’s little debt.

The very low risk premiums on emerging market debt are almost certainly the result of activity by highly leveraged hedge funds, borrowing for example low interest Japanese yen and investing in emerging market bonds. The existence and size of these funds is yet another reason to be thoroughly bearish on the world financial system currently; they are an accident waiting to happen. Once the market cracks, Argentina will default again – yawn – but so will a lot of other countries that had been thought sound.

The one exception to the carnage in emerging markets may be those few markets where liquidity is high and hedge fund investment low, in particular the major oil exporters such as Saudi Arabia. The Saudi market is down 60% from its February peak and now represents good value, since in a crisis the huge pool of Saudi liquidity will tend to return home, driving up the domestic market. However, to invest in Saudi Arabia you have to live there, a price those of us with a taste for fine wine or single-malt whisky may not wish to pay even in a major world recession.

It won’t be the 1930s, because we will have inflation. This will prevent asset prices from falling as low as they might, will raise the equilibrium level of stock prices closer to their current level, will allow companies to cheat consumers and shareholders and the government to cheat everybody in pricing, profit reporting and taxes respectively, thus reducing the deflationary effect of collapsing profits and fiscal balances. Nevertheless, the downturn won’t end quickly, as excesses that have taken more than a decade to build up will take at least half that to unwind.

Whenever reality strikes, and the market ceases running on mindless euphoria, we can thus expect 5 years of declining stock prices, declining house prices, rising unemployment, rising federal budget deficits, continual squeeze on corporate earnings and successive bankruptcies. How deep the drop goes, how quickly the U.S. begins to climb out of it, and what state the country will be in when it does so will depend on political decision making by the Administration, Congress and the Fed. Since George W. Bush leaves office in January 2009, well before the bottom can have been reached, and Ben Bernanke’s term of office ends in January 2010 unless he is extended (which, if things have gone wrong he won’t be) we can have no idea of how those political decisions may be made other than by staring, horrified at the collection of Presidential candidates vying for our votes in 2008.

As for Bear chances, they depend on how long the correction is delayed. If euphoria persists into 2008, or long enough into 2007 that the market has still risen on balance at year end, then the likely Bear result on the S&P 500 Index for the decade of the 2000s is 5-5, with 2008 and 2009 joining 2000, 2001 and 2002 as Bear years. Only if reality hits in early 2007, or hits very sharply in late 2007, will 2007 be a Bear year too and give the Bears a victory over the decade.

Of course, 5-5 was all the Bears managed in their best ever decade, the 1930s. It’s tough lonely work, being a Bear.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)