It was only a little more than a year ago when Barack Obama’s populist rhetoric helped propel the Democrats into absolute control of the Senate and House. My, how things change.

Last week a Republican won “Kennedy’s seat” in Massachusetts.

Say goodbye to a tax on carbon. And say goodbye to an $849 billion healthcare reform bill. The Democrats opportunity to fleece the tax payer has been wasted on internal bickering.

Perhaps the funniest thing about this win is how much Scott Brown – the Republican who took the “Kennedy Seat” – used to have in common with the Democrats.

He voted in favor of requiring every citizen of Massachusetts to buy healthcare. And just last year he voted in favor of the Northeast’s Regional Greenhouse Gas Initiative, a regional cap and trade scheme.

But Scott Brown is a skilled politician, able to switch his “beliefs” when he senses where the votes are.

He won because he advocated a smaller government. That’s where the votes are.

Obama promised change, but nothing has changed. His “Big Business” fight was in vain as the people who elected him saw how he continued to bail out banks and even car manufacturers. So now voters are pissed at the government.

If Obama plans to keep the Democrats’ majority in the Senate and House, he will need to step up the campaign rhetoric. And last week, he came out swinging.

Not only has he proposed putting a “Too Big to Fail Tax” on banks that took TARP cash, but he’s asking for banks to shut down their proprietary trading desks. Proprietary trading makes up about 10 percent of Goldman Sachs’ revenue alone.

These are things that ex Fed chairman, Paul Volcker has been advocating for some time. Volcker helped destroy the inflation of the 70′s by implementing tough policies that other central bankers just couldn’t follow, like targeting the growth of the money supply to non-inflationary levels.

I’m shocked that Obama is listening to Volcker at all. Up until now, Volcker had been drowned out by Keynesians like Larry Summers. Finally, he’s spoken up and got Obama’s attention.

And Democrats in the Senate, spooked by the Republican win, are suddenly rethinking Fed Chairmen Ben Bernanke’s re-nomination.

All of this has added a lot of uncertainty into the market. The result is that the Dow Jones, S&P 500 and Nasdaq all plummeted last week.

Over the past three days, the Dow Jones has dropped nearly 5%. And even though the Slow Stochastic and RSI are becoming oversold, we could see even more selling.

Corrections usually produce drops of 10-20%. A 10 percent drop would take the Dow to 9,600. But I think this correction could get much worse.

You see, the big reason why the economy has stabilized is because manufacturers are operating more as stores restock depleted inventories.

This historically brings in a flood of cash as manufacturers spread the wealth amongst their employees and suppliers. Inventory growth could easily add two or three percent to GDP in the fourth quarter of 2009, and even the first quarter of 2010. It’s also the first step to a true economic recovery.

The next step, though, depends on the consumer.

With a U-6 unemployment rate of over 17.3% and climbing, consumers can’t afford to buy a new 3D HDTV. They can barely afford the milk.

Making matters worse is the fact that consumer credit has dropped for 10 straight months, hitting levels unseen in over 40 years.

See, banks are actually being responsible by only making loans with a good likelihood of being paid back. During a recession, that excludes the majority of America. And the economy will clearly suffer as a result, since credit affects the supply of money available in the economy.

But that’s what happens during a debt deflation. Debt levels are cut down as people default and pay off their debt. That leaves little else to buy expensive goodies like TV’s.

The second half of the year is entirely up to the consumer. And neither James nor I have any faith.

We’ll get a gauge for how bad things might get later this week. I expect to see the Dow begin trading higher by Wednesday or Thursday and attempt to break above its 50-day moving average. If it fails to get above that moving average, we could see another thrust down.

At that point we’ll have to make some adjustments to the Strategic Investment portfolio to remove some risk. One viable option includes reducing our exposure by 50% and then hedging the rest of the portfolio with a few short recommendations to prevent any further losses should the market keep dropping.

Take care,

Charles Delvalle

Co-Editor

Strategic Investment

It’s amazing how much hustle and bustle there can be in a town supported by government spending.

I’m talking about the capital of Oregon and the town I’m spending Christmas at, Salem.

Here, the government with its four state penitentiaries and state offices is the number one employer. That’s not the only way Oregon State supports its people, though. One out of six Oregonians are on food stamps. And unemployment benefits are way up.

God forbid you try and drive the streets in December, though. A three mile drive to the other side of town could take you 45 minutes.

I shouldn’t be shocked, though. After all, this is what a 7%-11% variable state tax produces: A false sense of normalness.

You see Oregon, like much of the US, is suffering a structural problem in its economy. The problem is that the state hasn’t fully switched over to new types of jobs.

Everything here is a little dated, down to the advertising. The state used to get a lot of support from timber mills. But that changed in the 80′s. From oregonlive.com…

Since the 1980s the lack of a national forest plan is a major reason Oregon has had 200 timber mills close, causing some 50,000 people to lose their jobs. Much of rural Oregon has been economically ruined. Many rural towns used to have a lumber mill. Now most are gone. Rural counties have been providing services for their citizens by using federal timber money in the county payments program that in 2012 will cease. Oregon will have to keep these counties afloat.

We have lost thousands of aluminum industry jobs because of plant closures. More than half of our pulp and paper mills have closed, costing thousands of jobs. Major steel plants have closed, costing thousands of jobs. Heavy construction has lost thousands of jobs. Machine manufacturing plants have closed, costing thousands of jobs. The high-tech industry has lost thousands of jobs. Transportation manufacturing has lost thousands of jobs. Oregon has lost thousands of food processing jobs.

The sad part is we’re still losing jobs, 120,000 since November 2007.

Oregon’s solution also mimics most of the US: create government jobs to pick up the slack from private demand. But that doesn’t work.

Politicians have dreams of power and grandeur. Years ago John Maynard Keynes gave politicians the idea that they could control the economy like a machine, through deficit spending and monetary policy. And they have been striving for it ever since.

Bush Jr tried by dropping interest rates to 1%, boosting stimulus spending during downturns, stating a war, and cutting taxes by over $1 trillion.

Today, Obama tries his hand at playing “god” by outdoing Bush Jr. In most regards, Obama is doing the same as Bush. He’s cutting some taxes, passing stimulus measures, and increasing military spending. But unlike Bush, Obama’s focus is on spending, not tax cuts.

He already passed a $787 billion stimulus package in February. He’s also promised to use some of the returned TARP cash to fund another stimulus program next year.

That’s on top of Cash for Clunkers and the hodge podge of other increased spending initiatives being passed, including the “Health” reform that purports to cut medical costs by adding a trillion dollars a year to health spending, without increasing the supply of doctors, hospitals and nurse by one iota.

I’m afraid that as long are people are worried about the economy, politicians will argue for more stimulus. And this stimulus will inevitably make its way back into the economy.

This makes it tricky to forecast the market.

If it weren’t for government intervention, the current rally would have ended long ago. It may not have even started, who knows?

But at some point, all of this cash flooding into the economy will lose its potency.

Is that point right now? It’s hard to say.

A quick look at the chart above of the Dow Jones shows my biggest concern.

You see, in previous issues James talked about how Quantitative Easing flooded the market with liquidity as the market began to move higher in March. Basically, the Fed poured cash into the hands of the primary dealers, probably with a wink and a nod understanding that they should use the “profits” from quantitative easing to buy the stock market. Our suspicion is based on the fact that the stock market bottomed at roughly the same time the Fed began buying Treasuries.

But here’s the problem. The Fed has stopped buying Treasuries and suddenly the stock market begins losing steam. By the first quarter of next year, the Fed’s QE program ceases completely.

Will the stock market drop as a result of reduced liquidity? It’s a risk that James and I think about, especially in this market.

As of now, though, the portfolio is still looking golden. No major news to announce this week, which is expected since Christmas is right around the corner.

Next week will be a light and short trading week since it’s a holiday. The Market will close on Thursday by 1 PM Eastern Time.

Be aware that light trading means we could see sharp moves up or down. But generally the market has an upward bias leading into the holiday.

Speaking of holidays, I hope you’ve got most of your shopping done. I finished last week by getting my Fiancé a digital picture frame and an iPod gift card for my nephew.

The bottom of my tree is getting packed.

Happy holidays!

Charles Delvalle.