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