The economy is looking good. That’s what we keep hearing. And most of America believes it. But beneath the surface issues are lurking, and they’re not too far below the surface.

Last week’s issues in the stock market are only a partial indicator of what’s lurking for the US economy. People panic selling, a few down days on the DOW, and then the FED stepping in to reassure the market.

So, where are we really at, and what does it really mean?

The stock exchange is not the economy

First off, the DOW and NASDAQ do not directly represent economy. They’re a compilation of prices of specific stocks being traded. Nothing more. And stock prices don’t necessarily indicate much beyond what investors perceive a company to be worth.

Prices in the stock market have disconnected with the real economy, and they’ve been disconnected for a long time. Why is that? Easy money.

With the lower rates available during the 90’s there was a higher amount of liquidity in the economy. That means a larger money supply, which could translate into inflation (bidding up prices to keep pace with a growing money supply). But throughout the 90’s nobody seemed to worry about inflation. It didn’t show through in consumer or producer prices. But it did show through somewhere else.

The stock market.

When more people want to buy stocks prices get bid up. When more people have access to cheap money (borrowing), they bid up the price of the stock. Does that mean that the value of the company increased? No. It just means that folks with extra cash are over bidding.

That’s only part of the stock market bubble that occurred in the 90’s, but I think you get the picture.

Extra Bubbles

After the 90’s blow off, there was still an excess of cash and credit. Money was redirected, and a good bit was redirected into the housing market. If this doesn’t sound familiar I’ll give you a simple reminder. The 87 market crash, followed by the real estate boom, followed by a real estate crash in the early 90’s.

Do we have a similar scenario today? Yes, but it’s worse. The stock bubble and real estate bubble have regrown together. And they’re both built on super low interest rates. And with last week’s market concerns over the subprime lenders what did the Fed do? Lowered rates. Gee, nothing like putting gasoline on a fire that should be allowed to burn out.

A long way to fall

At this point, there’s a long distance for our economy to fall in order to get back to something approximating equilibrium. The economy works in cycles. And the upward cycle that started in the mid-90’s has been continuing, with government entities stepping in to keep it going. The more they attempt to thwart a retreat in markets, the worse the retreat will be when it finally comes.

It seems to me the housing market will lead the way now. Over leveraged home owners will start the downward trend, and this time the Fed might not be able to fix it. A foreclosure is a foreclosure. The best part…..home prices will retreat heavily over the next few years.

Why do I say that?

Simple, the housing market has been overbid for a long time. With easy credit, ARMS, Interest Only Mortgages, etc., consumers were allowed access to homes they couldn’t normally afford. It allowed them to buy more house, or bid up smaller homes. With buyers outbidding each other on a weekly basis, sellers could take a $150,000 house they bought a year ago and sell it for $200,000 with no improvements (the flippers).

Now that these sub-prime buyers are feeling the squeeze they’ll need to get out of their over leveraged homes. And if they can’t move it quickly, what happens? They’ll drop their asking price. But, if new buyers are now gun shy about high prices and short term mortgages the sub-prime owners will soon learn about creating bargain basement prices.

It will become a vicious cycle. Even with the recent rate cut, the process has already started. And that process is sending out minor ripples to the rest of the markets in the US already. Wait until the real selling starts, foreclosures accelerate, and home builders stop building because they can’t sell their current inventory.

Oh, and wait until the “boomers” start withdrawing their investments to live on (a story for another day)………..

Insights on recent activities can be found in Bill Fleckenstein’s latest piece regarding the role central banks have played in all of this.

Also, other good reads from today are:

• http://www.nytimes.com/2007/08/20/business/20bernanke.html?_r=2&ref=business&oref=slogin&oref=slogin
• Fed’s Cut Not Justified
• Subprime Infects $300 Billion of Money Market Funds, Hikes Risk
• Plunge Protectors on the Job