Investment Outlook for 2011 – Equities vs Bonds

The more things change, the more eerily familiar they seem to be. It has been months since I updated the blog; ignoring the daily drivel proves useful as the stock market rally have stayed on course. Will 2011 bring more riches for investors? I am cautiously optimistic about the investment outlook, especially equities, though it could be a rough ride with stock markets nearing a major crossroad.

Stock market indices have run up in a hurry in 2010, delivering double digit growth. Just yesterday, the S&P 500 came up to 1286 which is near my target of major resistance at 1300. It could turn down abruptly from here or overreach at 1320 by end January but one thing is certain, there is limited upside in the short term. I will not advocate any more investments at such levels but whether we should sell is another issue to look at in a while.

To be sure, there are enough fuel for the next leg of stock market rally. Companies are reporting heady profits and sitting on cash, the US economy is recovering and unemployment figure dropped to 9.4%. To further whet your risk appetite, 2011 is the 3rd year of US Presidential term, a traditionally bullish period rewarding investors with positive returns since 1939.

But there is always an element of risk when we are investing. You should never invest more than you can afford to lose. This principle will come in handy in the next few weeks. Bullish sentiment is on the rise, which is an useful contrary indicator to tell us about an imminent correction.

The US housing market is still in doldrums, banks are still under-capitalized and burdened by toxic assets. Europe debt crisis is far from being resolved while the good credit of US is at stake if the debt ceiling is not raised. Interest rates could be raised soon which could derail the weak recovery of the global economy.

Yes, there are enough dark clouds to make us grumpy. But given a choice between investing in bonds or equities, I will choose the latter. While bond issuers had a bumper year by raising capital cheaply, investors got the short end of the stick with paltry yields. It barely covers inflation and we have to contend with bond prices tumbling as much as 30% (terrible for a “risk-free” asset) if contagion effects are not dealt with.

Despite the Fed’s efforts at keeping yield low, the 10-year Treasury note has risen to around 3.35% from 2.48%. According to the WSJ, the price of 10 year notes has dropped 5.5%, and 30-year bond (more sensitive to yield changes due to longer duration) has fallen by more than 7%. That is only the beginning of a potential meltdown.

Bad Year for Bondholders

I have nothing against bonds, especially Treasuries. They are in most circumstances risk free; if you hold to maturity, you get back your principal plus coupon payments. Sweet! It used to be easy for uneducated and risk averse investors like retirees to pick AAA bonds and sleep soundly at night, but not these days.

Currently, the biggest risk of default come from sovereign debts in Europe. The full brunt of this crisis has not been felt and will not be confined to Europe alone. Major banks with huge exposure may bite the dust and set off another confidence crisis and credit crunch similar to that after Lehman Brothers collapse. Yields will rise making it tougher for profligate states to raise money. Bond prices will also tumble affecting current bondholders.

After the rescue of Greece and Ireland, investors heaved a sigh of relief but Portugal and Spain are now tottering precariously. It is a matter of time before they also test the strength and resolve of the monetary union. Spain’s debts is no trifling matter, easily eclipsing Portugal’s, and it doesn’t look like the Spaniards will react well to austerity measures as they are already staring at a daunting 20% unemployment rate.

A bright spot is that the richest euro nation, Germany, has rebounded strongly with its economy growing at 3.6% (its biggest increase in 20 years). Retail sales, business confidence and exports are also improving. However, the Germans are in no mood to celebrate with more bailouts to dish out.

In February, German courts will rule on the constitutionality of bailouts. A negative decision could unleash mayhem on sovereign debts and affect market sentiment. Even if the decision is favorable, state elections in Germany this year could increase uncertainty of bailouts as German taxpayers are mostly dissatisfied with indulging their spendthrift neighbors.

Municipal bond is another hotspot. US local governments had put off tough decisions which leaves the fiscal situation straining at the seams in 2011. California, Illinois and New York are struggling with budget deficits. There are no easy options. Balancing the budget by cutting expenses will put many government employees out of job while raising taxes will incur the wrath of taxpayers at a time when they are trying to make ends meet. Unless the federal government steps in or more investors take on credit risk, else a default and haircut for current bondholders is certain.

Bondholders are also feeling the heat from a potential hike in interest rates. That is looking increasingly likely with inflationary pressure mounting. Despite Ben Bernanke’s insistence on deflation, food prices are being ramped up across the globe especially in the second half of 2010, thanks to QE II and volatile climate which saw several food producing regions battling drought, wildfire or floods.

The UN Food and Agriculture Organization’s (FAO) index of world food prices has risen 32%. And the Economist magazine shows the commodity-price dollar index for “all items” has increased significantly by 30.6% year-over-year. Food itself is up 24.9%.

Food is a basic necessity for human survival; if prices are left unchecked, it is a recipe for social upheaval. As the poor spend more of their income on food, when prices go up 30% to 50%, it could be a matter of life and death for peasants while the rich will not blink an eye spending an extra few hundred dollars.

There are a few ways to deal with inflation, one of which is to ensure wages move in tandem. China has raised the minimum wages in Beijing by 20%, the second such rise in barely six months. Clearly, the scepter of social unrest is weighing heavily on the Chinese government.

I am all for raising minimum wages, but the middle class is likely to stagnate. Despite higher corporate profits, employers still prefer to seek cheap labor by outsourcing jobs or relocating factories instead of rewarding their employees. In any case, increasing wages is not tackling inflation at the source. End of the day, we only end up chasing prices higher which leads to more inflation.

To combat inflation, a hike in interest rates is most effective. Central banks, including the Federal Reserve, have a primary mandate to ensure price stability. Once you lose the mandate, unhappiness can spill onto the streets in the form of strikes and riots. Higher political risks is bad for countries which depend largely on foreign investments.

It is too early to judge if Ben Bernanke is right to prop the housing market and stabilize the banks with 0% short term interest rates while driving long term interest rates down through purchase of Treasuries. But his actions have caused runaway commodity prices which will certainly sap the life out of the US economy. If input prices rise indefinitely without a corresponding increase in output prices because consumers either refuse or cannot stomach the increase, something is gonna give.

I read with a tinge of regret that Paul Volcker has left the Obama’s team of economic advisors. We will need him because the Federal Reserve is not known for interfering with the market unless they have a crisis on hand, hence we can rest assured that inflation will not be acknowledged till CPI numbers take on epic proportions.

Back in 1979-1983, the US faced high inflation and stagnant economic growth. Federal Reserve chairman Paul Volcker announced that he will stop at nothing to break the back of inflation and proceeded to jack up interest rates to 15%. Naturally, the US went into a recession but growth resumed in 1983. More importantly, Volcker set the foundation for a strong US economic recovery.

Well, double digit interest rates is going to cause a lot of pain for debtors who have to make higher interest payments. Bondholders also suffer from a fall in bond prices and lose the opportunity cost of achieving higher yield.

However, I doubt such high interest rates will happen today, even if a gradual and moderate increase is inevitable. The US has a $14 trillion debt and counting. Paying off 11% could render the US insolvent as the government receives only $1.45 trillion in income last year. There is also the bloated housing market and banks’ losses from mortgage loans to consider in any massive rate hike.

Turbulence in Bond Market is Good News for Equities

The stock market rally has been impressive since coming off March 2009 lows. It is noteworthy that the crowd has not even got in on the action. Investors have been parking their idle cash in bonds, despite sovereign debts hogging the headlines. Bond mutual funds and municipal bonds received about $267-billion in net new cash flow in 2010, while stock funds lost almost $30-billion.

There is still a lot of cash sitting on the sidelines and if they pour into the stock market upon the next correction, I am optimistic about the SPX clearing 1300 and making an assault on 1500 by end of the year. Any talk of a bubble is getting ahead of ourselves unless a sustained net flow of funds into equity markets appears. More importantly, we need a mania from the crowd, usually seen in an IPO fever where investors go into a frenzy over quick and easy money from IPOs without the need to consider fundamentals (Facebook’s IPO in 2012 will be interesting).

I agree that stock valuations are not cheap currently – dividend yields are 2% and PE ratios above 20 on the S&P 500. But neither have stocks become so expensive that we should start selling. If we take an optimistic approach and consider forward earnings, valuations of most blue-chips are in fact fairly priced.

Besides undeployed funds, stock markets can get a further lift from a flight in bond markets. For the time being, investors’ nerves are calmed by Portugal’s successful bond auction. But it should be noted that China and Japan have given a big helping hand. Japan is in a bit of fiscal mess themselves and China can be capricious in dispensing favors so there is no guarantee on the outcome of future bond auctions.

Equities will be the major beneficiary of hot money flow rather than commodities which have already run up substantially. Further upside could affect consumers’ demand and threaten a weak recovery in the global economy. The risk profile of bond investors also favor defensive equities over the more volatile commodities market.

Properties are also likely to take a backseat after the slew of cooling measures announced by governments. Housing is a politically sensitive issue when young people wanting to start families are priced out of the market. China is stepping up efforts to curb speculation and ensure affordable housing for the masses. Supply is not causing sky-high prices though. A search on Youtube videos show many empty malls and condominiums in China. The number of vacant properties is not surprising when a 15-storey hotel can be built in 6 days. Apparently some investors are happy to just let their assets collect dust and wait for prices to appreciate.

The Federal Reserve is also expected to maintain a weak US dollar to boost exports and “inflate” debts away. That will benefit stock markets as a weak dollar forces people to invest rather than keep money under their mattress. The US dollar could decline to low 70s in the next leg of the stock market rally.

No matter what monetary policy Ben Bernanke adopts, the US dollar will be trashed in the short term. More Quantitative Easing will give rise to hyperinflation and devalue the dollar, while raising rates too high will see US expends all its income to pay interest costs, eventually bankrupting itself and destroy the dollar. Once the US economy gets back on a firm footing, the dollar will regain its strength but that is not expected to happen till 2014.

While I am optimistic about the stock market due to favorable fundamentals, it doesn’t mean we throw caution out of the window. I favor equities making new highs but it bears remembering that we are in a secular bear market. This rally has been powerful because we came off a low base of more than 50% retracement from 2007 highs but the cyclical bull will end at some point.

Hence, there is a second scenario that stock markets will have a deep correction of at least 25% and go into a lengthy consolidation. SPX could fluctuate around SPX 950-1000, a comfortable equilibrium over the last decade. In this case, we should not get overly bullish nor discard our stock holdings. If you bought into defensive and dividend paying stocks, you just need to wait patiently for the secular bull to arrive and deliver lucrative returns, most likely in 2015.

We will get better clarity of the situation come April. Always remember to prepare for the worst and hope for the best. But this time, the worst will not include a stock market crash below SPX 666. If it does, we are in a lot of trouble because the Federal Reserve has not much ammo left to revive the market after setting interest rates at near zero and printing crazy amount of money. However, we could test 850 before ending the secular bear decisively.

Buy some Gold As a Hedge

Gold has fallen from its peak of over $1400 to $1360 recently. There are many reasons for a correction in gold prices, US dollar rally, profit taking, easing of geopolitical tensions, recent sale of gold by IMF, etc.

You may be tempted to sell gold during this correction but preserving a 10-15% allocation in the portfolio is actually prudent. Since 2002, gold climbed from $275 an ounce to new highs of $1,400. There is no indication of a long term reversal just yet. In fact, the sparkling performance in gold will continue onwards to $1800 with weakness in the US dollar and a trigger happy Ben Bernanke when job creation stalls again.

Gold has always protect our wealth when inflation is rampant. So keep your gold and buy into the stock market on any sizeable correction. That is all for today, hope you guys have a great year ahead!

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Traditional IRA versus Roth IRAs – Which One Makes Sense?

This guest post was written by Brandon Langston of RothIRA.com. Looking to start a Roth IRA? Learn more with RothIRA.com’s free resources, calculators, and guides today!

There are several types of individual retirement accounts (IRAs) available to aid in retirement savings. Of the close to a dozen different types of IRAs, there are two that are very popular among savers. Both offer unique benefits and each can be a great tool in saving for retirement. Here we take a closer look at the traditional IRA and the Roth IRA.

Traditional IRA

The traditional IRA is an excellent savings tool that can help individuals and married couples put money aside toward their retirement. One of many IRAs that have immediate tax advantages, the traditional IRA allows for a tax deduction of contributions in the year they are made.

This can be very beneficial to individuals and married couples who are interested in reducing their taxable income for the year, while allowing for tax deferred growth on all contributions.

The drawback of immediate tax benefits however are the income taxes paid on distributions at a later period. If distributions are taken before you reach age 59 1/2 you will be charged a 10% early withdrawal penalty on top of taxation at your current income tax rate.

Eligibility requirements for the traditional IRA are fairly simple; you need only make contributions from taxable income and be under the age of 70 1/2.

Distributions from the traditional IRA have already been covered, however it is important to note that this type of retirement account, requires minimum mandatory distributions once you reach age 70 1/2. If you fail to take the minimum required distribution, expect a 50% penalty on the amount not withdrawn going directly to the IRS.

Roth IRA

Now that we know how the traditional IRA works, we can compare it with the Roth IRA. Again, like the traditional IRA, the Roth IRA is also an ideal tool to save toward retirement. That is about where the similarities end.

Contributions to a Roth IRA are not considered tax deductible and will be subject to income tax when you file your income tax return for the year in which contributions were made. While some people find this to be a disadvantage, the long-term benefits are actually very attractive.

Since contributions are made with after tax dollars, you will never again pay income tax on Roth contributions or earnings when you take a qualified distribution. This means contributions to the account can be withdrawn at any time tax-free and earnings from the account are tax-free after you reach age 59 1/2. Earnings taken before 59 1/2 or the five-year anniversary of the account being opened will be subject to 10% penalty.

Contributions must be made from taxable compensation like the traditional IRA, however there are no age restrictions preventing you from contributing to your account once you reach age 70 1/2. In addition, distributions from the account are not subject to the minimum mandatory distribution rule.

This means you can continue to add to your account for the remainder of your life and money in your account can remain there if you choose without fear of a 50% penalty from the IRS.

There are benefits to both types of IRAs which means savers must carefully consider all of the options available before making a final decision.

More on this topic (What's this?)
Why You Should Have a Roth IRA
How to Open a Roth IRA
Roth IRA vs Traditional IRA
Read more on Traditional IRA, Roth IRA at Wikinvest

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Simple Tips to Negotiate Credit Card Debt

This is a guest post by Kevin Craig who is a financial writer. He has helped lots of debt burdened people with free counseling and advices on many finance related topics.

Debt has become a severe issue in America and people are looking for ways to come out from its trap. The easiest way they find to eliminate their existing debt is by filing bankruptcy. They tend to overlook the negative impact of filing bankruptcy as it not only ruins your credit report as it hovers on it for 7 to 10 years but also your financial career. The employers avoid giving jobs to bankrupts as the filers’ reliability is questioned.

Therefore it is advisable to find other alternatives to bankruptcy for instance debt negotiation or debt consolidation. This negotiation program helps to eliminate debt by making the outstanding balance as well as the interest rate affordable for your pocket so that you can pay off.

The following tips would show you ways to negotiate with the creditors to lower your debts without the help of a professional in order to achieve a debt free life without ruining your financial career.

Effective ways to negotiate with the creditors:

1) Acquire knowledge on the pro consumer rights:

In order to negotiate with the debtors you need to have enough knowledge about the rights enforced by the government. Federal Trade Commission has introduced Fair Debt Collection Practice Act to safe guard the rights of the consumer. This Act helps to negotiate with the creditors and can put an end to the unfair collection practice of the creditors.
If you are well accustomed with the law then it would be easier to negotiate with the creditors. On being aware of the pro consumer rights and law implemented by FTC the debtors can avoid the harassing threats of the creditors. If the debt collectors violate the law then you can lodge a complaint against them at the attorney general’s office. You can get a good deal by threatening the creditor to take legal action against the creditor.

2) Record the conversation with the creditor:

Make sure that you record the conversation with the creditor so that it can act as evidence if you can plan to take any legal action against him. Inform the debt collector that you have recorded the conversation then you can negotiate with him on your terms. In this way you can avoid the abusive calls of the creditor as he would know on violating the Act he might be in severe trouble. Keep a track of the collection calls and also maintain a record of the collection letters.

3) Maintain a document:

You need to maintain a note of the following things:
A) Time and date of each collection call
B) Name of the collection agency
C) Collection agent’s name and employee registration number

If you need justice against the malpractice of the creditors then you need to maintain evidence that would act as a proof before the attorney general’s office.

Keep a written agreement of the payment plan: If you have managed to negotiate a payment plan with the creditor then ask him to give in writing that he has agreed to the repayment amount. If he gives you a detail description of the payment plan then he can’t dissuade from the terms of the amount decided by you even if he wants to.

If you are sending the creditor the detail of the payment plan then try to send a certified letter. You would add credence to the letter by sending a certified mail. As the creditor receives the letter you would get a receipt of it. Keep a copy of the letter and the receipt.

4) Threaten him of filing bankruptcy in order to negotiate:

If you inform them that you are planning to file bankruptcy then he would take initiative to negotiate on the outstanding balance as well as on the interest rate. As he would be aware that if you declare yourself as bankrupt then he won’t even get a penny that he can get after negotiation. Therefore he might agree on the terms of your negotiation.

So these are the few effect ways to negotiate your debt with your creditors. Follow the steps and achieve a financially secured future.

More on this topic (What's this?)
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Read more on Credit Cards, Debt at Wikinvest

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Buy On The Dips For Next Phase of Stock Market Rally

The past month has been kind to the stock market as investors hoped on to a nice lift after the World Cup distraction. August will present a tense period though in terms of market movement. While April’s high beckon tantalisingly, the stock market could fall flat or lose steam as there are not much good news left to propel the rally.

In the short term, bulls have an upper hand in momentum and risk appetite to breach minor resistance at 1120 while bears have to exert themselves strengneously for stock market indices to tumble under the 200-day moving average. In fact, some analysts expect SPX to clear 1180 before a correction.

So far it has been a good second quarter. Earnings have mostly surprised on the upside and it is encouraging to see businesses improve cashflow and repair their weak balance sheets. Huge cash hoards put them in a strong position to expand, reinvest and hire new staff.

On the economic front, things are looking up for Asian countries like Japan, South Korea, Taiwan, thanks to a robust recovery in exports. Singapore forecasted a GDP growth of 13-15% for 2010 and is set to be the world’s fastest growing economy.

This achievement is actually hollow if income levels do not rise in tandem with the cost of living. A steady growth of 3-6% in a Goldilocks environment (not too hot or cold) is better for workers and businesses. There is no point to celebrate a record year of 15% growth if Singapore report a technical recession for the next 2 quarters.

Such a weird combination is not unlikely given Singapore’s open economy which makes it extremely vulnerable to external factors. It was the first Asian country to slip into recession when the financial crisis created pandemonium in 2008. If G20 nations got ahead of themselves on fiscal retrenchment, a global slowdown is inevitable and will hit Singapore badly.

Export nations can heave a sigh of relief though as austerity measures are currently restricted to Europe which have to exhibit resolve in reducing fiscal deficits by half in 2013 and stabilize debts by 2016 to appease creditors. Austerity is not a word to associate with Ben Bernanke in the best of times and certainly not when he has declared US economic outlook to be “unusually uncertain.”

He is confident the Federal Reserve has not run out of bullets and stands ready to resume large scale purchases of mortgage-backed securities or U.S. Treasurys when the economy deteriorates. If there is one thing to be said about Ben Bernanke, it is his determination to defeat deflation but inflation is already creeping up with his loose monetary policy.

Tipping the scale over to stagflation or hyperinflation will cause a lot of pain to savers and conservative investors but that is hardly his concern right now. There is also a US mid-term election in November so one can’t expect much political will to reduce spending or stop Quantitative Easing.

The presence of a plunge protection team and prevalent view that Ben Bernanke will only raise interest rates in late 2011 will provide a firm support for stocks and commodities, with the only casualty being the US dollar.

Besides interest rates, fiscal spending and earnings presenting little risk of changing course, investors are feeling more upbeat from stress tests. Last month, 91 Euro zone banks were tested on their ability to weather a 35% downturn in the stock market. The result (84 banks were in the clear while 7 banks need to raise 27-billion Euros) was better than expected and critics worry if the stress test was too lenient.

Nevertheless, it managed to shed some light on captial adequacy and extent of collapse of European banks in another “severe” recession. The renewed confidence in Europe, especially the PIGS, has seen credit default swaps on Greek bonds sliding sharply.

Recently, Spanish banks which have been borrowing record amounts from the European Central Bank were able to raise funds from international capital markets. Stocks in Europe and the Euro had moved higher but this could be a temporary reprieve as danger still lurks over Europe sovereign debt and banks’ off-balance sheet liabilities.

To calm investors’ nerves, China has also embarked on a stress test of their own. Much has been said about a bubble forming in China’s property market as the inflated real estate prices is reminiscent of Japan in the 90s. When the bubble burst, Japan suffered a Lost Decade as the economy got stuck in a deflationary spiral. Till today, Japan’s banking system is still struggling with bad loans and investment opportunities are limited.

The wealth created by a bubble is illusory and it is hard to get back on your feet again, unless you reflate another bubble or suffer for years to eliminate the imbalance. China’s banking regulator has yet to confirm if they will set worst-case scenarios of 60% decline in real estate prices to assess banks’ fallout when homebuyers default.

Regardless of the parameters used, China’s baseline growth of 8% is safe and its stock market has already corrected substantially. There is much room to play catch up once the stress test result is out.

It is hard to see a black swan event which will bring the stock market back to its knees in the next few quarters. Now is actually a good time to allocate your portfolio strategically into stable dividends stocks and hold it for the long term. The weak US dollar trend will further boost stock market as investors shun the “safe haven” and plough into risky assets to protect their purchasing power.

Tactical play will enhance your yield if you are disciplined in buying on the dips and selling into strength to maintain your core asset allocation. However, it can be dangerous if you have itchy fingers and go long or short aggressively based purely on emotions.

The next 3 to 4 weeks may allow you to ride the bull higher but do not forget that the July rally has been operating on weak volume and the higher the stock market rises without significant volume, the greater the possibility of another flash crash. A correction, say by end August or September, is good in working off overbought conditions and bring stock market indices closer to equilibrium.

You can’t time the market as the best analysts also cannot tell with certainty where the market is headed until there is a clear breakout from April highs and July lows. Instead, just look at this consolidation period positively, in preparation for the next leg up. The longer the consolidation, the more forceful will be the break out which could occur early next year.

As for the bonds market, a revival of interest is also taking place which indicates investors are less fearful of drastic decline in bond prices as they believe interest rate hike will not be implemented soon. Corporates, municipals and governments are raising bonds and investors are gobbling them up. Can’t really blame them when inflationary pressure is building while money in the bank offers pathetic returns.

The huge US budget deficit, projected to surpass $1.4 trillion for a second consecutive year, should normally raise eyebrows among bond vigilantes but from the recent sale of two -year notes, 10-year bonds with record low yields (below 3%), the market is less concerned with government spending than with getting the economy back on track.

The huge inflow into bond market has also coincided with a huge outflow from mutual funds away from equities as investors worry about a major correction and prefer the relative safety of bonds. While we should maintain high quality bonds in our portfolio, it is worth noting that equities will prove to be a superior investment compared to the low coupon rates in the next few years.

Sometimes we should ignore the noise and just focus on buying on the dips and accumulating slowly. It is the best approach as we are in a secular bear market and S&P 500 will not recapture the 2007 high of 1565 anytime soon. Neither will we see another crash hot on the heels of the March 2009 lows.

Make no mistake about a V-shaped recovery, it is anything but. The US economy is in doldrums and is not expected to recover its full potential for years. Two years of stimulus programs and money printing have done nothing for unemployment figures, so economic benefits have not really trickled down to households and workers.

No wonder US consumer confidence is at its worst level in 5 months but it is also good news from a contrarian perspective as more pork barrels have to be handed out…

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Stock Market Investing From May to November Fraught With Danger

Stock markets are set for a roller coaster ride this week. While strong 1st quarter profits were reported and the US economy grew 3.2% in the first quarter, slightly short of economists’ forecast but still made for a third consecutive quarter of growth, investors were spooked by lingering doubts on the viability of Greece’s financial rescue.

Two months of wrangling on the terms of financial aid was brought to bear as Greece received a bailout of €110bn over 3 years, sponsored by the EU-IMF. The olive branch was expected after Greece’s close brush with bankruptcy last week. All hell broke loose after European Union revised upwards Greece’s 2009 deficit to 13.6% of GDP and rating agencies downgraded its credit to junk status, limiting access to fresh funds.

The first disbursement of bailout money will be made before May 19 to avert a default, but there is no guarantee financial stability will prevail in the eurozone. If Greece bite the bullet and persevere to put its finances in order, they will face a recession and deflationary pressures which will cripple their economy for years.

However, given Greece’s abysmal record in fiscal discipline, it is doubtful if the austerity measures will be implemented fully. Greece promises to cut its budget deficit to 3% of GDP by 2014, but reining in spending is a tough call, with mounting political pressure from rioting workers and pensioners. From the initial response, a deadlock may ensue and hold the economy to ransom which essentially defeats the purpose of a bailout.

It is ironic that with this bailout, bond vigilantes have shifted their scrutiny to other debt laden nations in the Euro zone. Greece is but the tip of the iceberg, they came first to the party with hat in hand and are now safe, at least for a year. A dangerous precedent has been set though. How can Europe not save Portugal or Spain after handing Greece a lifeline?

Besides the PIGS (Portugal, Spain, Italy, Greece), you can count Austria, Belgium, Hungary, Ireland, and UK in the soverign default risk category. US and Japan have worrisome debt to GDP ratios too but because the former possess a reserve currency (licensed printing press), while the latter has a springwell of domestic savings to tap on for cheap government loans, their financial woes are not expected to blowup any time soon.

And since we are talking about irony, it is worth mentioning that the sovereign debt crisis is set to boomerang back to the banks which started the financial crisis with their reckless and greedy behavior. To prevent a total collapse during the darkest hours of the mayhem, European banks transferred toxic assets from their balance sheets onto the states, which were deemed better able to absorb such risks. Countries also adopted loose monetary policies to jump start their moribund economies. Add in lower tax revenues to these Keynesian efforts, the result is astronomical budget deficits.

The fact that European banks hold a lot of Greek, Portuguese, Italy and Spanish debts is not lost on investors, especially the ‘shorts.’ If these countries default, the banks will definitely require another round of capital raising to bolster their balance sheets. But what if capital markets froze again and unlike 2008, you can’t bank on another bout of taxpayers’ rescue as fiscal budgets are already maxed out?

I hate to say this but financial Armageddon awaits Europe. As a monetary union, you have to sink or swim together. If more countries start asking for bailouts, the entire euro zone will face higher interest spread, and the euro could be non-existent if the political limitations of euro zone are not fixed.

Seeing how Europe struggles brought back memories of the Asian financial crisis in 1998. Not surprisingly, “Sell in May and go away” strikes a chord with many investors. The cliche does not always apply but it is a good rule of thumb. Historically, stock investing during the period from May-November is fraught with danger or at best rewarded with meager returns. Moreover, with a remarkable gain in the stock market (S&P having risen 75% since bottoming out in March 2009), it is time for a considerable pullback.

To be sure, a lot of positive news had been priced in amid the stock market rally. The V-shaped recovery and optimistic valuations appear realistic to many investors despite unfavorable aspects like high unemployment, rising debts, higher taxes, etc. While not exactly in a stock market mania, investors have cast aside their fear.

Thankfully, the stock market decline recently may keep our feet firmly on the ground. This is a time when investors should review their portfolios and make adjustments by offloading deadweight, shifting into defensive sectors and putting stop losses into place.

Usually, when investors shun stocks, they head for bonds market which are considered safer investments. You get a fixed income annually and if you hold it to maturity, you get back your principal. But bonds suffer from interest rate risk.

In the past, bond prices had plunged by 20-30% when interest rates double. As the US bond market is much larger than the stock market, many “risk averse” investors are going to feel poorer due to the losses from their fixed income assets.

When will Ben Bernanke raise interest rates is unclear but if futures on federal funds is any indication, the zero-rate policy is likely to be abandoned in November or December. Indeed, with the economy on the mend, Ben Bernanke has little excuse to delay raising interest rates and combat inflation. We may even see hyperinflation by 2012, thanks to energy/commodities which are in a secular bull market and the Fed’s misjudgment.

If you still favor bonds, you should go for short term Treasuries (3-6 months) because the longer the maturity date of your bonds, the higher your losses if rates surge. Right now, anything more than 2 years is a dangerous bet.

In the stock market, rising rates which translates to a higher cost of capital, will be detrimental to businesses but especially so for financial, property and construction counters. With higher instalments, investors will think twice about purchasing houses. The effect of lesser buyers coupled with desperate sellers who are on floating rate mortgages and about to reset higher will not be kind to the property sector. REITs, if they happen to have excessive debts and require refinancing, will also be tested once interest rates increase.

As for China, it is losing its lustre as a get-rich-quick destination right now. The government has clamped down hard on property speculators, restricted hot money inflows and outflows and it may yet raise banks’ reserve ratio requirement for the nation’s banks to 18%.

All these measures are calibrated to burst the bubble and yield benefits in the long term, but in the short run, nobody knows if the pendulum will swing too far and result in a second dip. Thus, parking cash in yuan, hoping there will be an appreciation, is not a sure bet if the Chinese economy cools down drastically.

Under such circumstances, gold remain the favorite asset for investors who love a safe haven. Even if gold achieved a year high of $1169, there is more upside to go. The frenzy which ensues from a Europe collapse will only add to gold’s appeal. And with the ongoing debasement of US dollar, gold has no direct competitor when it comes to preserving our purchasing power.

You can print out trillions of dollars to pick up the slack in the private sector or distort market machinations but you cannot change the primary trend which shows that stocks are in a secular bear market. Stock market can go up higher or lower but it has to come back to its equilibrium, say Dow Jones Index of 10,000, which is why some astute pundits have pointed out that this round figure is nothing to crow about and we will see more of it before the whole episode is over.

As I mentioned in my last post, this is not a year to attempt speculative activities and buying stocks aggressively is a dangerous approach. However, I do encourage buying on the dips, say after 10-15% correction. We have not seen the worst of the carnage which will probably gain momentum in June but if it is any consolation, there could be a rebound in early 2011.

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Investing Pitfalls In the Year of Metal Tiger

The Year of the Metal Tiger is upon us. Traditionally, the Lunar New Year is a festive period where the Chinese celebrate by giving angpows, buy new stuff after doing a thorough spring cleaning, clear outstanding debts and look forward to bountiful rewards. However, given that the tiger is a ferocious animal, this year is generally not good for risky ventures. To succeed in investing, we will need the traits of a tiger – courage, stealth and strength.

Currently, the stock market rally has stumbled into a roadblock. Since its January high, major stock market indices have fallen about 5-8%, prompting some investors to question if a repeat of the 2008 crisis is imminent. To be sure, a typical correction of 10-15% bodes well for the stock market as it gathers strength to make new highs. The situation gets a bit worrisome when the market plunges more than 25%.

The S&P 500 is still hovering above major support at the 200-day moving average but potential time bombs could break that resilience and marks a new bear market which last for a year or more.

Sovereign Debt Defaults

The Greeks are in a tight spot after its deficit rose to 12.7% of GDP. Greece’s economy remains in bad shape – GDP fell 0.8% in the fourth quarter, continuing a 0.5% drop in the previous quarter. Its cost of capital has increased to nearly 7% for a 10-year loan. Paying exorbitant prices for loans is the last thing Greece needs when it is still trapped in a recession.

To restore confidence, Greece has promised to slash its budget deficit to 3% within 3 years but can they deliver? Working on a smaller budget is not easy when the nation is accustomed to living beyond its means and public sector demands are high. If Greece bites the bullet, economic activities will slow down, resulting in lesser jobs and smaller tax base, from which it still has to meet obligations. Civil unrest and depression are almost a certainty.

There is little room for European leaders to maneuver on the Greece fiasco (they are damned if they do and doomed if they don’t) but a quick decision is needed as uncertainty fuels more speculation. Bailing out Greece will open the floodgates and there is no going back to a fiscally responsible policy. Portugal, Italy or Spain will be asking why they have to endure austerity while the Greeks continue with their frivolous behavior?

Besides moral hazards, it is also beyond the capacity of eurozone to resolve all the PIGs debts without bringing ruin to the euro and defiling everybody’s balance sheets. Nevertheless, there are compelling reasons to do something for Greece.

Firstly, a Greece default could cause a mark-to-market of other sovereign debts and drive up the cost of insuring government bonds, depriving healthy nations of cheap loans too. We could very well see another credit crunch if the implicit backing of eurozone behind members’ finances is gone.

Next, Europe cannot shirk its responsibility of granting Greece admission when it has never complied with fiscal discipline. The previous Greek government spent recklessly and created fictitious accounts with the help of Goldman Sachs but nobody intervened. Thirdly, the cost of a bailout is relatively small compared to the trillion dollar injection of funds into financial institutions during the sub-prime crisis.

Lastly, cutting Greece off destroys the prestige and benefits that comes with a eurozone membership. If members start dropping out, the eurozone could be left with only rich nations like Germany and France. That makes the euro (at one time, billed as a reserve currency to rival US dollar) a laughing stock.

Actually, the euro has been on precarious grounds from day one, you can’t forge a monetary union without a political union. While the European Central Bank sets the monetary policy (interest rates, money supply, etc), it cannot control fiscal deficits in each nation. Politicians answer to their own electorate and fiscal discipline does not make you popular if it means lesser spending and higher taxers.

The euro is also a double-edged sword because of its inflexibility. During boom years, the low interest rates spur economic expansion but when a member runs into trouble, it cannot devalue its currency and export its way out of trouble by making products/labor more competitive.

European leaders are now setting Greece a deadline to implement new cuts and taxes as well as investigating investment banks which created elaborate schemes to conceal Greece’s burgeoning debts. It is likely that all these are just for show, Greece will make the right noises about resolving its debts and eurozone will eventually extend loans individually to Greece. Everything will be fine but don’t be tricked into thinking sovereign debts are behind us.

Greece is at best a Bear Stearns or Northern Rock in the grand scheme of things. It accounts for only 2.7% of European GDP, about the amount of US banking assets Bear Stearns had before they collapsed. Being the first guy in the spotlight is actually a blessing in disguise for Greece. The question is who will be Lehman Brothers among the debt laden nations?

Spain looks to be a good candidate. At almost 20% unemployment and 10% fiscal deficit, Spain’s problems will easily overwhelm Germany. The Spanish banks have massive amounts of overvalued real estate on their balance sheets but the government is confident of working things out. Let’s hope they do have a solution, else…

Is United States Immune To Sovereign Debts Default?

What happens to the PIGS, we could very well be talking about the United States. Whether it is Dubai or Greece, there is a limit to which a nation can snowball or rollover its debts before bond vigilantes impose themselves. By virtue of a reserve currency and being the strongest economy in the world, the bond market has been very tolerant of United States spending habits.

But make no mistake, US debts are making Treasuries investors nervous. Can United States ever or intend to repay all its $12 trillion debts? The financial crisis has taken a heavy toil on America, considering the debts piled on in the past two years alone. With federal funds rate near zero percent and buying of $1.25 trillion dollars of mortgage backed securities, toxic assets in banks are now the government’s problems. The spread between yields on 2-year Treasury notes and 30-year Treasury bonds as well as TIPS spreads (an inflationary gauge) has increased as a result of such actions.

Timothy Geithner doesn’t believe US will lose its AAA bond rating or default. He is probably kidding himself. Historically, great nations or empires crumbled when their finances went bankrupt. Geithner’s confidence will do little to inspire investors if US do nothing to reduce its budget deficit.

The situation is not expected to improve soon though. The 2009 budget deficit of $1.4 trillion (nearly 10% of GDP) was unprecedented, and over the next decade, the Obama administration has projected $9 trillion deficits. That figure will spiral upwards if additional wars, bailouts, stimulus programs, health care reforms are required.

The longer tough choices are delayed, the more difficult the solutions. Ben Bernanke has laid out his exit strategies which will have the Federal Reserve removing the props “before long.” Once we see economic growth in the U.S., there’s no reason the Fed should not increase rates, especially when inflationary pressures are building. When interest rates go up, bond prices will tank. The 10-year Treasury note could possibly yield 5-6% when the Fed takes its foot off the pedal.

To prevent another costly bailout which the US can barely afford, tighter regulations are necessary. Two years into Quantitative Easing, the troubles in US financial system are not over yet. More US banks are expected to fail as a tidal wave of commercial properties loans turn sour in 2010. In addition, the enormous stash of derivatives financial institutions carry in their inventories are akin to nuclear bombs but bankers have not learned any lesson from the financial crisis and continue the proliferation of such toxic papers.

While financial booms and busts are inherent in a capitalist market, such cycles shouldn’t bring down the entire economy. Financial markets need rules and careful monitoring so that failures are less frequent and devastating. The aim is not to curtail innovation or free will but to prevent irresponsible and reckless behavior. Obama already has an excellent adviser in Paul Volcker and it now depends whether he possess enough gumption to push through the financial reforms.

Will China crash?

Another shock to the stock market in 2010 is the potential crash in China. Chinese exports rose 21% year on year in January but fell 16.3% month on month. The vacancy rate for commercial buildings in tier 1 cities are reaching almost 50% and the overhang is a concern. Besides real estate, a lot of oversupply exists in in the steel, cement, car and shipbuidling industries which cannot be absorbed by domestic consumption alone.

Either China ramps up its exports or it follows US consumption habits by letting its citizens swipe credit cards with abandon, else slowing down production and investment is unavoidable in 2010. That will take some steam out of the economy.

Investment guru, Marc Faber, no longer believe that China can sustain the frantic pace of economic expansion. He said: “China’s economy will slow down “meaningfully” and may even be at risk of a “crash” because of the nation’s excess capacity and as loan growth slows.”

Actually, Beijing’s measures to increase bank reserves and restrict bank loans are essential to prevent overheating. Allowing the economy to become a bubble and then bursting will threaten social stability. The Chinese authorities are acting in line with the Basel Committee’s recommendations – banks should keep assets that are easy to value and wouldn’t be sold at fire-sale prices in times of stress. Lenders should increase the amount of equity and retained earnings to better cope with losses.

I am positive on China’s growth prospects in the long term. If you look at Vietnam which is struggling with 25% inflation and have devalued the Dong several times, the Chinese are actually prudent in taking bitter financial medicine before things get worse. It will be a great folly to bet against a country with $2.4 trillion dollars in foreign reserves. And let’s not forget that China still has much competitive labor and land to tap on as industries just relocate from the richer Eastern to Western or inner cities region for the next phase of growth.

Invest With Prudence

Commodities (like gold, silver, and grain) are expected to do well in the Year of Metal Tiger. The recent weakness in gold represents a good opportunity to accumulate. It is prudent to hold some gold in your portfolio while waiting for full effects of sovereign debts to play out. You never know if more fictitious statistics are uncovered, more money printing is needed or if wars will break out. War is always a convenient solution to divert people’s attention from economic woes and avoid uprisings.

However, gold will not chart a smooth path upwards. You can expect volatility, like gold falling back to $800, before it breaks new highs. Nevertheless, the fundamentals for gold remain intact and you should purchase gold (between 10-15% of your assets) for retirement purposes, instead of using it as a trading instrument.

If you are interested in bonds, it is not exactly a safe haven. If interest rates are raised later in the year coupled with sovereign debts failing in unison, bond prices could plunge drastically. Any positive momentum that comes from a Greece bailout will be short-lived. You will do well to sit on cash or fixed deposits than get into the bond market right now.

As for the stock market, I will say the Dow Jones range of 9500-10500 is not attractive for us to pick up any more stocks. If you are already vested, you can just sit tight as the stock market has a high probability (it is not guaranteed, investment decisions are usually made on probabilities) of making a 30% advance from 10000 DJI level. From there, it is up to you whether you want to sell or hold for the long term.

Conversely if there is any break below 9500, there are some bargains to look at. It is a good idea to invest progressively, about one-third of your spare cash on blue chips. Any more market dips will present opportunities to accumulate at lower prices.

Staying diversified and on the right side of the market is important to make profits for this year. Most importantly, don’t be greedy.

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Don’t Be Suckered By Stock Market Rally In 2010

Global stock markets are poised to end on a high for the year after mounting an explosive recovery since March lows. The stock market rally, nearly ten months in duration, has surprised many naysayers with its longevity and magnitude. Nevertheless, after such a run-up, some consolidation is in order.

Rampant bullishness in the stock market disappeared over the past weeks and is likely to remain so till the end of the year. Stocks in various sectors (ranging from financial, property, construction, oil and energy) remain range-bound and though major indices are creeping up, they are being led by fewer counters and on low volume.

Bulls vs bears battle may be evenly split right now but according to most analysts, the stock market rally going into the new year is alive and kicking. Their forecasts of 1250-1300 are realistic enough with the 50-day moving average of 1,085 holding firm and could provide a launch pad for breakout in the coming weeks.

However, whether the S&P 500 can hold its ground till the end of 2010 is another question altogether. If you have gone through the internet and housing bust, you will know that analysts reports must be read with a healthy dose of skepticism. And when most of them agree, alarm bells should start ringing.

As a buy-and-hold investor, there are much to worry about, but you should enjoy the rosy picture of improving economic conditions being painted in the short term. Confidence in a robust economic growth has underpinned the optimism in stock markets.

US economic indicators are mixed but certainly more encouraging than in March. Expansion in the manufacturing sector is slowing down but the Federal Reserve’s industrial production report showed a month-over-month increase.

Jobless claims fell by 28,000 last week to 452,000 – the lowest level since Sept 2008 before the implosion of Lehman Brothers sent financial markets into a tailspin. Barack Obama is still not happy with the unemployment rate though and has urged banks to lend more aggressively to small businesses.

I am not sure if that is a good call because 133 banks have failed so far by acting against their better judgment during the boom years. It is actually refreshing to see banks exercising prudence and shoring up their balance sheets. But even if all the redtapes are removed, many businesses are still wary about expanding production and increasing payrolls when consumption is still anemic.

If businesses or consumers are not taking advantage of cheap loans, you can rest assure that speculators are relishing the zero interest rates. Herein lies the crux of the problem, the cheap cost of capital is actually doing little in creating jobs and demand. It is a jobless economic recovery.

Where has the money flowed to? A good guess is Asia which has seen asset prices rising up without supporting fundamentals like increasing income or productivity. A case in point is China which has seen land auctions fetching record prices in Guangzhou and in Shanghai recently, despite concerted measures to cool the red-hot market.

To quell investors’ uncertainty, China has committed to another 8% GDP growth for the year 2010. If they mean what they say, banks will not pull the stops on lending but they will certainly have to raise core capital to buffer against the prospect of more bad loans. With the momentum carried over from 2009, this 8% target is achievable. However, the Chinese government should be mindful of over-heating and ensuring that its frothy assets do not follow in the footsteps of Dubai.

The Singapore government has also predicted GDP growth for 2010 between 3-5%, on the back of improvements to global economic conditions. Meanwhile, Thailand have joined Malaysia and South Korea in reporting a turnaround in exports as they posted the first export increase in 13 months.

Without a doubt, economies are on the mend. How could it not after massive stimulus programs and additional fiscal burdens bore by governments around the world? The Federal Reserve must take credit for creating a feeling of “prosperity” with their Quantitative Easing and zero rates policy.

In their year-end meeting, the Fed indicated that interest rates will not be raised for an extended period, so that fledgling growth in the economy is not jeopardized. Such “accommodative” circumstances means champagne will continue to flow at the party. Investors have little choice but to pour their money into stocks, commodities or properties because deposits offer paltry returns while money printing turns their cash into trash.

Indeed, I believe stock markets may keep on rising in the short term. You can announce all the bad news right now and investors will not bat an eyelid. However, when market sentiment turns around, good news may be interpreted badly – whether the glass is half full or half empty is up to the analysts or big boys to decide.

There are a number of ways to give stock markets a rude awakening. The US dollar is staging a recovery as investors bet on imminent rate hikes and weakness of other major currencies. I have little love lost for the US dollar but compared to other major currencies, it is a safe haven. The euro may come under intense pressure if highly leveraged members start clamoring for bailouts.

The flight to safety could lead to the unwinding of carry trades which will further strengthen the dollar. During the financial crisis in 2007, the unraveling of the Japanese carry trade was painful. But it will pale in comparison to the destabilization created by a stampede out of the US dollar carry trade positions built up this year.

Even Jim Rogers who has been arguing that the US dollar is collapsing is buying dollar for the past two months. He remains a commodity bull and will sell dollar on the rebound. The US dollar dominance will not last but its revival means we should hedge our positions or take some profits.

Besides the US dollar gyrations, sovereign debts are another major concern. Last month, Dubai World dropped a bombshell when it requests for a standstill on debt repayment. The writing was actually on the wall for businesses in Dubai as they could not collect payments for months and projects came to a standstill, but for unknowing investors sold on the compelling Dubai fairytale, they were just not prepared that their “triple A safe” investments could again have the makings of a fraud.

The general assumption was that Dubai World is a government owned entity backed by oil revenues in UAE. However, that crashed to reality when the Dubai government distances itself from the the problems in Dubai World. Fortunately, the timely $10 billion loan provided by Abu Dhabi, on the day Nakheel was to default on its bonds, saved the bonds market from a confidence crisis.

However, before investors can heave a sigh of relief, the threat of Greece defaulting on its sovereign debts hit the headlines. Greece’s deficit stands at about 13% of GDP (close to the US level) while its debts are expected to rocket to 113% of GDP against an EU target of 60%. Clearly, such profligacy is a recipe for disaster.

Europe has no lender of last resort and the members are reluctant to pay for Greece’s irresponsible behavior out of moral reasons. Without a bailout, Greece has to slash deficits aggressively or face currency revaluation. Reduced spending and tax increases are inevitable but austerity is easier said than done, what with soaring unemployment, plunging asset prices as well as strikes and violence by anarchist mobs.

Pressure continues to pile on the Greek government after Moody downgraded its credit rating, following in the footsteps of Fitch and S&P. Due to the higher credit risk, the spread for Greece government bonds increased, implying higher interest rates for new or rollover loans.

Greece may be the first member of the European Union to be brought to its knees by the debt markets but it won’t be the last. Other participants in the debt binge include Austria, Belgium, Italy, Spain, UK, Japan, and not to forget America.

The US run larger deficits than any of its counterparts, to the tune of $1 trillion per year (maybe more with social and medicare obligations coming), the day of reckoning when lenders refuse to finance these deficits is approaching.

Yet, there is no sign of America slowing down in its spending, despite debts crossing $12 trillion. The Treasury expects the bailout to cost $200 billion less than expected, and that it should be able to recover most of the money it lent to financial firms.

Great news but if you think excess TARP funds can be directed towards cutting deficits, you are wrong. Obama is already planning for stimulus package III and Timothy Geithner wants to use the money to purchase Treasuries. The ideology of “deficits don’t matter” is too deeply engrained in America’s psyche.

If creditors start to get tough, will there be simultaneous sovereign defaults including America? William Buiter leaves us in no doubt, saying: “The massive build-up of sovereign debt as a result of the financial crisis and especially as a result of the severe contraction that followed the crisis, makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral….”

Investing In Gold

The global economy recovery depends on borrowed money. America will continue to spend until they can’t. Can your investments weather the shock of sovereign defaults? The best way to protect yourself is to buy a few ounces of gold.

Some analysts believe gold is a bubble but I don’t think so. Yes, it has fallen about 10% off its peak of $1226 an ounce and may even correct below $1000. Nevertheless, the fundamentals are intact to send gold higher in the next 5-6 years. Gold will react favorably to global stimulus efforts, which are forcing governments to print cash and erode purchasing power.

Inflationary pressures are building up strongly and will likely erase deflation in the new year. Inflation is a silent tax which affects everybody but for those who are are heavily leveraged, it lightens their burden as debts are paid with cheaper dollars. That is certainly more appealing than scrimping and depriving yourself of material comforts.

Compared to deflation where people hoard cash and demand declines, economists will like to convince us that inflation is good as it pushes up assets prices, provides jobs, increases income and investment and boost tax revenues.

Well, inflation will be back with a vengeance and that will be reflected in the commodities market. There is no need to keep track of the funny money created as gold preserves our wealth by tracking inflation closely.

Also, if you believe in Jim Rogers, commodities are in a bull market and we are only half way through. As a long-term gold investor, the daily movement in gold prices should not concern you – just buy gold on the dips and sell only when gold reaches a mania. Though gold is on a super bull run, weigh the risk-rewards carefully when using Cash Advance to enhance profits.

Keep An Eye On The Exit

It bears remembering that the stock market is forward looking (about 6 months), so if you expect interest rate hikes in the later half of half of 2010, keep a close eye on the exit door when summer comes around.

When stocks are rising, it is easy to be suckered into the stock market as everybody wants a piece of the action. However, your world will come crashing down if the music stops after you invested your life savings. The key to successful investing is not to lose money or at least, not too much of it.

It is hard to stay on the right side of the bets all the time. You can be less wrong though if you choose sectors which are resistant to rate hikes, like gold and natural resources. The financial sector has hidden risks in delinquent mortgage loans, derivatives and sovereign defaults but having some exposure to quality financial stocks can provide strong upside potential.

For those who do not want to invest, it is best to save up your money and wait for better opportunities since valuations are high right now. Prices will definitely come down as we are in a secular bear market which may extend beyond 2015, if we consider 1999 as a starting point.

I suggest fixed deposits as the best option to preserve your principal. They are guaranteed by the state, in the case of bank runs. Long-term bonds or structured deposits are not fail-proof.

While they offer higher yields than fixed deposits, the returns have to weighed against exposure to credit risk. Ask yourself if it is worth getting the slightly higher yield, only to suffer losses to your principal in a black-swan event, which can wipe out your returns many times over.

That is all for now. Happy New Year to you guys. By the way, what are your investment expectations in the new year? More profits or losses? Going all out or cutting back?

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Get Real On The Economic Recovery And Stock Market Rally

Third quarter earnings season is still ongoing but if you read closely into the numbers, fundamentals have barely improved, which stand at odds to the heady valuations arising from this stock market rally. On the bright side, JP Morgan and Goldman Sachs reported blowout earnings. However, trading is the name of their game which has little bearings on lending, production and gainful employment in the real economy.

It is unclear how well the balance sheets of the remaining Wall Street bastions stand up to scrutiny when interest rates are raised, mark to market accounting resumed and all the fanciful Fed’s creations (like Primary Dealer Credit Facility, Commercial Paper Funding Facility, Term Asset-Backed Securities Loan Facility, Term Securities Lending Facility Options Program, etc) are withdrawn.

Ben Bernanke is reluctant to raise low interest rates but he has been quick to toast his “success” in saving America and the world from financial meltdown. Bernanke said: “History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers responded with speed and force to arrest a rapidly deteriorating and dangerous situation.”

While Ben Bernanke’s resolve in throwing money from his helicopter is impressive, history will remember him fondly not for the amount of dollars he can print in record time nor his financial creativity but rather the exquisite timing of his exit strategies. Liquidity injections canot continue indefinitely without leading to massive asset bubbles. The Fed will have to pull the trigger (I hope sooner rather than later) and that will lead to a shakeout for equities, commodities and dollar short-sellers.

Harsh facts are never appreciated when everybody is having fun at the party. Lest I keep repeating the same old bleak story and being deemed as a gate-crasher or scare-monger, I have refrained from posting too often in this blog. But it will be remiss of me not to mention that this rampant bullishness prevading the stock market is raising alarm bells.

Today, we are, at best, peering into a nascent economic recovery but Dow Jones Industrial Average have already crossed 10,000 (about 30% off the all time high of 14,198 in October 2007) when peak euphoria reigns amongst investors. If that is not getting ahead of ourselves, I don’t know what is.

Bank of America gave us a measure of reality by reporting a $1 billion loss, its fifth straight quarterly loss. To be sure, the financial sector is still in murky waters. What has changed over the last year is not the debt crisis but rather a reshuffling of cards. Instead of transferring risks to unknowing investors through securitized debts, the US government has been forced to gobble these toxic assets and shoulder immense financial risk.

The solvency of major financial institutions has come at the expense of insolvency to the US government. If financial institutions get into trouble again, what are the odds of the US government mustering another rescue when its credit is hanging in the air? Can the Federal Reserve double money supply as coolly it did over the last year? Will taxpayers, consumers and investors not bat an eyelid as their purchasing power and dollar denominated assets go into the dumps?

Knowing that the next financial crisis could require as much, if not, more resources to resolve, and the Federal Reserve could be found sorely lacking by then as the dollar loses its status as the world’s reserve currency, it is rather baffling that financial institutions are still resisting reforms to get their house in order. Perhaps it is inevitable that this unregulated financial system, as we know it today, has to crash into oblivion and be rebuilt from the ground up again.

I have nothing against attractive remuneration for top performers. You can’t fault traders who netted, say, $1 billion and they lay claim to 50% of profits while the owners and creditors who came up with the capital get the rest. However, when the traders lose $3 billion the following year and even compromised the company’s financial position, they lose nothing except their bonuses or jobs while shareholders, bondholders and even taxpayers have to step in to pick up the tab. Capitalism is not about privatising rewards while socialising the risks, but apparently the rules of the games can be changed.

Dollar Crisis And Commodities Boom?

Reckless money printing by the Federal Reserve has devalued the dollar, and we can expect a dollar crisis to play out within the next decade. Already, murmurs of discontent are getting louder amongst key players.

Rumors are rife that a meeting among Arab States, China, Russia, and France hopes for a discontinuation of oil trading in U.S. dollars. In the short term though, the dollar could strengthen as the stock market experience a major setback but its demise is inevitable if federal debts continue to pile up and the US economy weakens.

Currently, the US government is not in a hurry to defend the dollar. Without turning off the printing presses and reining in excess liquidity, Timothy Geither has only paid lip service to the notion that that America supports a strong US dollar. Exporting nations in Asia are left with little choice but to implement currency intervention, in light of narrowing US trade deficit which signals a rebound in US exports.

The dollar crisis has lent weight to investors like Jim Rogers who believe that commodities is the best place to be. I don’t doubt his words as supply and demand support his judgment. In fact, crude oil could very well run out in a generation’s time. If oil continues its uptrend, other commodities (food, metals, etc) are bound to follow.

But until the global economy gets back on a firm footing, any commoditiy boom is far-fetched. China, in its bid to sustain 8% economic growth for “social stability,” may well have decoupled from the deflationary environment in the US. China’s voracious domestic consumption is looking very promising, just over their eight day National Day holidays, retail sales of consumer goods surged 570 billion yuan, up 18% compared to last year.

But it is impossible for the Chinese to pick up all the slack in global consumption. Thus, while a collapse in commodities is unlikely, prices may fall from current levels and stay low for a while. That will actually benefit a weak US economy which is 70% dependent on consumption.

Printing more money which results in inflation and then runaway prices of oil and food is self-defeating. Raising interest rates will cause a sell-off in commodities which is a boon for consumers and businesses rather than a stock market rally fuelled by speculation and greed.

For those who are thinking of using commodities as an inflation hedge, it is also not a wise idea. Fortunes can be made or lost on a wrong bet, even for seasoned investors who study technicals and fundamentals closely.

A Global Double Dip Recession

Another rapid slump in global economy is far from impossible. Double dip recession could arise from sky-high public debts or another financial crisis sparked by delinquency in prime mortgage loans, risky commercial sector or derivatives. Geopolitical rivalries in the Middle East and Noth Korea also threaten stability. And not to forget trade conflicts which could result in protectionism or rather beggar thy neighbor policies.

If the global economy slids back again, a fresh round of stimulus packages could be harder to coordinate in the face of precarious budget deficits and debts. This could be the start of a multi-year recession, lasting at least 3 – 5 years.

America is moving in a similar trajectory as Japan when they lost their way after a housing bubble burst in the ’90s and bad loans overwhelmed their financial system. Till today, Japan has not really emerged from its lost decade. It is too early to say if Ben Bernanke has steered America away from the crippling deflation which plagued Japan or banished the ghost of the Great Depression.

Despite the stock market rally, consumer spending has not picked up. Equities may have enriched a select few but Americans are still struggling with job losses and lower income. In August, it was reported that consumer debt declined a further $12 billion, marking the seventh month of debt contraction in a row.

Since the credit crisis struck, consumers have reduced their debt by a record $113 billion (excluding mortgages). Either Americans are tired of using credit for discretionary spending or the credit crunch has not really abated as banks remain fearful of making loans.

Not surprisingly, US retail sales fell in September after the Cash for Clunkers program ended. Hopes are now on the fourth quarter where the retail industry brings in the bulk of its profit but I am keeping my fingers crossed as record unemployment will dampen holiday sales.

Dark Clouds Behind Singapore’s Economy Recovery

Singapore was the first Asian nation to announce a recession but its economy has rebounded with an 14.9% expansion (following the 22% growth in the second quarter), prompting the government to raise its full-year economic outlook. Being an export oriented nation, our modest recovery bodes well for the health of most Asian economies.

Nevertheless, MAS has kept its monetary policy steady, being cautious about the sustainability of this recovery. If private consumption in the developed nations do not increase when effects of stimulus programs wear off, we have to brace ourselves for a W-shaped recovery.

There is no doubt that things are picking up but it is too early to pop the champagne. In fact, I believe next year will be similarly, if not, more challenging. The sole pillar of our economy during this harsh recession was the construction industry which attained double digits growth while other sectors languished.

However, this sector is losing some steam. As it is, construction dipped by 0.6% while manufacturing and services were up 35% and 9.5% respectively. There could be more contraction to come. Due to lacklustre interest from buyers in 2008, many developers were vexed by their inventories and were on the verge of selling at greatly discounted prices. Interest in bidding for new plots of land was scant. Fortunately, demand for mass market residential properties spiked in recent months. 

Construction companies will feel the brunt of this “quiet” period next year, just when most of their existing projects are completed. Competition for new projects, especially from the private sector, will be keener, driving down prices. We can expect fewer companies reporting fat profits and there could even be a weeding out of the weak players which will increase unemployment figures.

The integrated resorts (two biggest construction projects in Singapore) are scheduled for completion by mid 2010. Whether new public projects can absorb all the resources being freed up remains to be seen. The “idle” situation may persist for a while as private developers are still building their land banks and the planning and approval process takes time. Hopefully, by then, other sectors of the economy will have firmed up sufficiently.

In view of the challenging times ahead, I believe the stock market is too optimistic with its valuations of 15-25 times earnings. Stocks have rallied aggressively since March. Most of them are trading above their 200-day moving average and with no sign of slowing down. In this kind of bullish environment, fundamental analysis seems really foolish. A monkey, with no baggge of knowing how bad things really are, could have made huge profits just by throwing darts in the dark. 

It is at moments like these when rational investors are blinded by greed and let their guard down. If you are seduced by lucrative gains made from stock market speculation, count yourself in good company.

Sir Issac Newton, a man renowned for his achievements in the field of physics, was left in financial ruin when he succumbed to the South Sea bubble. In 1720, the South Sea Company’s shares soared before plummeting and becoming worthless. It has no viable business but it was able to issue shares due to insatiable demand from investors, aided by rumors and speculation.

We should not forget that in the short term, the stock market behaves like a voting machine, swayed by emotions and fuelled by momentum, but in the long term, it is a weighing machine. Fundamentals have to come into play but of course, the million dollar question is when. Unfortunately, nobody can time the market accurately.

The bullish momentum may not exhaust itself just yet as there are no shortage of investors coming round to the idea that “this time, it is different,” so more cash is expected to flow into the stock market. It is getting close to a final hurrah though.

Rather than being obsessed with calling a market top, we should just maintain a neutral stance and stay vested, or for the risk averse, take profits off the table (which I have done progressively since August). By divesting all our stock holdings, we may miss out on more upside. I am not keen to buy more stocks but if you want to do so, remember to keep your stop losses tight and never maximise your leverage.

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