The Contrarian World Order

By Andrew Gordon

The Dow, S&P 500, and even the Nasdaq are bulldozing their way up the charts. After surging the week before Thanksgiving, the “Big Three” indices managed to mostly hold onto their gains through the holiday-shortened week.

So have you already forgotten about the sharp downturn from mid-May to mid-June? Are you beginning to think that Fed chief Bernanke has the magic touch? Are you planning to celebrate the soft landing nobody thought was possible at your Super Bowl party?

If you are, I’m about to rain on your parade. You won’t like what I have to say, but hear me out anyway. I’m going to explain to you the three reasons why a soft landing is a pipe dream.

1. The other shoe is getting ready to drop.

How long can an economy slow down before earnings are affected? We’ll get our answer next year when earnings growth will enter single-digit territory for the first time in several years. As a matter of fact, the last time it happened was back in 2002.

And it’s not going to take much to knock this wobbly rally off its tracks. Truth is, this current market spurt is being fed by a measly handful of companies (that are admittedly doing extremely well). The record-breaking Dow features 21 companies that are at least 20% underwater from their highs of a few years ago.

The S&P is pretty much following suit. Fewer S&P stocks than usual are performing better than the overall index this year. In other words, the S&P has hit a new six-year high on the strength of relatively few stocks.

If you’re looking for a reason why your mutual funds didn’t do so well this year…well, you’ve just found it. The pickings are slim.

And there’s of course the underwhelming Nasdaq. It’s up 11% so far this year. On November 6, it passed the halfway mark of its 2000 peak. And it only took nearly seven years to do it.

That about covers it, doesn’t it?

My conclusion: Most companies in the “big three” indices are flatlining, despite giving investors double-digit earnings growth.

My question: What’s going to happen to them when they show investors more tepid earnings growth?

My prediction: It ain’t gonna be pretty.

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2. The market is walking on eggshells.

The economic news has been mixed, though predictably mixed. I believe we’re one unexpected news event away from the market taking a dive.

You see, all the predictable bad news is already priced into the market. The super-cooling of the housing sector is by now old news. The market now barely hiccups at bad news on housing, as it did on November 17. Housing starts plunged to their lowest level since July 2000. Investors were so shocked and dismayed that both the Dow and S&P finished higher by the end of the trading day.

But the potential for future unexpected bad news abounds. It could come from the energy sector (an incident in Nigeria or a dozen other places could touch it off), the consumer sector (hopes for a busy Christmas shopping season could be dashed), price indices (inflation could erupt), China (if its economy overheats), or a number of other places.

3. Dancing on a tightrope.

It seems that market investors have all chosen sides. They fear inflation more than anything else. Or they fear an economic slowdown more than anything else, including inflation.

There’s a guaranteed loser in this tug-of-war. My fear is that whoever loses will take it out on the market, as well they should.

Nobody has actually said this, as far as I know. Let me be the first one.

Either eventuality stinks. One of them will come to pass, and it’s going to land a hard body blow to the market.

The chances of the market escaping from this ambush unscathed is so remote that I’m willing to bet the old Indonesian rupiah I still carry around in my wallet on it.

We’re in a worsening slowdown right now and inflation is under the heavy sedation of negligible economic growth. But things could change. The sedation could wear off, if and when the economy springs back to life. Inflation could then rise up to terrorize the market.

But if the economy continues to sputter, the market would surely suffer the consequences of blunted earnings growth.

The Fed of course thinks it can square this circle. But I see no middle ground here. It’s either the economy or inflation. One is going down and one is going up. Either way, the big loser will be the market.

In my contrarian world order, good and/or mixed news is merely the precursor of bad news. Inflation under control is the flip side of a devastating economic slowdown. And the current record-breaking market growth only goes to show you how weak the market really is.

Now, I’m not asking you to live in my world (I wouldn’t do that to you!). I’m only suggesting you may want to mark my words and make certain preparations.

So, for the sake of your portfolio, consider staying short U.S. dollar bonds. And buy precious metals as a safe haven from inflation or recession. Lastly, don’t forget to tighten up the stops on your stocks. Do these things, and the contrarian world order won’t seem nearly as threatening.

Good Investing,
Andrew Gordon

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Market Watch

Avoiding Risk While Playing the
Explosive Derivatives Market

By Andrew Gordon

The best thing to happen to hedge funds was the near collapse of Long-Term Capital Management some seven years ago. Fourteen banks had to cough up $4.2 billion to bail out LTCM in late 1998.

Why so much? LTCM was leveraging its capital 25 to one. The last thing the hedge fund industry wanted was Uncle Sam lording over them. So the industry quickly took steps to improve the exchange of information about counterparty risks. And last year, the hedge funds’ in-house watchdog group – the Counterparty Risk Management Group – recommended extending the reporting of large exposures to hedge funds.

Most of you have heard about Amaranth’s sudden demise. It couldn’t recover from making the wrong bet on gas prices and went out of business last month, but at least its funds were leveraged just four to one. Unwinding its investments wasn’t nearly as difficult or messy as unwinding LTCM’s.

Despite its explosive growth, the derivatives market isn’t nearly the risky place it used to be. And one of the savviest players of derivatives is Goldman Sachs. It blew past analyst expectations for third-quarter earnings in September and has more than $1 trillion exposed to derivatives (though only $58 billion when you net out leverage).

Whatever the markets are doing, Goldman has shown the knack of making money on a consistent basis. But if you really want to profit from a derivatives market that has more than quadrupled in the past six years, I have an even better recommendation.

I explain everything in my next issue of The Wealth Advantage. What I like about it is that it gives you the profit potential of a hedge fund investment without the steep costs and huge pools of money needed to just be allowed to play.