Second Quarter Forecast: Three Predictions, Three Ways to Profit

[Editor's Note: In late 2008, in the depths of the global financial crisis, Money Morning's Shah Gilani told you about five looming "aftershocks" that could lead to major profits. Each prediction came true. Now, in the introductory installment of Money Morning's "quarterly outlook" series, Gilani tells us what's in store for oil prices, U.S. stocks and interest rates. The second series installment, an analysis of the U.S. housing market, appears elsewhere in today's issue, and can be accessed by clicking here.]

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With the first quarter of 2011 behind us, there's a lot to take away and learn from – especially when it comes to the direction of oil prices, interest rates and stocks.

Granted, we're right now navigating one of the most uncertain periods in modern global history. But if you're a trader or an investor, knowing how markets have been reacting to recent news and events provides you with some valuable insights that you can use going forward.

And after we address each of these three topics – oil prices, interest rates and stocks – we'll be able to recommend some specific moves that investors should consider.

So let's look at each topic more closely.


A "Black Gold" Backgrounder

Oil prices, based on New York Mercantile Exchange (NYMEX) crude futures, rose 18% in the first quarter. Not that rising oil prices were a shock to anyone: After the once-seemingly invincible Hosni Mubarak lost control of Egypt – igniting protests in oil-abundant Saudi Arabia and outright revolution in oil-exporting Libya – an upward surge in the price of "black gold" would seem to have been a virtual certainty.

But a deeper look at what happened with oil during the first quarter may upend your thinking.

For instance, though oil prices did rise, why didn't they really soar?

With revolution threatening the status quo in the oil-producing Middle East, crude prices could have been expected to soar – challenging, or even surpassing, the record high of $147 a barrel set back in July 2008.

But that hasn't happened – for three not so obvious reasons.

One reason is supply. There's still a good amount of crude available on world markets.

Then there's demand. With China raising rates – and Brazil, Australia, the United Kingdom and now the European Central Bank (ECB) following suit – there's a very real fear that the once-hot emerging markets, as well as their slowly recovering developed counterparts, might cool down or lose momentum altogether.

But there's a third reason that oil prices may flatten out and recede to the $80 a barrel level. If there are relatively peaceful revolutions in the Middle East (which is a long shot given the West's desire to maintain the status quo) – which I would define as having popular governments take over state-owned oil producing fields, more oil is likely to flow, not less.

As long as the United States supports Saudi Arabia, Western oil companies are assured of huge profits. In exchange for access to advanced American weapons systems, which they pay for with U.S. dollars earned from selling us their oil, the Saudis regulate oil prices by increasing or decreasing their output to stabilize prices. Who determines what those prices should be? U.S. oil companies do.

The greatest fear U.S. and Western oil companies have is that popular and peaceful revolution in the Middle East will lead to lower oil prices – that new governments pump oil to meet the enhanced expectations of more open economies.

Unless there's a peaceful transition in the Middle East that favors expanding revenue over squashing political dissent, count on oil gently settling down, or even dropping below the $80 level, but staying high enough to make the next upsurge less surprising and more profitable for big oil.

The Real Outlook for Interest Rates

Rising oil prices – especially rising gasoline prices – act like a "tax," and soak up disposable income from consumers. Even so, while we can't avoid the fallout from rising-petroleum-byproduct prices, that fallout is predictable and limited in scope.

The same can't be said of rising interest rates, which we also saw during the first quarter. The effects of interest-rate increases are quite widespread – and long-lasting. But that's not necessarily bad, as we'll soon see.

Investors and economists throughout the world are right now very worried that rising commodity prices, along with escalating oil prices, will ignite inflation and launch it into a previously unknown orbit. Already, central banks have been lifting reserve requirements and hiking rates to fight the dreaded return of inflation.

That's almost ironic, given that only 18 months ago deflation was the worry du jour.

Keep that lesson in mind: When conditions change, they can change quickly.

When it comes to rising rates, my reaction is: "So what?" Rising rates are not only long overdue, they are actually good for us all.

As long as rates don't rise precipitously – but move up slowly and predictably, giving consumers, investors and economies time to adjust to the incremental increases – a semblance of financial normalcy might just be restored.

After all, the current environment of artificially low rates favors spenders and speculators over savers and investors. We've had enough of that, for heaven's sake.

While interest rates – based on the bellwether 10-year U.S. Treasury note – were volatile in the first quarter and ended up higher overall, there wasn't much to fret about. The 10-year Treasury rose from 3.30% to yield 3.47%.

That's not precipitous by any measure.

I'd be worried about markets forcing rates higher themselves if central banks weren't already taking the steps they're taking. But as the ECB demonstrated just yesterday (Thursday), the world's central bankers are taking action.

If the only worries that we have in the face of inflationary expectations are rising commodity prices and rising oil and gas prices, we may have nothing to fear after all. Rising rates not only cool down economic growth, and signal to markets that central bankers are in their watchtowers, they simultaneously can also kill off overly speculative trading in commodities that forced prices higher to begin with.

Commodity prices are "elastic." That means that the prices move up and down based on supply and demand. Lately, supplies have been tight because of global weather conditions and because speculators have been bidding up prices, stockpiling everything, and the public has been "piling on" with each of these trades – chiefly by grabbing commodity exchange-traded funds (ETFs) with both hands.

It's a classic bubble. And it's just waiting for a pinprick to cause it to burst.

That "pinprick" could take one of several forms. All we need is for higher rates to squeeze the cost of carrying speculative positions, or for high prices to translate to greater crop plantings aided by a turn to more favorable weather patterns (which we didn't have last year) and the "imitation-inflation-migration trade" will implode.

There's a difference between raising rates to combat inflationary expectations and markets pushing rates higher because deficits keep rising. The deficit fulcrum that's forcing rates higher has to be watched separately, because the fallout will be broader. In other words, inflation expectations can be pierced, but ballooning deficits can't be popped and ineffective action to reduce them could eventually push rates significantly higher.

That brings us to stocks.

Will the "Wall of Worry" be Enough?

If you ever wanted an example of climbing the so-called "wall of worry," you saw it during the first quarter of 2011.

U.S. stocks managed to turn in a stellar first quarter – in the face of rising oil prices, rising rates, rising commodity prices, revolution, earthquakes, tsunamis, nuclear fallout, insider-trading scandals and self-trumpeting, wannabe U.S. presidential candidate Donald Trump offering to take on both China and U.S. President Barack Obama in a cage match.

For the year's first three months, the Dow Jones Industrial Average rose 6.4%, the Standard & Poor's 500 Index rose 5.4%, and the Nasdaq Composite Index rose 4.8%. If there's a message to be drawn from those first-quarter results, it's this: During that time period, in the face of all the negatives thrown at the U.S. stock market, there was nothing the markets weren't willing to discount.

But the real question, of course, is this: What can we expect going forward? Will stock prices go higher, still?

The short answer – yes.

Forget the headwinds – of which several are forming. The U.S. stock market still has a massive tailwind that should continue to propel it forward.

I'm talking about liquidity, "QE2," U.S. Federal Reserve largesse, a banking system that's sitting on fat reserves, and U.S. corporations that are sitting on almost $1 trillion in cash.

Money moves markets. If the laundry list of negatives – several of them very serious in nature – that sprang up during the 2011 first quarter weren't enough to halt, or even slow, the stock market's advance, I'm betting that U.S. stock prices still have some room to run.

Of the many lessons that traders and investors get, the most valuable ones are repeated time and again: As the market moves forward, up or down, it shows us what the current catalyst happens to be.

Naturally, that catalyst can change. But the lesson of the first quarter is that this market wants to go higher, has the fuel to go higher and will go higher until that fuel runs out – or gets watered down by new events and news that changes our realities.

And that brings us to the biggest question of all: Given our expectations, what, as investors, should we do? Let's look at the three areas that we've chosen: Oil, interest rates, and U.S. stocks.

Moves to Make Now

Because I think oil is headed lower, I like buying "puts" on the United States Oil Fund LP (NYSE: USO), an exchange-traded fund (ETF) whose net asset value (NAV) changes in conjunction with changes in the "spot price" of light, sweet crude oil.

Because I believe that interest rates are headed higher, I like buying the ProShares Ultrashort 20+ Year Treasury ETF (NYSE: TBT). This is a "leveraged ETF" whose share price goes higher when interest rates increase, and goes lower when interest rates fall.

Lastly, because I continue to believe that the U.S. stock market will go higher until the Fed mops up the excess liquidity in the system, I like buying the SPDR S&P 500 ETF (NYSE: SPY), whose share-price movement will generally follow the price-and-yield performance of the S&P 500 Index. [Editor's Note: This liquidity-driven bullish view has been a consistent Gilani mantra - he even included it in his 2011 projection for the U.S. stock market, which was part of the Money Morning "Outlook 2011" Economic-Forecast Series that was published late last year.]

But don't forget: If deflationary fears can change to inflationary fears in a matter of months, faster-moving markets can change in mere days. Always use "protective stops," and raise them as your profitable positions rise.

Actions to Take: In the first quarter of the New Year, U.S. stocks seemed to defy gravity – or, at least, any and all bad news. After the once-seemingly invincible Hosni Mubarak lost control of Egypt – igniting protests in oil-abundant Saudi Arabia and outright revolution in oil-exporting Libya – oil prices jumped, causing gasoline prices to do the same.

Continued sovereign-debt woes out of Europe added to the list of things that investors could opt to worry about, as did the earthquake, tsunami and subsequent nuclear power plant disaster in Japan.

And, yet, U.S. stocks kept rising: In the first three months of 2011, the Dow Jones Industrial Average rose 6.4%, the Standard & Poor's 500 Index rose 5.4%, and the Nasdaq Composite Index rose 4.8%.

Going forward, investors clearly need to keep track of three key factors: Oil prices, interest rates, and stock prices. All three represent points of concern.

But all three also represent profit opportunities.

On that latter point, here's what Money Morning's Shah Gilani believes investors should consider:

  • Oil Prices: Because he thinks that oil is headed lower, Gilani favors buying "puts" on the United States Oil Fund LP (NYSE: USO), an exchange-traded fund (ETF) whose net asset value (NAV) changes in conjunction with changes in the "spot price" of light, sweet crude oil.
  • Interest Rates: Gilani believes that interest rates are headed higher, which is why he favors buying the ProShares Ultrashort 20+ Year Treasury ETF (NYSE: TBT). This is a "leveraged ETF" whose share price goes higher when interest rates increase, and goes lower when interest rates fall.
  • U.S. Stock Prices: Lastly, because Gilani continues to believe that the U.S. stock market will go higher until the Fed mops up the excess liquidity in the system, he likes buying the SPDR S&P 500 ETF (NYSE: SPY), whose share-price movement will generally follow the price-and-yield performance of the S&P 500 Index.

[Editor's Note: In the shadowy world of Wall Street, Money Morning Contributing Editor Shah Gilani is a rare commodity.

As a retired hedge fund manager who's willing to share the secrets of what goes on behind Wall Street's "velvet rope," Gilani is able to spot the stock market's hottest profit opportunities.

And since he's no longer part of the Wall Street power structure, Gilani is also willing to show you how to capitalize.

Gilani recently helped develop a strategy for individual investors to bring in the big money Wall Street tries to keep for itself.

And we're willing to share that secret strategy with you.

To find out more about this strategy - and more about our worldwide team of global-investing experts - please just click here for a report from our monthly affiliate, The Money Map Report. You'll never regret it.]

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. STOICA | April 9, 2011

    Hello Dr. Kent Moore,
    I,am a young girl from Spain thanks a late for the information about the investment there are a litlle complicated but very intresting ! i want to invest my money in PCD, OIL ,LITHIUM !plese tell me what steps i have to make ? and where i have to ask about this investments here ! Thanks a late -Ioana Stoica

  2. Steve | April 17, 2011

    Shah Gilani:
    Thank you for your very thoughtful columns. I never feel you are trying to sell something, but instead, you give sage, unambiguous advice for us poor investors, generously passing forward your experience and knowledge. Your advice includes the broad economic landscape which backs its soundness, and you are humble in your advice to alert us to the quantumness of timing when irrationality can take the helm.

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