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After a wild first quarter that included unrest in Egypt, Libya and Saudi Arabia, a spike in oil and gasoline prices, an apparent acceleration of inflation and continued global debt fears, investors need to embrace investment strategies and investment choices that will provide returns even as they manage risk, says Money Morning Chief Investment Strategist Keith Fitz-Gerald.
In a wide-ranging interview with Executive Editor William Patalon III that represents the latest installment of Money Morning's "Quarterly Report" series for the 2011 second quarter, Fitz-Gerald talked about the first quarter and provided a detailed look at what he sees ahead. For instance, Fitz-Gerald said that:
- Despite the bull market in U.S. stocks, the U.S. economy and accompanying financial system isn't as strong as it looks, noting that "there are still massive cracks in the system."
- Investors should make sure to watch the U.S. Federal Reserve, since its decision to continue or to end its current monetary-policy strategies could determine where U.S. stock prices go from here.
- Prices will continue their general upward trajectory, which is why he ultimately sees oil at $150 a barrel, gold at $2,500 an ounce and silver crossing the $50-an-ounce threshold.
Fitz-Gerald also detailed some of the investment strategies investors needed to consider, including the use of "inverse funds," dividend-paying stocks, and so-called "glocal" stock plays. "Glocal" stocks are the term Fitz-Gerald uses to describe large, U.S.-based multinational corporations whose global operations include a local presence – especially in the crucial markets of China and Greater Asia. Most of these companies are publicly traded, and have their shares listed on the Standard & Poor's 500 Index today.
What follows is an edited transcript of the question-and-answer session that Patalon hosted with Fitz-Gerald.
William Patalon (Q): It was quite a first quarter, Keith: We had unrest in Egypt, Libya and Saudi Arabia, among others, a spike in oil and gasoline prices, a continuation in the sovereign-debt crisis, fears about the economic health of China, and the terrible tragedies in Japan. How much of an effect will all this have going forward, what should investors watch for and what other "hot spots" are you watching?
Keith Fitz-Gerald: It sure was. In many ways, we are truly entering uncharted territory. A few years back, any one of these things would have tanked the markets all by themselves. But now, with everything at once we're getting the opposite and the Standard & Poor's 500 continues to demonstrate a surprising resilience. Many people are chalking this up to earnings or some other factor, but I think it comes down to the Fed's "all gain, no pain" bailout strategy.
The problem is that you can't fix the underlying problem by piling on more debt when it was too much money that caused the global financial crisis in the first place. This obviously hasn't stopped our central bankers from trying. But the laws of money are immutable and will eventually catch up.
To that end, I am watching the Fed very closely right now. [U.S. Federal Reserve Chairman Ben S.] Bernanke, who recently announced that the Fed may buy back maturing debt as a means of perpetuating the bailout, is effectively perpetuating QE2 without creating QE3 … or 4. I hope he has not fallen into the same trap as [predecessor Fed Chair Alan] Greenspan, which is believing his own genius … but I fear it may be too late.
No nation has ever bailed itself out by doing what we are doing … ever.
(Q): We're getting a lot of mixed signals related to the U.S. economy. What's your outlook for the domestic economy in general? What could help it? What could hurt it?
Fitz-Gerald: It's absolutely possible to be a market bull but an economic bear, or vice versa. I don't believe growth here is anywhere near as strong as the numbers suggest. Everything I am seeing suggests that there are still massive cracks in the system. Until companies start hiring and increasing their top lines, earnings will remain a game of capitalizing on overseas growth – at the expense of domestic U.S. growth – and cutting costs.
As for what could help, higher rates and a strong dollar. I am well aware that the critics of such things say that would tank the economy, and it might … but so, too, would a heart attack fell an ill patient. People tend to emerge from operating rooms healthier than they went in. Band-aids won't cut it much longer and I think the level of public distrust over the budget fight is proof that this specific realization is dawning on an increasingly large number of people.
(Q): Related to that … it seems like global inflation fears are finally taking hold: We just saw a major rate increase by the ECB, and a smaller one by China. How worried are you about inflation, what are you expecting and what can we do about it? What do investors need to watch for?
Fitz-Gerald: I believe inflation is already here and has been for some time. The fact that inflation statistics are beginning to take hold in data sets that are heavily manipulated to suggest it's under control says to me that inflation is far worse than people imagine. I am not especially worried about it, though, because we have spent an inordinate amount of time preparing Money Morning and Money Map Report subscribers for this. But for people who have not yet zeroed in on it, the window is closing. Solid choices remain. By that, I mean international stocks, dividend-paying shares, and holdings related to energy, commodities and agriculture.
(Q): Speaking of inflation, what's your outlook for oil? How should investors play that expectation? What about gold? What's your outlook and how should investors play that outlook?
Fitz-Gerald: I see nothing that would cause me to change my opinion that prices will be far higher in the years ahead for all these things. For example, I see oil at $150 a barrel, gold at $2,500 an ounce and silver crossing the $50-an-ounce threshold. These gains obviously will not come in a straight line, but against the backdrop of a weak-dollar Fed, they will come.
A key thing to consider is that all of these investments will likely hold their value fairly well if the markets fall apart. More importantly, they'll also accelerate as worldwide growth resumes. So they are good choices for protecting your wealth. And they are good choices for building your wealth, as well, which many investors fail to realize.
(Q): U.S. stocks more or less held their own. What's your outlook for the U.S. stock market in general for the next three months? For the rest of this year? What factors will favor that outlook, and which ones could derail that outlook? I know you've repeatedly talked about the Fed and its monetary policies being the key? Perhaps you could articulate that again for us here….
Fitz-Gerald: Barring a massive about-face from the Fed, I still think we're on track to see the S&P 500 hit 15% for the year, though I want to emphasize my expectation that the bulk of the gains will come this fall. At the beginning of the year, I said we were due for a pullback into June and that appears to be just about on track. My guess is that this will be the result of some sort of misguided "relief" rally that's related to the looming budgetary battle. Don't forget, we're likely to see a new debt ceiling in May, after we pierce the current one.
And, again, while there are all sorts of reasons why this may happen, it once again comes down to the Fed. Even though most people, including myself, are thankful for the rally Team Bernanke has created, there is a dawning reality that there are major cracks in the system and that the Fed has not addressed any of them. So, like a drug addict, we will accept the short-term "feelgood" sensation – knowing full well that the longer-term use of cheap money will kill us … or at least force this nation into the financial equivalent of "rehab."
Politicians will continue to do what they do best … kick the can down the road and hope somebody else has to clean up the mess.
(Q): What sectors do you like? What ones should be avoided? What types of stocks will do well in the environments that you described? Could you name a few? Also, even though I know that "the best offense is a good defense" in environments as uncertain as this one, perhaps you could also mention a "rocket rider" or two.
Fitz-Gerald: There is no question in my mind that "glocal" stocks are the place to be. These are companies that have valuable – immediately recognizable – brands, globally diversified revenue streams and experienced management capable of outthinking feckless government officials who don't understand how money actually works or why it continually crosses borders in search of better treatment. My favorites include energy and supply sectors, technology and infrastructure. All of these trends have trillions of dollars behind them worldwide and will not stop anytime soon.
As for the kinds of stocks that do best in fractured markets, that's pretty simple: It's the same sectors I've just mentioned, especially when you include stocks paying dividends. Companies that pay dividends are not only more stable in volatile markets, they tend to produce better performance over time.
Besides, I never have a problem with receiving periodic payments of cold, hard cash that also helps offset some of my ownership risk.
There's one other point worth noting, Bill. People have spent an inordinate amount of time recently discussing U.S. Treasuries. And some big names – such as Bill Gross of PIMCO (Pacific Investment Management Co. LLC) – have come out against owning them. So far, they've been wrong. Not only have U.S. Treasuries held their own because of the "flight-to-safety" factor, but against the backdrop of global risk they've actually appreciated. I don't think that's going to last forever, which is why I'm encouraging people to shorten their bond durations up to five years or less, and to even consider investing in specialized choices like the inverse funds we use from time to time in The Money Map Report and our other premium services.
Okay, here's another key point: Don't forget about inflation. There is no more serious threat to your money than its evisceration at the hands of inflation. And the Fed's denial that inflation exists – or exists only at levels so low that it is still safe for the central bank to continue forward with its stimulus strategies – stands in complete ignorance of the facts and reality.
Not only is inflation already here, but it's working its way through our economy at anywhere from 9% to 20% a year – depending on what you're measuring. I believe that you've got to allocate at least part of your portfolio to hedging that risk, or you will wind up with a far different financial plan than you envision.
Now that we're living into our 80s and beyond, the risk is that we run out of money before we run out of life. That wasn't the case a few decades ago when we had much-shorter lifespans and much cheaper healthcare.
(Q): As we both know, there's a big fixed-income contingent among our readers. And there's been a big concern about muni bonds and about U.S. Treasuries – each for very different reasons. What's your outlook for interest rates in general, what does that mean for bonds and what should investors be looking at right now for the income part of their portfolios?
Fitz-Gerald: Well, we just answered part of that, but let me take this one step further. I think that the Fed is operating under the assumption that it's in control.
In reality, the single-biggest risk comes from a group referred to as the "bond vigilantes," who may ultimately decide that U.S. government debt is literally not worth the currency we carry in our pockets. Bond vigilantes are investors who protest interest-rate policies by selling bonds and driving yields higher. When yields go up, borrowing becomes more expensive and debt becomes worth even less.
While many people believe the vigilantes went out of style in the 1990s, today they're back and, thanks to the use of credit default swaps, they're more ruthless and more powerful than ever. In fact, trading houses like Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM), and others have so much financial clout that they can attack entire countries – such as Greece, Ireland and Portugal, for example.
So far, the bond vigilantes haven't attacked U.S. debt, but they will eventually. And when they do, we'll see rates hit 5% or more, depending on how badly they bludgeon the Fed. Chances are we'll see them hit the U.S. dollar at the same time, which will exacerbate the problem.
Remember, interest rates are not simply the yield you receive. Traders view them as an indicator of risk – a risk premium. To traders, higher-risk investments command higher premiums. If that doesn't make sense, think about it this way. Insurance companies charge disproportionately higher premiums for 16-year-old male drivers than they do for 45 year olds who are married and have two kids because they know the former represents a substantially higher risk than the latter.
(Q): What markets outside the United States do you favor right now, and why? Are there any to be avoided?
Fitz-Gerald: Anything in Asia continues to be attractive. That's the single-biggest-capital-expenditure region for most of the S&P 500 companies right now, and it will remain that way for years to come. It doesn't matter what industry you choose – from almonds to electrical grids, the Asian Rim is attracting billions. South America, especially with regard to Brazil, is in much the same boat in that Brazil is creating an entirely new "wealth magnet" for regional capital in much the same way China is in the Pacific Rim. I can also make the same argument for OPEC countries – regardless of region, by mere virtue of the fact that they control something the world needs more of … oil.
The upshot is very simple. So-called "developing countries" entered this financial crisis with lots of debt and have piled on more. Many so-called "emerging countries" came into this with comparatively little or no debt, and are going to emerge in far better fiscal shape when we ultimately get to the other side.
Put it this way: Money is leaving the "nanny states" of the West and going to the "BEEs," or Big Emerging Economies. There's a lot of talk out there from analysts who think that these countries can't absorb much more, or that somehow the money will stop. History demonstrates that these analysts will be proven wrong. Not only does growth create excess capacity, but the growing numbers of working people in a region creates wealth.
(Q): And that wealth will create additional profit opportunities for investors who understand this new dynamic?
Fitz-Gerald: That's right, Bill.
(Q): Keith, before we wrap this up, is there anything else that you would like to mention?
Fitz-Gerald: Hmmm…yes, I think there is.
I hear a lot of talk from investors who are anxious to make up losses, and with good reason – they've been "halved" twice in the last decade.
The problem is that now is not the time to take big risks. Now is the time to pay careful attention to what you buy and why. It's also time to pay extreme attention to things like "trailing stops" which can not only help you minimize losses if things reverse from here, but which can be used to automatically capture profits, too.
There is still plenty of opportunity for the taking … if you know where to look and what to do when you find it.
(Q): Thanks, Keith. Let's circle back again soon.
In light of that advice, it's important for investors to remember that the Fed's policymaking Federal Open Market Committee (FOMC) will conclude a two-day meeting today (Wednesday). But there are some important changes that are well-worth noting.
FOMC policy announcements have traditionally been made at about 2:15 p.m. (ET), following the final day of the meeting. But today's announcement has been moved back to 12:15 p.m. (EDT), because Fed Chairman Ben S. Bernanke is expected to hold a press conference and then field roughly 45 minutes of questions from reporters. This press conference – which the Fed says will now be a standard post-meeting event – was added so that the central banker would have the opportunity to answer questions about the central bank's decisions.]
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