2011 U.S. Economy Forecast: Three Ways To Profit In The Second Quarter

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.

(And investors will need to adjust their entire portfolios, not just their oil investments. If you're interested in a way to prepare your portfolio for the coming market upset, click here for a free trial of our new investor report, Tri-Alpha Strategy for Banking 158% to 685% Gains in 12-24 Months.)

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) - that 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. Despite the refusal of the U.S. Federal Reserve to raise its rates, central banks across the globe 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, the world's central bankers are taking action. The U.S. Federal Reserve has yet to act, but it will soon be forced to.

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.

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.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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