Risks Across All Markets Necessitate Careful Asset Allocation

First, let me introduce myself. I’m Douglas Davenport, editor of the All-Weather Investor and Inflation Survival Strategy investment services. If you have already joined one or both of these portfolios, you know that they’re based on an objective, trend-following trading model I developed years ago with my mentor, the legendary investor Sir John Templeton.

This proprietary trading model has helped my clients beat the S&P 500 by a wide margin, quarter after quarter, year after year, in both up and down markets. The model allows me to dispense with forecasting, guessing and wishful thinking, and focus strictly on what the markets are doing right now. In this way, we’re able to catch every major move across a variety of asset classes, and successfully navigate difficult market environments such as the one we’re seeing now.

Of course, I can’t tell you exactly what my trading model is saying at the moment, or which ETFs I’m investing in to take advantage of the market trends. But I can tell you about the risks I’m seeing in each of the major asset classes, and how they’re likely to affect the markets over the next quarter.

Overall, my outlook for global growth is improving, mainly due to the continued flow of money from central banks around the world. The U.S. Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan, among others, are still concerned enough about the state of the global economy that they have pledged to keep monetary expansion alive and interest rates low for the foreseeable future.

The ECB is buying more assets in an attempt to keep the euro currency from toppling.

The ECB in particular is back in the crosshairs following the recent bank panic and bailout in Cyprus. And now there’s talk that Slovenia could be the next domino to fall in the ongoing sovereign debt crisis. Meanwhile, the unemployment numbers across the region, especially in Spain, are unacceptably high, and there is growing social unrest in the PIGS countries (Portugal, Italy, Greece and Spain), not to mention political gridlock in Italy. European central bankers know that their problems are far from solved, and they’ve responded by stepping up their asset purchases.

And what about the emerging markets? The engines of global growth over the past decade or so are also showing troubling signs of weakness, acting as an anchor on economic expansion.

It’s clear that the global debt crisis will take a long time to work out. And while the slowdown in the emerging markets has cut into demand for commodities and kept a lid on inflation, eventually price inflation will have to increase in order to shrink the real value of debt. How this plays out will be very important to sustained growth worldwide.

Are Equities in Line
for a Pullback?

Despite all these problems, the global equity markets have been doing remarkably well.

Is this another case of “irrational exuberance”?

Or did the market bottom in March 2009, barely four years ago, mark the beginning of a new secular bull market?

I think the answer may be somewhere in between, but it does look like markets are very much overbought. Equity investors have priced in a great deal of good news on growth for 2013. However, earnings forecasts for the S&P 500 have been trimmed by about $9 per share over the past year. Profit margins are also likely to fall.

So in my opinion, the odds of another correction are growing rapidly. But keep in mind that the central banks are still keeping the markets propped up. Their massive quantitative easing programs won’t allow for a major downturn. Instead, I think we’re likely to see a relatively mild event, marked by a drop of 4 percent to 9 percent in the S&P 500, similar to other pullbacks since 2009. When that happens, it should be treated as a buying opportunity.

When Will Bond Yields Start to
Reflect Inflation Risks?

Meanwhile, despite the recent rally to a record high on the Dow Jones Industrial Average, it appears that investors in the U.S. are still under-allocated to equities and over-allocated to fixed income.

Globally, bond yields reached a multi-decade low last summer and have risen since that time in most countries. But the current U.S. bond real yield is still about zero (after inflation and taxes), and it does not reflect inflation risks.

Inflation is generally tame in most countries considering the massive amount of monetary injections. However, the central banks want and need inflation, and they will eventually get it. If you’re not prepared, you could get caught flat-footed.

When Will Gold’s
Consolidation Phase End?

Gold and other precious metals are clearly in a corrective phase and have been since topping out in 2011. Why has gold consolidated for this long?

The answer is a combination of factors, including improving confidence in the financial system, weak inflation, a major slowdown in demand from China and India and a much stronger U.S. dollar. In addition, gold is still primarily a hedge, and may not turn around as long as the stock market stays on a roll.

In fact, these trends could all carry on for a while longer. But in the longer term, I believe the fundamentals for precious metals remain positive. It appears gold is just building a new base to launch its next upswing. However, keep an eye on the support level around $1,550 an ounce. If gold breaks down through that price, it could fall even further before the trend turns positive.

How Long Will Commodities
Weakness Persist?

As I mentioned earlier, China’s weak growth has limited demand for most commodities. And reports of build-ups in copper and aluminum stockpiles imply that weakness could persist for a while.

In the energy markets, crude oil has traded in a very narrow range since 2011 and near-term risks appear to be to the downside. But one asset that has shown marked improvement is North American natural gas. It has started to recover from the lows of 2008, and it has nearly doubled since the low in 2012. Natural gas prices may have more upside due to larger depletion rates that were originally expected from many gas fields.

Will the U.S. Dollar Remain Strong?

The dollar has certainly benefitted from the strong performance of the U.S. stock market, but it may also simply look good compared to its competition.

Expectations for U.S. growth are stronger than other G-7 nations, and the dollar still has the benefit of being the world’s reserve currency.

In addition, the dollar is helped by the continued weakness in the euro zone. The euro has to be weak to pull the region out of its ongoing slump, and in fact, the shared currency has been in a downtrend since 2008. But I think it still remains overvalued versus the dollar.

Risks and Rewards in the Coming Years

In the short term, floods of liquidity from the central banks will continue to support global stock markets. U.S. equities should continue to outperform and emerging markets will underperform in the coming months. Europe should see some boost from additional monetary policy, but progress on structural reforms in southern Europe and political friction make that challenging to say the least. The choppiness in the gold market will continue before its next long-term leg up begins. And we may soon begin to see signs of inflation in the U.S. bond market in the form of higher yields and lower bond prices.

Longer term, it’s an understatement to say that we are facing huge risks. It’s obvious to everyone by now that the global rally has been primarily driven by central bank money printing, creating an artificial financial environment.

The world’s biggest central banks have added an astounding $8.7 trillion of liquidity since 2008, while slashing interest rates well below the rate of inflation. This massive amount of liquidity has found its way into the markets.

At some point, all this quantitative easing will end. The resulting worldwide deleveraging will create massive problems for the equity markets. There’s no telling when this sea change will happen, so it’s imperative that you develop an exit strategy now.

The fact is, most of the world’s economies remain very fragile without central bank intervention, and their markets’ confidence could be easily shaken at the first hint of stimulus withdrawal. Members of my All-Weather Investor and Inflation Survival Strategy services are preparing for just such an eventuality.

Sincerely,

C. Douglas Davenport, J.D.