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Profiting From Commodities, Tech and Emerging Markets Capital Waves

/ Investing 2010 Mar 30, 2010 - 06:24 AM GMT

By: Money_Morning

Best Financial Markets Analysis ArticleWilliam Patalon III writes: It was November 2008, and a global financial crisis that started in the U.S. credit markets had already leveled such one-time corporate stalwarts as Lehman Brothers Holdings Inc. (OTC: LEHMQ), Fannie Mae (NYSE: FNM) and American International Group Inc. (NYSE: AIG). The U.S. economy was in an apparent freefall, and stock prices wouldn't hit bottom until early the following March.


In the midst of that chaos, Money Morning's Shah Gilani made five predictions, anticipating five looming "aftershocks" he said were certain to come true.

He was correct on all five counts - every prediction came true.

This wasn't the first time Gilani has made such bold predictions - and been proven right. In July 2008, for instance, when crude oil was trading at a record high of $145 a barrel, he predicted that the "black gold" was destined for a major fall - even though many pundits were calling for prices to spike as high as $200, $250, $300 and even $500 a barrel.

Once again, Gilani was right.

Gilani, a retired hedge-fund manger, Money Morning columnist and noted expert on the global credit crisis, has been able to do this time and again for one simple reason: He understands the power and profit potential of the global financial market's "capital waves."

"Capital waves create some of the biggest trading opportunities in the markets today," Gilani said in an interview last week. "Investors who are able to spot capital waves and identify their likely impact have a huge advantage over those who don't."

And the profit plays that loom are shaping up as the biggest and best, yet.

William Patalon III (Q): Shah, you've been talking a great deal recently about the power and profit potential of "capital-wave investing." What are "capital waves" and why is this such a powerful strategy?

Gilani:Capital waves are the single-most fundamental and important factor in any price action. Prices - of anything, in any market -- don't move unless capital moves in or out. On a larger scale, waves - as opposed to, say, ripples - result from large, and oftentimes gigantic, flows of capital in and out of stocks, entire sectors, industries, markets, asset classes, or countries. Institutional investors deal in large quantities of capital: These institutional players understand what the small investor hasn't grasped, or has forgotten about - capital moves markets. It's not a simplification, it's a fact: Getting in on giant rising waves and getting out of the way when they crash - or even better, positioning yourself for the crash that results from the exodus of huge capital allocations from faltering positions - is as powerful a strategy as there ever has been, or will be.

(Q): So one of the points that you're making is that these capital waves not only point you toward the biggest profit opportunities … they also steer you away from the major danger points?

Gilani:Yes. Investors get too bogged down in thinking about making money. They forget that making money has an even more important component - not losing money. There are always opportunities to make money. But it's capital preservation - not losing money - that keeps you in the hunt. By always - and I mean, always - being aware of the "wave action" in the markets in which you're invested, you can avoid big losses. Small losses are part of being in the hunt. They're fine and investors need to embrace them as part of a big-game hunt. Big losses from not getting out of the way of a crashing wave will not only destroy your capital ammunition, it will make you gun-shy to get back in - usually at the exact time when a new wave is building and you should be getting back in.

(Q): How quickly can these "waves" move?


Gilani:Waves used to start very small and build over time. Now, with huge pools of capital traversing the globe at the speed of a mouse-click, they can happen quickly. When it comes to the building of a large wave, I'm not talking about over night. I'm talking about over weeks and months. And sometimes - in the case of super "rogue" waves - we're talking years. Generally, my analysis points to the "implosion" - or rollover of big waves - to be, at the very least, four times as fast as the build-up. For example, the giant subprime wave took about eight years to build, but gathered a lot of height in the last two years of its growth. It took less than one-quarter of that time for the resulting financial tsunami to completely devastate world markets. Talk about a rogue wave.

(Q): We're effectively just into "Year Two" of a near-record bull market. After the near-record run we had last year … and factoring your capital-wave philosophy into the equation … what's your outlook for U.S. stock prices, and the outlook for this domestic bull market?

Gilani:I see a disconnect between the economy and the stock market. Basically, even though we've seen good earnings numbers, lots of analyst upgrades, and signs of recovery in the corporate sector, I don't see that translating to the traditional engine of growth in the U.S. economy - the U.S. consumer. Fundamentally, what has happened has been gut wrenching for Corporate America. But the really good news is that most of the companies that took decisive-and-drastic action in the wake of the credit crisis and the U.S. recession will be poised for solid gains in the future. The stock market has anticipated all that and has risen accordingly. As far as the capital wave of money entering the market, it's only just begun.

Even though I think the consumer has a ways to go before he or she contributes in any meaningful way to gross-domestic-product (GDP) growth, the sheer amount of capital on the sidelines points to higher equity prices. There are going to be bumps along the way, and I believe the market rally would be more sustainable if we had a meaningful correction. But the trend will remain upward as long as capital continues to come off the sidelines.

(Q): How about for the U.S. recovery? Can capital waves have an economic impact, as well as a capital-markets impact?

Gilani:Yes. Capital waves, such as we're seeing in the stock market, translate to greater optimism in a general sense. That's good for consumer confidence, if it continues. If the market relapses, I believe that would be the trigger event for a double-dip recession. But, at some point, housing prices will stabilize and capital will slowly start to move back into real estate. If sufficient waves of capital move into bank stocks, their capital ratios will be better and they will be more comfortable lending to homeowners. When that happens - and when we look past the gloom and doom of broken-home dreams - we'll see a real, long-term and healthy improvement in the U.S. economy, as a large capital wave will lift undervalued residential and commercial real estate.

(Q): What's the single-biggest - or two-single-biggest - capital-wave profit opportunities that you are currently projecting? What market, sector or country do you like right now? What are the hints, signals or indicators that tell you this?

Gilani:In terms of sheer size, the U.S. deficit is a Category Five hurricane. I don't see it getting any smaller because I don't see any political will to curb expenditures. What's more, tax receipts will be weak for years to come, regardless of changes in the rate structure. Right now, interest rates are - and I believe, will continue to be - contained by sluggish consumer demand, restricted bank lending and high unemployment. But once optimism returns and conservative inventory rebuilding is met by actual growth in domestic demand and a worldwide revival, interest rates will rise.

What's important is the velocity of any movement out of U.S. Treasuries. Rapidly rising rates will create a cascade of selling in some stocks and financial instruments, and a flood - and by "flood," I mean a flash flood - into other instruments, specifically commodities. That's the other giant capital wave that's going to generate huge trading opportunities … commodities. I watch the two-, 10- and 30-year bond spread relationships and I view those differentials as a measure of sentiment and risk aversion relative to the risk-free rate of the long bond. I also model the slope of the yield curve; credit spreads (junk bonds over U.S Treasuries and AAA corporates); and the dividend yield and ERP (equity risk premium) on the Standard & Poor's 500 Index - to name the major undercurrents in my interest-rate model. As far as countries, I'm inclined to go where the volatility is, because that's where the action will be. I want a front-row ticket on the China ride. Talk about massive capital waves!

(Q): On the flip side, what do you see as the single-biggest danger spot, right now? What's sending that "stand clear" signal?

Gilani:Domestically, big banks haven't used the windfall profits from the free money provided by the U.S. Federal Reserve to meaningfully rebuild their capital. These banks will continue to squander profits on bonuses under the misguided premise that they have to pay up to attract and keep the best talent. What's shameful is that the banks are actually referring to all the managers who oversee the big risk-takers who generate the big gains that imperil the banks and the economy when their schemes implode.

As far as these big banks go, they're all too-big-to-fail at this point, and the concentration of assets into these banks and the need for them to make big bets to generate decent returns on investment and equity simply means we can expect still more concentrated bets. That means more macro bets made on the same side, and that means more systemic risk. Mid-size regional banks and almost all the community banks have tremendous volumes of distressed-commercial-real-estate assets on their books.

I'm worried about how that overhang will affect lending to consumers, small companies and business start-ups. I'm concerned that the low-interest-rate environment is facilitating excessive leverage again and that bubbles are forming. The reach for yield in a low-interest-rate world is one thing that steered investors to subprime when real rates of return fell below actuarial requirements for significant growth in portfolios to meet future liabilities and expectations. We're there again. Just look at the reach for junk and the narrowing of credit spreads across the fixed-income spectrum. Next we'll see more covenant-lite bond deals. Bubbles are definitely forming.

(Q): What are some of the other most promising capital-wave investing opportunities?


Gilani:What's promising is the future. Technology is always a bright spot. Healthcare always presents opportunities. Emerging markets are a beacon of promise. Currency plays are another promising frontier. All of these areas - as well as asset-class opportunities in developed world economies, commodities, and interest-rate trades - will see massive waves of capital rushing in and rushing out. I see tremendous capital wave opportunities for the foreseeable future. It's truly a brave new world.

(Q): What's your view of the global commodities sector? What "waves" may come into play there?

Gilani:We're seeing capital move into commodities in anticipation of a worldwide economic recovery. We haven't seen any huge capital waves yet, but believe me … they're coming. There has been inventory build-up and producers are gearing up for higher demand.

But there's a bogeyman out there. China is the wildcard. If China loses steam, or if the real estate bubble that's been building in China bursts, there will be a very rapid pullback in the capital that's being applied to commodity plays. If that slows - or shuts down - commodity producers, commodity prices could actually implode. If that happens in the next few months, what will result will be the greatest opportunity in our lifetimes to load up on commodities for a long, steady climb higher without any significant pullbacks. In the meantime, we will see prices rise and fluctuate. You can't not be in commodities now. You just have to have a defensive mindset and portfolio protections in place.

(Q): What are the "wild cards" out there?

Gilani:The wild cards are the same as they have been. A terrorist attack in the United States. A terrorist or criminal group with a nuclear device and the determination to deploy it. A flare-up in the Middle-East and military strikes. North Korea being North Korea. The failure of a "too-big-to-fail" bank. A stock-market implosion caused by a computerized glitch, or some type of "new" trading programs going haywire. A virus, either a biological one or a computerized one that brings the world to its knees. Any number of threats are out there, known and unknown. But, that doesn't stop the world from turning and nor should any of those prospects ever stop investors from investing. It's just a reminder that having a bail-out and exit plan is always prudent.

(Q): What's the one prediction that you're working on, thinking about, or preparing to make that would probably most surprise investors?

Gilani: I'm already out there with a call that gold is overbought. It looks like a contrarian and bold call, but I'm comfortable with my analysis. Of course, when you make a call like that - in a world where "wild cards" are everywhere, and where another wave of capital can come flooding in as the result of a panic - it's only smart if you manage the risk vs. the reward. Which is exactly what we did. We are risking a very small amount of capital for a potential windfall. There are three other big capital waves that we're getting ready to play. And, like the gold trade, we'll be taking small risks for potentially huge gains. Every trade is a risk/ reward equation. Risk a little to make a lot and over our two-to-three-year time horizon you will be surprised how quickly a fortune can be made.

(Q): Anything else you'd like to add here?

Gilani:I really want to impress upon investors that it's not the needle in the haystack that will make you rich. It will if you find it, but so will picking the right lottery numbers. It's easier to invest in haystacks - and it's a lot safer. Applying investment capital into growing waves where more capital will propel your position forward is easy if you pick the big themes. Following the big capital waves will also help you see when they're exhausted and starting to roll over. Getting out at the right time will not only save you money, but it will empower you to get back in when you see another opportunity starting to ripple.

Source: http://moneymorning.com/2010/03/30/capital-waves-4/

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