How to Invest in the Third Year of a Stocks Bull Market

By: Money_Morning

Martin Hutchinson writes: The current bull market in U.S. stocks celebrated its second birthday on March 9.

With human beings, a 2-year-old is a lusty toddler with a lot more growing to do. For a bull-market-run in stocks, however - particularly a bull market as vigorous as this one has been - the two-year mark is a good time to start searching for some serious signs of aging.

Don't get me wrong: The U.S. bull market could continue - indeed, it probably will continue for some time to come.

But we are almost certainly much closer to its end than we are to its March 9, 2009 day of birth.

And that reality means that we need to invest in a certain way.

A Historic Surge
On March 9, 2009, the U.S. Standard & Poor's 500 Index closed at 676.53. Two years later, it had reached a close of 1320.02, a rise of 95.1% - and a "total return" in excess of 100%, if dividends are included.

This kind of a bull-market run in stocks is a very rare event, to say the least. Indeed, the S&P 500's two-year rise is the largest since 1953-55. The only other preceding comparable surge took place from 1932-34.

The long-term fate of the previous two U.S. bull-market surges was very different. The 1953-55 surge led to a four-year bull market, and overall to a 13-year prolonged rise that took the index to almost four times its 1953 level.

On the other hand, the 1932-34 surge proved to be something of a false dawn; the market faltered thereafter. In 1937-38, in fact, U.S. stocks experienced a renewed decline that wiped out most of the gains that they'd achieved in the earlier period from 1932-34.

After that, it wasn't until 1949 onward that U.S. stocks resumed a firm, upward trend.

In the current U.S. bull market, the surge is more likely to resemble the 1932-34 period than it is the exuberant 1950s boom.

Although corporate profits have risen healthily - so that the theoretical Price/Earnings (P/E) ratio on the S&P 500 is lower now than it was in 2009 - that surge in corporate earnings is very artificial. It was ignited by the opportunities that American companies were given by the monetary policies of U.S. Federal Reserve Chairman Ben S. Bernanke. Those policies have enabled firms to leverage themselves at very low cost.

Legendary U.S. Treasury Secretary Andrew W. Mellon in 1929 defined the healthy policy when a bubble bursts as one of liquidation, to purge the rottenness from the system.

This time around, unfortunately, very little of that valuable liquidation has occurred.

Admittedly, Lehman Brothers Holdings Inc. (OTC: LEHMQ) was allowed to go bust and Merrill Lynch (NYSE: BAC) and The Bear Stearns Cos. were absorbed. But Citigroup Inc. (NYSE: C), General Motors Co. (NYSE: GM), Chrysler Group LLC and American International Group Inc. (NYSE: AIG) were all rescued from liquidation by taxpayer handouts, and have been allowed to continue operations.

Even Fannie Mae (OTC: FNMA) and Freddie Mac - the epicenters of the entire multi-trillion-dollar housing disaster - have been allowed to stay in business with huge public subsidies.

Thus, the huge removal of capital from old, unprofitable activities and its redeployment into new and value-creating activities - which is the healthy role that "recessions" play in a capitalist economic system - has been blocked.

That means that the current economic recovery is artificially old; the "green shoots" of true growth are very feeble and employment creation is far below par. All of this could change very quickly - for the worse, if one particular variable were to change.

I'm talking about interest rates.

Indeed, interest rates are right now the sword of Damocles that are hanging over the bull market, and that will determine its future.

At some point, surging inflation - both direct, and from the zoom in commodity and energy prices - will force the Fed to push up interest rates. Moreover, the continued enormous budget deficits will at some point take a toll on the U.S. Treasury bond market, pushing up yields.

If you're trying to figure out when all of these different issues could intersect, to create the scenario that I've sketched out for you here, it seems to me that the third quarter of this year is a likely candidate.

You see, once Bernanke's "quantitative-easing" purchases of Treasury bonds end in June, the market will be forced to face up to the fact that the Fed has been purchasing more than half the new net issuance of Treasury bonds, and buyers for the other half will have to be found.

Apart from causing massive losses to the financial sector - almost certainly largely unhedged, since "gapping" (borrowing short-term money and lending long-term) has been very profitable, indeed, for the last two years - this rise in interest rates will substantially reduce U.S. corporate profits.

When that does occur, you can expect it to be accompanied by a major downturn in the stock markets.

Moves to Make Now
To survive the shift that's coming, you have to embrace a very specific mindset - and adjust your holdings accordingly. First and foremost, you have to realize that sound, long-term profits are unlikely to be available in this market and that speculative short-term gains must be sought, with the majority of our capital being kept in cash.

Buys in the commodity sector, such as iron-ore heavyweight Cliffs Natural Resources Inc. (NYSE: CLF) and metals miner Teck Resources Ltd. (NYSE: TCK), along with the iShares Gold Trust Exchange-Traded Fund (NYSE: GLD) and the iShares Silver Trust ETF (NYSE: SLV), will allow us to take advantage of the final gains of the current cheap-money period.

However, we should already look to be protecting ourselves from any losses that would accompany the end of the U.S. bull market, or perhaps even to profit from the inevitable downturns in the stock-and-bond markets. Let's do this by using the ProShares UltraShort Lehman 20+ ETF (NYSE: TBT) for the bond market and a long-dated out-of-the-money S&P 500 "put" option or two - perhaps the 700s of December 2013 (CBOE: SPX1321X700-E) - to protect us in stocks.

Finally, the outlook for many of the emerging markets is better than it is for the United States, since their growth is stronger and their budget problems mostly weaker. For a single holding, the iShares MSCI Emerging Markets Index ETF (NYSE: EEM) is a solid pick, with net assets of no less than $36 billion.

[Editor's Note: There's a segment of the stock market whose investment returns are five times that of the typical stock.

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Fortunately, Money Morning Contributing Editor Martin Hutchinson is among that 1%. The 37 years he spent as an international merchant banker gave him that knowledge, and that insight.

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Source : http://moneymorning.com/2011/03/22/...

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