Maintain Nerve

In terms of rollercoaster rides, investors around the world will surely feel like they have been on a big one this week. Although we missed the 'excitement' on Monday due to Martin Luther King Day, international stock markets suffered their biggest falls since the panic following 9/11.

"...we believe that whilst some sections of the market are likely to come under increasing pressure in the months and years ahead, our strategy of overweighting commodity, energy, and value situations should continue to reap rewards."

Selling was unprecedented and looked set to continue into Tuesday until the Fed came to the rescue with an emergency 75 basis points rate cut. Recession fears surfaced again on Wednesday, before talk of a $15 billion bailout of credit insurers by leading banks once again restored some investor confidence.

So testing times, but what does it all mean for the market, and more importantly, for Fat Prophets Members?

The short answer is that we believe some sections of the market are likely to come under increasing pressure in the months and years ahead, but despite this,our strategy of overweighting commodity, energy, and value situations should continue to reap rewards.

Now the long answer...

Starting from a charting perspective, the recent correction clearly exceeded initial expectations. On Wednesday, the S&P500 touched an intraday low of 1270.05, before finishing in a flourish at 1338.6. At the low, this was some 306.04 points below the October all time high of 1576.09.

However, considering the strong reversal in momentum on Wednesday combined with many indicators now being in 'oversold' territory, a rebound appears likely in the near term.

Longer-term, we cannot rule out additional volatility in the months ahead. Should a more substantial correction develop, a credible target is the 38.2% retracement of the 2002 to 2007 rally, which lies at 1264. This region sits just above longer-term support at 1224.

Unfortunately gauging the direction of the market during periods of uncertainty such as today is made all the more difficult by event driven moves. However, one should bear (pardon the pun) in mind that bear markets are characterized by vicious rallies. In the last bear market in the US (2000-2003) the S&P500 rallied by around 20 percent on three separate occasions.

While we certainly don't anticipate a rally of that size over the next few weeks, it does suggest that markets can bounce back considerably from extremely oversold conditions. 

At this point it is also worth talking about the psyche of markets, and their relevance to the events of this week, and indeed recent months.

Market corrections move at an incredible pace, and this therefore makes them emotionally challenging for all investors. When markets fall for an extended period, or just have very sharp short-term corrections, fear begins to creep into investors' psyches, and they begin to make irrational decisions.

It must also be remembered that a large number of investors in today's stock market have never experienced a major correction before. They have enjoyed the market's seemingly inexorable climb since the tech bubble deflated, with the apparent expectation that this is the only way that a market can travel. These sorts of investors are the first ones to panic and bail out.

Adding to the negative momentum is the predominance these days of investors that have borrowed heavily to invest. A typical investor has the decision of whether to remain patient or to sell during volatile times like we see now. However, many leveraged investors do not have the option of making this decision. Rather, it has been taken away from them by 'lenders' who require investors to sell stock in order to fund margin calls.

"One currency that cannot be debased is gold. Although the current market environment looks dire, we believe the circumstances are extremely bullish for gold."

Our message for Members however is not to throw in the towel and join in should any further panic selling emerge. If there are some exposures you feel uncomfortable with, use any ensuing market advance to exit or lighten your holdings. But for reasons we will explain, we believe panicking and moving wholly into cash is not the answer, despite the fact that it may feel 'safe'.

By all means, accumulate cash if possible, as there are bound to be some excellent buying opportunities to come out of this panic.

We have mentioned inflation and deflation in our outlook piece this year as a way to describe the big picture direction of the market. We are currently experiencing a large deflationary force in global asset markets, brought about by excess debt in the financial system, (in turn brought about by an historic credit bubble).

The only asset that does well in a deflationary environment is cash. But as we explained in our outlook piece, we don't think this deflationary period will endure for too long. Why is this? Because the global economy can't afford it to.

This is because there is so much debt in the financial system. Deflation increases the real value of debt, which is not good for the US with the highest absolute levels of debt in the world.

So, as we have mentioned on a number of occasions, we expect ongoing official intervention in the markets, with the aim of offsetting the current deflationary force with inflationary policies.

We have already seen the Federal Reserve make an emergency 75 basis points rate cut in response to market carnage this week, and we expect more rate cuts are on the cards. This could come as early as next week when the official Fed meeting takes place and we would not be surprised to see another 50 basis points cut then.  

Also, we expect more fiscal stimulus from the Bush administration and Congress. Last week's announcement of $150 billion in tax rebates was met with a market sell-off.  We believe Wall Street is expecting much more, and they'll very likely get it.

A preliminary agreement between the administration and Congress has apparently been reached. The total cost of the package is said, not surprisingly, to exceed the initial $150 billion proposal and includes measures to also help shore up the housing market.

And in case you missed it, the National Association of Realtors reported on Thursday that house prices recorded the first annual drop since they began keeping track in 1968. The 1.3 percent decline was accompanied by a whopping 13 percent fall in total home sales.

Meanwhile, internationally the Bank of England could also be forced to start lowering interest rates soon, too. The UK housing market is in trouble and the fact that London is the financial center of Europe (if not the world) means that falling financial markets will have a large impact on economic growth.

Despite representations to the contrary, displeasure with the strength of the euro could mean that the ECB is not far behind in cutting official rates.

What this all means is that fiat currencies will be the ultimate loser. Official actions will be designed to reduce the purchasing power of currencies', i.e. create inflation. In an era of floating currencies, inflation generally wins out. When currencies were fixed to gold (under the gold standard) deflation usually carried the day.

One currency that cannot be debased is gold. Although the current market environment looks dire, we believe the circumstances are extremely bullish for gold. Collapsing equity markets virtually assures a co-ordinated official response, and gold will eventually discount the long-term damage that this will do. Whether this occurs next week or later this year, we have no idea. However the fact that gold has already headed back over US$900 an ounce towards record highs, should come as no surprise.

To be clear, lowering official interest rates will not fix the global economy's problems. All it will do is create another bubble, this time in real money - gold. There are obviously risks to this scenario, however we believe the alternatives are less palatable and because of this, globally, governments will attempt an 'inflationary bailout'.

If the inflationary scenario plays out, the forces benefiting gold will also be bullish for all 'real' assets, including oil and base metals. If the purchasing power of fiat currencies decline, then by definition the value of real assets relative to those currencies will rise.

Of course, we also need to consider demand and supply factors. The key issue in our minds is the extent to which the current business conditions in America will impact upon the health of the world economy. Financial markets at present seem to be opting for the worst-case scenario, judging by the pessimistic coverage in the media and the huge falls on world stock markets.

We however are of the view that the global economy will avoid recession, although major economies like Europe, Japan and Asia generally, are likely to see a slight easing in growth rates.

China and India will be key. Both countries have massive urbanization and infrastructure programs underway that involve heavy spending on housing, roads, railways, ports, bridges, power stations and the like. Both countries have massive rural populations that are engaged in the biggest urban migrations ever seen. These major structural changes will not stop because of short-term financial woes in the US.

And exactly how important is the US these days? Between 2000 and 2006, the United States' share of the world economy fell from 31 percent to 27.7 percent, whilst in 2000 the value of companies listed on US stock exchanges represented close to 50 percent of all stock exchanges around the world, but this has since fallen to less than 33 percent.

The US is not disappearing by any stretch, but it is becoming less important, particularly with respect to commodity exporting countries. The chart below demonstrates that while America will continue to grow, over time it will represent an increasingly smaller portion of the overall world economy.

Furthermore, China and India are the world's two most populous nations. They have incredible internal growth engines that will continue their inexorable development. We believe they will continue to suck in commodities at a rate that will see the world's miners struggling to keep up.

Indeed, while economic growth in China is anticipated to slow somewhat this year (from the 11.4 percent in 2007 announced yesterday), at just below 10 percent this still represents an extraordinary growth rate by anyone's measure.

Given all this, what is our investment strategy?

Recall an important point that we made last year. We warned that the worst of the US sub-prime mess would not be seen until after the first half of 2008, as we prepared investors to expect volatility. Such has proven the case. However we accompanied these remarks with the argument that the longer-term health of the resources market should be unaffected, as demand for commodities, whilst likely to ease somewhat, should still remain buoyant.

And so to this end our strategy remains the same. We favor resource related stocks over the financials. Although the urge to sell out of the market and move to cash might be great, we would caution against this. If we are right about our inflationary forecast, cash will not do well relative to equities. Certainly accumulate cash in the short term, but look to deploy these funds as opportunities arise.

Smart investors will appreciate two important things about the current market environment: firstly, resource stocks are by no means over-priced and given the recent market fall-out, now represent even better value (see Rio Tinto in today's report); and secondly, the emerging economic powerhouses of China and India are not going to disappear.

In summary, the events of this week should see an ongoing co-ordinated official intervention in an attempt to arrest the deflationary decline we are now experiencing. This should lead to select asset inflation in the months ahead. By this we mean that in general, commodities should continue to do well while those stocks impacted by the ongoing fallout from the imploding credit bubble will continue to struggle.

The key in these sorts of markets is to remain patient. We would anticipate a continuation over time of the strong recovery seen earlier in the week, albeit with large amounts of volatility.

Withstanding the swings of the market is not a pleasant experience. But the key to 'surviving' such periods lies in maintaining a rational viewpoint and not panicking. Given the environment, we will continue to provide weekly updates and reinforce our long term investment strategy.