Shilling’s known for calling it as he sees it. In his most recent INSIGHT newsletter Shilling sounds a note of strong pessimism, but thankfully also gives us some direction on how to position our portfolio for what he sees as a sluggish economy ahead.

Economic View

Shilling believes the economy is going to get much worse from here on out. In fact, he is pretty sure we’re headed for another recession in 2012 and perhaps another decade of flat GDP growth. The reasons he cites are high unemployment and federal deficits here at home, regional conflicts abroad, and increasing global unrest.

Shilling also lists nine well-formulated reasons to support his pessimism, but we won’t go into that here. Suffice it to say that his reasons do hold some merit.

Shilling’s List – What To Sell

Sell U.S. Home Builders. Shilling believes this sector has over-binged, that home prices could still drop another 20%, and recommends selling home builder stocks if you own any.

Sell Realty Investments. He urges real-estate investors (Steve: such as some of my listeners that have second homes and investment properties) to get out now before prices drop further and you’re stuck in a market with no liquidity.

Sell U.S. Bank Stocks. Shilling thinks regulatory uncertainty, gridlock in Congress, and underwater mortgage loans will weigh heavily on bank stocks.

Sell Commodities. He believes commodity prices are bubbles that will soon pop because of sharply reduced demand in the weakened global economy he’s predicting. He also believes there’s far too much speculation in commodity prices that is removed from reality, and this cannot continue when fundamental demand drops.

Sell Emerging Markets’ Stocks. With low returns at home,U.S. and European money has driven up emerging markets’ stocks to unsustainable levels. He sees a correction coming as weak demand fromU.S. and Europe grinds emerging economies to a stop, withChina most at risk.

Okay – good to know and imbibe into our investment decision-making subconscious mind. Now let’s see what he wants us to buy.

Shilling’s List – What To Buy

Rental Apartments. Okay… so he’s negative on housing and thinks the American dream of homeownership has temporarily gone awry (Steve: remember – his thoughts, not mine) so he suggests investing in rental apartments because more Americans will be renting, on tighter budgets that favor apartments. (Steve: in the rest of the world, more people rent and live in apartments than own single-family homes.)

North American Energy. Very simply, with increasing conflicts in oil producing nations (many run by oppressive dictators or monarchs),America plans to reduce its dependence on foreign oil. And sinceAmerica has a voracious appetite for energy,U.S. energy producers will do well over the long run.

Income-Producing Stocks. According to Shilling, the stock market’s gone nowhere over the past 12 years. So he recommends income stocks – utilities, drugs, telecom, preferred shares and the like. (Steve: I agree in that it’s important to have dividend stocks in your portfolio.)

Treasury Bonds. Despite all the naysayers, Shilling lays his trust inAmerica. He thinks Treasurys will offer a safe-haven in what he sees as a coming deflationary storm.

The American Dollar. And he believes the American dollar will hold its value way better than most other currencies.

So, the good news here is that Shilling isn’t asking us to get out of stocks altogether. He’s just asking us to rebalance our portfolio to play it safe, should his forecast become reality.

Now remember, the list above only reflects one man’s views. So after you read this, please do not rush off to call your broker and execute these trades. Heed Shilling’s advice, talk to your financial advisor, and let your collective best judgment prevail.

If you want to act on nuggets of his advice that make sense for your portfolio then I suggest you use ETFs, futures or indexes that give you the upside while minimizing your downside.

Shilling paints a kind of worst-case scenario. In response, the best investors do not bury their heads in the sand but analyze such points of view – so they can ready themselves should calamity strike. The best also know that no one can predict with certainty what lies ahead. So they keep themselves informed but don’t get overly alarmed or influenced by any one.

So keep a balanced view and a cool head, and invest for the long run.

The market’s skittishness tells us that investors are nervous about all sorts of things:

- Unemployment stubbornly holding above 9% (it’s 9.2% if you believe official figures)

– Continued weakness in the housing market

– Political wrangling over the raising of America’s debt ceiling

– The highest trade deficit in three years

– Possible repercussions from the ending of QE II in June (that’s the Federal Reserve’s second Quantitative Easing package which expired June 30^th)

– Sovereign debt crises in Greece, Italy, Spain, Portugal, Ireland, and who knows where else

– The Arab Spring (revolts in some oil-exporting Arab nations such as Syria, Libya, Bahrain, Tunisia and Egypt) 

Are you nervous yet? 

I thought you might be. And you know what? Your nervousness might just be good for your portfolio. Here’s why. 

Prices Reflecting Reality  

Earlier, stock prices may have risen artificially because of the massive sums injected into the economy after the financial collapse. But now, with the end of QE II, each company’s stock price is beginning to reflect its competitiveness and profit potential in the quarters ahead – which is how companies should be valued. Weak companies will see shares dip as investors put their money to work elsewhere. Strong companies will likely benefit from this rush to quality. So, if you are a value investor, as many of my listeners are, good things may lie in store for you. 

Climbing a Wall of Worry 

I’ve spoken before about the benefits when investors have to climb a wall of worry. It makes them evaluate the repercussions – on their stocks – of everything that they are worried about. In so doing, they tend to gravitate towards high quality companies with good prospects in even a weakened global economy. If climbing a wall of worry is what gets investors to top quality companies, so be it… and I am all for it.  Also, once again, if investors are worried, stock prices are usually more fairly valued.

Good is Great 

When there is so much to worry about, even the smallest good news comes as welcome relief. On the flip side, when investors are drunk on a bubbly stock market, they tend to disregard good, solid news and punish companies overly. The current doom and gloom opens up the real possibility of a pleasant surprise over the next six months. We, hopefully, may just find out that things aren’t so bad, and that could boost shares once again. If that happens, it’ll likely boost high quality companies only as chastened investors stay away from random stocks. 

Dividends Again

When markets are high, investors often disregard solid, dividend paying companies in favor of high flying stocks. But when times get tough, many companies bring back or boost dividends to attract investors. Some large companies pay well over 3%, which can add nicely to your returns.  Also, companies will buy back their own shares, which spreads the wealth to existing shareholders-another way your company share price might increase. 

Low Interest Rates 

When the economy is weak, central banks prefer holding down interest rates to keep the economy from getting worse. Weak demand also keeps a lid on prices. Both, low interest rates and low inflation can be good for corporate bottom-lines and for the stock market as a whole. 

I believe it’s a good thing when investors do not take stock returns for granted, as they have many times in the past. This nervousness from time to time is like a cathartic awakening that makes investors realize, some of their follies makes them clean out the junk in their portfolios and makes markets healthier for the long run. 

One Final Thought 

Everyone has a story about how they just KNEW they should have gotten out of the market prior to the crash of 2008. Or how they knew they should have bought real estate in 2002. They recall their gut feelings and perhaps a phone call to their advisor telling him to sell. The point is that it is the action –whether you sold or not–that matters not the thought. Thinking about it does not reduce risk or create gain. 

So many today are worried about the stock market and are still unwilling to step in and take some risk. As the economy continues to grow and markets rise —over time—it will be the action you take today which will determine your future. 

Just thinking about it will get you nowhere.

Anyone who plans to manage or be actively involved in managing his own investments should know how to read financial statements and accounting footnotes (which, by the way, is often where the real nuggets of material information lie). 

In addition, here are a few handy tips to help you succeed with investments you plan to make on your own. 

Risk Capital 

Only invest money you can afford to lose. This excludes your 401(k), IRA, and the bulk of your savings. If investing is a hobby, start with anywhere between $500 and $5,000 but no more (unless you have millions in the bank already). Indulge your passion, but only to the extent of winnings on this portfolio. And do not rush to bet the bank if you run across some beginner’s luck. Give your initial investment at least 3 years before managing more of your own money. 

Written Plan 

Think of your $500 or $5,000 as a business investment. Before you plow it into the market, develop a written investment plan – what are your goals, what are your benchmarks to measure success and failure, how long do you plan to keep at it before throwing in the towel, what would your expenses be (such as investing newsletter subscriptions, which really is not such a bad idea if you can find a good one), how much could you afford to lose without sinking the ship (remember, a business cannot lose all its working capital if it hopes to survive over the long run), and so on. Again, ask your friends and colleagues who manage their own money, and I’ll bet you a dollar that not one of them has a written investment plan. 

Track Your Investments 

Well, the IRS wants you to… unless you’re playing with fire and managing your own IRA and 401(k). Develop a simple spreadsheet with the trade date, number of shares, purchase and selling prices, commissions, profit (loss), original investment thesis, and reason for selling. It’s pretty easy once your start. Then review this weekly or monthly to see which of your ideas worked, which didn’t, and how far off you were on some (as you inevitably will be). A tracker helps develop your investing gut over time. 

Focus On What Works 

Too many people bounce from stock to stock, and especially abandon their losers. Your losers could turn into real winners because dips may well present excellent buying opportunities if your initial investment thesis was well developed. Additionally, your investment tracker will tell you what works best for you, so focus on what works… it’s a pretty simple idea.

Sleep Well 

Don’t let daily news bites upset you or your portfolio. Track your investments daily or weekly, but not minute to minute. Diversify your portfolio and include stop losses so the % loss on your entire portfolio is small enough that you don’t lose your peace of mind. I am amazed at how many lose sleep and get stressed when they actively manage their own money. Losing sleep over investments is JUST NOT WORTH IT! 

Accept Responsibility 

Good investors do not get influenced by strong personalities. Good investors also manage to keep their portfolios afloat in even the worst of times. They listen to investing ideas from everyone but do their own research before pulling the trigger. And take full responsibility for their investing actions, particularly their losses. 

See… all I’ve said above is really just common sense, but we all know the saying… 

Act on these ideas and you could enjoy a lifetime of investing as a hobby with just a small initial investment, with the added upside of generating good returns. Good luck!

In fact, many analysts look at housing data to gauge the health of our economy. Very simplistically, if folks are above-water on their homes, they feel confident and spend on all manner of things – new clothes, cars, home improvements, new businesses and so on. When their homes are worth less than what they bought them for, they feel less inclined to go out and spend or start new businesses.

The state of housing, in turn, depends on the following factors: 

Employment: Sort of obvious, isn’t it? Without jobs, people cannot take out loans to buy homes so housing demand drops, and home prices either stagnate or dip (as they have done since June 2006). So we must see meaningful job creation before a recovery in housing. 

New Housing Loans: Take data on new mortgage loans, and then strip out refinancings (because they do not indicate new home purchases). What we’re left with are mortgages for home purchases – compare this to historical numbers to see if loans are rising or falling, and at what rate. This is a two-way indicator. It tells us if Americans are taking out loans to buy homes and if banks are upbeat enough about the economic future to make loans to creditworthy buyers. 

Housing Inventory: Basic supply and demand between homes available for sale versus home buyers. As a rule of thumb, if there are more homes for sale than buyers plan to purchase in 6 months, prices fall. When housing inventory is less than 6 months, prices typically rise. For example, during the housing bubble, inventory was often less than 4 months. When the housing market crashed, inventory exceeded 12 months. 

If we factor in shadow inventory – properties which could come up for sale because borrowers are more than 90 days delinquent on their mortgages – housing may take slightly longer to recover.

Price Trends: Watch housing prices for signs of strength of weakness. Rising prices bode well. Falling prices typically suggest economic weakness. 

Construction Activity: When there is a lot of existing inventory of homes for sale, builders hold back on new home constructions. Builders may also hold back if they expect economic weakness because they wouldn’t want to build homes with few takers down the road. 

Lumber: 88% of all U.S. lumber goes into housing construction. Thankfully, the lumber market attracts few speculators, so lumber prices pretty accurately reflect real supply and demand. If prices start to go up, we can be pretty sure that construction activity is on the rise – a good early sign of a recovery in housing. 

Knowledge is power! So… now that you’re considerably wiser on the factors that impact housing, you will find yourself perking up every time you see them on paper or hear some talking-head spout these numbers. Almost subliminally, you will pick up information that earlier just went over your head. My hope is that, armed with this information, you will develop a keener sense on housing related signals, their implications for the economy, and more specifically, for your portfolio, and make better investing decisions.

However, smart investors know that their portfolios must contain blue chip stocks, growth stocks, and dividend heroes. 

Now… broad market forces control stock dips and rallies, and even the best run companies take a dive when investor sentiment sours! 

However, fortunately for investors, individual companies, not market sentiment, control the fate of their dividend payouts. So, even if a solid company’s shares drop on a broad market pullback, it likely will still pay out dividends if its earnings stay solid. 

So dividends are an investor’s friend because they provide income that gooses market returns, and a layer of diversification against the broader market. 

When markets are rallying, most investors, barring the level-headed and well-advised ones, pooh-pooh dividend stocks and focus solely on stock gains. When markets sour, investors come back to dividend payers. 

Moreover, sane investors always seek out diversification and have a portion of their assets in bonds or CDs. But what is one to do when 1-year CD rates are no higher than 1.3% and inflation is running at about 2.2%, as it currently is. 

This is when you should look for strong dividend paying stocks. Moreover, dividend payers may be less risky than bonds because bonds lose value when interest rates rise but dividend payers may well increase rates. Plus, you always have the option of selling your shares and shifting into higher yielding bonds when the time is right. 

But again, what is one to do if even large-cap US stocks on average deliver a dividend yield of only 2.2% – just about in-line with inflation?

The answer, my friends, is to look abroad for dividends! Because foreign stocks deliver significantly higher dividend yields than their counterparts in theU.S., partly because many foreign companies have a more traditional approach – that their earnings belong to shareholders and must be returned as rising dividend payouts. 

I know, it’s as if everyone is urging us to sell our jewelry or invest in gold or gold coins.

I know from experience that it’s a sign. It’s a big fat market signal. But I’ll get into that in a minute.

Investors tend to flock to gold when there is instability in the global stock or currency markets. The reason for this is gold is viewed as a safe haven or a hedge for stocks or currencies. Therefore, if you’re using gold in your portfolio to hedge against any downside risk then that could be a good decision. However, if you’re interested in taking your money for retirement and buying gold in expectation of earning crazy high rates of return, then you may want to think twice about taking this risk.

History proves that during U.S. economic recessions gold tends to trade relatively high relative to its historic average. The question now becomes, since we’re not in a recession why is gold still trading so high? Well here may be a few answers…

The constant uptrend in price for the past two years has been partly a result of the dramatic increase in demand for the precious metal from developing countries, mostly China and India.  

For example, India’s consumer demand for gold (jewelry, bars, and coins) is a whopping 1,035 tons, China demands a second of 714 tons, Europe is third with 306, and the U.S. and the Middle East fall in last at nearly 239 & 225 tons respectively, according to the World Gold Council. The demand for the yellow metal is extremely high, which helps to keep gold prices high.

But there are other considerations as well. 

Gold has never been easier to buy and sell as an investment as it is today and the reason is the introduction of a new type of investment called the exchange traded fund or ETF. Used to be that in order to buy gold as an investment, one had to purchase the bullion from a reputable source and have them store it in a vault which required you to pay storage fees. You had to be certain the gold was certifiable and buying and selling came with the additional cost of big commissions for every transaction.

Today, through the ETF, one can just buy it and sell it like a stock. Every share represents a certain fraction of actual gold sitting in vault and the price of the ETF very closely tracks the price of the precious metal.

Making it easy to buy and sell, attracts more investors, especially great pools of capital from hedge funds, institutions and thousands of small investors.

This will lead to higher prices as speculators continue to push up the value of the ETF for trading purposes only. This price movement does not take into account the actual fundamentals of supply and demand.

Keep in mind, that what goes up in speculation can also come down in speculation. Once rising consumer prices start to taper off and the world economies and currencies start to repair themselves into better shape, precious metal may not look so attractive and prices could come down like a rock. All you need is for Gold to revert back to its historic average price and you would see the metal decline significantly in value.

Pinpointing the exact time when a peak in the price will turn into a valley is pretty much impossible; no one has a crystal ball, but one must be aware and prepare for the eventuality of falling gold prices.

Here’s another consideration to remember: the best investments are always those that actually are productive in nature. For example, investing in an oil refining company that produces refined oil or a manufacturing company that produces consumer goods would be considered great investment prospects. Investments which generate cash which can be reinvested or used by investors to live on are the cornerstone for creating real wealth.  Gold however, produces nothing. No income, no jobs, or any economic value. It serves no industrial purpose. Its price is only driven by supply and demand for items of adornment, or as a rock to hide under in bad economic times.

Simply put, gold has been an investment over time.

So if you’re a speculator and you’re in the position to speculate with your money then do so of course, but buyer beware and good luck.  However, if you’re nearing retirement or are already retired, you may want to think twice.  Ask yourself: Is buying gold now an expression of the “Greater Fool” Theory. This is the idea that the only reason to buy something is with the hope that you can sell it to someone who is a greater fool than you.

Gold may be at that point right now, just like real estate was in 2005 and Internet Stocks It seems most of the best returns have already been earned by the investors who got in a few years ago. If you’re looking to play the gold commodity now then it may be a little too late.

So, getting back to the big, fat market signal I was talking about earlier, Remember, by the time an investment is marketed to the general public as we see today in television ads to buy or sell gold, or the ADS we saw 6 years ago to buy and sell real estate or anything touting “next big” investment, it’s already too late to get in.

These signs are indicative of a peak and soon due for a reversal. History has proven this theory over and over again. Oil and Gas in the 70’s and 80’s, internet stocks in the late 90’s, Real Estate in the mid 2000’s and with structured products like the mortgage backed securities that played a part in nearly causing Armageddon in 08’.

The point is, when things are extremely popular and it has become the new “hit sensation”, when it pertains to investments that is, stay away from it, and if you own any of it now is the time to sell.

Let’s take a deeper look so you can make the right decision should your advisor offer them to you.

Tax Deferred Annuity

A tax deferred annuity is an investment product offered by insurance companies where more often than not, you invest a lump-sum to receive a handful of benefits.

Here are its key features:

Tax deferral – you are only taxed when you withdraw funds, much like an IRA.

Your money can be invested at a guaranteed fixed rate of interest (Fixed Annuity) or in mutual funds with returns based on market performance (Variable Annuity).

A Fixed Annuity offers CD-like fixed interest rates whose safety is backed by the insurance company.

A Variable Annuity invests in mutual funds that may contain stocks or bonds, so returns are tied to fund performance and inherently fluctuate. Your money is not guaranteed by the insurance company.

You pay penalties for the early withdrawal of earnings prior to age 59 ½ and all earnings withdrawn will be taxed at regular income rates (as opposed to much lower capital gains rates).

That was the easy stuff… let’s dig a little deeper

Years ago, when capital gains and income taxes were higher, annuities were an attractive investment. You could defer your investment earnings until retirement or such time you were in a lower tax bracket and benefit from withdrawing your money at lower tax rates. Now that tax rates are lower and rates on capital gains are only 15%, annuities have become far less attractive. Many correctly question the logic of paying back 38% of their earnings in taxes instead of only 15%.

Designed to Sell

Insurance companies are in the business of creating products that agents will be able to sell to meet public demand. This may be a fine attribute for a sneaker maker or car manufacturer, but it is a dangerous idea in the investment world. It has been shown time and time again that investing in the most popular idea is a sure way to lose money. Think Internet stocks of the 90′s and Real Estate in 2005. It’s the same old story – when markets go down and people are scared, insurance companies bring out a slew of annuities with certain “guarantees”. Guarantees which limit volatility right at the time you need “upward” volatility to recoup paper losses. When markets are hot, they bring out their most aggressive offerings to entice you to buy and reap the benefits of the current bubble.

We have now entered a time when, after 10 years of mediocre market returns and a lot of volatility, insurance companies have de-emphasized growth and focused on income.  After all, no one believes in growth anymore! This new focus takes our eyes off the tax problems I mentioned above and concentrates our attention on our new, latest “worry”:  The fear of outliving our assets and dying penniless. Here is the new pitch: “How would you like to receive regular, guaranteed income for the rest of your life without having to worry about scary markets or dire economic conditions”. Sound too good to be true? Maybe, but it’s the perfect sell to a worried world.

Guaranteed Income Schemes

Since many seniors fear their nest eggs will not see them through their many years of retirement, insurance companies have now added a new feature which seemingly enables your wealth to grow in spite of the stock market’s performance… the impossible made possible, brought to you by the geniuses at your favorite insurance company!!

These products have names like Guaranteed Minimum Income Benefit (GMIB), Guaranteed Minimum Withdrawal Benefit (GMWB).

For example, under Guaranteed Minimum Income Benefit, you invest in the company’s variable annuity for a specified time, typically 10 years. If the market does not perform well, the company guarantees your investment will grow “on paper” at a rate of 5% or 6%. This is called the “base benefit” amount. Can you get this money at any time? No, it is only on paper to calculate a future income benefit when you are ready. 

 The insurance agent basically says, “You pay us an extra insurance premium and we will guarantee a set income to you in 5 or 10 years, even if your account value falls to zero”. The mutual funds you invest in can’t go to zero and the insurance company knows this – but nevertheless it imparts a certain peace of mind to the investor. 

The Bottom Line 

So, many pay this expensive extra premium and very few will actually receive this benefit near the end of their lives.  Most will have wasted their money. 

So you can see the selling cycle continues and once again, we have reacted with our emotions and made the same fatal flaw that got us to this point again and again. 

Want to get the respect you deserve and actually accumulate wealth? Here’s what you do. The next time things get dicey and your agent or broker tells you about a safe guaranteed investment, stop. Think. Do the opposite. Invest in stocks to take more risk.  After a while when stocks rise in price-as they always do-and your agent recommends an annuity with features which enhance the growth of your stocks, stop. Think. Do the opposite. Invest in safe fixed investments. 

In other words, do the exact opposite of what you feel and don’t let the agent convince you otherwise. This will greatly enhance your prospects for success. It’s not that hard, you just have to understand how things work and follow these simple rules.

Interest Rates

Recently, the minutes of the Federal Reserve Board’s April 2011 meeting revealed that the Fed was in no immediate rush to raise interest rates in order to encourage business investment, and to foster economic growth.

U.S. businesses are well-aware of this incredible window of opportunity to raise cash at rather low interest rates, because they know that this will soon give way to higher borrowing costs. As a result, many cash strapped and cash rich firms are rushing to raise capital.

Even Google – with a cash hoard of $36.7 billion – decided to get in on the action. It recently announced a public issue of corporate debt with three interest rates 1.25% notes due 2014, 2.125% notes due 2016 and 3.625% notes due 2016. What Google will do with that extra cash on top of its existing stash, no one really knows. My guess is they’ll invest it, make more than the interest due, and juice profits further even though they state that the cash will be used “to repay outstanding commercial paper and for general corporate purposes”. Yaa, right!

LinkedIn’s IPO Surge Sets Stage for More Internet IPOs

It’s not 1999, but it almost feels like it – with Microsoft buying Skype for $8.5 billion and LinkedIn shares surging on its Initial Public Offering. LinkedIn’s IPO was a major test of investor demand for a new wave of fast-growing social Web companies. And investors passed the test with flying colors!

LinkedIn’s shares opened at $83 – near double their offering price of $45 – rose to a high of $122.70, then settled at $94.25, giving the company a market capitalization of almost $9 billion – 584 times last year’s earnings and 37 times last year’s revenue.

“If LinkedIn is worth $10 billion, you got to think, what is Facebook worth?” remarked Peter Falvey, a managing director at Morgan Keegan.

How LinkedIn will grow to justify this super-lofty valuation, God only knows. Can it achieve such super-charged growth and profitability as it faces competition from Monster.com and CareerBuilder.com? Time will tell, but I somehow doubt it.

While the strong pop in shares is great for LinkedIn shareholders, it could ultimately be an albatross for the company and for investors that bought-in at lofty valuations.

Non-distressed homes… signs of moderate recovery?

According to Citigroup, the prices of homes in certain non-distressed sectors may actually be rising. Citi divided the market into two categories: distressed and non- distressed.

Aggregate prices for all houses sold dropped about 1½% in March 2011. However, prices of non-distressed properties actually increased by about 1%. Citi further states that its analysis does not support bearish predictions that housing could drop another 10% to 20%.

So things may well be looking up on the housing front.

Commodities

Oil is trading at $100 per barrel, 13% below year-to-date highs. Cheaper oil should lower business expenses and lead to better profitability, and hopefully more hiring and fewer jobless claims.

In other commodity news, banks in Hong Kong were asked to increase capital reserves, a step seen as China’s attempt to dampen access to easy funding, cool economic growth and curtail inflation. In response, Copper – an indispensible metal for industrial growth – fell for the first time according to Bloomberg. Copper futures are now down 10% year to date and off 13.5% from earlier highs.

What does this all mean…

- low interest rates                   √ CHECK

- bullish IPO response               √ CHECK

- positive signs in housing         √ CHECK

- dropping commodity prices     √ CHECK

A continuing low interest rate environment is good for business. LinkedIn’s enthusiastically received IPO suggests investor willingness to re-embrace risk. Housing seems to be doing okay in non-distressed sectors that were not subject to builder excesses.

At the same time, commodities suggest moderation from the rapid economic growth rates inChina,Indiaand other emerging economies – a controlled slowdown is always better than a blowout at high speed.

So broadly speaking, the news is reasonably positive.

Now… one should buy when the news is awful (as it was in 2008) and refrain from buying when the news is good, ironic as it sounds.

So perhaps, for the moment anyway, investors should avoid getting in to the market at this ‘good news’ inflection point. It’s better to wait and see whether the good news is a short-term blip or the beginning of a new trend.

Always intellectually challenging… that’s why this business is so much fun. If you choose to sit it out for now – enjoy your holiday!

Finance undoubtedly is a science based on valuation methodologies, debt-to-equity ratios, weighted cost of capital, earnings growth rates, return on invested capital, competitive positioning, macroeconomic trends and several other numerical factors.

You cannot understand investing by merely observing the fruit of the tree – you must know how deep and strong its roots grow beneath the soil, and whether those roots can withstand a heavy storm or will give way to merely a strong breeze.

Paradigm

Scientists use the word paradigm (pronounced para-dime) to describe a pattern, model or framework that stands true for long periods of time. Paradigms generally hold true until internal or external changes cause fundamental and often disruptive shifts in the model or framework.

In finance, studying historical paradigm shifts helps us understand disruptive factors and predict future trends.

In an April 2011 newsletter, prominent investment strategist Jeremy Grantham identified four paradigm shifts in the global economy – in oil, metals, agricultural commodities and weather patterns.

Let’s get his take on each.

Oil

In 1974, while most commodities trended downward, oil rose abruptly. Caused in large part by the formation of the Organization of Petroleum Exporting Countries (OPEC), a global cartel formed to regulate each member-nation’s oil production and export volume. However, OPEC seemed to have the complete opposite effect – prices rose even more after its founding.

Grantham has analyzed oil price trends and statistics and concluded that oil prices trade for long periods within a narrow band, but occasionally trade higher into a new band. In other words, they experience – a paradigm shift.

- First shift: Oil prices averaged $16 per barrel for nearly 20 years but in 1971 jumped to a new level at $35 per barrel. 

- Second shift: Oil prices averaged $35, and jumped to a new average price of $75 in 2007 

- Possible third shift: Right now, prices average $75, and could rise to a new average of $180 if history holds true.  

Grantham expects oil prices to reach a new average price of $180 per barrel as another paradigm shift takes hold. (Yes, I too am hoping this does not come true.)

Metals

Due to the rapid growth of several emerging economies, many industrial metals have seen dramatic increases in demand over the past decade. One such metal is copper, which is currently trading near the top of its long historical price level partly because of high demand from countries like China, and partly because the costs of extracting and processing the metal have gone up.

All easily minable copper has been exhausted so miners now have to dig up 50% more ore to extract the same amount of copper or develop new mines in remote locations. As Ivan Glasenberg, CEO of copper mining powerhouse Glencore, says “We took the nice, simple easy stuff from Australia, the U.S, went to South America and now we have to go to remote places.”

Grantham’s research shows that copper trended down for nearly 100 years until 2002, when it hit a 110-year high in 2010. This leads him to predict a second paradigm shift in copper prices to a new higher price band.

Agricultural Commodities

Wheat, Rice, Corn, and Soybeans – unlike other commodities, are still considerably below their previous highs experiencing only minimal price swings. Historical price data does not suggest a paradigm shift based on Grantham’s model, but prices could move dramatically if weather patterns impact crop yields. We’ll have to pay close attention to the weatherman.

Weather

Very rarely do all agricultural commodities move in tandem, either during a drought or after a flood, both of which are the result of unstable weather patterns. Recently unstable weather has been the norm over the past 12 months (the central U.S. has just experienced the worst floods in 80 years). Prices are expected to decline next year as the weather improves.

Paradigm Shifts and You

To be successful, every investor should know as much about the global markets as possible and hopefully this article will deepen your knowledge and understanding of the events which impact the markets. Having an unshakeable idea of the fundamental nature of trends can give you the perspective needed to understand current events.

You see, it is the use of science not art that will help you create the most wealth.

Fed Chairman Ben Bernanke notes that “Rising commodity prices are a result of the rising demand of emerging economies”.

The changing face of emerging economies

As developing nations such asBrazil,Russia,IndiaandChina(collectively “BRIC”) continue to grow and develop, they have witnessed:

1. The migration of citizens from rural areas to cities.

2. A transition from poverty to a large freshly-minted middle class with disposable income that they eagerly spend on all manner of goods – cars, refrigerators, flat-screen TVs, laptops, cell phones, jewelry, branded goods, food, cosmetics, clothes, and more.

3. Huge investments in infrastructure – roads, subways, airports, telecom, technology, and farmlands lost to malls, apartment buildings, hotels, golf courses and office parks.

4. Heavy demand for energy (coal, nuclear, petroleum), water, financial services, capital markets, colleges, etc.

Developing economies are driving a real and urgent demand for all commodities – cement, iron and steel, copper, gasoline, chemicals, wheat, gold, silver and so on – with businesses outbidding each other to keep their factories humming. 

Economics 101 – this voracious demand has led to an inevitable rise in commodity prices worldwide, leaving developed nations to cope – with higher prices at the pump, for food and just about everything else.

Aging workers

On the one hand, emerging economies are growing like there’s no tomorrow. On the other, their aging workforce raises questions about the sustainability of this growth.

Census numbers show thatChina’s elderly population has grown rapidly while its 14-and-under population has plummeted. Basically, there aren’t enough youngsters to replace older folk who are moving into retirement. 

According to Harvard Professor, Richard Cooper,China’s median age will go from 35.2 to 47 between 2010 and 2040,Russiawill go from 38.5 to 47, andIndiaandBrazil’s median population will remain current to theU.S. 

Which begs the question, how long can Chinamaintain its strong manufacturing growth and exports if it just does not have the human capital to replace aging workers?

Investing opportunities

Emerging growth is driving up sales, profits and share prices of companies catering to this huge demand.

So how can you as an investor participate in this?

Fortunately, it’s not that difficult. You can invest in:

- Emerging market ETFs (Exchange Traded Funds)

- Shares of Blue Chip companies with a large footprint in emerging markets

- American Depositary Receipts (ADRs are shares of non-American companies traded in dollars onU.S.exchanges)

- Mutual funds that invest in foreign companies

Many large-cap companies draw a substantial chunk of their earnings from foreign operations. Foreign operations contributed to:

- 50% of the revenue of large global S&P 500 companies in 2010

- 28% of the revenue for companies in the S&P 500 as a whole, up from 24% in 2009

Know the risks

While emerging economies are growing, they are also facing a lot of concomitant problems.

For example, in China, there’s been an unprecedented rise in wages that has made its products less competitive, debt levels have grown much too fast and banks have no real idea about the number of bad loans, and housing prices have risen to bubble levels. 50% ofChina’s GDP is driven by capital spending on unnecessary airports, roads and high-rise apartments.

If the economy slows, a lot of this demand could fizzle out almost overnight – ghost towns with half constructed towers, a reverse exodus back to villages, social unrest… and an inevitable drop in demand and commodity prices.

In many of these markets, the economic “car” is moving so fast that if there is a blowout it could lead to a big crash.

So investors should consult their financial advisors, be cautious, and carefully invest only a small portion of their portfolio, preferably in blue chip companies that have globally diversified earnings, that are not overly exposed to emerging markets, with products that would still be in demand were a crash to come… soaps, shampoos, computers, burgers, pizza, mobile phones, colas… you get the picture. Bon voyage!