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Why India, China, and the US Will Have the Devil to Pay in 2012


Instead of focusing your energies on shorting US stocks, figure out how you can make money when Indian and Chinese real estate and credit markets collapse in 2012.

As a young man growing up in India, I was a voracious reader. I read pretty much everything I could get my hands on. And if I didn't have anything to read near me, my friends used to joke that I would be reading the phone book! That was not a fair characterization but like all tall tales, fairly descriptive of the situation. One of the books I read was The Devil to Pay by Earl Thompson. This was a fairly heavy book for a teenager in that it had some nasty portions to overcome, but overall, I would say a searing, terrific, hell of a novel by a fairly unknown but gifted writer, developed in the mold of Jack London. The ending in the book describes the title and it is pretty devastating.

Now 20 years later, when I look at the investing landscape as a hedge fund manager, I am certainly reminded of the title and the horrific ending of that book. If you are a trader, stock jock or a plain vanilla investor, you must stop and think about what I am about to describe.

Whenever I am about to plan for investing in a new year, I start with creating a basic sketch of what the year is going to look like (see my past predictions here) and how it resembles another year from the past. So when I came up with an investing plan for 2010, I wrote for my bosses in the hedge fund where I worked previously that 2010 will either look like 2004 or 2000.

My thesis that 2010 will look like 2004 was that we were coming off a pretty big year in 2009 just like in '03. However, in 2004, the rally in the S&P 500 stalled out around April. In particular (since my specialty was tech stocks), I noted that Tech stocks peaked that year in April and plunged. I predicted something similar to happen in 2010.

On the other hand, I also sketched an alternative scenario where 2010 resembled 2000. I wrote that if 2009 resembled 1999 in that we had a rip-roaring rally that peaked in March 2000, then 2010 would see a similar early rally that would stall out after an early surge. Sound familiar?

Both outcomes predicted a peak early in the year and then a plunge. So I was pretty short by April 2010 for a decline that came as I expected in Tech stocks. However, the decline in 2010 was halted by a surprise macro ingredient (which I failed to take into account) that was missing in both 2004 and in 2000: Quantitative Easing.

This meant that my playbook for 2010 being either 2004 or 2000 was only half correct. The rest of the playbook (and the decline) was postponed to another year, thanks to Fed intervention.

Remember however that when a market decline is artificially halted by external action vs. a market's own internal mechanism such as improvement in the market (or economy's) fundamentals, then the possibility of the decline being over is very remote. Think of it this way: A market that suddenly runs is like a runner applying a soothing analgesic to his fractured leg during a marathon. Yes the pain subsides and he starts running again but after a few minutes his leg goes completely kaput and he collapses. That's what happened to the real economy in 2010. All the leading indicators of the economy collapsed but the market zoomed ahead when Ben Bernanke promised QE2 in August'10.

So, when I look at what's ahead for 2012, I keep coming back to the unfinished decline in 2010 that was halted by the Federal Reserve. It did not result in fundamentals improving but only put more money into reserves as M2 and M3 surged but not the Money Velocity (circulating) in the real economy. Thus we had more "liquidity" but not more "investment". We got higher multiples for peak estimates of profits, but not a higher rate of profit growth.
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No positions in stocks mentioned.

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