predicting the future year


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The bear case rests on two major Federal Reserve policies: [i] the [gradual] withdrawal of QE and [ii] the continuance of ZIRP. If either one is reversed, the stock market reverses.

There is however the interest rate curve to consider, other than the short end which is controlled by the Federal Reserve.

10yr

The 10yr has bottomed. It has also started what looks like a new trend higher. This is in large part because the Fed switched its QE purchases away from the 10yr and back to MBS securities [to hold mortgages lower] and the banks’ balance sheets.

In the short term, a very indefinite period of time, I don’t believe that a rising interest rate effects stocks in a negative manner. After all buying against the trend of rising yields, costs you money. Also currently the real return is far lower, thus stocks, which appreciate nominally, continue to benefit.

At some point though this changes. At some point the relative risk of the so called risk-free return outweighs the nominal [or real] returns on holding stocks. At that point, we see a rotation out of stocks back into Treasuries. Will that point be reached in 2014? I don’t think so, but, watch it nonetheless.

Margin Debt.

Margin debt suddenly started to be discussed again within the last two weeks. Margin creates leverage. High leverage that remains unhedged, creates higher volatility. Higher volatility creates a higher perceived risk. Both of these combine into shortening the ability to hold investments, and magnify losses to the position. That margin debt is again at or near all-time highs argues for an increase in volatility. Data here

Volatility-Final-591x456

Sentiment.

dumb money

Sentiment is also driven via the media. Whether that be the traditional media or the newer blogoland. All forms of sentiment tend to conform to the current trend. When at extremes, also tend to be wrong.

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Let me start with this last year’s stock market. Retrospectively in a few years the refrain will likely be, oh, that was an easy market it only went up. Because [pretty much] it only went up, it has been a very difficult market to stay long in [lots of Hedge Funds couldn't or didn't] and underperformed.

parabola

So of course the question is: does this bull market continue? The answer at least from this chap is:

parabola collaspe

This is based on empirical data, a true statement. It is likely to be true at some point in the future also. The question again is, assuming that it is true, when? That of course is the question that no-one can actually answer although many will try.

One approach is to elucidate the variables that actually created the bull market from March 2009 through to today. Clearly QE must be on the list.

9-7-12-QE-Chart-SP

Also something that should be considered is that in a period of consolidation, the breakout, if it occurs, is substantial and sustained. As can be seen, the consolidation was significant and the breakout higher [for whatever reason] could run a lot farther than many might expect.

3-23-12-SP-Cycles-Nominal

Another argument for the continuation is that current valuations are not in that turnaround zone, the P/E still below 20 at 18.

crestmontbull

Sentiment fluctuates. Until recently however we have had a number of perma-bears. Some quite recently have flippe-flopped, but there are still enough out there to give the bull some legs.

eeyore

Interest rates at the short end are going to be held low. This means ongoing credit creation.

3mth

Unemployment remains high. This will allow the Federal Reserve to hold QE for longer, and also maintain the low interest rates until the inflation even on the manipulated CPI ratchets too high. However for the moment unemployment will not make any meaningful improvements.

Inflation also remains according to the manipulated CPI ‘low’. Clearly this is false, however until the mainstream start to shout fire, the general perception is that inflation is low will remain.

In summary, these have been the primary drivers of the surge in the stock market. Should they all remain, then there is no reason why the market cannot move higher in 2014.

I will look at the bear case in part II

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snoopychristmas

Predicting the future year.

This will be my annual attempt at predicting the future year. I’ll start this year by using last year’s quote:

You cannot step twice into the same river, for other waters are continually flowing in

Heraclitus, Fragments.

While that is certainly true, what we do know is that while the water is new, the essential component of the river is the same, viz. flowing water.

Inflation.

Which is our river of money being created at an increasing rate by the Federal Reserve. Last year I stated that CPI inflation would be kept in check through the destruction of credit. That will still be a factor this year. As is the desire of individuals to hold cash, or, the demand for money. The rate of new money creation under QE Infinity is accelerating. Will it or can it exceed the rate of new money creation?

This is a central question and not an easy one to answer. The Federal Reserve has indicated that it will continue to expand the money supply until an unemployment figure of 6.5% is reached. This ensures that money creation will proceed uninhibited for quite some time.

Money destruction will also continue, but at what rate? No one really knows. The idea is that at whatever rate might eventuate, the Federal Reserve can exceed that rate and maintain an excess of about 2%, which is the targeted inflation rate.

This also assumes that the other component, the demand for money, which is currently near highs, remains, or maintains those highs.

M2V_Max_630_378

This remains a danger; should money destruction slow for any reason, and the Fed not adjust in time, then, the inflation rate could kick higher and create an excess supply, driving individuals to demand less cash. This would, or could drive a reallocation into “things”.

Earnings

This is really a follow on from inflation. Nominal earnings will rise with inflation. This will under an unrestrained Fed policy of expansion see nominal earnings higher. Real earnings on the other hand will stagnate.

Economic theory informs that businesses cannot pass forward taxes. Inflation is a tax, and as such cannot be passed forward to the consumer. Real earnings therefore will either stagnate or fall.

Revenues and margins will come under increased scrutiny. Falling revenues will impact high cost producers far more significantly than the low cost producer who can absorb the extra costs into their margins. In an economy with stagnant wages revenues have to fall or remain stagnant themselves. Commodity price increases however force the reduction in margins to producers, unless, they can pass their increased costs forward, which, as stated, cannot be done. Instead, we see reduction in package weight etc at the constant price. In other words, the price increase is hidden.

The businesses that can best situate themselves to government largesse will be the big winners in the market next year. Banks and financial services will as they did this year, do well. Banks claim a slice of government inflation far ahead of many others. Also larger capitalized companies that have the political connections to benefit will also be ones to watch.

Healthcare once again will be a strong sector. With the demographics of an aging population combined with Obamacare, price pressures will be firmly higher, expanding earnings, and possibly even creating real earnings to boot.

Of course you will have those outliers that just find their time. Josh Brown has made a call for [i] robotics [ii] 3d printing. Both of these are interesting and definitely worth keeping an eye on.

Deficits.

Will continue to grow. Unlike the MMR advocates who claim that deficits “don’t matter”, Cullen Roche being one of the advocates, deficits do matter. They matter for the simple reason that government cannot fund its spending from tax receipts. If this is the case, then, they must either [i] borrow, [ii] increase taxes [iii] cut expenditures [iv] print.

With the current debate with regard to the fiscal cliff…it is clear that the only option all can agree upon is…increase money creation [printing] via demand deposit expansion at the Federal Reserve. The deficits, the larger they are, the greater the risks of creating a fast increasing inflation, which, can quite quickly escape control and become self-sustaining.

Medicare spending, according to this data, is slowing. If accurate, the projected deficits will not be as catastrophic as initially projected, providing some wiggle room.

orszag_graphofyear

Interest Rates.

Will remain low. Bernanke via his commitment to unlimited QE has stated as much. Bonds are a dead asset class for the foreseeable future. This will place upwards pressure for investment money into commodities and common stocks.

I have played around with “stock picking” last year and found that the best results are to be found in the index ETF’s. It is far easier to have an already diversified list that already carries good volume, and let the ETF managers rebalance via the common stocks. ETF’s are a good way to play the market. Of course you will never get the VHC/AAPL etc type of returns. If you can pick these sorts of stock, then, hell son, pick “em.

Unemployment

Will remain high, and possibly even start moving higher again. The inflation of Bernanke will not ultimately allow the repricing of wages without creating new unemployment.

Inflation [amongst other things] is designed to lower wages. Wages are already stagnant. As prices rise, so more and more will be forced to look for higher wages or take action to get wage increases. This will force the high cost producers to bankruptcy, which puts everyone on the unemployment line. We saw hints of this with Hostess late last year as their costs were already crippling the firm.

A cost push inflation as it is called hasn’t really been seen in the US since the 1970′s. Whether we shall see one starting next year is an interesting question…I think no, not with unemployment as high as it is. However, if a point comes where you simply can’t meet the escalating costs of bills, electricity, petrol, food, etc, people become a little desperate.

Here in NZ the price rises in food etc is ridiculous. Petrol is at all time highs with petrol taxes slated to go higher. NZ remains [relative to other countries] low in the inflation being imposed, but we are starting to see significant unemployment as businesses go to the wall. Increasingly the recession/depression is biting here.

Europe in jumping on the QE bandwagon has condemned itself to high unemployment for a significant period of time. High unemployment leads to an increasing disintegration of society and increased violence.

The French, now being taxed to the limit, are no strangers to industrial action and along with the Spanish, who have nothing to lose, will drive a lot of European social unrest.

Gold

Gold will remain volatile, always looking to shake traders out of the trade, nothing new there, but, it will rise. Gold however it is priced or valued is priced or valued against fiat money. Fiat money in the age of constant QE is and must lose value or purchasing power. Thus gold priced against a depreciating asset must gain value. The same argument goes for silver. To trade gold you need some methodology to keep you in the trade for the required time period.

The trade will end, more or less, with the end of the QE experiments around the world and rising interest rates. As that is unlikely to occur this year, you should have at least a year to hold and gain some capital appreciation through that holding period.

Energy

With the discovery, or pending production of shale gas etc, energy is less of a sure thing [stock trading wise] this year. The increased production could lead to new revenue streams for the respective corporations, but commodity prices might fall hurting higher cost producers.

The end of cheap energy might be yet delayed. Industrial production has depended upon cheap energy since the industrial revolution. Predictions of falling and slowing growth have been predicated on ever higher prices in the commodity markets for at least a couple of years now. Now, I’m not so sure. Of course China, India and eventually Africa will and are demanding higher quantities of energy, but with coal reserves, natural gas and new oil finds, it seems, for the moment that new supply will trump new demand.

War

War has always been a political tool to subjugate a home population. A population focused upon an external enemy, focus less upon the real enemy, viz. their own politicians and bureaucracy. This will be a common theme as, wherever you look currently there is economic stagnation and social unrest.

Civil wars are particularly destructive as essentially both sides in any given country lose. How close is America, or a major European country to a civil war? Probably not that close, but that you even have to think about it rather underlines the severity of the situation at present.

The problem is [or part of it anyway] that with constraints on government spending, without a credible threat, spending on the overseas military is likely to be cut. Iraq was never a popular war. Neither is Afghanistan. The US public and the rest of the world, just don’t get it.

Market

The market will have a positive year. While eventually the inflationary policies of the Federal Reserve and Treasury will catch up with them, creating another bust, that may even exceed the 666 lows in the S&P500 of 2009, they likely won’t occur in 2013. Rather, we will see the continued nominal gains continue, certainly through the first half of the year as inflation creates real losses in the economy. Stocks therefore are an inflation hedge, protecting purchasing power rather than increasing it.

Bonds are a deathtrap simply waiting to spring. Shorter maturities are in real terms yield negative, the longer maturities, if not negative are pretty damn close to it. At some point, although not next year, interest rates will rise. When they start to rise, the rise in % terms will be brutal, destroying huge wealth as they rise.

Corporate bonds have enjoyed an easy market. Corporations have sold record amounts into the end of 2012. Some are paying out special dividends, some are buying back common stock. They have found that the cost of capital is far, far lower, than raising equity capital.

Should interest rates rise, and they realistically can do nothing else, investors will be sitting on losses that accelerate. Corporations that sold the debt, could have the option, although I doubt they’d bother, of buying back the debt for a profit. It is however far better to wait. Bond market trends are big, decade consuming trends.

Stay well away.

Regulation.

The cost to business in complying with the endless red tape of legislation spewed out by Congress will as it always has increase. More totally useless regulation will choke off competition and innovation, which are necessary components o9f economic growth. Capital is reduced through the costs of compliance.

holtzeakin_graphofyear

Black Swans

As last year, I don’t anticipate [who ever does] a major stock market disaster, viz. collapse. There will be the usual fluctuations as there always are, but without those, who would win and who would lose money in the market?

The issue, will again as it was this year, be that traders/managers/etc simply cannot believe that the market will rise against a backdrop of increasingly poor economic data. That earnings cannot continue to rise/stay high etc. As such there will be numerous scares panics with acute and severe price declines that will shake traders out of positions. Short term traders, as they have this year, will bitch incessantly about rigged and difficult markets that do not trade to their chart patterns and technical triggers.

The problem of course is that major players know all about technicals, charts, quantitative methods, and, when new edges are discovered, you have non-trading researchers giving them all away in academic papers.

flippe-floppe-flye

Will have a huge year to make up for his dismal year. In the early going, he will refrain from too many public calls, preferring instead to make some big gains early on from some real hindsight trades that just happened to come good. Of course, then he’ll start believing his own press, again, and make some big public calls, that, as this year demonstrated, will have very variable results.

Summary

In a word…be long. It will be easier to be long the market, than individual stocks. Individual stocks can obviously outperform the market, but also under-perform the market.

Until next year…

snoopychristmas

Last year I made my predictions here. Pretty spot-on. I will of course be playing the same game this year, who can resist?

The question however is…did my “predictions” actually make money? Could you have benefited from them?

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Graph1_10Dec2012

Obviously the answer is yes.

To gain access to the trading system, a weekly subscription is the way to do so.

snoopychristmas

The predictions for next year have already started. Many of them focus on the fiscal cliff. Markets day-to-day currently are focused on the fiscal cliff. The likely outcome of the fiscal cliff debacle will be further can kicking.

Government essentially has only one policy and answer to everything…inflation. This is not particular to this government, Kings essentially had the same answer, they were just a little more restrained in their depredations.

Returning to the purpose of all this angst…where to invest money? You only have limited options. Bonds, Stocks, Commodities, Property, Exotics. Bonds are at the top of their bubble. Sure they may still return a few percent in nominal terms, but essentially they are dead money and carry the most risk.

This leaves the rest. Have a read of what the professionals suggest.

The last time we heard from Codexis, we took a look at the firm’s financials, which all kept pace with estimates. Codexis offers an interesting business model in that the firm focuses solely on developing custom yeasts and other biocatalysts. Currently Codexis is paying the bills by producing high-dollar petrochemicals for the pharmaceutical industry, but has been actively trying to enter the biofuel market by developing yeasts that break biomass down into sugar as part of a research agreement with Royal Dutch Shell.

That research has paid off in Codexis’ newly announced CodeXyme cellulase enzyme product line. The new enzymes are designed to produce sugar from cheap, local feedstock sources. A cheap sugar supply is key for Codexis, whose other biocatalyst work is focused on producing high-value, sugar-alcohol-based industrial petrochemicals.

It also means a potential new source of revenue for Codexis’ customers. Codexis has a partnership with Raizen, Brazil’s largest sugar producer and a massive ethanol producer. With Codexis’ new enzymes, Raizen will be able to convert leftover biomass from sugar production into ethanol, freeing up more of its sucrose to sell in the sugar market. According to Biofuels Digest, Codexis CEO Alan Shaw has priced the leftover biomass from traditional sugar production at $50 a ton, or as low as $10 in Raizen’s case, which, in his eyes, is like “making gold from dirt.”

This is the one to watch. The technology is just about there. With Congress failing to renew the corn ethanol subsidies, that competition is gone, leaving the door wide open to CDXS and its competitors, which aren’t that many.

With the backing of Royal Dutch Shell, capital is not an issue, nor is the risk of bankruptcy, failure to raise working capital etc. This one is fast reaching its time.

The annual stab at predicting. Always fraught with problems, always fun to try.

You cannot step twice into the same river, for other waters are continually flowing in

Heraclitus, Fragments.

INFLATION:
Inflation through money creation, via the Federal Reserve, will continue unabated. Bernanke has said as much already, and the effects of raising rates in a Presidential cycle, simply will not happen. The real question with inflation is what will the ‘demand for money’ look like, and what effects will it have?

The demand for money will remain high. Credit destruction will ameliorate the credit creation, thus keep the rate of CPI inflation somewhat constrained. CPI inflation will rise, driven largely through oil prices that keep energy costs and transport costs high through the CPI that includes these prices. The smoothed version will show lower increases. The inflation through the PPI however is a different story altogether. Here rising prices will continue to hurt the higher cost producers, which largely are the smaller capitalization stocks and private businesses.

EARNINGS:
S&P500 earnings increased 17% YoY to November 2011. This was due to what? Certainly there will be an inflation gain in there, particularly when you consider the relative weights of the capitalizations that make up the index.

Energy and Healthcare keep increasing their prices due to inflationary pressures created by the Central Banks. With regard to healthcare, these price increases are engendered through subsidy or oligopoly pricing enabled by the government. This type of inflation will continue in any industry that is the recipient of government subsidies.

The takeaway however is that ‘earnings’ will continue to increase in the S&P500 index. Earnings have benefited from the ability of businesses to cut employment. How much fat is left on this bone is debatable, but, increased earnings, in a still lowish inflation environment, could well drive a P/E expansion, which is just another way of saying expect the market [as an index] to rise beyond expectations of the consensus.

Therefore, the stockmarket, the index, will enter a trending volatile period. With sentiment low, decreasing institutional participation, the market will climb the proverbial wall of worry, in part on an improving and inflated earnings growth.

DEFICITS:
Will continue to grow. This obviously is another driver of the inflationary pressure that will continue to exert an influence. Industries that continue to hold government contracts and influence can and will increase their prices to government who are not price sensitive, that is to say they will pay higher prices that could not normally be passed onto the individual without reducing volume units supplied.

We saw one debt ceiling crisis last year, I’m sure Obama, and other candidates, would like to avoid another, their credibility, competence and morality were severely questioned due to the last debacle, in a Presidential cycle, they will want to avoid a repeat performance: thus debt ceiling restrictions will prove no barrier to further expanding the deficits.

BONDS:
Will due to the deficits continue to be sold. Sold to whom? There will be the usual support from the big shops like PIMCO who got badly burned this year on a ‘short’ call on US Treasuries. Various Pension Funds and Insurance Companies, but after that the primary buyer will again be the Federal Reserve, essentially monetizing the debt. As Bernanke is willing and able to create ever increasing fiat money, at least for the moment, interest rates will remain low. They will not be allowed to express a ‘market rate’ which would trigger in very short order another plunge into deep recession. Avoid Bonds like the plague. The returns are virtually nil. They will however provide a tailwind for equities.

PRESIDENTIAL CYCLE:

Year 1: The Post-Election Year
The first year of a presidency is characterized by relatively weak performance in the stock market. Of the four years in a presidential cycle, the first-year performance of the stock market, on average, is the worst.

Year 2: The Midterm Election Year
The second year, although better than the first, is also is noted for below-average performance. Bear market bottoms occur in the second year more often than in any other year. The “Stock Traders Almanac” (2005), by Jeffrey A. and Yale Hirsch, Hirsch notes that “wars, recessions and bear markets tend to start or occur in the first half of the term.”

Year 3: The Pre-Presidential Election Year
The third year or the year preceding the election year is the strongest on average of the four years.

Year 4: The Election Year
In the fourth year of the presidential term and the election year, the stock market’s performance tends to be above average.

In his study “Presidential Election and Stock Market Cycles,” Marshall Nickels of Pepperdine University analyzed stock market bottoms in relation to the presidential cycle. In the period from 1942 to 2006, there were 16 presidential terms and 16 market lows corresponding to those terms.

Three of the lows occurred in the first year of the presidential term, 12 in year two, one in year three and none in year four. Of the 16 bottoms, 15 occurred in the first half of the term and only one in the second half of the term.

2012 is a Presidential election year. The election will take place in November. It is another one of those seasonal trends that stockmarkets love. The underpinning economic theory however is one of loose monetary and fiscal policy. We already have that, we may get increased inflationary stimulus, we most certainly won’t get less.

The winner? Romney. Obama will join the other ‘loser’ 1 term Presidents.

HEALTHCARE:
Demographics are not the only driver of rising health care costs in the U.S. When passed in March 2010, the Patient Protection and Affordable Care Act—popularly called “Obamacare”—was intended to lower spending on medical care over time. The question is: would it?

After months of debate, several lawsuits, and multiple competing federal court rulings, the Affordable Care Act will have its day in court. That day will determine the nature of freedom in America. the US Supreme Court agreed to examine the constitutionality of the health-care law sometimes known as Obamacare. The main question is its “individual mandate,” specifically whether the federal government has constitutional authority to require citizens to purchase health insurance. For that justification, supporters have looked to the Commerce Clause in the Constitution, which gives Congress the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.”

But for the Commerce Clause to provide sufficient authority to the federal government to mandate that everyone buy health insurance, choosing not to buy health insurance has to be regarded as “activity.” Thus, under the Constitution, and the Commerce Clause, is this possible or likely?

If the Supreme Court does not clarify the question of whether the Commerce Clause applies to inactivity, the individual mandate in the Affordable Care Act may become the precedent upon which future activists justify even further expansion of government power.

The Supreme Court has in its history widened, and narrowed the definition of ‘commerce’. The case that may pertain in this instance took place in the Lochner era of 1905 to 1937. Here the Supreme Court decision struck down a law that limited the number of permissible hours of working in bakeries. The majority of the Court held that the state law [New York] violated the freedom of contract. That the freedom of contract was an integral part of the liberty provided under the 14′th Amendment protecting the due process clause.

I think therefore that the abomination that is Obamacare, will in possibility be struck down by the Supreme Court. US medical costs are seriously out of control.

The thing with Obamacare is this: the law has not been in effect long enough for the effects to be seen. The medical costs have been rising for different reasons. They rise mostly due to the influence the large pharmaceutical companies have upon government. So while the repeal of Obamacare is a good thing from the point of view for the Constitution, it will have little or no effect on medical inflation. For serious inroads here, a game changing innovation is required, possibly from gene therapy.

Healthcare costs will continue to drive medical inflation, and hence earnings. Earnings that will contribute to the aggregate earnings of the S&P500, as will the energy sector.

UNEMPLOYMENT:
Unemployment is a lagging indicator. It lags at the turns. As a stockmarket indicator, not too much attention should be allocated. The economic policies that are required to improve employment are however an issue for employment. The cost of employment at the margin, or the ‘discounted marginal value product’ [DMVP] of employment is the variable that creates or destroys jobs.

Unemployment was also driven by businesses cutting jobs to maintain profitability. How much further this could run is questionable. If there is more fat on the bone, unemployment could well rise as ‘costs’ cannot be passed forward to the consumer. This would suggest that the consumer goods stocks might come under some pressure to cut employment to maintain profitability. Consumers do not have much, if any slack, for increasing discretionary consumption: rising energy costs will further erode purchasing power. As utilities operate more or less as small local monopolies, these costs can be passed forward to a degree.

EUROPE:
Remains a mess. It however limps forward under a mixture of austerity and inflation. This mixed policy bag cannot be good for the majority, and even Germany will feel the effects. The effect, relatively speaking, is a positive for the US.

CURRENCY DEVALUATIONS
With all trying via currency devaluation to capture exports, something has to give: all cannot devalue at the same time. The result will be an increasing atmosphere of tariffs and protectionism, which inevitably raises international tensions, which under the law of monopoly increases the actual number of wars.

WAR:
That the US finally pulled out of Iraq, the question is for how long can they avoid becoming embroiled in yet another war? Already Iran is claiming, due to trade sanctions, to seek control of the oil transport water lanes. The sanctions were put in place due to Iran seeking nuclear weapons. Israel is particularly aggressive in this geographical region, and has strong influence on US foreign policy, which remains Imperialistic. Therefore while the US has ended one war, they will soon be embroiled in another. The Welfare-Warfare-State cannot have it any other way. Again, either US military based stocks and/or major energy producers.

ENERGY:
Oil prices will continue to rise on the back of world-wide inflation. To such an extent that many economies will not be able to afford the prices. Coal will make a comeback, certainly in Chinese consumption of energy needs. In the absence of any real viable alternatives, coal consumption and production will pick-up. The ETF KOL [which I hold] will likely see some price appreciation and provide some diversification via holdings of Chinese coal producers.

GOLD:
Is the ‘bull’ run in gold over? I really don’t know. Gold and Silver tend to appreciate in value under conditions of uncertainty and inflation. We’ll have inflation, we’ll have uncertainty, but I’m not sure that we’ll see gold gaining new highs, at least not immediately. To me gold looks to be heading towards $1300.00oz. At this area, or even a little lower, then, possibly, the gold bull might resume. If gold is your thing, then avoid gold mining stocks, which are just destructive of value, stay with the actual metal itself.

BLACK SWANS:
Will be white. The biggest shock to investors will be the rise in the market, against all expectations, against the news-flow, against the direst of predictions.

SUMMARY:
You want to be in the market, against all better judgments. The two markets that are viable are the market for common stocks, and the commodities markets.

Go here to read all about it.

Fidelity have some interesting ideas. Here is the first one I went to:

The materials sector comprises companies that are involved in the discovery, production, and processing of both raw materials (gold, copper, timber) and synthetic materials (chemicals, containers, packaging, and steel). The sector is made up of three primary industry groups: 1) chemicals, 2) metals and mining, and 3) paper and packaging companies.

While materials is considered a cyclical sector, industry performance can vary within the sector due to supply levels and the health of end markets. Many components of the sector are considered to be performance leaders during the early stages of an economic cycle, particularly chemicals and paper products. Conversely, some companies within the materials sector have very defensive characteristics, such as companies that make bottles and cans. Some segments tend to have their own cycles. For example, agriculture is typically driven by factors related to weather, regulatory concerns, and emerging-market demand. Gold, meanwhile, is sensitive to the ebbs and flows of the global economy.

Based on our analysis, there is a compelling investment opportunity in the agriculture industry due to strong demand, limited natural resources, and a finite number of supply solutions. Continued world population growth has always been a stable driver of agricultural product consumption. The world population is expected to increase from 6.9 billion in mid-2011 to 9.3 billion in 2050.1 Placing more pressure on demand are two factors: changing diets and biofuels.

As consumers in developing regions improve their standard of living, they are also consuming more food and, in particular, more protein (Exhibit 1, below). Increased food demand from emerging economies—a result of higher per capita income—is responsible for much of the increased consumption. For example, Chinese per capita consumption of meat and dairy rose 91% and 300%, respectively, from 1992 to 2007.2 While demand growth has been strong for some time, the recent sustained period of high global growth has taken a large toll on global inventories, particularly of grains. This creates a multiplier effect on the demand for agriculture, as it takes nearly 10 pounds of corn to develop one pound of beef.3

Another important driver of agriculture demand is the increasing use of biofuels. The rising economic and environmental costs of fossil fuels have mobilized world political leaders to search for alternatives, such as ethanol made from corn or sugar. In America, 40% of the corn crop is currently diverted to make fuel for cars.4 Many analysts expect that the U.S. ethanol mandate set by the Renewable Fuel Standards, a program created under the Energy Policy Act of 2005, will continue to grow. In October 2010, the EPA granted partial approval for usage of E15, a blend of 15% ethanol and 85% gasoline.

Biofuel mandates in the U.S. and the European Union that favor domestic production will continue to put pressure on prices. According to the United Nations (U.N.), world food prices in 2011 were at their most expensive levels in real terms since the U.N. first began tracking the numbers in 1990. Grains, in particular, saw sharp increases: corn prices were up 53% and wheat prices rose 47%.5

Biofuels. I was just looking at biofuels earlier in the day. CDXS is the play in this area. Check out this post earlier today If you don’t like CDXS, then you have an alternative in this space for consideration.

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