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2007 to 2013: A Look at the Markets

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At the height of the real estate bubble in October 2007, the DJIA traded at 14,164.43. Financial institutions had heavy exposure to the collateralized debt obligation (CDO) market in the form of mortgage-backed securities, while banks were frantically writing and packaging sub-prime mortgages. In the meantime, the credit default swap (CDS) market was virtually unregulated; insurance companies were selling them with abandon. On the surface, the US economic machine was humming along.

Then the real estate market crashed. Credit markets dried up overnight. The stock market plummeted. In sum, the United States of America went into a recession.

Fast forward to the present day. As of market close on April 25, the DJIA traded at 14,676, significantly higher than the 2007 record. The S&P 500 traded a few percentage points shy of its historical high as well, within striking distance at 1,579. Read together, this may inspire confidence in the economy and coax the average investor back into the market. However, upon closer inspection, this economic house of cards will fall.

Firstly, the recovery of the stock market cannot be looked at independently of Federal Reserve interventionism. Begun in 2008, the Fed is currently in its third round of Quantitative Easing (QE), a relatively new form of monetary policy by which a central bank purchases assets from the private sector. Each round of quantitative easing has directly corresponded to a stock market rally. However, a number of economists are concerned that the market is now addicted to “QE medicine.” QE3, the most potent dose yet, has somehow had the most subdued reaction from the market, furthering this argument.

The U.S. Bureau of Labor Statistics (BLS) next reported that March 2013’s seasonally adjusted unemployment rate had declined to 7.6%. With a high of 10% in October 2009, the unemployment rate has significantly fallen over the last few years. However, the unemployment rate fails to include discouraged workers. Discouraged workers are those who are not counted in the work force, as they do not believe that a job exists for them. This past March there were 803,000 of these workers. If these workers were counted in the work force, the unemployment rate would not look so inviting.

In addition, the BLS reported the U.S. Consumer Price Index for All Urban Consumers (CPI-U) in February 2013 at 2.0% on an annual basis. While lower than the US historic average of 3%, depository institutions now hoard $1.8 trillion in total reserves, an all time high. If banks begin to lend this money, that inflation rate could skyrocket.

Finally, 4Q U.S. GDP growth was reported at a paltry 0.4% on an annualized basis. However, the housing market’s comeback since the financial crisis continued in 2013, as housing prices rose 7.1% in year through February while housing inventory remained low. Consumer spending also rose in March despite an increase in the payroll tax and budget cuts. These happenings are favorable, but are certainly outweighed by continued uncertainly in the global economy. Europe has still not addressed the systemic problems that caused its economic downturn in the first place. The Cyprus scare would be nothing in comparison to the collapse of a major European nation.

There are many ways to hedge against these risks, thankfully. An investment in gold insures against inflation and excessive central bank action. Furthermore, the downfall of any major economy would necessitate the ruin of the domestic currency therein, resulting in massive inflows to safe havens like gold. Ways to make this play are ETFs like ETFS Physical Palladium Shares (NYSEMKT: PALL) and SPDR Gold Trust (NYSEMKT: GLD).These ETFs track the spot price of the underlying rare metal. Investors should be advised that the return from an ETF is contingent upon appreciation in the price of gold. 

ETFS Physical Palladium Shares holds 100% physical palladium bullion. A notable risk is the possibility of supply shocks, as much of the world's palladium is located in Russia and South Africa. Another risk is that a large majority of the demand for palladium is derived from the automotive industry. As a result, palladium is not viewed as a safe haven to the same degree as silver and gold. SPDR Gold Trust, on the other hand, is a much more conservative play. The Trust holds gold in entirety.

Gold mining companies such as Barrick Gold (NYSE: ABX) should also be considered. As a corporation, both capital gains and dividends constitute  return on investment. Barrick Gold does not currently have a P/E ratio, as their earnings per share have been negative over the last 12 months. Gold has experienced significant capital outflow in past few months, so this is to be expected. The good news is that Barrick Gold has experienced significant revenue growth over the past few years, despite reporting negative earnings.

If you’re looking to hedge against the market as a whole, inverse ETF such as UltraShort S&P 500 (NYSEMKT: SDS) or ProShares Short S&P 500 (NYSEMKT: SH) will do the trick. UltraShort S&P 500 offers a return that is double the inverse of the S&P 500 index, while ProShares Short S&P 500 offers the direct inverse. Accordingly, UltraShort S&P 500 is defined as a leveraged fund and is a much more risky play. Which ETF is a better fit for you depends on your time horizon, liquidity needs, and other investor-specific characteristics. With global macroeconomic headwinds blustering, every portfolio should have at least a minor position against downside risk. 

So what’s changed since 2007? Well, not too much fundamentally. Dodd-Frank and Basel III have helped eliminate systemic risk in the US economy, but the fundamentals do not justify current stock market price levels.  

Be warned. 

See http://jameskerin.wordpress.com/ for more work by the author!

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