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Wednesday, 29 December 2010

3 Investment Traps for 2011

It's the end of the year and Wall Street is busy selling their New Year forecasts.

According to 10 strategists and investment managers polled by Barron's, there's no cloud in the sky. The future's looking bright.

If you've followed Wall Street forecasts for a few years, you must have discerned a pattern: Forecasts are always rosy. If Wall Street analysts were meteorologists, their outlook would always be 'sunny' unless it is actually raining.

Therein lies the problem; Wall Street never sees hard rain coming and only offers an umbrella after investors have gotten trenched. The purpose of this article is to provide an out of the box forecast with analysis you won't hear on the Street.

Insiders vs. Analysts

Analysts have their optimistic disposition implanted by the companies they cover. Corporate managers have every incentive to stay positive for as long as they can.

Ironically, as CEOs project record high earnings, insider selling has picked up as

Investors Intelligence reports that: 'there was a sharp acceleration in the pace of insider selling over the last week, as if they suddenly all received word that the index highs would end.'

Who would you rather believe - analysts (and their sources) with an agenda or the action of insiders with skin in the game? Something doesn't seem right if insiders want you to do as they say but not as they do.

Unbridled Enthusiasm

Mark Twain said that: 'When I find myself on the side of the majority, I know it's time to find a new place to side.' The majority of investors (and analysts) now believe in rising stock prices.

Sentiment gauges have recorded readings not registered since the 2007 all-time highs, or before the May 'Flash Crash.' This is usually a sign of a market that's getting ready to roll over.

Trap #1

This brings us to the first investment trap for 2011 - equities. After rallying more than 85%, the major indexes a la Dow (DJI: ^DJI), S&P (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) are simply overbought, over loved and overvalued. This doesn't mean that they have to crumble tomorrow, but NOW is the time to think about protection.

In each of the past three years, January trading has delivered a surprise shot of reality. Don't be surprised if it happens again in 2011.

Sectors with the biggest gains include retail (NYSEArca: XRT - News), consumer discretionary (NYSEArca: XLY - News), materials (NYSEArca: XLB - News), and technology and these are also the most vulnerable to correction.

Even though it defies Wall Street's approach of linear extrapolation, sectors that do well one year, rarely top the list the following year. It would make sense to either buy put protection - which is historically cheap due to a low VIX - or set mental stop-loss safety levels to avoid suffering through a painful correction.

In an effort to keep this article brief, we won't delve into the Europe crisis. One of the ETF Profit Strategy Newsletter's predictions for 2010 was an increase in sovereign debt defaults. The Europe crisis will be with us for a while and will turn into a big drag for developed markets (NYSEArca: EFA - News) eventually.

Trap #2

A rush for tax-free yield drove investors into municipal bonds. Chasing yields can be a pricey mistake. If you plot dividend yields against stock prices over the past 100 years, you'll quickly notice that periods of low yields are generally a good time to sell, not buy stocks.

The muni bond market has been an obvious, but ignored, house of cards. California is nearly bankrupt and every other state or municipality has seen their tax revenue dwindle. Loaning money to municipalities is like giving a car loan to someone who just lost their job. The default risk is high.

On August 26, the very day Treasuries and muni bonds topped - the ETF Profit Strategy Newsletter told its subscribers to get out of muni bonds, corporate bonds and Treasuries. Prices for bonds have tumbled since and the danger isn't over. The three trillion muni bond market is in serious danger. Now is the time to worry about return of your money, not return on your money.

Trap #3

Not all is as it seems and if you put your trust in the Fed, you may soon be disappointed. Quantitative easing in general, and QE2 in particular, was supposed to stimulate the economy, increase inflation and the money supply.

As the chart above shows, it didn't do any of the above. QE2 also was intended to lower interest rates to increase lending and make mortgages more affordable. The chart below shows what the interest of the 10-Yr Treasury has done since QE2 was launched.

The Fed is treating the previous indulgence in debt by taking on even more debt. This is like taking more heroin to kick a drug addiction. It will keep you functioning for a while, but eventually your system will shut down. The only chance of success is to detox.

The Minefield Looks Pretty

To sum up, we are looking at a minefield covered by a beautiful blanket of flowers. The Fed - although it's failed to jolt the economy - has succeeded in inflating stocks (NYSEArca: VTI - News) and commodities (NYSEArca: DBA - News). It has served as fertilizer for fake growth.

But sentiment is indicative of a market ready to roll over. Similar sentiment readings and warnings by the ETF Profit Strategy Newsletter in December 2008, January 2010, and April 2010 led to declines from 9 - 29%. Aside from Fed induced liquidity, there's not been much reason to believe this time will be different.

In terms of breadth, we note that fewer than 80% of S&P 500 stocks are above their 50-day moving averages, as the index itself is moving from one marginal new high to the next. There were also fewer new 52-week highs in December than there were during the April highs.

Enjoy the Sight, Mind the Feel

Creeping up trends like the current one can go on for weeks. But take a look at the price action leading to the April highs and it becomes clear that such stair stepping up trends tend to end very abruptly and without warning.

That doesn't mean the market has to crumble tomorrow, but if you choose to maneuver through trap-infested territory, it pays to be careful and protect yourself.

The ETF Profit Strategy Newsletter provides important support/resistance levels that serve as an early warning signal twice a week. The break of certain resistance levels could break the bull's spirit and cause an April/May like air-pocket decline.

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