Jan 13, 2011

India Stocks: Surprising Indicator Shows Tough Road Ahead for Stocks

By Andrew Mickey, Q1 Publishing

Forget about the statistics, estimates, and computer models.

The future of the U.S. economy and where U.S. stocks are eventually headed is already playing out in India. They’re just coming together at a more accelerated place.

The recent sudden change in India shows exactly what’s likely to happen in the United States in the months and years ahead.

The impact of it all on most investors’ portfolios is going to be just as big too. Whether you’re on the good or bad side of that impact will be whether you see what’s going on there now, why it’s happening, and have good idea of when it’s going to happen. All of which are dissected below.

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Inflating a Your Way to Prosperity

Much has been made about the “recovery.”

Despite the mainstream headlines, most of the gains have come from inflation.

Rising prices have played a large role in getting consumption and production back to 2008 levels. Although final GDP estimates are a ways away, 2010 was on pace to have shown a total recovery from the credit crunch as annual GDP will exceed the 2008 high.

The official recovery has grown so strong, the Fed even recently estimated real GDP growth to come in at 3% to 4% for 2011.

The real economy, however, has been much different than the official economy.

One of the best indicators of the real economy is rail traffic. The amount of goods shipped between producers and consumers shows how much economic activity is actually taking place.  

The chart below from the Northwestern University shows rail traffic is still well below its 2008 levels:

This is all why the government keeps telling us we’re recovering, yet it sure doesn’t feel like it.

Despite this difference between the two economies, the official inflation rate has been relatively benign in the United States. Price rises in one have been offset in others. For example, collapsing housing prices have offset the rise in food and energy costs in most official estimates. But if you’re not looking to buy a house and you’re still eating, you’re feeling the inflation.

Whether inflation ever appears in official government statics or not doesn’t matter. The markets will eventually wake up to it and when they do, we don’t have to look far to see what will happen.

It Can (and Will) Happen Here

To see the impact of the rising inflation and what it will do to United States economy and U.S. stocks, all we have to do is look at India.

India’s economic recovery has been a strong one. GDP is back to near double-digit growth rates. The BRICs are roaring back and India is right on pace with them.

The big driver of the growth has been the Indian economy’s inherent advantage over the rest of the world – its young population.

As we noted in December 2008 for investors looking at the truly long term potential of investments in India:

India has everything going for it. It has a relatively young population. Its workforce will be growing for decades. It has the government institutions in place to protect property rights to support a capitalist economy. As a result, it could very well be the best place to invest if you’ve got a long-term time horizon.

Inflation, however, has followed closely on recovery’s heels. Even India’s excellent economic fundamentals haven’t been able to overcome the multiple impacts of rising prices.

The chart below shows India’s inflation rate collapsed in 2008, yet in less than a year has soared to a recent high of more than 10%:

The key here is that the sharp rebound in inflation has prompted India’s central bank to take action. Chakravarthy Rangarajan, the prime minister of India’s top economic advisor, recently warned, “Persistent price gains may require an interest-rate increase this month.”

Long story short, India’s “free money” punch bowl is about to be taken away.

The expected rate increases has sent India’s stock market tumbling. India’s primary index, the Sensex, has fallen nearly 10% in less than two weeks to start 2011. The India Fund (NYSE:IFN), one of the few funds that allow foreigners to invest directly in Indian stocks, has fallen 20% from its 52-week highs.

More importantly, this is proof that when central banks are forced to start addressing inflation, investors are going to flee stocks. Therein is the problem for the United States.

Inflation: When, Not If

The current rally has been built on the “free money” policies of central banks around the world. And when they signal they’re going to slow the party down, a correction shortly follows.

Right now, all seems good in the United States. Official GDP has fully recovered to 2008 levels. The Fed and countless economists see further growth ahead in 2010. Official inflation is virtually non-existent.

At this point in the recovery, however, it remains a matter of “when” inflation will appear in the official U.S. estimates (it’s already here in the real economy), the Fed will move to counteract it and the U.S. markets experience the same sudden and severe impact as India’s markets have gone through in the past few weeks.

In the short-term, it’s not likely a problem at all. Janet Yellen, the Vice Chairman of the Federal Reserve, said the most recent round of Quantitative Easing has created or saved 1.8 million jobs so far and will be responsible for another 1.2 million jobs as the money printing program continues.

With rationale like that, the Fed’s going to be keeping the free money spigot wide open for as long as unemployment stays high. But there will come a time when they can no longer keep it going. When that happens, it’ll be time to make the move.

For now, the best action to take is to stick to the best low-risk/high-reward stocks you can find, buy into any significant weakness, keep your stop-losses in place if when it all falls apart, and keep on buying the assets which will perform best in an inflationary environment.

Many investors are speaking with their investment dollars are saying “it can’t happen here” as they continue to buy more and more stocks and bonds. However, it can and will. Be prepared.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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