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Keys to riding this year's roller coaster

What will turn me bullish? The question comes up often, generally referring to my views on the stock market, particularly U.S. equities, and the American economy.

The key, as always, is to be on the right side of the trade. Every period has its lessons.

For example, 2007 taught everybody that it never hurts to take profits after the market doubles and that if something appears too good to be true, as was the case with the housing and credit bubbles, it probably is.

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The lesson in 2008 was about preserving capital and managing risks. Then, in 2009 the market taught us that it was vital not to overstay a bearish stance in the face of massive fiscal and monetary stimulus, even if the economy was in a deep recession for half the year.

Last year's lesson was on how to handle market swings. It is very tempting to look back at the past year and conclude that it was a great year for the markets because the S&P 500 rallied 13 per cent from January to December, but that is about as relevant as the fact that by the end of August, the S&P 500 was off 14 per cent from a nearby peak and the TSX was down 6 per cent.

The market heads into 2011 in much the same condition as it started 2010 - with plenty of optimism and growth priced into the U.S. equity market while facing another year chock full of "event risks" that will likely produce some very nice trading opportunities.

Last year, my focus was on mitigating downside risks and preserving capital at the expense of capitalizing on all the mood swings that took place. In 2010, the concerns were over Greece, health care, the end of the first round of quantitative easing, and the mid-term elections.

In 2011, the event risks that could generate significant buying opportunities are even larger in number and more diverse. These range from the financial problems in Ireland, Portugal and Spain; mounting worries the U.S. will hit the debt ceiling; U.S. state and local government turmoil; another down-leg in U.S. home prices; surging food and energy prices; and heightened inflation pressure.

Be Alert for Opportunities

The threat of higher interest rates in the emerging markets (especially China) continues, and with the end of the second round of quantitative easing in June, Federal Reserve chairman Ben Bernanke will again have a tough choice to make between unwinding the Fed's bloated balance sheet or reinforcing speculative behaviour in risky assets by embarking on yet another round of quantitative easing. In this light, I fully anticipate another roller coaster ride in the markets this year.

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While it is important in these volatile times to remain alert for opportunities that may arise, you should have a long-term view of what the next three to five years are likely to bring. In that light, I reiterate the six strategies I am optimistic on for the intermediate term:

  • Buying large-cap equities that have strong balance sheets, pay out a consistent dividend stream, have stable earnings growth and enjoy low correlations with the U.S. economy. I remain in the camp that believes higher quality equities will provide more sustainable returns over time.
  • Purchasing commodities, especially in the energy sector, as well as precious metals as a hedge against recurring weakness in global currencies. I am also optimistic about the agricultural sector and related stocks.
  • Investing in fixed-income securities, especially corporate bonds. I see tremendous opportunities in the high-yield sector in particular.
  • Looking for classic diversified hybrids, such as convertible bonds, that have low volatility and yields that exceed what anyone can get in the government sector.
  • Exploring capital preservation strategies such as hedge funds that go both long on assets they like and short the ones they don't.
  • Maintaining an emphasis on Canadian dollar investments as well as a diversification toward the faster-growing emerging markets. There are also some fairly compelling valuations in the euro zone, notwithstanding the fiscal woes along the periphery. And I am also eyeing Japan, which may well be the turnaround story for the year, though a more substantial weighting would require signs that the country's long-term decline in profitability has come to an end.
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