Market Madness: How to Play Bonds, China, and Gold in 2012

By: Money_Morning

Martin Hutchinson writes: Yes, I know that markets are irrational.

I read Charles Mackay's 1841 classic, "Extraordinary Popular Delusions and the Madness of Crowds" long before it ever became fashionable.

Even so, when you think about it, 2011 must set some kind of record.

As investors, that means we need to decide whether this madness will continue in 2012 and which direction to take.

Take the madness in the bond world, for instance.

Long-term bonds of a country with an out-of-control budget deficit and a worrying trade deficit are currently yielding 1.6% below inflation.

In other words, year after year, investors are willing to pay 1.6% of their capital to hold them. On top of that, investors have been so keen on this miserable asset in 2011 they have bid up its price by no less than 26%.

Conversely, China is revolutionizing the world economy.

Year after year, China puts up growth rates of 8% or more, and the latest data suggest that will continue throughout 2012.

What's more, Chinese stocks stand on a bargain-basement price-to-earnings (P/E) ratio of less than 8-times earnings. Yet, in 2011, investors shunned these bargains, giving the Chinese market a pathetic return of minus-22%.

It is Madness I Tell You
Do you see what I mean when I talk about irrational?

To a Martian, these statistics would be proof that earthly markets had lost their collective minds. That's not just a random walk - it's a deliberate stroll that will destroy your wealth.

For investors, it raises the question of how long this irrationality is going to last. Will this extreme irrationality persist in 2012, or will it reverse?

The first conclusion to be drawn is that current markets are unhealthy, and largely the product of government meddling.

Western governments have been pumping money into the global economy since 2008, and running budget deficits larger than ever before in peacetime. Meanwhile, the Chinese government has been engaging in massive "stimulus" itself, but financing it through the banking system.

When you look at current markets as massively distorted, the right conclusion becomes clear: Treasury bonds are a bubble, inflated by massive money printing worldwide and the troubles in Europe.

And while they may have done well in 2011, they are likely to reverse sharply sometime in 2012. Therefore, Treasury bonds should be avoided at all costs.

As for the Chinese economy, it is facing severe headwinds due to massive problems in the banking system that will make some kind of crash and recession inevitable.

The Bright Spots are China and Gold
However, the latest data from behind the Great Wall is still encouraging. China's purchasing managers' index in December ticked back up to 50.3 from 49 in November.

If that were a U.S. index, it would suggest the economy was just barely expanding.

However, according to The Economist and Goldman Sachs Group Inc. (NYSE: GS) analyst Yu Song, the Chinese index is mis-calibrated - a "break-even" index of 50 actually corresponds to industrial production growth of about 10% per annum!

The index would actually have to fall to 44-45 before zero growth was reached and it's currently well above those levels.

That suggests Chinese growth may slow, but will likely continue in 2012 at a rate that would be a roaring boom by Western standards.

Even still, investors looking to invest in China should avoid the banks, and other sectors such as construction and automobiles that depend on bank finance.

However, a modest investment in basic consumer sectors, such as food processing and clothing, may well make sense. After all, the Chinese economy isn't going away any time soon. So basic goods purchased with cash by the middle classes are probably a good investment area.

Consider China New Born Corporation (NYSE: BORN), for example. The company makes corn-based edible alcohol, a key ingredient in the Chinese drink of baijiu.

Since Chinese consumers pay cash for their booze, they may tend to drink more, as Americans once did during the Great Depression. China New Born Corporation is currently priced on a 1.6-times earnings multiple and at 43% of book value, as if it was a swindle. But the reality is the company was brought public properly with Goldman Sachs as the lead, so is likely to be on the up-and-up.

For those who don't want to speculate on the proclivities of Chinese drunks, there's always gold.

It may have fallen out of favor recently, as T-bond prices have soared even higher, but it looks a much better safe haven to me.

U.S. Federal Reserve Chairman Ben S. Bernanke has said he's not increasing interest rates until the middle of 2013, the Bank of England has announced a huge new bond buying program, the European Central Bank (ECB) is certainly not going to tighten any time soon and Japan also looks unlikely to do so.

All that money has to go somewhere, and gold looks the obvious beneficiary.

The easiest way to play the bull market in gold remains the SPDR Gold Trust (NYSE: GLD). However, to get a greater upside potential, you may want to consider long-dated call options on GLD.

For example, the January 2014 240 options (equivalent roughly to a gold price of $2,400 per ounce) are trading at $7.70 right now, giving you a big profit if gold trades upwards in a final "spike" to $3,000 or $4,000, as it well may. For instance, on a historical basis, the gold price quintupled in the 18 months between 1979 and 1980.

But remember, as MacKay astutely reminds us, the madness of crowds never ends well.

Source :http://moneymorning.com/2012/01/11/the-madness-of-crowds-how-to-play-bonds-china-and-gold-in-2012/

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