Because human psychology is slow to change, a broad economic move usually occurs in three stages. The first stage begins when some unexpected event shatters an overdone psychological environment. Yet, while some people respond immediately to this new lesson, most people, as they find it outside their past experience, do not believe it. They need more evidence — that is, a second stage. Typically, the majority become convinced during the second stage and therefore the psychological background changes. People begin to act differently, and their behavior soon affects the performance of the economy. (Dick Stoken, as quoted by Arthur Zeikel in On Thinking)

Something big has happened. Something has changed. And it could change the way we think. Instead of believing that ‘recovery’ is right around the corner, we may begin to think it will never come.

David Rosenberg says that major changes in our attitudes will come in 8 different areas:

EIGHT AREAS OF BEHAVIOURAL CHANGE TO WATCH FOR IN 2012

1. Frugality on the part of the global consumer (living within our means; retirement with dignity)
2. Austerity on the part of sovereigns (spending cuts/tax reform)
3. Nationalism (an umbrella for protectionism and isolationism: mean reversion for globalization)
4. Political movement along the ideological and fiscal spectrum (from gridlock to change)
5. Geopolitical change (wars, elections and regime changes)
6. Changes in inflationary/deflationary expectations
7. Changes in growth expectations
8. Changes in asset allocation preference (fund-flows/de-risking)

The main risk for 2012 is the potential for Europe to plunge into a deep recession. Other risks relate to a Chinese hard landing and fiscal austerity triggering weaker growth in the US.....

The shadow cast by Europe means greater uncertainty than normal. However, despite reasonable profit growth, shares have fallen suggesting they have already discounted a lot of the bad news. On top of this, everyone seems to be bearish and monetary conditions are easing further. If the European Central Central Bank (ECB) steps up its involvement as we expect and monetary easing continues elsewhere, shares will ultimately have a much better year ahead.........

2011- this volatile, trendless market has been unkind to Wall Street pros and Main Street investors alike.

Indeed, buy & hold investors have had more ups and downs this year than your average rollercoaster. The third and fourth quarters alone had more than a dozen market swings, ranging from 5 percent to more than 20 percent. Despite all of that action, the S&P 500 is essentially unchanged year-to-date....

3 basic enemies
1. Mr Market. He is, as Benjamin Graham described him, your eternal partner in investing. He is a patient if somewhat bipolar fellow. Subject to wild mood swings, he is always willing to offer you a bid or an ask. If you are a buyer, he is a seller – and vice versa. But do not mistake this for generosity: he is your opponent. He likes to make you look a fool. Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is. And perhaps most frustrating of all, Mr. Market has no ego – he does not care about being right or wron...

2. next rivals are nearly as tough: they are everyone else buying or selling stocks.... Investing is a rough and tumble business. It doesn’t matter where these traders work – they may be on prop desks, mutual funds, hedge funds, or HFT shops – they employ an array of professional staff and technological tools to give themselves a significant edge. With billions at risk, they deploy anything that gives them even a slight advantage. ...... Armed only with a PC, an internet connection, and CNBC muted in the background, investors face daunting odds. They are at a tactical disadvantage, outmanned and outgunned.

3. Ourselves ... you may be the opponent you understand the least of all three. It is more than time constraints, lack of discipline, and asymmetrical information that challenges you.

...By definition, all investors cannot be above average. Indeed, the odds are high that, like most investors, you will underperform the broad market this year. But it is more than just this year – “underperformance” is not merely a 2011 phenomenon. The statistics suggest that 4 out of 5 of you underperformed last year, and the same number will underperform next year, too.

[There are] a variety of problems when it comes to investing in equities: our instincts often betray us. To do well in the capital markets requires developing skills that very often are the opposite of what our survival instincts are telling us. Our emotions compound the problem, often compelling us to make changes at the worst possible times. The panic selling at market lows and greedy chasing as we head into tops are a reflection of these factors.

The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making. Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated – and that does not help returns.

... If we can manage our emotions and prevent them from causing us to make decisions out of panic or greed, then our investing results will improve dramatically.

One final thought. Smaller investors do not realize that they possess quite a few strategic advantages – if only they would take advantage of them. Consider these small-investor pluses:
• No benchmark to meet quarterly (or monthly), so you can have longer-term time horizons and different goals
• You can enter or exit a position without impacting markets.
• There is no public scrutiny of your holdings and no disclosures required, so you don’t have to worry about someone taking your ideas.
• You don’t have to limit yourself to just the largest stocks or worry about position size (this is huge).
• Cost structure, fees, and taxes are within your control.
• You can reverse errors without professional consequences – you don’t get fired for admitting a mistake.
• You can have longer-term time horizons and different goals.

1. U.S. consumers will shift from a 25-year borrowing-and-spending binge to a saving spree. This will spread abroad as American consumers curtail the imports of the goods and services many foreign nations depend on for economic growth.

2. Financial deleveraging will reverse the trend that financed much global growth in recent years.

3. Increased government regulation and involvement in major economies will stifle innovation and reduce efficiency.

4. Low commodity prices will limit spending by commodity-producing lands.

5. Developed countries are moving toward fiscal restraint.

6. Rising protectionism will slow—even eliminate—global growth.

7. The housing market will be weak due to excess inventories and loss of investment appeal.

8. Deflation will curtail spending as buyers anticipate lower prices.

9. State and local governments will contract.

We know, we know, we know - stop telling us, already - Marcus Padley - February 4, 2012

Before we have to read another opinion about the market, let's get a few things clear.

We know there has been a 25-year credit boom and we know that whoever borrowed the most money is up the creek without a paddle.

We know that some individuals, businesses and countries don't earn enough to service their debt and we know that unless that debt is forgiven or restructured, they will go bust.

We know there is an exclusive club of countries that are ''too big to fail'' and that their governments will ride to their rescue, plugging the holes with more debt, which they most surely can't pay back but will take anyway because there is no other option, and, in doing so, will consign their economies to years of austerity-inhibited zombie growth.

We know that all the rescue solutions now being discussed are just a reshuffling of the deckchairs by self-interested governments and bureaucrats backed into a corner by necessity. And we know there's a risk the spin will run out and the ship will sink, taking the equity and property markets with it. We know.

We also know the heady days of ingrained irrational exuberance - of borrowing to consume and borrowing to speculate; of assuming equity markets will always go up and property investment is safe - are no longer assured. We know the long-term outlook for the market has been dulled by a huge debt hangover and we know that in the short term, one or other European nation could default and generate panic. We know, we know. Stop telling us, we know.

Everyone has got the message and, as a result, any investors who don't want to take the risk are already nestling in term deposits and are not coming back until someone blows the all clear.

Which leaves everyone else - the people who know the risks but have chosen to play anyway. They fall into two groups: one is looking for action while the other has been forced into equity-market interest by falling interest rates. Faced with decreasing returns and rising living costs, this group is looking for income and is prepared to take a risk to get it.

...... Last year, one in four stocks went up. The game now, as always, is finding those stocks while staying clear of those that are going down. How do you do that?

One of the best ways to pick stocks is to pick themes; to come at the stocks from the top down. Last year for instance, the main drivers were a flight to income stocks and away from resources. Who would have thought Telstra's total return last year would hit 29.4 per cent, while Rio Tinto would fall 28 per cent?

Themes that are working so far this year include, first and foremost, a resources resurrection on the back of less concern about China, whose recent gross domestic product figure settled a lot of nerves, while further easing of Chinese policy is in the wings. It looks like China may just retain growth of 8.5 per cent this year and, on the back of all that, commodity prices have firmed and BHP and Rio Tinto are looking better. It may change at any moment but is good for now.

Other themes include buying any stocks that prove themselves to be ''safe'' in the results season. On telling us their results would be OK, Leighton Holdings jumped 15.8 per cent and Ausdrill 27.6 per cent.

With the focus so acutely on risk rather than reward, the results season will be quite polarised.

Any company that tells us their results are OK, replacing fear with certainty, will jump. And the stocks that hold the most fear offer the most upside, such as currency-affected stocks, steel stocks, retailers, media stocks and those that are dependent on the sharemarket.

It won't take much to set them off and, on recent experience, you will still make money even if you miss the very first move.

The other big theme is the chase for defensive stocks with a decent dividend. We have listed these on the website this weekend.

This is the game this year - playing themes and picking stocks. It's not rising-tide investment, it's taking advantage of anything on offer over any time frame. It requires a bit more effort, of course, and a few basic trading skills but, for some of us, that's the fun bit.

Read more: http://www.smh.com.au/money/we-know-we- ... z1lOBxytVR

Felix Zulauf's market prognosis

The trouble is that when you have an over-indebted economy, you can’t use monetary policy to offset this because monetary policy doesn’t work anymore, only fiscal policy does.
...
Obviously monetarists believe that when the central bank’s balance sheet explodes, it raises final demand in the economy. I don’t believe that will happen, because the transmission mechanism is broken. But what it is doing is that it’s reducing systemic risk, so that risk assets can recover. That’s all about the rally that we’ve seen since last October.

I think the rally will continue into the end of the first quarter, or maybe a little bit further. And this flood of money means my original scenario could be pushed out further in time. I had been expecting that problems would start in the second quarter of this year, and there would be a correction. But now this cyclical rolling-over could be pushed out. From this summer to fall of 2013 seems to me the most vulnerable period for markets.

The very big picture is that markets in the United States and Europe are in a long, sideways value compression period, similar to what we saw from the mid 1960s to the early 1980s. This current one started in 2000, and will probably last into the second half of this decade. And it’s very similar to what you saw in Japan, with cyclical run ups and cyclical corrections. And these cyclical moves are usually triggered by government programs – both monetary and fiscal.
...
But I think we are now dealing with a structural weakness in consumption in the industrial world due to declining prosperity. Real disposable personal income in most industrialised countries is stagnating, or even declining. And that means China has to change its model. Its export industries won’t be as vigorous as they used to be, both as a result of the weakness in demand outside China, and also because Chinese labour costs have risen sharply in recent years.

So China has to change and put more focus on domestic consumption. But this has important implications for Chinese growth because domestic consumption doesn’t have the same multiplier effect on the economy as investment. So what we’re likely to see is that China’s growth rate will decline from around 9-10 per cent per annum, to around the 6-7 per cent level.

And it also means that demand for commodities will slow. It won’t collapse, but it will slow. Commodity prices will tend to underperform equity prices during periods of “risk on” trading.

But I would make an exception for two commodities – oil and gold. Oil, because the oil price is driven by geopolitics, and the geopolitical situation is very fragile. And gold because, in my view, gold is a currency. Central banks – in the United States and Europe – have no choice. They have to continue printing money to prevent their systems from collapsing, and this will debase their currencies.
...
The other alternative, which I think is actually more likely, is that central banks will step in and take over the financing role that creditors used to perform. That’s already happening. In the United States, the central bank is buying Treasury bonds. In the United Kingdom, the Bank of England is the largest holder of government bonds. In history, whenever we’ve seen a central bank finance more than 30 per cent of government expenditure, we’ve always had a highly inflationary period four to five years later.

So, at the moment, you have two countervailing forces. On the one hand, you have a high level of debt, which is a highly deflationary force, which results in lower economic growth and a decline in prosperity for the masses. If you let this run unchecked, it leads to depression and the collapse of the system.

In order to counter these deflationary forces, governments and central banks adopt policies aimed at fiscal and monetary reflation. At the moment, we’re weaving between these two forces, and at any moment, it’s a question of which force is stronger, and whether it’s risk on, and risk assets go up, or risk off and risk assets going down.

Eventually there will be a conclusion, either a systemic collapse or a rise in inflation which will lead in some countries to hyper-inflation. And hyper-inflation itself always leads to systemic collapse. It’s an ugly situation, no question.
...
Emerging economies are in a much better structural position. Most of them have relatively low debts, they don’t have welfare systems they can’t finance, and they have much better demographics, so they have a built-in natural growth rate in their economies.

They are the place to be in the long run. The only problem is they are intertwined with our world, and when our world suffers systemic problems, they will have a cyclical correction. But that’s where the money should flow.

Finally, what is the outlook for the Australian economy?

You are blessed. You’re far away from all these problems. Australia is the major beneficiary from the rise of China, as rising commodity prices have helped your economy and led to prosperity.

The only issue is that if China has a cyclical correction, you will probably have a recession. I think that if China’s cyclical downturn comes in the second half of this year, or next year, Australia will fall into recession.

On balance, while there will likely be bouts of volatility and the period from May to October is often weak, we remain of the view that this year will be far better for risky assets such as shares than the last two have been.

we suggest watching the following indicators:
> Bond yields in Italy, Spain and France as a guide to whether the European debt crisis remains under control – so far so good with Italian spreads to Germany actually falling though the recent back-up in global bond yields.
> The US ISM index – again so far so good with the ISM trending higher but remaining well off the virtually impossible to beat highs it reached early last year.
> Chinese money supply growth as a guide to the Chinese economic outlook. This has slowed from around 30% year-on-year (yoy) in 2009 to around 15% yoy, but does appear to be stabilising.
> The A$ – again so far so good. The A$ is a good barometer of global health and while it has come off its recent highs it remains strong.
> World oil prices – at present the rise has not been enough to choke off global growth. But if oil prices rise another US$20 a barrel or more it could become a problem.

Concluding comments

Behavioural finance reminds us that investors have a tendency to give more weight to recent experience than is rationally justified. The last two years have seen an outbreak of doubledip worries from around April/May resulting in 15% plus falls in share markets, so it’s natural to assume the same this year. But things are rarely that simple and while some sort of correction is almost inevitable in the months ahead there is a good chance that after two years of disappointing returns shares will surprise on the upside this year.

Given that shares are cheap relative to alternatives, monetary conditions are very easy and there is lots of money piled up in bond funds that could flow into shares my bias is the latter

Investors are now investing for total real return. by Curt Custard, Head of Global Investment Solutions UBS

While that seems simple, in reality the 'Great Moderation' of the Volcker/Greenspan era changed how and why we invest. Before that, from the 1950s through the 1970s, investors were primarily concerned with securing a positive real return. They wanted to look at their end-of-year statement and see their account going up, and they hired active managers to achieve this goal. The Great Moderation changed that. Active managers were categorized by asset class, and their performance was measured against a market aggregate benchmark. With rally after rally in equity markets, investors began to accept a hypothetical 30-year horizon where equities would always outperform in the long run.

While that sounds fanciful now, it persisted over the golden age of the Great Moderation, when recessions were rare. The equity risk premium was something people believed in, just as they believed that house prices would never fall. That idea framed the way people thought about risk. So we had the rise of terms like 'alpha' and 'beta', and ever-smaller subdivisions of asset classes and styles such as growth equities or small/midcap equities. But now investors are returning to their roots – they want their money back, preferably with a return in excess of inflation.

Get your income from equities, not bonds.
During the 1950s and 1960s, the earnings yield from equities exceeded that from bonds. Why? Because equities were riskier, so they paid you more to compensate. During the late 1980s and 1990s, equities achieved their growth from rising share prices, largely as a result of taking on more operational leverage. Bonds offered higher yields than equities. Today, investors want cash in hand – and companies, whose cash pools are substantial, are accommodating. Earnings yields are at cyclical highs, and dividend payout ratios have been rising. Bond yields no longer have a clear advantage over equities' earnings yields or dividend yields.

There is no such thing as 'risk-free'.
The notion that something is 'risk-free' is an idea that academics made up to make their models easier to build. The idea fails the 'real life' test. You would have to be living under a rock not to have read the headlines surrounding the European sovereign bond crisis. Some European government bonds are now as illiquid as US mortgage-backed securities were at the height of the 2008 crisis.

But we should not be surprised. In 2008 how many investors thought that LIBOR (London Interbank Offer Rate) was a proxy for hard cash when they bought a 'LIBOR-plus' fund? Many investors thought that those investments were 'cashplus' with low volatility. They were wrong. Now academics, regulators, rating agencies and investors have to rethink their models. There is no such thing as risk-free and there is no guarantee that liquid markets will stay liquid. Now, as in the 1970s, there is no sure prospect of getting a positive real return from your fixed income investments.

Investment banks and commercial 'money center' banks are contemplating divorce.
The plan was simple. Combine a boring bank's large deposit base with an investment bank that could leverage that cheap capital base by doing interesting things in the market. During the Great Moderation, investment banking boomed as everlower borrowing costs meant that leverage levels could be taken ever higher and large profits from trading ensued. This worked for a long time and financial stocks grew, like tech stocks before them, to a huge share of the S&P 500. Not any longer. Now many investment banks will either have to raise capital themselves or exit risky, higher return-generating activities.

Once bitten, forever shy.
The 2008-09 crisis came when a large part of the 'baby boom' generation was moving from the accumulation phase of their financial life to the de-accumulation phase. That is, they went from saving to spending. They lost a lot of money during the market crash, and many exited the markets either at or near the lows, locking in their losses. Academic studies from the Great Depression show that once investors are burnt, they are much more resistant to taking risk again. That is doubly true of investors in the later stages of their lives. They are more likely to take whatever gains or losses they have and lock them away, forgoing future gains to protect their current assets. What makes this even more pernicious is that many institutional investors, above all defined benefit pension plans, are behaving in the same way. Both these behaviors will take years to play out. Over time, investors will switch their preferences from equities to fixed income, which would slow any fall in bond prices.

Beware the Law of Unintended Consequences.
With new regulations coming into force around the world, politicians and regulators have got what they wanted: Banks are reeling in their risk-taking behavior. But those politicians and regulators need to be careful of what they ask for. In Europe, where a great deal of economic activity is financed by bank loans, the new regulations – coupled with the 'austerity budgets' – will make financing much more difficult to obtain, slowing economic growth and curtailing investment.

In markets where banks were intermediaries, liquidity will dry up, bid/ask spreads are likely to widen, mutual fund costs could increase, and investment innovation may be curtailed. All of which will end up hurting investors, who may have to pay more just to invest their money. In a low-return world, increasing transaction costs imposes an extra burden on investors trying to meet their investment goals.

All six trends described above are going on right now, moving slowly under the surface. All of them are likely to shape investment policy for the coming years or even decades. We are moving forward in time but in investing terms we are moving back to a period before the Great Moderation. We have entered a more volatile period for economies and for markets which, coupled with a graying population with a preference for cash, will have a profound impact on how we invest going forward. We are going 'back to the future'.