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Forty-one months, and counting… Complacency is a dangerous thing in the investment world. With stocks around the globe trading at either all-time highs or at their highest levels since 2001, it’s time to brace for a severe market correction, or worse. And history suggests that the next correction will be sudden and global, as bourses from New York to Tokyo head south. On average, stocks suffer a 15% downturn in bull market cycles. Yet, since the bear market low of October 2002, the S&P 500 Index has not declined more than 7%. It’s now up a cumulative 45%. At 41 months and counting, this rally is over-extended and long overdue for a correction.  Investors remain complacent in the face of rising geopolitical risk, high oil prices and rising bond yields. Emerging markets are home to the biggest concentration of speculative frenzy, up more than 200% since late 2002. Indeed, few stock markets are cheap in 2006, with the exception of mainland China, German blue chips and Japanese multinationals.  Markets are also overvalued globally, so foreign stock market diversification isn’t likely to protect your portfolio. Since the mid-1990s, international markets and Wall Street have become increasingly correlated. The last bear market from 2000 to 2002 painted a sobering picture as international diversification failed to offset domestic portfolio losses. That means a major sell-off in the U.S. will force virtually all other markets to head south.  Overconfidence + War + The Derivatives Time-Bomb = Surging Volatility  Investors are alarmingly overconfident. One way to measure this overconfidence is with the CBOE VIX Index, or Chicago Board Options Exchange Volatility Index. The VIX is a market sentiment gauge, measuring option-trading “complacency” based on the S&P 500 Index. When traders are bullish, the VIX declines; but as traders brace for volatile markets, the VIX tends to rise. The VIX is now below 11, its lowest level since the mid-1990s, indicating a market completely unconcerned about downside risk. At the market low in October 2002, the VIX peaked at over 50, suggesting stocks were heavily oversold.  The Middle East and Asia also threaten the world markets. Bogged down in Iraq and Afghanistan, the U.S. saber-rattles a defiant Iran over their nuclear arms and the Israeli-Palestinian conflict is once again a global wild card.  Rising trade tensions also threaten global markets as China continues to log record trade surpluses with the U.S. and the EU. Rising protectionist sentiment may lead to tariffs on Chinese imports. The likely result: a global trade war that plunges global markets into a tailspin as other countries impose their own tariffs, thereby curtailing trade flows. That exact scenario 75 years ago helped bring about the Great Depression.

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The last time world markets were held hostage by derivatives trading was in August 1998 when the near-demise of hedge fund Long Term Capital Management unleashed a tsunami of panic selling. In just a few days, Wall Street and international markets were crushed as LTCM almost went bankrupt, resulting in a stunning 15% plunge for the S&P 500 Index in August. 

And in 2006, the derivatives time bomb is more serious than ever, as hedge funds, insurance companies and Wall Street banks hold trillions of dollars worth of these contracts—and no one knows their real market value! 

The only thing that prevented a market collapse in 1998 was the intervention of the U.S. Federal Reserve to inject liquidity—fiat money—into the banking system. And indeed, the LTCM bailout was the beginning of the Fed’s “easy money” policy, only now coming to an end. And that spells BIG problems… 

Rising Interest Rates Bring the Derivatives Time Bomb Closer to Detonation 
The last time the Fed raised interest rates led to disastrous global consequences. Rising U.S. interest rates were the “nail in the financial coffin” for Thailand and other Asian emerging markets in 1997. Credit tightening also brought down Orange County, California in 1994, leveled the bond market that same year and knocked several hedge funds out of business. 

With the Federal Reserve now into its 25th month of tightening, the Fed is slowly draining liquidity from global markets. And the European Central Bank (ECB) and the Bank of Japan have now joined it in adopting a tight money policy. In other words, the world’s largest three central banks are simultaneously cutting off liquidity from the financial markets. The consequences are completely predictable: highly leveraged investors will be forced to sell, leading to a cascade of global liquidation of stocks, bonds and real estate. 

What’s more, with every incremental rise in interest rates, the derivatives time bomb comes closer to detonation. A major share of the derivatives market consists of credit derivatives—essentially insurance contracts to either augment or offset losses in bonds. Those who bet on lower interest rates stand to lose hundreds of billions of dollars. 

Anticipating the Bear, Riding the Bull 
The TSI portfolio continues to log big gains from diversified investments spread across the markets. Even though we anticipate a market decline, we’re not selling everything and running for the hills. 

The key is to buy appropriate hedges that will rise in value as the broader market declines. And beginning this month, we’re adding what I consider the single best investment product ahead of the next market plunge: the Profunds UltraBear ProFund Investor Class. It’s an ongoing bet on market declines—and because you’re purchasing a mutual fund, and not options or futures, you won’t have to worry about option expiration or throwing more money into a declining futures contract to increase your margin. 

This fund provides twice the inverse performance of the S&P 500 Index, representing America’s 500 largest companies. If this broad market declines, you’ll earn twice that rate of decline; conversely, if the market rises, you’ll lose twice that sum. In 2002, the last year the S&P 500 declined, the fund surged 38%. That’s exactly the negative correlation we’re looking for when markets tank. 

For traditional portfolios invested in stocks and bonds, a maximum 10% allocation for portfolio hedges is sufficient. If global markets continue to rally, the value of the reverse index fund will fall, but your other 90% invested in global markets will easily offset the losses incurred from a bear market bet. Essentially, this will be your portfolio insurance. 

The Profunds UltraBear ProFund Investor (symbol URPIX) requires a US$15,000 minimum investment. 
The fund is available no-load through most discount brokers. Its CUSIP number is: 743185-878. Visit Profunds at www.profunds.com. 

Look Within TSI for More Bear Market Hedging 
Several investments already in the TSI portfolio provide additional diversification across asset classes, ensuring negative stock market correlation. 

Gold should also be a part of your bear market strategy. Gold bullion remains in an exciting bull market and will eventually smash through its 1980 all-time high of US$850 an ounce cracking US$1,500 or more. This rally, supported by the best fundamentals and highest degree of macroeconomic uncertainty in a generation, will likely coincide with a fresh U.S. dollar crisis, mortgage-backed disaster in real estate and a derivatives-based collapse. 

Buy Goldcorp (NYSE-GG) on intermittent weakness below US$25 a share. Recommended in TSI 1/05, Goldcorp has rallied 80%, and is still climbing. Goldcorp has become one of the world’s premier gold mining companies, supported by mind-blowing earnings, superb management, the lowest production cost per ounce among major gold producers (US$180/oz. in 2005) and world-class properties through cunning acquisitions by Ian Telfer, its CEO since January 2005. 

Also, with interest rates on 90-day Treasury bills and money-market funds now approaching 5%, cash is again looking attractive. Make sure your portfolio has sufficient liquidity to take advantage of the bargains when the markets correct. 

Stocks are rapidly approaching their day of reckoning. Equities should have corrected at least 15% or more, months ago. The longer this rally continues, the larger the inevitable correction is likely to be. 

Forty-one months…and counting. 
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The Strange Disappearance of 100,000 American Millionaires. Last year, the number of American millionaires fell by 100,000.  Yet 200,000 new millionaires showed up overseas.  Why?  Because hugely profitable investments are being hidden from you by a cartel of lawyers, regulators and Wall Street special interests. Like our recommended investments that gained 787% and 1,894% during the bear market and our other investments up 106%, 131% and 169%. Find out what they don't want you to know...