Housing Market Update: Home Builders Show Optimism

New-Home Sales Fall in 2011 -- Existing Home Sales Show Improvement

Last Thursday, the US Commerce Department reported that 2011 was the worst year for new-home sales since 1963. It attributed the decline to competition from resale homes, which are much cheaper, primarily because of foreclosures and short sales. (Short sales are when lenders accept less for a house than what is owed on the mortgage.)

Although new-home sales represent less than 10 percent of the housing market, they have a powerful multiplier effect and are usually a good indicator of economic momentum. For example, the National Association of Home Builders says that each new home built creates an average of three jobs for a year and generates nearly $90,000 in tax revenue.

With 30-year mortgage rates hitting a record low of 3.88% last week, and employment showing signs of improvement, homebuilders and economists believe that 2011 may have been the bottom for new-home sales and that there may be a rise in sales in 2012.  However, that rise must be substantial in order to bode well for the economy. Economists suggest that at least 700,000 new homes must be sold annually to indicate a healthy economy, but only 302,000 new homes were sold in 2011, compared to 323,000 sold in 2010.

While new-home sales have come out with disappointing reports recently, existing home sales have had a positive trend over the past few months, excluding December. The Pending Home Sales Index, a leading indicator that gauges the demand for resale housing, showed a 7.3% gain in November and 10.4% increase in October. Still, existing home sales fell -3.5% in December, missing the -1.0% consensus. However, existing home sales in December 2011 were above sales of December 2010, indicating a slight improvement, and existing home sales rose 1.7% in 2011 to 4.26 million from 4.19 million in 2010.

Home Prices Drop Even Further

Many Americans have been putting off buying homes at all, in part to see how low those prices --including prices for new homes—will go. In fact, new home prices have decreased as home builders have slashed their prices to stay competitive, adding to the supply of relatively cheaper homes.

The median sales price for new homes dropped last month to $210,300, a significant year-on-year decline of -12.8%. 

Despite dropping prices and low sales, economists and home builders remain optimistic. They believe that record low interest rates, job growth and bargain home prices will give consumers the confidence to enter the housing market.

China Faces More Challenges

A Little History of China's Economy

With China's economy growing at an average of 10% over the past 30 years, the Asian nation has earned its rank as the second largest economy, surpassing Japan in 2001, and now right on the heels of the first-ranked US. So, what led to China's relatively steady 10% growth over the years?

In 1978, China embarked on a series of economic reforms that gave its economy the potential to grow, but only after its communist ruler, Mao Zedong, died. Mao had established an autocratic socialist system that imposed strict controls over everyday life, which consequently limited workers' productivity. After Mao's death, his successor Deng Xiaoping, led a movement for economic reforms. Deng was a politician who had a vision of China becoming a socialist market economy. He successfully pushed for greater openness in both the social and political arenas, and that led to more foreign investment and trade within global markets. The reforms encouraged the formation of private businesses, relaxed state control over some prices, and led to large investments in industrial production and in the education of workers.

After the economic reforms were implemented in 1978, China's growth took off, with millions of Chinese citizens being lifted out of poverty as the per capital income nearly quadrupled. The driving force behind China's growth can be partly attributed to its ability to build, acquire and use new factories, and to manufacture machinery and communications systems, all of which caused a sharp increase in worker productivity. A report by the IMF states that from 1979-1994 productivity gains accounted for more than 42% of China's growth.

China GDP Growth (RMB & %) Since 1978

China's Economy Today – More Challenges Despite Growth

Although only 50 years ago China had a closed and centrally planned economic system, today China plays a more open and international role as the world's largest exporter. Its exports now represent over 30% of its nearly $6 trillion GDP—which is about half of the US’s GDP. Still, despite China’s extraordinary growth, its per capita income remains below the world's average and the Chinese government faces many economic challenges.

One major economic challenge China faces today is an unusually high domestic savings rate of 51% and, consequently, a low domestic demand, leaving China exposed to international demand for its exports. Another challenge is sustaining adequate job growth. After the economic reforms of 1978, Chinese workers flocked out of rural farmlands and into industrial cities, picking up jobs in manufacturing and service sectors. This caused a high supply of workers, but the number of new jobs has not kept up with that growing workforce, creating an imbalance that has kept workers' wages relatively low. Thus, while cheap labor may make it attractive for multinational corporations to make foreign direct investment in China, the low wages have limited the standard of living of the Chinese workforce.

China also faces other challenges: reducing the corruption of government officials, mitigating environmental damages from air pollution and soil erosion, and addressing the consequences of its “one child” policy, as China is now one of the most rapidly aging countries in the world. Moreover, China’s sustained growth has led to inflation exceeding the government’s target of 3%. China, therefore, has been raising interest rates to purposely slow economic growth and steep price increases. Still, raising rates is a double-edged sword; while raising the rates will slow the lending that, in part, led to the increases in real estate prices and inflation, the higher rates will also encourage the citizens to save even more money, and that could further hurt domestic demand for goods.

Although China’s economy has experienced extraordinary growth over the past 30 years through rapid growth in investment, increases in worker productivity, and decreases in population growth rate, China has also developed many deep-rooted economic problems. Today, China’s government promises to continue implementing economic reforms to deal with such economic problems. For now, however, if China’s economy continues to grow at a 10% growth rate, it will become the largest economy in the world by 2035. However, will China's economy really continue to grow that fast in the next 23 years?

Hard Or Soft Landing In China?

China's growth has slowed to 9.2% in 2011 and many analysts suspect that this slowdown (soft landing) will continue during 2012. But will China's economy instead take a huge dive (hard landing) as it faces a real estate bubble, high inflation, local government debt problems, and less global demand for exports with continued weakness in Europe? Or, will China’s government be able to further exercise its fiscal and monetary controls enough to mitigate these problems before they explode?

While I believe that policy makers in China have the ability to mitigate these issues, I also believe that addressing them with fiscal and monetary policies alone will not be enough. A primary reason for anticipating a hard landing in China is because it is not a consumer based economy. The Chinese save much of their income for a variety of social reasons, including the “one child” policy. This emphasis on saving reduces domestic demand for goods, leaving China very exposed to global demand. If that global demand falls –for example, in response to the European crisis-- China will be significantly impacted. Another potential problem may arise if China continues to import more and export less, possibly creating a significant deficit. These issues, combined with local government debt issues and higher than desired inflation caused by China's stimulus in 2008, all point to a potential hard landing in China this year.

While many analysts maintain that China now, and in 2012 is headed for a soft landing, FXI, an iShares Index ETF that follows the performance of the 25 largest companies in China's equity market, was down 17.5% this past year. Thus, the markets seem not to agree with the idea that China is simply in a slowdown, and that is causing much uncertainty. In fact, Lawrence Summers, former Secretary of the Treasury and economic adviser to President Barack Obama, said "China is the great unanswerable question... whatever you think the range of possible outcomes is [for China] over the next 25 years, it is wider."

No one can accurately forecast global demand for China's exports, especially with the continued uncertainty in Europe, but it seems that if China continues down its current path without making significant structural changes, as it did in 1978, it may eventually have a larger economic slowdown. To maintain a strong economy, China, as Robert Zoellick, President of the World Bank, once said, "needs to develop its domestic markets, allow small firms access to capital, and allow for more innovation."

Opinion: China's Growth Will Continue To Slow If No Structural Changes

Many analysts predict that China's economic growth in 2012 will be between 7 and 8.5%. Although I agree with analysts that China will continue to be a leader in economic growth in coming years, I believe that without large structural changes, the level of growth it will experience will continue to slow. Such slowing growth may cause investors to panic, as they fear a possible hard landing. For this reason, I recommend paying close attention to China's import/export markets and its domestic demand, as they may be good indicators of a hard landing.

Kicking The Can Down The Road - European Debt Crisis

How Are Europe's Peripheral Countries Staying Afloat?

The US is actually involved in bailing out the European banks.

This is because the Federal Reserve is giving funds (over $100 billion so far) to the ECB through a "temporary US dollar liquidity swap agreement". Since the ECB won't buy the bonds from Europe's peripheral countries itself, the ECB is now lending to European banks by giving the banks unlimited 3-year funding at a 1% interest rate (the ECB has now lent some $639 billion to banks, double the amount analysts predicted). The European banks are now hoped to turn around and buy the bonds of the peripheral countries with those funds.

Ultimately, the Fed is lending to the ECB, the ECB is lending to European banks, and the banks are taking those loans and are supposed to buy the bonds of the peripheral countries so that their governments don't default on what they already owe, at least for now.

The ECB balance sheet is now at a record high of 2.73 trillion euros.

Italian Debt Auction

Today, Italy was still unable to raise the maximum amount it wanted (8.5 billion euros) when it auctioned 7 billion euros of 10-year government bonds, even though Italian lenders borrowed 116 billion euros as part of the ECB's offer of unlimited 3-year funds. Yesterday, however, the 3-year Italian treasuries were sold more easily, as the ECB's funds made a big difference for yields, which dropped more than 2% to 5.62%.

Some European analysts say that the auction today was successful, because bond yields were lowered a bit below 7 percent as there was more demand for these bonds. Investors, some analysts say, are becoming more comfortable with the higher bond yields. However, in the US, the analyst's sentiment is a little different as there was only a small reduction in Italy's 10-year yield, after the bold lending move by the ECB, a near 7 percent yield is still very high. 

In my opinion, the just under 7 percent yield of Italian 10-year treasuries is unsustainable in the long-run, and since Italy has debt of around 120 percent of GDP and needs to raise another 150 billion between February and April, I have serious concerns about Italy meeting its bills. If Italy is unable to find buyers of its debt at an affordable rate and if the ECB does not use its power to buy Italian bonds with newly created money (which would remove the incentive for governments to control their spending (Mchugh)), then Italy very well be on its way to default.

Unfortunately, adding to the problem, is that the stress tests by the European Banking Authority (EBA) has revealed that European banks need to raise another $149 billion in extra capital to offset a fall in the value of their existing holdings of government bonds issued by troubled peripheral European countries (the economist). European banks may be using the 3-year funds from the ECB to meet these requirements rather than buying short-term bonds from peripheral European countries.

Still, there is no doubt that the ECB gave a huge short-term debt boost to Italy. But, the investors who bought 10-year Italian bonds are taking a major risk as there is a lot of uncertainty surrounding Italy and its potential default.

 Stay Out: All Of EU Will Be Affected By Potential Defaults

With banks holding back lending to meet their capital requirements and perhaps buying government debt that still may default in the future, I am short Europe and the Euro. Although some of the stronger northern European countries may be showing signs of growth (ex: Germany), I believe that the concerns of the weaker southern European countries and their potential default will prove to outweigh some growth and ultimately that those concerns will be costly for all of the EU.

I am short the Euro vs USD because there are significant signs of growth in the US, while Europe struggles to get its debt problems under control. I believe that over the next few months investors will start pulling their money out of Euro denominated securities and start buying dollar denominated securities, pushing the dollar up against the Euro.

Guest Commentator: Ralph Vaz -- Bank Regulation Since 2008

 Banks: Regulation vs Free Market

Since the 2008 financial crisis, the financial sector has come under criticism for its behavior leading to the crisis, generating a classic economics debate of regulation versus free markets and highlighting the predator-prey relationships between the government, businesses, and the people. The government argues that businesses prey on the people, while businesses argue that the government preys on them through regulations. So we again face the age-old question of how much (if any at all) regulation is good or necessary?

Glass-Steagall Act: 1933

After the bank failures during the Great Depression, the Glass-Steagall Act was passed with the intention of separating commercial banking activities from investment banking activities. Many considered the growing involvement of commercial banks with stock market investments to be both highly inappropriate and one of the main causes of the stock market crash. The banks took on excessive risk by investing depositors' money into high risk assets. As a result, the objectives of banks came under scrutiny. The companies that banks invested in were given shady loans by those same banks.  

This was seen as a major conflict of interest. The Glass-Steagall Act aimed to solve this conflict by forcing banks to specialize in either commercial banking or investment banking, but not both, setting a maximum of 10% on the amount of income a commercial bank could get from securities. Most of the banks reacted harshly to the regulations; many argued that some diversification is necessary to help banks reduce risk.

As the years passed, banks became more transparent about their practices. Consumers and regulators came to believe that this growing transparency would keep banks from assuming too much risk. As a result, in 1999, Congress passed the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act.

Period of Deregulation

Repeal of Glass-Steagall through the  Gramm-Leach-Bliley Act has often been attributed with contributing to the financial crisis of 2008. This argument stems a concept everyone will remember: sub-prime loans! Sub-prime loans are those given to people who are not very credit-worthy. A higher interest rate is placed on these loans to compensate for the higher risk of lending. In general, sub-prime loans are considered risky loans. Before the Glass-Steagall Act was repealed, sub-prime loans made up about 5% of all loans. After its repeal, by the peak of the crisis in 2008, sub-prime loans had grown to 30% of all loans.

Post-Crisis impact 

There have been several attempts to re-enact the Glass-Steagall Act, most notably by Senator John McCain in 2010. President Obama also supported the "Volcker Rule," which proposed several laws similar to Glass-Steagall. The main goal of the "Volcker Rule" is to ban proprietary trading, which is trading on the banks' accounts with customers' deposits. Proprietary trading was very common in the period leading to the crisis and firms such as Goldman Sachs made as much as a quarter of their profits from proprietary trading.

In 2010, President Obama signed into law the Dodd-Frank Act, which includes many provisions of the Volcker Rule. Dodd-Frank was meant to reform Wall-Street and protect consumers from the type of predatory lending that led to the sub-prime crisis. However, there has been much debate about this law. Although the law passed, bankers still are arguing that the law imposes regulations that are too strict, while consumers maintain it does not offer enough regulation to protect the borrowers. So far,  the main components of the act have yet to be felt, although they are certainly in progress.

Stress Tests

Recently, there have been further developments on the regulation of large banks. For instance, there will be a heavy emphasis on using stress tests to determine how banks would do under conditions like those seen in 2008. The EU already has implemented such tests, and major European banks have been struggling to meet them due to the illiquidity of the markets. 

Additionally, by 2013 financial firms will be required to hold at least 5% of their assets in reserves at all times, or face a surcharge penalty for assuming too much risk. In the years leading to the  crisis, most banks were holding only around 3% of their assets as reserves. The increase in the capital requirement was adopted because a greater reserve could be used as a cushion in periods of high distress on the markets. However, banks argue that greater reserve requirements will stall growth by reducing lending.

Basel III

Many of the Dodd-Frank regulations are based upon the Basel III, an international regulatory standard, although they are not nearly as severe as Basel III. In fact, some U.S. banks fall under both US and the Basel III regulations and therefore will face stricter capital requirements. Both the U.S. and the Basel regulations are targeting banks deemed "systematically" important, or important enough to impact the market as a whole.

There are concerns that the regulations will result in less liquidity in the markets, and increase costs for banks at the absolute worst time. But the Fed believes the benefit of reducing the chances of another crisis outweighs the short-term costs of making loans available at cheap rates.

How Will This Impact U.S. Markets

In the short run, I feel that most of the impact from regulations is already built into the stock market price. We saw the markets struggle immediately after the announcements of further regulations, and the financial firms impacted by the regulations took the biggest hits. It is still important to note that all the provisions of the regulations are not finalized. The Fed is expected to release further details in the months to come (likely by March). Pay close attention to all details released and the reaction of lenders to those details. If the regulations turn out to be more severe than expected, then I would certainly expect more of a short term hit to the financial sector.

As Jon pointed out to me, the next few years look to be very gloomy for banks until the business cycle repeats itself (regulation vs deregulation). Until there is more stability in the markets, a large concern for banks is that they will have to find new ways to make profits without making risky investments. 

Guest Commentator: Ralph Vaz

President of the Society of Individual Investors (SII)

http://www.sii.org.vt.edu/

The Federal Deficit -- Is Another Downgrade Aaa Big Deal?

A Little History on US Debt

The US government has not always run a deficit. In fact, when looking back at the US debt’s financial history, the US has really only run deficits during wartime or during financial crises-- until the 20th century. In the 20th century, the US acquired more significant deficits both in war and peace times. These occurred following WWI, the Great Depression, and WII, and in almost all years since 1960, whether we were at war or not (Chantrill).

 US Debt (% of GDP since 1792)

In the current millennium, public debt has increased by over $500 billion each year since 2003, with increases of $1 trillion in 2008, $1.9 trillion in 2009, and $1.7 trillion in 2010. As of mid December, the gross debt was over $15 trillion, $10.5 trillion held by the public and $4.65 trillion from intergovernmental holdings.

What Is A Deficit And Is It A Problem?

How is this deficit created? Simply, the federal government spends more than it takes in from its receipts (ex: taxes), so it borrows money to carry out what it promises that we will receive as benefits, including Medicare, new roads, defense, education funds, and so on. Is this really a problem?

Yes in the long-run and no in the short-run. In the long-run, if the US continues to borrow to meet its bills, there will come a point when its loans become more risky and lenders will start requiring higher interest rates. The concept is similar to when an investor requires a higher rate of return when he lends money to a company that is already in debt up to its eyeballs, and continues to acquire more debt. If the US government were a company, it would be selling junk bonds. Ironically, though, US Treasuries are currently considered among the safest assets in the world. Funny, isn't it?

In the short-run, it is not a problem and this is because, believe it or not, markets are not nervous about lending to the US. In fact, last August when S&P downgraded the US government's credit rating, its borrowing costs actually fell further. Clearly, the markets disagreed with the rating agency. But, what if another rating agency downgrades US government debt?

Another Downgrade?

Today, another rating agency, Fitch, warned the US of a credit downgrade, unless we solve our growing debt problem. Last month Fitch put the US on negative outlook, citing the failure of the special congressional committee to agree on at least $1.2 trillion in deficit reduction measures.

Fitch said in a statement, "Federal debt will rise in the absence of expenditure and tax reforms that would address the challenges of rising health and social security spending as the population ages... the high and rising federal and general government debt burden is not consistent with the U.S. retaining its 'AAA' status despite its other fundamental sovereign credit strengths" (Huffington Post).

So, what are we doing to fix this problem?

Fixing the Budget: What is the Super Committee?

We've all heard of the US budget "super committee" but what exactly is it, and what has it done to help fix the debt problem? The super committee, formally the "Congressional Joint Select Committee on Deficit Reduction," was created through the Budget Control Act of 2011 signed by President Obama and is made up equally of Republican and Democrat lawmakers to help control our federal government's budget deficit. The hope is that the committee will agree on some $1.2 trillion in budget cuts over the next 10 years. Now, however, we are just scuttling by, as last August we did not default on our debt by immediately raising the debt ceiling (a power of Congress) by $400 billion. So basically, we just borrowed more to pay off the interest payments and debts we already owe.

Last month, because of political gridlock, the super committee failed to come up with a budget plan. The Republicans did not want any tax increases and wanted to protect the tax cuts for high earners while Democrats did not want to make cuts in Social Security -- Medicare & Medicaid -- unless Republicans agreed to tax increases. Unless the committee comes up with $1.2 trillion in cuts by 2013, there will be automatic across-the-board spending cuts by our government.

Surely, controlling our spending will be one of our greatest challenges in coming years. As for now, there seems to be no real solution as Fitch continues to threaten a downgrade.

Another Downgrade May Not Be A Big Deal? What Now?

Fitch will probably cut the US's AAA rating by the end of 2013 if Congress is unable to formulate a plan to reduce the budget deficit after next year's congressional and presidential elections. For now, rating agencies will continue to warn Congress to get its act together and make cuts. Overall, like the European sovereign debt crisis, this issue is a slow moving train wreck and will continue to make headlines until fixed. 

Although a major problem in the long-run, the US government has the ability and tools to help avoid the consequences of overspending--such as higher borrowing rates-- by limiting our spending. Also, unlike individual EU nations, we are able to control our money supply more easily and if we have trouble paying our debts, the Federal Reserve can print more money to help repay them. Based on the past response of the markets to a downgrade and the faith of the markets in the US government to repay what it owes, I do not think that another downgrade by a rating agency, such as Fitch, will have a large impact on markets.

Current Financial Figures and Organizations You Should Know

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US Department of the Treasury: Headquartered in Washington, DC the Department of Treasury is an executive department that is responsible for producing all US currency, collecting taxes, paying bills, managing government accounts, supervising national banks, advising on domestic and international financial, monetary, economic, trade and tax policy (advises on fiscal policy, the ultimate responsibly of Congress), enforcing tax laws, and publishing statistical reports (wiki).

Timothy Geithner 

(Secretary of Treasury)

Who is in Charge?

Timothy Geithner, former President of the Federal Reserve Bank of New York, has been the Secretary of the Treasury since January 2009.

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The Federal Reserve System (the Fed): Headquartered in Washington, DC the Fed is the central banking system of the US responsible for addressing problems with banking panics, to strike a balance between private interests of banks and the centralized responsibility of government, to manage the US money supply, to maintain the stability of the financial system, to provide financial services to depository institutions, and to ultimately strengthen the US standing in the world economy.

The Fed structure is composed of the presidential appointed Board of Governors, the Federal Open Market Committee (FOMC), twelve regional Fed Reserve Banks, privately owned US member banks, and various advisory councils. The FOMC is the committee responsible for setting monetary policy and these policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches. The authority of the Fed is derived from statutes enacted by the US Congress and is subject to congressional oversight (wiki).

Ben Bernanke

(Chairman)

Who is in Charge?

Ben Bernanke, former tenured professor at Princeton and scholar of the Great Depression, has been the Chairman of the Federal Reserve since February 2006.

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International Monetary Fund (IMF): Headquartered in Washington, DC the IMF is an organization of 187 countries that work towards fostering global monetary cooperation, securing financial stability, facilitating international trade, promoting high employment, sustaining economic growth and reducing poverty around the world (wiki).

Christine Lagarde

(Managing Director)

Who is in Charge?

Christine Lagarde, a former French lawyer, has been the managing director since July 5^th, 2011

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The European Central Bank (ECB): Headquartered in Frankfurt, Germany the ECB is in charge of defining and implementing monetary policy for the Eurozone, to conduct foreign exchange operations, to take care of the foreign reserves of the European System of Central Banks, and promote smooth operation of the financial market infrastructure. The ECB has the authority to issue euro banknotes and members states have to ask the ECB for permission before issuing euro coins. Recently, in May 2010, the European Financial Stability Facility (EFSF) was created to safeguard financial stability in Europe by providing financial assistance to Eurozone Member States (wiki).

Mario Draghi

(President)

Who is in Charge?

Mario Draghi, former governor of the Bank of Italy, has been the President of the ECB since November 2011.

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A Few Faces You Should Know:
Lloyd Blankfein (CEO and Chairman of Goldman Sachs): http://en.wikipedia.org/wiki/Lloyd_Blankfein

Jamie Dimon (Chairman, President & CEO of JP Morgan): http://topics.bloomberg.com/jamie-dimon/

Henry Paulson (former Secretary of the Treasury & CEO of GS): http://en.wikipedia.org/wiki/Henry_Paulson

Bill Gross (Co-Founder of PIMCO): http://www.forbes.com/lists/2009/20/power-09_William-H-Gross_3ESQ.html

Warren Buffet (Chairman & CEO of Berkshire Hathaway): http://en.wikipedia.org/wiki/Warren_Buffett

Bill Gates (Chairman of Microsoft): http://en.wikipedia.org/wiki/Bill_gates

Be Wary of Emerging Markets: BRICS & N-11

What Are the BRICS and N-11 Countries?

The BRICS refer to Brazil, Russia, India, China and South Africa. These countries are at a similar stage of newly advanced economic development and have symbolized the shift in global economic power away from the developed G7 economies (US, UK, Canada, Japan, Germany, Italy, and France). In fact, it is estimated that the BRICS economies will overtake the G7 economies by 2030.

The N-11, or "Next Eleven," are the countries (along with the BRICS) that have a high potential of becoming the world's largest economies. These countries are: Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey, and Vietnam.

Jim O'Neill, the Chairman of Goldman Sachs Asset Management, coined these phrases and evaluated these countries based on their macroeconomic stability, political maturity, openness of trade and investment policies, and quality of education.

Investment Strategy: Following Growth Around the World

O'Neill's criteria in determining which countries are among the fast growing economically (the BRICS and N-11) are important to consider when deciding which investments to make, especially when analyzing individual companies. For example, a new company with an exciting new product may be attractive, but if its country's government does not have strong patent or copyright laws, it may be difficult for that company to make sustained profits; the weak laws of the government could end up slowing growth in certain industries.

In other words, there are many factors that may be outside a company's control that should be considered before investing in that company. Fundamental analysis -- the analysis of income statements, balance sheets, etc. -- is not enough.

Instead of simply diving deeply into the specifics of an individual company with fundamental analysis, O'Neill takes a different, wider approach, stepping back to also look at which countries he believes will have the most growth in the future. O’Neill maintains that finding the country with the right infrastructure, economic policies, and laws, such as strong patent and copyright laws that promote the potential for growth, could be just as important as finding a profitable company. A growing economy gives a company more opportunity to grow itself, which goes back to the saying, "a rising tide lifts all boats."

After evaluating these countries, a process similar to evaluating an individual company, and then deciding where the best potential lies, the next step is to determine which industries are high growth and likely to be successful in those countries. Finally, decide which companies within those industries have good growth potential, and why. In sum, finding a good investment begins with a snapshot of which countries will likely have growth in the future, then narrowing the search to specific industries and companies. I call this strategy "Following Growth Around The World."

In analyzing countries –and companies-- some questions to ask are: What laws or economic policies will affect it? Is it likely these laws or policies will change? Is there a growing population and what will its consumption most likely look like in the future? Is such population growth good or bad for the company/country? Who is in charge, and why, and where does he/she want to take the country/company?

Emerging Markets Hot or Not During Potential European Recession?

It is also important to remember that these emerging markets are just that, up and coming. They are not already as developed as, say, the U.S. or Germany, and their economies and markets may swing with more volatility than the economies of developed countries, especially in times of economic turmoil. In contrast, during good times, their economies may flourish and expand more quickly than a more economically developed country.

Currently, however, if you are not an investor with a high risk tolerance, I would recommend avoiding the N-11, as they have experienced over 20% decline during the past 6 months, according to Goldman Sachs' N-11 Equity Fund. Similarly, the BRIC 40 Index, which provides exposure to 40 leading companies in the BRIC countries, also has fallen over 20%. This is in comparison to the S&P 500, representing 500 large US companies, which has fallen only 4% over the past 6 months. Europe, while facing sovereign debt problems, has fallen almost 30% during the same time period according to Vanguard's European ETF, which is composed of over 450 stocks of companies in 16 different European countries.

Recommendation: Stay Out, Wait Until The Dust Clears, And Then Re-Evaluate

Overall, I suggest avoiding companies that have their core businesses in the BRICS or N-11. This is because, in general, emerging markets such as the BRICS and N-11 are more sensitive to market swings. During extreme crisis, market correlations tend to go to 1. However, while this correlation means all markets are brought down by a significant economic crisis, markets such as the BRICS or the N-11 whose economies are more underdeveloped, have greater volatility and a greater likelihood of being dragged down significantly.

With continued uncertainty about the economy after the 2008 crisis, in addition to the unknown economic reforms and restructuring that Europe will make after its sovereign debt crisis subsides, I recommend waiting out the storm by playing it safe in US large cap stocks. Although investors may think that each dive in the market presents a buying opportunity, I believe this is just speculation keeping the market afloat. I think an appropriate approach with this strategy would be to wait until the dust clears, identify which countries' economies survived the best, and then re-evaluate which countries have the greatest potential for growth.