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Small investors are increasingly out of the market. Hedge funds are mostly losers. Virtually all investors in the market are having trouble making money. What is to be done?

Older investors will remember when we had “buy and hold” as an investment strategy. This was possible because of decades-long up trending markets. Since 2007, it has been chaotic. We went down 58% to March 2009, and then up 100% to April 2011. Where do we go from here? A shrinking majority think we are fundamentally in a bull market, and a growing minority think a bear market is right ahead. Since April of 2011, we have gotten accustomed to up and down days frequently moving more than 1% or 2% per day. A lot of people are losing money in this market.

The first issue that investors must decide is the longer-term direction of the market. Is the market going up or down in the next few years? I hold a minority opinion that the market will go down dramatically in the next few years due to profound imbalances in the economy as described in this article. Yet, there is still a majority who think the market will go up and a nearly equal number who think there will be at least a short-term decline before going up. Now, more than ever each investor or his investment advisor must take that decision, market going up or down, prior to investing.

I believe most of us are more afraid of losing money than making money. If you feel uncertain what the direction of the market is, you are better to be out of the market. Invest in short-term government securities or government guaranteed CDs. Wait for the day you feel confident where the market is going. (It is absolutely wrong to think that the market is almost always going up, although it is true that up cycles tend to last longer than down cycles.)

These days you also need to make a second decision. Is inflation heading our way or deflation, or even stable prices? Generally speaking, if the economy is stable and does not require government intervention, inflation probably is not a serious risk. If there are troubles in the world economy, then the issue of whether you have to watch out for inflation or deflation is much more of a risk. In my mind, a blind man must see a troubled world economy and therefore most people must give serious consideration to whether we will see inflation or deflation. Once again, I am in the minority in seeing deflation, not inflation, as the problem. These ideas are detailed in this article mentioned above. As a one liner, I see deflation being caused by a world-wide write-offs of bank loans. There will be several trillion dollar losses absorbed by the US financial system because of US housing loans, because of losses related to a coming European banking and sovereign debt collapse, and because of the biggest losses of all in derivatives. (We would probably have had the derivative collapse in 2008 if Treasury Secretary Paulson had not bailed out AGS and saved Goldman Sacks and much of the banking system). All of these losses lead to shrinkage of the money supply and this leads to deflation. I repeat, I am still in a minority position here, but the trend is every day to more people supporting this position that deflation, not inflation, is the problem. If deflation is the risk as I think, then gold, oil, commodities are not hedges for the coming economy. Furthermore, long-term bonds will fall in value as interest rates increase. In a deflationary environment, short-term government securities are the only safe place. Then, the question becomes which government. In a world in transition to new world leaders in the next decade, one does not know where to go. I believe US government securities still will be the safest of all in this uncertain world economy.

We have now concluded that investors must take two decisions: first, are world markets going up or down? Secondly, you must decide if the risk is inflation or deflation. These are two decisions that most Americans never even consider much less have an informed position on. Readers of Seeking Alpha know these issues exist, but there is much disagreement on what is the right answer.

If your conviction is that markets are going up, I wish you luck and hope that you are right because it will be better for everyone. However, I think you are wrong and will only consider the other case of a declining market in this article. If we consider that markets are going down, we have the question of when, how much and what is our position on inflation.

My recommendation to most investors is that you stay in short-term government securities or government guaranteed deposits. Your best course of action is to protect your principal. This is not the time to look for higher interest earnings from high-risk investments. Seeking profits with high-risk bonds is highly dangerous for you. In both the deflationary and inflationary scenarios, bond interest rates will rise, possibly dramatically. If you hold longer-term bonds, you could be looking at 30% to 50% declines in the current value of these bonds. If we go to the high rates in the period of Paul Volker killing inflation, the losses on bonds will likely be very significant. Additionally, municipal and state bonds are very high risk for the next few years.

The more adventuresome will look to short the market. This is almost unthinkable in many conservative portfolios that are managed. Few individual investors short the market. While there are futures contracts that permit shorting the market, these are with high leverage and therefore intrinsically carry more risk in relation to the amount directly invested. Most investors will wish to invest via ETFs that facilitate shorting as a normal stock transaction, but where the ETF shorts the market. That is, when the market goes down in price the ETF goes up in price. There are also leveraged ETFs that double or triple the leverage of the actual change in the underlying index value. Investors should be warned that ETFs carry two types of risks that can adversely affect the investor. First, inverse and leveraged ETFs, if there is up and down movement in the value, may not track the price directly with the underlying index or stock because of the way the day-end valuations change when leveraged. Secondly, most ETFs work with indexes. They do not buy or sell underlying shares. In a period of market instability, which could happen in a sharply declining market, share valuations could be unstable or non-operative for a time.

In summary, investors must now start making unaccustomed decisions. I view this as important because I believe we are likely to have a repeat of the 1929 economic decline, which is described in the hyperlink above. I would like to conclude with a brief summary of why I hold this view. We are concluding a 30-year long asset bubble where most financial assets are greatly overvalued. This has been built up by a massive increase in the money supply. When the music stops of increasing bank loans to support new, higher prices, the bubble will collapse. Bold action by the American government prevented this from happening in 2008. But the European situation will play out in a way that Europe cannot solve the problem and will lead to world-wide contagion. Europe, together with the pending trillion dollar problems in the US, will inevitably lead to a world wide financial collapse, and therefore a stock market collapse.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: How To Invest In This High-Risk Environment