The Standard & Poor’s 500 Index is up 58% from its March lows, gold has finally broken through the $1,000-an-ounce level – and may go higher – and bond yields have fallen substantially in spite of the huge U.S. budget deficit.

It’s really not difficult to tell when you’re in a bubble. What’s tough is trying to figure out how to invest while it’s developing.

When current Fed Chairman Ben S. Bernanke doubled the monetary base in a few weeks last fall, it was pretty obvious that the extra money would appear somewhere, either as zooming asset prices or as surging inflation. After all, the rapid increases in the U.S. money supply after 1995 produced a stock-market bubble and then a housing bubble.

And don’t forget about interest rates. When oil prices doubled in less than 12 months between 2007 and 2008, it was because Bernanke aggressively cut interest rates after the recession first hit in late 2007. So you’d have to believe that money supply was irrelevant not to expect markets to start behaving oddly at some point.

Silver and Gold …

That’s why – since late in 2007– I have been recommending investments in gold and other hard assets. While the recession had sharply reduced demand for oil, causing its price to drop from its record high of $147 a barrel in July 2008 to around $30 in February, the gold price had dropped only from its March 2008 peak of $1,000 to around $700, before rebounding. Gold prices remain far below the inflation-adjusted equivalent of their 1980 peak, which would be around $2,300 per ounce today.

Likewise, silver prices are even further below their 1980 peak, which would be around $130 per pounce, or nearly 10 times the current level. Since both gold and silver markets are relatively thin compared to the money available – annual gold production is only $100 billion at current prices – the potential for a run-up is considerable.

The difference between a bubble and a sound bull market is that a bubble happens more quickly. Normal valuation metrics get ignored. You couldn’t rationally justify – on any sort of long-term basis – the dot-com stock prices of 1999, the California house prices of 2005, or the $147-per-barrel record oil prices of 2008.

Similarly, today’s cost of extracting gold is nowhere near $1,000 an ounce. Mining costs have increased. But extraction costs are still only about $400 an ounce for top-tier miners.

Likewise, with inflation at 2% and U.S. budget deficits at more than $1 trillion per annum, there’s no justification for a 10-year U.S. Treasury bond yield below 3.5%.

Let’s look at stocks. And let’s say that the market of early 1995 – when the Dow Jones Industrial Average was at 4,000 – is a reasonable base for estimating a fair value for the U.S. stock market. If that were the case, then inflating the Dow in line with nominal gross domestic product to keep it at fair value would bring us to a current day estimate of 7,800.

[The Dow closed yesterday (Thursday) at 9,783.92. To reach this “fair-value” level, the Dow would have to drop 1,984 points, or 20% – enough of a decline to qualify as an official “bear market.”]

However 1995 wasn’t a bear market, and economic and earnings prospects that year were really good. Besides, the Internet was just starting its rise to prominence. Today, we’re in a deep recession, with huge budget deficits and high unemployment, yet the Dow is closing in on 10,000.

In other words, U.S. stocks are overvalued. Even after the bearish trauma of last year, we remain in a stock-market bubble.

Four “Bubble” Investing Strategies – Including the One That Works

Bubble investing is different from bull-market investing. There aren’t many “good” values, so you have to be very careful.

One bubble-market strategy is to just put everything in cash and hide under the bed. How boring! Plus, as your neighbors brag about their profits at cocktail parties, you’ll feel like an idiot until the bubble bursts. Remember, even after your neighbors’ profits have turned to losses and you look smart, you can never get those cocktail parties back!

That doesn’t mean you should abandon prudence, however. You should certainly keep much higher cash reserves than normal. Indeed, consider investing a chunk of that cash in one of the non-dollar-denominated WorldCurrency Access Deposit Accounts offered by EverBank.

At the same time, it’s a pity to completely miss out on the returns one can earn in a bubble environment. But you have to careful and smart.

A second bubble-investing strategy is to find something that isn’t overvalued, and buy only that. That strategy worked great for me back in 1999. I was working in Croatia, which was going through a deep economic crisis. NATO was bombing neighboring countries in the Kosovo War. That played merry hell with tourism, Croatia’s main foreign currency earner. Croatian shares – there were about six at the time – were each selling at less than five times earnings. So I invested in Croatia and made out nicely when the war ended and things returned to normal.

The problem with that approach is globalization. It was just possible in 1999 to find undervalued investments, if only by putting your money close to a war zone. It isn’t really possible now, at least not to any great extent. Three months ago, there were lots of shares even in the United States, which had been bombed out by the downturn and hadn’t recovered. There aren’t many left now; if a share is bombed out today there’s probably good reason for it.

A third potential strategy is to try to time the bursting of the bubble. For example, you could buy the ProShares UltraShort Trust (NYSE: TBT), inversely related to twice the Lehman Brothers Holdings Inc. (OTC: LEHMQ) 20-year bond index. Then you’d wait for the bond market to crash, and TBT to soar.

But there are two problems:

• First, the ProShares UltraShort Trust has a fair-sized tracking error, because they have to rebalance the fund daily. Thus if you hold it too long, you won’t do as well as you should.
• Second, the bubble can take a long time to burst; meanwhile it goes on inflating and you get killed. In the long run, it was a good idea to short Cisco Systems Inc. (Nasdaq: CSCO) in 1999. In the short run, it wasn’t so clever.

The Winning Play

The normal investment approach, to buy only the most conservative companies in an overvalued but bubbly sector, also doesn’t work. Everybody else is looking for them, too. And that means they end up being overvalued. Besides, they will advance only modestly with the inflating bubble, so you won’t make enough to compensate for the risk of buying too high.

The best alternative, therefore, is to buy bubbly investments – but the junk, not the cream. Buy gold and silver mines that even at $900 an ounce have only been running at close to break-even, because they have expensive deposits.

Don’t buy political risk (i.e. mines in dodgy countries), because if the gold price goes up, the local dictator will seize your company’s winnings. But operating risk is okay. And high operating costs are fine. If your mine has operating costs of $800 an ounce, you’ll make out like a bandits if gold goes from $1,000 an ounce to $1,200. That way, you need only put a modest amount in the investment, and it will zoom up to several times what you paid, making as much profit as if you’d put your entire fortune in something conservative.

Make sure to put only a portion of your money in such a play. Keep the rest in cash.

When to sell? Well, start selling at the first signs that the Fed is beginning to take inflation seriously, meaning the central bank will be pushing up interest rates. You’ll know when this is because you’ll likely start hearing a lot about Fed “exit strategies.”

Don’t be greedy – better to sell too early than too late. Better to leave the theater at the first wisp of smoke, than to wait until the entire crowd is panicking and heading for the exits.

I hate bubbles. And I hate Bernanke and the other central bankers for causing them by their misguided monetary policies. But you can make money out of them. Just don’t get carried away.

Source: The Only Way to Profit from a Stock Market Bubble

I’ll believe that when I see it. When was the last time the government completed any project on budget?

And I’m not the only one with doubts.

Health Systems Innovations, a health care consultant that has worked with private health insurers, estimates that Senator Kennedy’s bill would cost $4 trillion over 10 years.

Ouch…

Should a health care plan be passed that even resembles anything like the current proposals, $2 trillion in final costs would be a minor miracle.

A trillion here, a trillion there. Pretty soon, you’re talking about real money.

As these health care reforms gather momentum, I’m going to explore a few more investments that should thrive in the face of a major health care system overhaul, regardless of any health care reform plan that may be passed…

Health Care Reform : Protecting Against Inflation With Bond Funds

Despite the President’s popularity, he’s not likely to get everything he wants. Some sort of compromise is to be expected. One thing we can assume is that the cost of any health care reform plan – regardless of whose it is – will be a 13-figure number (i.e. more than $1 trillion).

On a macroeconomic level, that would likely be inflationary and cause bond prices to decline. So if you’re a bond bear, here are two instruments for you…

• UltraShort 20+ Year Treasury ProShares (NYSE: TBT): This ETF is not for the faint-hearted. It seeks to perform at twice the inverse results of the Lehman Brothers 20+ Year U.S. Treasury Index. So if the Index drops 5%, TBT should rise about 10%.

• ProFunds Rising Rate Opportunity (RRPIX): This is a mutual fund that also seeks the inverse performance of the bond market. Its results aim to correspond to 125% of the inverse of the daily movement of the 30-year Treasury bond.

Profit From Health Care Reform with Biotech & Selling Put Options

Recently while researching stocks that would profit during the health care reform process, I discussed the attractiveness of investing in biotech companies that treat rare diseases.

One of the companies I’ve recently discussed, Genzyme (Nasdaq: GENZ), had a major setback when it disclosed problems at one of its manufacturing facilities. The stock price took an immediate hit.

I believe these difficulties are temporary and I still like the company. But if you’d prefer to reduce your risk further, you can look at selling put options on GENZ at a lower strike price. My colleague Lee Lowell just talked about a put selling strategy earlier this week.

I explained to Lee why I like GENZ, but wanted a good put-selling trade for investors who want to own the stock at a lower price. Here’s what he suggested…

• Sell the October 2009 $47.50 puts, currently trading at $1.50 on the bid. This means for every put that you sell, you will collect $150.
• Keep in mind that one put contract represents 100 shares.

• If GENZ never sees the $47.50 strike, you keep the $150.

• If the stock drops to or below $47.50 at expiration, you’ll be required to buy the stock for $47.50 (100 shares of GENZ for every put contract you sell). But remember that you collected $1.50 already, reducing your cost basis to $46 per share.

So if you like GENZ, but would prefer to own it at a lower price, this is one trade to consider.

Health Care Reform: Two Biotech Companies Set For Profits

I’ve recently suggested a few other biotech stocks to my subscribers, including:

• Best-in-class generic drugmaker Teva Pharmaceuticals (Nasdaq: TEVA).
• Another generic drugmaker to look at is Watson Pharmaceuticals (NYSE: WPI). Watson just announced its acquisition of privately held Arrow Group, a generic biotech drugmaker, with significant international operations.I like this move by Watson, as it broadens the company’s reach both in products and markets served.

The bottom line is that while health care reform could very well change the investing landscape within the sector, you can always find opportunities if you know where to look.

Good investing,

Marc Lichtenfeld

Source: Health Care Reform: Five Ways to Profit With Biotech Stocks & Bond Funds

For example, Health Systems Innovations, a healthcare consultant that has worked with private health insurers and the McCain presidential campaign, estimates that Senator Kennedy’s bill would cost $4 trillion over 10 years.

Should a healthcare plan be passed that even resembles anything like the current proposals, $2 trillion in costs would be a minor miracle.

A trillion here, a trillion there. Pretty soon, you’re talking about real money.

In my column last week, I offered three biotech stocks that should perform well, regardless of any healthcare reform plan that may be passed. As those reforms gather momentum, I’m going to explore a few more investments that should thrive, even in the face of a healthcare system overhaul…

Make Money From Bond Market Trouble

Despite the President’s popularity, he’s not likely to get everything he wants. Some sort of compromise is likely. But it’s safe to assume that the cost of the healthcare plan will be a 13-figure number (i.e. more than $1 trillion).

On a macroeconomic level, that would likely be inflationary and cause bond prices to decline. So if you’re a bond bear, here are two investments for you…

• UltraShort 20+ Year Treasury ProShares (NYSE: TBT): This ETF is not for the faint-hearted. It seeks to perform at twice the inverse results of the Lehman Brothers 20+ Year U.S. Treasury Index. So if the Index drops 5%, TBT should return rise about 10%.

• ProFunds Rising Rate Opportunity (RRPIX): This is a mutual fund that also seeks the inverse performance of the bond market. Its results aim to correspond to 125% of the inverse of the daily movement of the 30-year Treasury bond.

How To Buy Genzyme For $47.50

In last week’s column, I discussed the attractiveness of biotech companies that treat rare diseases.

But one of those names, Genzyme (Nasdaq: GENZ), had a major setback this week when it disclosed problems at one of its manufacturing facilities.

I believe these difficulties are temporary and I still like the company. But if you’d prefer to reduce your risk further, you can look at selling put options on GENZ at a lower strike price.

And when it comes to selling puts, look no further than Lee Lowell. He’s the master at this strategy and is currently riding a 100% winning streak since his Instant Money Trader, which focuses exclusively on this strategy, began last November.

I explained to Lee why I like GENZ, but wanted a good put-selling trade for investors who want to own the stock at a lower price. Here’s what he suggested…

• Sell the October 2009 $47.50 puts, currently trading at $1.85 on the bid. This means for every put that you sell, you will collect $185.

• Keep in mind that one put contract represents 100 shares.

• If GENZ never sees the $47.50 strike, you keep the $185.

• If the stock drops to or below $47.50 at expiration, you’ll be required to buy the stock for $47.50 (100 shares of GENZ for every put contract you sell). But remember, that you collected $1.85 already, reducing your cost basis to $45.65.

So if you like GENZ, but would prefer to own it at a lower price, this is one trade to consider.

Add Watson To Your Watchlist

In my column last week, I also suggested best-in-class generic drug maker Teva Pharmaceuticals (Nasdaq:TEVA).

Another generic drug maker to look at is Watson Pharmaceuticals (NYSE: WPI). Watson just announced its acquisition of privately held Arrow Group, a generic biotech drug maker, with significant international operations.

I like this move by Watson, as it broadens the company’s reach both in products and markets served.

The bottom line is that while healthcare reform could very well change the investing landscape within the sector, you can always find opportunities if you know where to look.

Source: Four More Ways To Profit From U.S. Healthcare Reform

In a speech before the student body, Lil’ Timmy told those gathered that Chinese dollar holdings and investments in U.S. debt were safe and that the U.S. Treasury and Federal Reserve are committed to a strong dollar policy.

Ha! That’s a good one. And the Chinese students let him know it, with a collective belly laugh. I suspect some of them were actually rolling on the floor. And they weren’t laughing with him. They knew he was full of it. I expect you do too.

Despite ongoing assurances to the contrary, the U.S. government doesn’t want a strong dollar policy. In fact, they WANT to inflate the dollar to nothingness. They just don’t want it to happen overnight.

The official U.S. debt is around $13 trillion. But that is only part of the story. Do you remember Enron and WorldCom and the fraud of “off-balance sheet accounting”? This is a dishonest accounting trick whereby companies set up satellite corporations to hide their true liabilities from auditors and investors.

The king of off-balance sheet accounting would have to be the U.S. government. You see, the “official debt” doesn’t include the very real obligations our country owes for Social Security and Medicare. Add these and a few other entitlement programs to the equation and the United States’ TOTAL debt is in the neighborhood of $100 trillion.

This is an astronomical sum of money that can NEVER be paid in real terms – even if most government services were virtually eliminated and taxes were doubled across the board. The only solution is to inflate the debt away by devaluing the dollar. The scoundrels in Washington are rarely honest about anything. You didn’t expect them to actually run a tight ship and pay our debts legitimately, did you?

The only problem is that the present financial crisis, bailouts and money printing operations have rapidly accelerated the process. The bond market knows it. And China knows it.

So how do the Chinese plan to protect themselves? And more importantly, how can you protect your wealth and profit?

First of all, it is important to understand that what countries say they are doing with their currency and foreign reserve holdings and what they are actually doing are rarely the same. Poker players don’t show their hands and use intentional misdirection. In this poker game however, the stakes are in the billions and trillions. So you have to learn to read through the headlines.

China says that they are still committed to their investments in U.S. Treasuries… that they will continue holding dollars… and that gold is not really an option. What else would you expect them to say?

In reality, China has been adding to their gold reserves as fast as they can without driving the price up too quickly. And they have been doing so undercover, through intermediaries. They are also soaking up nearly every ounce of gold that is produced within China. While China is now the number one gold producing country in the world, their production does not hit the world markets.

Diversifying out of their dollar holdings is a tricky process as well. China obviously can’t just dump their dollar holdings overnight. What they are doing instead, is slowly converting their debt instruments and paper wealth into real things… copper, steel, lumber, concrete, cotton, wheat, soybeans and precious metals.

And instead of buying long dated U.S. Treasuries that mature in 20 or 30 years, they are buying instruments with shorter term maturities.

And finally, of course, the Chinese (and other countries as well) are plowing any excess exchange reserves back into their own country to provide economic stimulus. In November, the Chinese government announced a nearly $600 billion internal stimulus package.

This is bad news for the U.S. government bond market. Just as America’s spending goes parabolic and we need to sell more debt than ever, the biggest buyer is walking away from the trading floor.

The Federal Reserve might control short term interest rates, but it is the market that controls long-term rates. And just like any market, this one responds to supply and demand. With a budget deficit of nearly $1.8 trillion this year and soaring deficits as far as the eye can see into the future, there is going to be a glut of supply. And we have already addressed what is happening to the demand.

The Fed’s solution is to step in and buy our own debt, when other countries and institutions are unwilling or unable to do so. But this creates a catch-22. This amounts to nothing more than printing dollars. And the more dollars we print to buy our own debt, the weaker the dollar becomes and the less likely that foreign countries are willing to buy.

In my view, there is only one way this scenario will play out. Get ready for soaring interest rates, hyperinflation and exploding gold and silver prices. It is not going to happen overnight, but I don’t see any way it can be avoided.

It used to be difficult for small investors to use the market to profit from rising interest rates. Today, it is as simple as buying or shorting an ETF. The chart below shows the yield on the U.S. 30-year Treasury bond. In the early 1980s the yield peaked around 16%. It has been falling ever since. As yields fall, bond prices rise, so what you are looking at below is a 28 year bull market in U.S. Treasury bonds.

But pay attention to the last six months…

That spike represents what I believe will mark the end of the bull market in the “long bond”. And it represents the beginning of a new era of rising interest rates.

Certainly, you should own gold and silver and precious metals equities. But you should also consider pairing that investment with a bet against long-term U.S. government bonds. The way to play it is to short the iShares Barclays 20+ Year Treasury Bond Fund (TLT) or buy the ProShares UltraShort 20+ Year Treasury Bond Fund (TBT).

The TBT is an exchange traded fund that returns two times the inverse of the daily performance of the long bond index. Do not buy your entire position all at once. Leg into this position incrementally over the next six months or a year.

To Your Success,

Jon Herring

The problem is the details of this developing story aren’t exciting or anything the average person wants to hear about. Most have little or no understanding about the specifics and frankly don’t want to know. But, this is a story that will be the make or break issue in the stock market, our economy, and the recovering world economy.

Monetizing the Debt

Essentially we are buying our own debt to keep the treasury prices up and the yields low. This is being done for two reasons; keep mortgage rates low to try and create a floor for real estate prices, and bail out Congress after its 30 year spending spree.

It isn’t working. Rates are moving up despite the White House’s efforts. This presents two very big problems.

First, our debt holders, China in particular, are worried that the U.S. debt they hold will become worth a lot less if this pattern of artificially propping up bond prices continues. Our government’s efforts to artificially hold up anything has always had the opposite result. In this case that would mean rates skyrocket and prices for our debt plummet.

If this happens China is stuck with our debt in a market where they can’t get what they paid for it. I know two things about the Chinese; they don’t lose and they don’t lose. They will not wait for this to happen which means if they believe we are sacrificing them for our own benefit they will dump our debt in a defensive move.

This means our bonds will be trapped in a death spiral of dropping value, exploding interest rates and a world market flooded with our debt. This is the worst possible scenario for us and the rest of the world.

The second problem is more fundamental. Where is Congress getting the money to buy this debt? We are broke! We are worse than broke; we are 10 trillion dollars in the hole.

Are those printing presses I hear? How much longer can we print money to buy up the debt from money we spent last year that we didn’t have? How about the money we spent in the first few months of this year that we didn’t have?

There may be some magic behind those doors in Washington, but I don’t see it. The most likely outcome of this situation, at least we better hope it unfolds this way, is much higher interest rates and a slowing to a stalled economy. This is the optimistic outcome.

Inflation with negative or no growth; 1974 all over again.

The obvious play is the same I recommended a few moths ago. Short the bond.

The best play is the TBT, Ultra Short 20+ Year Treasury ProShare. This pays twice the daily performance of the 20+ year treasury index. In other words as bond values drop and interest rates go up, this will pay you twice the value of the drop in the bond. If the bond drops 10% in value, you get 20% from the TBT.

The TBT is currently about half way between its 52 week high and low. Not cheap, but still way down from its highs.

The entire U.S. government has been handling our affairs like a bunch of drunken sailors on liberty. Vote buying with our money has reached the point of being criminal. It’s been a 30 year binge and now it’s time to pay the bills. You might as well make some money on it.

Source: The Next Shoe to Drop

The 30-year Treasury is now at its highest level since last November. The rise in bond yields has raised questions about whether the Federal Reserve will step up efforts – which began in March – to keep yields down through direct purchases of government bonds.

Tom Porcelli, economist for RBC Capital Markets, described it as a “terrible auction.”

Why is this bad news? Because such poor demand in the face of America’s requirement for record amounts of public debt will make it very difficult for the Fed to keep interest rates low.

You see, politicians pretend that there are few adverse consequences to their worsening debt addiction. And since the collapse of the debt bubble in 2007, they have been putting Americans in hock like it was going out of fashion.

Of course, all of this borrowing has very real consequences for Americans. As investor confidence and risk appetite return and US equities rally, investors are turning their backs on the low-yielding US bond market. As investors shun US treasuries, interest rates move higher to lure investors back into the market. This rise in treasury rates puts pressure on interest rates everywhere – from homes to cars to the interest corporations must pay on any new bonds they issue. Mark our words, higher interest rates in this market will just wind up choking off any real recovery.

The very real consequence of the rising long-bond yields can be seen in the recent rise in mortgage rates. This, again, from the FT:

Mortgage rates have been following the government bond yields higher. A 30-year fixed-rate mortgage averaged 4.84 per cent last week, according to a Freddie Mac survey, compared with 4.78 per cent the week before.

As underground investor Tom Dyson (who edits the excellent 12% Letter ), a rise in the long bond’s interest rate can crush certain income investments.

If the long bond’s yield rises from 4% to 8%, the yield on all other income investments must also rise by 4%. A 12% junk bond would become a 16% junk bond. A 14% dividend payer would have to become an 18% dividend payer.

As Tom says, the long-bond market is “weaker than a wet paper bag” right now. He reckons the magic number for shorting long bonds is 124.07. And the long bond closed at 123.26 on April 28 and is now making new five-month lows.

Here at Notes we smell opportunity. We have our eye on the ProShares UltraShort 20+ Year Trea ETF (NYSE:TBT) . This ETF has risen over 6% in the last five weeks or so.

In fact, some stock market mavens are even starting to bandy about the “E” word – exuberance – and say it’s time to adopt a highly defensive position, or to even take some money off the table.

“Awhile back, I said that fair value on the Dow Jones Industrial Average was 7,800 – and that was if the economy was operating efficiently,” said Money Morning Contributing Editor Martin Hutchinson, a former international investment banker who now operates the Permanent Wealth Investor trading service – and who was recently cited by Slate magazine for having called the stock-market bottom. “But the economy isn’t operating efficiently. We’re rolling up huge deficits, and are rolling out huge stimulus packages. Those will both be highly inflationary. I’d say that – right now – fair value on the Dow was about 6,500 to 7,000, though it could easily bottom out at around 5,500.”

The closely watched Dow zoomed 214 points, or 2.6%, on Monday to close at 8,426, although it dropped modest 16.09 points to close at 8,410.65 yesterday (Tuesday).

U.S. stock prices have been on a two-month roll. On Monday, the Standard & Poor’s 500 Index gained 29 points, or 3.4%, to close at 907, a four-month high. That broad index, used by investing professionals to benchmark the market, opened the year at 903.25. It closed yesterday at 903.8, meaning it’s actually in positive territory for the year.

The tech-heavy Nasdaq Composite Index jumped 44 points, or 2.6% Monday, to close at 1,763. Even with yesterday’s 0.54% decline, the Nasdaq is up 11.0% for the year.

It’s not just the fact that the market has bounced back that has Hutchinson and some other investors concerned – it’s the forcefulness with which stock prices have escalated. After closing at a 12-year low on March 9, the S&P 500 index has rallied about 34%.

Investors have become increasingly optimistic that the U.S. government finally has a handle on the credit crunch and the financial crisis that’s grown out of that nightmare of bad debt and parsimonious lending. There’s a belief that the U.S. housing crisis has reached bottom. Even Money Morning’s Hutchinson says that the rate of decline in the U.S. economy has almost certainly slowed substantially, meaning a bottom may not be far away.

But a bottoming out in the economy doesn’t necessarily mean the U.S. economy’s many problems are at an end, Hutchinson says. With all the stimulus money flowing through the economy, inflation is certain to be a problem, meaning interest rates have to increase, Hutchinson says.

For instance, during the 1990s, inflation averaged 2.9% and the 10-year Treasury bond averaged 6.67%. The gross domestic product (GDP) deflator inflation index was at 2.9% for the first quarter of this year, and yet the 10-yearTreasury was trading at 3.15%, Hutchinson says. That means interest rates have to increase – a lot, a process that’s certain to blunt an economic recovery, he believes.

And if that happens, U.S. stock prices – ahead of themselves already – will drop back, as well.

It was back in mid-October when Hutchinson said the fair-value level of the Dow was 7,800. To drop back to that fair-weather/fair-value target of 7,800 from its current level, the 30-stock, blue-chip index would need to fall 7.0%

That’s more than just a modest decline, and would clearly be painful in its own right. But the Dow would have to drop an alarming 17% to 23% to reach Hutchinson’s foul-weather/fair-value range of 6,500 to 7,000, and a downright sickening 35% to hit his possible market bottom of 5,500.

And Hutchinson isn’t the only investment expert preaching caution.

Take Pacific Investment Management Company LLC’s (PIMCO) fixed-income guru Bill Gross, who says investors are far too optimistic about the U.S. economy’s near-term prospects.

“Do not be deceived by the euphoric sightings of ‘green shoots’ and the claims for new bull markets in a multitude of asset classes,” Gross wrote in PIMCO’s May outlook. “Stable and secure income is still the order of the day.”

In theory, the stock market is forward-looking, meaning stock prices reflect a future – three to six months down the road – that is obviously unknown to investors. The hard-charging rally of U.S. stocks in recent weeks has prompted an even stronger belief that the economic rebound is at hand, and that the recession that started in December 2007 may soon be over – if it isn’t already.

That doesn’t mean there are no profit opportunities available. Plenty remain. But it does mean investors need to invest cautiously, and may need to make some profit plays more suitable for bear-market environment – just in case.

Some “smart-money” strategists say that it’s time to take money off of the table, MarketWatch.com reported. In a recent research call, for instance, Raymond James Financial Inc. (NYSE: RJF) market strategist Jeffrey Saut says he has put his trading account all into cash, and has taken defensive positions (typically those that are designed to rise in price if the market falls) in case of a correction in stock prices.

“We have made a lot of money over the last eight weeks and continue to think the trick from here will be to keep that money,” Saut wrote in that research call.

Converting your profits to cash is one way to play this uncertain stretch, Hutchinson says. But there are several other strategies that will position you to continue generating profits, while also hedging against potential market unpleasantness. In his Permanent Wealth Investor trading service, Hutchinson says to:

• Buy high-yielding stocks for both income and capital gains.
• Buy gold both to profit, and to hedge against the inflation that’s certain to arise from the big government spending programs.
• And buy so-called “inverse funds,” to hedge and to profit. One such suggestion is the ProShares UltraShort 20+ Year Treasury Fund (NYSE: TBT), which seeks investment results that correspond to twice the inverse daily performance of the Barclays Capital 20+ Year U.S. Treasury Index.

A new bear market isn’t a foregone conclusion, either. U.S. Federal Reserve Chairman Ben S. Bernanke says the U.S. recession could end this year, and says that economic activity could pick up substantially in the year’s second half.

And there’s also an interesting wildcard at play. It’s a bit of anecdotal evidence that has proven bothersome to some investing professionals because it doesn’t fit with the way market rallies typically play out.

In most stock-market rallies, the initial catalyst comes from the big institutional players, who ignite the upturn. As the media drumbeat of the rally grows stronger and louder, retail investors start to join in – a little at a time at first, but then in growing intensity. By the time the main group of retail investors make the move, however, it’s usually almost time for the institutional players to cash out, since the trend they invested to profit from is typically almost played out, MarketWatch reported.

That’s pretty much what happened during the dot-com bubble, and is why individual investors took it on the chin.

This time around, however, it’s been different.

But this time around, anecdotal evidence – such as trading data from online brokers E *Trade Financial Corp. (Nasdaq: ETFC) trade and TD Ameritrade Holding Corp. (Nasdaq: AMTD) seems to suggest that it’s been the retail-investing crowd that’s driven this rally from the very beginning, while institutions have stayed on sidelines, cash in hand, Barry Ritholtz, chief executive officer and the director of equity research at Fusion IQ, told MarketWatch.

“The ‘dumb’ retail money is leading the gains,” Ritholtz said.

That could end up being good news for the stock market: Institutional investors, afraid to have missed the rally, might step in more forcefully, fueling a new-and-longer leg of the current bull market for U.S. stock prices.

If it turns out that this is just a “bear-market rally,” however, bad economic news will halt the rally and cause investors to punt.

The bottom line: Over the long haul, economic reality will guide stock prices, Ritholtz says.

“In this type of environment, the market is guilty until proven innocent,” he said. “We have to assume this remains a bear market until we see a more normalized economy, a recovery in some employment measures, and real estate to actually start improving – not just to stop free falling.”

Source: Is the Stock Market Rally For Real?