Most investors are heading for huge losses

Let me explain. The shares of most sub-prime lenders already peaked out in late 2004. Throughout 2006, it became increasingly evident that conditions in the housing market were deteriorating. But investors kept on buying these stocks because the P/Es were low and analysts continued to recommend them, and because the Fed kept on telling investors that the worst in the housing market was over!

But consider the following. The news is always favorable near market tops or when a sector is about to peak out. Most analysts will also be most bullish about the prospect of a sector right at the very top of the market - remember high tech stocks in 2000?

Also, near stock market tops the price-to-earnings ratio is frequently low because the problem lies less with the "price" than with the "earnings". In 1929, the US stock market sold for less than 14-times earnings. But then earnings collapsed and stocks plunged by 90%.

Avoiding losses

So, how should an investor navigate in these difficult times? In the future, avoiding losses will be more important than making huge gains. Because of a weaker housing market and problems in the sub-prime industry one source of "excess liquidity" has dried up.

And while it may be premature to conclude that credit problems in the sub-prime lending market will spread, the risks that tighter credit conditions will spread throughout the capital market have increased. And the first casualties of less international liquidity would be emerging markets.

The Indian stock market has had a huge run since 2003 - admittedly from a very depressed level. In 2007, the Sensex increased until February 9th by 6.9% but then suddenly dropped by 7.4% leaving the market down 1.2% year-to-date. Similarly, the Chinese stock market has also all the symptoms of a stock mania and exiting would be prudent.

Gold to outperform

With very few exceptions, equity markets are over-bought, fully valued and vulnerable to some disappointments. For asset inflation aficionados, gold and silver should under any scenario (tight or easy money) continue to out-perform US financial assets.

Still, whereas I believe that in the long term the Fed will have no other option than to print money and embark again on a string of aggressive interest rate cuts, weakness in one market - housing - could now spread to other asset markets - including industrial commodities and precious metals. But at the same time, there is little doubt that Mr. Bernanke is precious metals' best friend.

After a disappointing 2006, Japanese equities could surprise in 2007 on a relative basis. Compared to the US households Japanese investors have only a very small percentage of their financial assets in equities. Also, the Japanese Yen has become inexpensive for exporters.