Double double toil and trouble.

The world’s financial market are only facing two witches stirring the pot, but between them they’re quite capable of adding a third bubble and bust in 2011 to the run that began in 2000 and continued with 2007.

I’d be a lot less worried about a potential financial bubble if it were just the Federal Reserve stirring the pot by setting 600 billion greenbacks lose on the global financial markets by the end of June 2011.

But the Chinese government with its $2.65 trillion in foreign exchange reserves is as much of a force—possibly more so—in inflating any bubble. It’s China’s effort to give that cash a home—and earn a decent return on it—that’s pushing up the price of iron mines and oil fields, gold, and the value of bonds denominated in Aussies and Loonies and Reais.

Which makes figuring out what to do about a potential 2011 bubble and bust—following in the footsteps of the bear market of 2000 and the financial crisis and bear market of 2007—so difficult. But in my November 9 post on the potential for a bubble I said I’d try so here’s how I’d approach the possibility of another bubble and bust.

In that November 9 post I laid out the reasons to think that the Federal Reserve might be creating another bubble (https://jubakpicks.com/2010/11/09/whoops-is-the-fed-about-to-do-it-again-create-another-asset-bubble-i-mean/ ) so I’m not going to cover that ground again. But let me take a paragraph or so to explain China’s role in any potential bubble.

China currently plays two roles in inflating asset prices around the world.

First, China’s extraordinary 10% growth rate becomes an excuse for investor to bid the price of global assets higher. Oil should sell for higher prices, for example, because China will need so much more of it in the coming decades. On November 10 the International Energy Agency forecast that China’s demand for energy will jump by 75% between 2008 and 2035. China alone will count for 36% of the growth in global energy use during that period.

The same story is used by traders and investors and Wall Street analysts to justify ever-higher prices for copper, corn, iron ore, nickel—you name it.

China’s economic growth is indeed stunning, but investing logic says that some part of that future growth is already embedded in today’s asset prices. Economic history says that higher prices change consumer behavior—we can already see that in China’s drive to follow the path of Japan, Germany, and even the United States and reduce the energy intensity of its economy. And those two elements set up the likelihood that t some point China’s demand for these commodities will disappoint investors even if China continues to grow at today’s stunning rates.

Second, think about what happens to all those surpluses that China accumulates after it accumulates them. They don’t just sit in a vault somewhere—they get managed. That means China buys things with them: U.S. Treasuries, Canadian debt, gold, iron ore mines, Greek government debt. And whatever China buys trades at a higher price than it would have without that buying.

In one critical way the $600 billion let lose by the Fed’s program to buy Treasuries and China’s $2.65 trillion in foreign exchange reserves have the same effect. All this money—from other sources—is looking for profitable homes. And as it flows to whatever asset and market promises that home, the total $3.25 trillion (or $5 trillion if you add in the $1.75 trillion in the Federal Reserve’s first program of quantitative easing) bids up the prices of the assets in those markets.

And the biggest effect is on asset prices—whether for stocks, or real estate, or iron ore mines or and oil fields—in developing economies. Yields are higher, growth rates are higher, recent and potential returns are higher. Why wouldn’t money searching for a home head in that direction?

But as I noted in my November 9 post, developing economies don’t present the largest and most liquid markets. India, for example, is struggling to absorb the $25 billion—the highest amount on record–that has flowed into Indian stocks from overseas equity funds in 2010.

$25 billion is a problem when the Federal Reserve and China are talking about $3 or $5 trillion? You see the mismatch that might lead to an asset bubble in the world’s developing economies?

How close are these markets to bubble territory? They’re on their way, according to some research from Morgan Stanley.

The good news is that at 22 times earnings adjusted for the economic cycle the emerging markets traced by the MSCI Emerging Markets Index (the ETF on that is the iShares MSCI Emerging Markets Index (EEM)) are just slightly more expensive than the Standard & Poor’s 500 at 21 times cyclically adjusted earnings. In further good news the MSCI Emerging Markets index is 14% below its 2008 peak.

So we’ve still got a way to run right?

The picture isn’t quite so reassuring, however, if you take apart the index and separate the still below peak valuation markets from the already above peak valuation markets.

Morgan Stanley reports that the stock markets of Columbia, Chile, India, Indonesia, Peru and the Philippines are all trading at multiples more than 50% above the average for the MSCI Emerging Markets Index for the last five years. (The corresponding good news is that Russia, Hungary, Poland, and Korea all trade at least 25% below the emerging markets average for the period.)

We need to look at one more possibility and scenario before we move to a strategy for avoiding another bubble: What happens if we’re wrong and the bubble that is now inflating doesn’t burst. What happens if, instead, it gently deflates?

You see I can think of a way out without a 2011 replay of the 2000 and 2007 busts. More than a few things have to fall in place for financial markets to avoid another bust.

• China has to slow its economy enough to slow inflation without stepping on the brakes so fast that the economy stalls. (What’s a stall in China? Anything below the 7% growth that the economy needs to soak up its annual supply of new workers.)
• China has to make visible progress to rebalancing its economy from exports to domestic growth. That would start to cut into the country’s trade surplus, increase growth in the current trade deficit countries, and produce the kind of quality of life improvements that China’s government needs to keep violence from rising in the country as raw GDP growth slows.
• China has to managed appreciation in the renminbi to help slow inflation and to help rebalance its economy while keeping bankruptcies at inefficient and unprofitable Chinese exporters to a manageable level.
• The Federal Reserve’s second program of quantitative easing needs to work—at least enough to get U.S. growth above the 2.5% level that’s a minimum for reducing unemployment
• The Federal Reserve has to handle the tricky withdrawal of quantitative easing without sending the economy back into a growth recession.
• A combination of Federal Reserve policy, fiscal discipline in Washington (all, right, stop laughing), and decent economic growth in the United States has to give the Federal Reserve room to start raising interest rates again in order to close some of the yield gap with emerging economies.

Put all that together and you could see enough growth in the global economy to justify a good part of today’s emerging market multiples and enough of a pull from improving growth and rising yields in the U.S. to slow the flow of hot money into emerging markets.

There’s not a lot of room for error in that scenario. But there is some. For instance, a crisis in the peripheral economies of the Euro Zone—Ireland, Portugal, and Greece—that didn’t turn into a crisis for the euro but that did raise fear among global investors so that the lower yields in the United States and Japan were over-shadowed by the safety of these deep and very liquid financial markets would help drain money out of emerging markets.  Of course, the crisis would have to be a Goldilocks crisis—not too hot and not too cold.

In my post https://jubakpicks.com/2010/10/26/how-to-profit-today-when-you-think-the-financial-zombies-will-walk-tomorrow/ I described how difficult it is to invest when you can so easily imagine everything going wrong. That’s a major challenge in devising any strategy for a potential bubble. You can’t just bury all your money in your backyard and stock up on MREs (meal ready-to-eat) because there is a realistic chance that the worst won’t happen. And money buried in the back yard won’t earn enough to put the kids through college or fund a retirement in any place where you’d actually like to spend your golden years.

As I see it, you’ve got two sets of options to pick from. I suggest mixing and matching both to calibrate any strategy to your own situation and sense of the world and to give your strategy the best chance of success.

First, you can try to invest in less risky assets, those that won’t take as much beating from a bubble and bust.

There’s very little that will escape all damage except gold. Gold is unique because investors regard it as a stable source of value even in the very worst of times. In fact as long as the worst of times doesn’t include mobs armed with weapons storming the home of anybody thought to have gold, gold actually goes up in value in risky times. Since gold has relatively few industrial uses, it doesn’t take a huge hit (although jewelry sales do decline) when the economy slows. In that way it’s a superior hedge to copper, say, which has many industrial uses. It should come as no surprise that copper prices dropped when the global economy slowed and the U.S. construction industry rolled over.

But you can construct a list of assets from less risk to more based on how close prices are to historic tops (or beyond) and the likelihood of a drop in economic demand. On this scale copper, iron, and Shanghai, Honk Kong and Mumbai real estate all look like risky assets that you certainly don’t want to own if a bubble bursts. Or even if a lot of investors get very nervous about a bursting of a bubble or a slow down in economic growth.

On the other end of the scale you have assets such as stocks paying healthy dividends from companies with a track record of solid cash flow even in tough times. E.I. DuPont (DD), for example, kept its dividend at a solid $1.64 a share through the financial crisis. That didn’t stoop the stock from taking a pounding in 2009 but the shares did hold value in 2007 and the first half of 2008 giving an investor extra time to plan an exit.

You can and should make these risk judgments not just among asset sectors but inside asset sectors themselves. A company with little debt and solid cash flow is a better bet to hold its dividend than a high-yield company with lots of leverage and that already pays out more than 80% of its earnings, for example.

A bank that is ready to meet the capital requirements of Basel III is a better bet than a bank that’s going to be looking for capital in what could be a very tough market.

Morgan Stanley has made that kind of discrimination among emerging markets. The company is recommending South Korea and China because it seems those markets as relatively cheap (and very well backed by national foreign exchange reserves) and advising that investors cut back in holdings in Indonesia, Malaysia, and the Philippines because, after huge runs, those markets are relatively expensive.

Remember we’re only half way through our strategic building blocks?

Second, you can try to time the bubble and bust. Stay in while there are profits to be made and jump ship when the markets look like they’re about to take a turn toward disaster.

Easy to say but hard to execute.

Hard. But not impossible.

Right now, most technical indicators are still pointing up for stocks in the United States and in other global markets in the medium and long terms. I think those indicators are—at the moment—correct. The fourth quarter should be good for stocks if only because the Federal Reserve and China are flooding the asset markets with so much money.

But I don’t know that these indicators will clearly signal any shift in the trend. They weren’t so clear in either 2000 or 2007 that most investors, even those who use technical indictors regularly, were able to see the peak and the coming drop.

I’d supplement whatever you can glean from the technical indictors with some basic knowledge of economics and investor psychology. Last week the Federal Reserve said it would buy bonds until June. That’s no guarantee, of course. The Fed could change its mind and stop the sales way short of June, especially because some Federal Reserve members think this new round of quantitative easing is a mistake. Certainly the Federal Reserve is under political pressure from newly confident Republicans to reverse course.

So how long can you count on the Fed to back up your stock portfolio? Certainly through the end of 2010 and almost certainly through the end of the first quarter. But if economic growth starts to look stronger than expected, the Fed could well cut back on its buying of Treasuries after that. Would that be good or bad for stocks? It’s very hard to tell if stronger growth would outweigh a reduction in cash, but an end to the Fed’s program would certainly add uncertainty to the markets and that’s never good. And investors who re now buying with the idea that the Fed is a reliable backstop through June would certainly be disappointed.

China is likely to follow a roughly similar timetable. The country may raise interest rates and try other measures to slow growth and inflation in the last quarter of 2010 and the first quarter of 2011, but the steps are likely to be gradual enough to assure that China’s growth stays at the high levels that emerging market valuations now assume.

How do I put this all together into a strategy?

I’d go with the trend in the fourth quarter and look for profits from the assets that have done well in the rally to date: emerging market stocks and ETFs, commodities and commodity stocks, machinery and materials stocks to name a few. I’d keep on eye on gold and add some to my portfolio as insurance on 2011whenever prices dipped. (10% of a portfolio seems a reasonable goal by early 2011.)

As we move deeper into the first quarter of 2011 I’d pay more attention to risk and try to move out of riskier asset classes and riskier members of asset classes. My goal is to stay invested to gradually diminish the risk in my portfolio as the quarter progresses. How far I go to reduce risk will depend on my read of the Federal Reserve and China. Are their policies working? Are they about to adopt even riskier policies themselves or disappoint investors by changing course?

2011 is shaping up as a tough—but not impossible–year to navigate.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/