As you know, the stock markets around the world have been taking a wild ride these past few weeks. The response to this activity has been sharp swings in sentiment. Unfortunately fear took hold early. But the market didn't drop further and a latent demand seemed to emerge.This led to the speculation that it had reached a bottom and the focus shifted to a longer-term, more optimistic outlook. For investors, it was a period to ignore the daily reactions and rapid mood swings, and sit back to assess the lasting prospects of their holdings.

US Fed officials have expressed concern about the trend in inflation. However, the markets took solace from comments from Chairman Bernanke that the Fed expected to control long-term inflationary expectations. He declared that the economy remains resilient to high energy costs and continues to prosper. He hinted that inflationary pressures are somewhat under control. This could be interpreted that the Fed may raise rates 25 basis points in June and likely in July as well, but may not need to continue to raise rates after this.

Although the US Fed will definitely have to raise rates further, econoic growth should remain reasonable. That means that earnings growth in the second half of the year should also be decent.The global economy is slowing, which will eventually lead to lower inflation rates.The outlook now doesn’t seem as good as it was a few months ago, but it is not all bleak. And with the S&P 500 Index now trading at under16 times operating earnings (on average), valuations are still good.The current uneasiness in the markets stems from speculation that the Fed may be going too far, and the realization that there is still fundamental demand for stocks. We can expect the markets to continue to be subject to volatility, as any bad news on inflation could stoke the worst fears. But until the market gets a clearer sense of the outlook for inflation and Fed policy, the prospects of a significant summer rally seem remote.

According to the International Monetary Fund (IMF), the Bank of Canada will likely need to make further modest hikes in its key interest rate to keep inflation in check. This comment came in the IMF's annual review of the country's economy: "Further modest increases in the overnight interest rate will likely be required to bring headline inflation back to target." The Bank of Canada's key lending rate is at 4.25 per cent following seven hikes since last fall. The IMF report praised Canada's recent economic performance, hailing its efforts to pay down the federal debt since the 1990s.

Sub-Emerging Markets
Morgan Stanley’s economist Stephen Roach believes that global investors have reason to be concerned about emerging markets. But it may be for the wrong reasons. Stock markets in Russia, India and Brazil have tumbled by 20 per cent or more in the past five weeks, with analysts pointing to fears of rising global interest rates and slowing global growth. Mr. Roach largely agrees with those who argue that emerging markets, which in recent years have built up foreign reserves, turned trade deficits into surpluses, and improved their credit quality, are different today than in past emerging-market collapses. But that doesn't necessarily mean they are now impervious to the sort of meltdown these stocks experienced in 1997 and 1998. At that time, emerging-market share prices tumbled nearly 60 per cent over a 14 month-period that included a round of Asian currency devaluations and Russia's government debt default.

He states "There's every reason to think that the next crisis in emerging-market economies will arise out of circumstances that will be very different than those that nearly brought the world to its knees in 1997-98."

The chief culprit this time is the exhausted American consumer.Mr. Roach suggests it is "increasingly likely" that the world's buyers of last resort will finally slow their consumption. He points to numerous factors, such as mounting debt and a cooling property market. "Emerging-market economies have not succeeded in boosting internal consumption, and as a result they remain heavily dependent on exports as the sustenance of growth," he writes. In other words, if the US doesn't consume, the developing world's economic growth is in peril.

The Gold Story
We have recently seen some of the worst one-day drops in gold since March 1980. It had its biggest plunge in 15 years, falling below $600 an ounce, and copper tumbled to a seven-week low as investors bailed out of commodities and equities over concern about rising global interest rates.

The 33 percent decline of gold from its high of $739.20, reached in May (see past issue of Intelligent Investor Report – All the Glitters is not Always Gold – May 06), is essentially payback for the excessive greed on the part of speculators who were chasing the momentum that occurred a couple of months ago. Should gold swing upward again, it won't be as quick a surge, because the metal will have to deal with fresh overhead resistance for the first time during its current bull market. Many new buyers with $700-plus prints on recent gold purchases might be having difficulty recalling why they bought in the first place.A $50 bounce from here might bring it close enough to take their losses and go elsewhere.

Either way, it is quite a change from years of hearing that gold was an insurance play against inflation, and less correlated to the stock market.

Volatility – emotion takes over
As an investor, you have to realize that stock markets around the world will continue to be volatile. Is there going to be a major market crash? Who knows for sure. What we do recognize is that the markets have crashed before and will crash again. All the veteran investor does know is that in time markets recover. Once you accept this, some of the emotion associated with the current volatility should dissipate. You will not be physically harmed, the markets will not end up at zero, and at some point they will recuperate. In this context, being overly upset is unnecessary and imprudent.

As long as you have a well diversified portfolio (in several asset classes, geographic areas and styles) and you rebalance regularly, you will reach your investment goals over the long term.

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