An ill wind for stocks is blowing from central bankers

After I got my bachelor of science in aeronautical engineering, I had the good fortune to land an engineering apprenticeship in Paris, at Avions Marcel Dassault (now Dassault Aviation).

The design office was run by an eccentric genius whose motto was: Focus diligently on the "most important variable," and everything else shall follow. This advice served me well as a budding engineer, and also later when, as a budding MBA, I strayed to investments. Because even in the complexity of money, I found, there often was a "most important variable."

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As I read books by certified market geniuses, I eventually learned that a most important market variable was whether the U.S. Federal Reserve was your friend or your enemy. How to tell? The discount rate, bank lending ratios, stock margin requirements, rate of money printing, all showed whether the Fed loved you or hated you at the moment - which mattered to stock market performance.

The Fed's spirit, it seemed, was like a strong wind blowing over the market's waters. When it was at your back, you could go sailing with stocks safely. (Though, of course, you had to do proper due diligence on your investment boats.) But when the Fed wind was in your face, you'd be foolish to go sailing far from shore, or even at all. The obvious question was: Can you tell which Fed weather we're having? The answer is, not all the time, but at market extremes the answer is often very plain, and then it becomes the "most important variable" of all.

A classic example for a Fed love for investors is the first quarter of 2009. With Wall Street banks crumbling, investors sure the world is ending, and depression surely at hand, the panicky Fed became your friend overnight, printing trillions of dollars. The European Central Bank did the same, as did China's. In fact, all over the world central banks printed money and relaxed investment rules, so, of course, stocks had one way to go - up, as I then pointed out in my Feb. 28, 2009, column.

What about today?

Today, I'm afraid, we're inching toward the opposite. Whereas a year ago central banks loved you, now they definitely don't, and it's getting worse. The Fed's monetary wind is no longer at your investments' back; it's shifting and may soon be in your face.

You may recall that since the beginning of the year I have been urging you to get more hedged. I think you should get more hedged still. To see why, and sticking to the same engineering principle, focus on the three largest economic engines: the United States, Europe, and China. The central banks of all three have begun to show enmity to investors and speculators.

The U.S. just raised the discount rate. Former Fed chairman Paul Volcker (the guy who in the early eighties raised rates to 20 per cent) has acquired more power, and more of his recommendations have become policy. And Fed chief Ben Bernanke, although bravely saying he'd like to keep rates low, may have to follow Europe and China. (In Canada, Finance Minister Jim Flaherty already tightened rules on mortgages, making way for higher rates.)

What about Europe? I'm afraid it looks just like the U.S. did before Wall Street crumbled, with small countries taking on the role of imprudent banks. Whereas U.S. banks had taken risks that the U.S. government had to pay for, Greece took risks that Germany is expected to pay for. But unless the Germans are willing to work to age 67 so the Greeks can retire at 63 (the Germans aren't), Europe must borrow more money - and raise rates.

What about China? Two months ago, for the first time, China's central bank ordered China's regular banks to lend less. At that time, I noted that if the Fed had ordered U.S. banks to lend less, the Dow would have lost 1,500 points in a few days. Yet when China did this, it was greeted with a yawn. Well, China just did it again. This time the market noticed, because more restrictive Chinese lending is bound to raise rates in China and moderate its demand for imports. The impact on world markets should be obvious.

Does this mean there are no worthwhile stocks to buy? Of course not, there are more than a few. But as in sailing, even if your boat is sound, it's not wise to sail it too far from shore when the wind is blowing against you and the barometer is falling. And right now the wind is picking up and central bank barometers in the U.S., Europe and China are falling fast.

What about gold and gold stocks? Unfortunately, based on past history, these, too, may temporarily weaken, as they do every time rates begin to rise.

So, as mentioned previously, stay hedged and stay close to shore - meaning more shorts, more cash, and more short-term bonds.

Full disclosure: I just switched some of my RRSP into Venator's income fund, whose bond duration is mostly short.