Why volatile markets are great news for smart investors

Markets and the economy are difficult to predict right now. But uncertainty and volatility can lead to big opportunities for bold investors to make money. Riccardo Marzi explains how.

Today's Money Morning is from our new contributor Riccardo Marzi. Here he explains his take on the markets and the philosophy behind his Events Trader newsletter .

The investment world has rarely been so confused. Inflation or deflation? Bull market or bear market rally? Everyone has solid arguments to back up their case, with respectable commentators lining up on every side of the debate.

So what does this mean for investors? Well, to be honest, I don't think anybody has a clue whether the market will be up or down in 12 or 24 months' time. But that doesn't mean there aren't opportunities.

Let me tell you about some of them and about why I think the markets will be volatile for a long while yet...

Just passively investing in the broader market today is a risky thing to do. No one's sure where it's going. Instead, the best bet for investors today is to focus on attractive individual stories and opportunities. This approach works far better now than it has for many years. While money was free and easy, hedge funds and other big players could leverage up (invest with borrowed money) and pile into any opportunity they spotted, wiping out any chance for retail investors to get in on the action.

But as the easy money has dried up, the price of risk has risen quite significantly. And that means that those investors prepared to shoulder some risk can achieve decent returns without having to borrow money up to their gills.

My philosophy is very simple. I try to spot securities that the market is mispricing, while trying to hedge, or minimize, risk. In other words, I'm looking for trading strategies where I can find decent potential upside while protecting myself from taking too much of a hit if it goes wrong.

The recession is leading to plenty of investment opportunities

I do this by using the same strategies that hedge funds have been using for years. And now that a lot of hedge fund capital has been pulled out of the market, these strategies are more profitable than they have been in a long time. For example, merger arbitrage yields in the region of 10% a year, a level last seen in 2002.

There are also opportunities in distressed assets and corporate turnarounds (don't worry if you aren't familiar with all of these terms. The recession is giving us plenty of material to work with.

Take GM. The car maker is sitting in Chapter 11 bankruptcy right now. It's the last company most investors are thinking about. But assuming the restructuring goes according to plan, the company will be viable again and history suggests you could make huge returns if you get in at the right time.

Then there's the tier 1 securities issued by banks (bonds and preference shares). In some cases, you could earn around 20% a year in these, if - as now seems clear - they will not be allowed to fail.

These are just a couple of the opportunities out there. There will be more to come because I reckon that markets will remain very volatile for the foreseeable future.

Investors are overestimating the strength of the recovery

The worst of the recession may well be over. But investors are currently overestimating the strength of the recovery, which makes me think that the surge of the past three months is just a sucker rally.

Why? It's pretty simple - it took years for all these imbalances to build up in the system. So it's going to take a lot more than 12 months or so for them to correct themselves. And the economy won't be turbocharged by cheap credit any more so we're in for a few years of sluggish or no growth while consumers, companies and the public sector repair their balance sheets and pay back the debts taken on in the good years.

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Property prices have further to fall too. Markets never fall to fair value they always overshoot on the downside. If history is any guide, expect the housing market to decline until 2011 or 2012. But this too will provide opportunities. My favourite for now is the commercial property sector, where prices have already fallen by more than 40% from the peak. Real estate investment trusts (reits) such as Land Securities or British Land could look very attractive indeed.

However, it's not time to jump in yet. If central banks genuinely start worrying about inflation, then rising interest rates could put further pressure on the sector for example. And we could also see some nasty surprises from abroad.

A volatile market means more opportunities for us

The recession is putting enormous strain on countries in the eurozone. Spanish unemployment has more than doubled in the space of a year. Italy's public debt to GDP ratio is heading from 107% to 125% next year, increasing the chances of a default if rates rise further. Portugal, Greece and Ireland all look vulnerable too.

But a bigger worry for now is Eastern Europe (see this week's MoneyWeek, out today, for more: Latvia is on the brink of crisis. If you're not already a subscriber to MoneyWeek, subscribe to MoneyWeek magazine). Here the global recession has been made worse by foreign-denominated borrowing. For example, Latvia's GDP has shrunk at an annual rate of 18% while countries from Estonia to Bulgaria are struggling badly.

The economic situation is bad enough for these countries. But the trouble is, they also owe a huge amount of money to other European banks, particularly in Sweden. So serious trouble in any of these countries could hammer both the euro and markets across the region, as investors worry about where the money will come from to bail out the trouble-spots. But again, that could create opportunities for example, in stronger countries such as France or Germany.

These are just some of the scenarios that I expect to profit from in the coming months. In short, I'd rather be investing in a volatile market like this than at the height of a bull market. I think it'll be a lot easier to make money, simply because there are fewer people and less money chasing a larger number of opportunities and that means more reward for those willing to take the risks.

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