What do you see as the main investment theme going forward in 2011?

Inflation is becoming a growing problem in foreign markets, but is barely registering here at home. There are several reasons for this:

• The deflationary overhang from the housing bust still looms large. Unemployment remains high, consumers are still paying down debt, construction activity is running at a fraction of its former level and many companies are finding it very difficult to pass along cost increases.

• The U.S. is not seeing much cost pressure when it comes to food and energy. Back in 2008, shale fracturing reached critical mass, causing the price of natural gas to collapse. Since then the new drilling technology has led to huge increases in supplies, keeping the price at rockbottom levels. Here in the U.S. you can buy a million BTUs of natural gas for less than $5. Getting the same amount of energy from oil now costs almost 4 times as much. Low-cost natural gas has far-reaching benefits for the U.S. economy. It’s holding down price increases for electricity, heating, fertilizer, plastic, packaging and even chemicals. Because all of these elements figure into the cost of agriculture and food production, the U.S. is seeing substantially less inflation in that area too. Overseas, where food and energy production are closely tied to the price of oil, many costs have doubled or tripled in the past two years.

• Growth rates for GDP and productivity have slowed in the U.S., but both are still climbing at a sustainable 2-3% clip. Domestic firms can still boost wages each year without having to pass along the added costs. Few other countries are in this enviable situation. They either have stagflation (flat GDP with inflation, like much of Europe) or they are dealing with wage-driven inflation (large annual increases well in excess of productivity growth, like many emerging markets). Furthermore, the U.S. does not consume much additional energy for each additional dollar of GDP it generates (emerging markets need 3-5 times as many BTUs). This means the U.S. can grow without inducing inflation. Emerging markets cannot.

What does all this mean for investors? On the stock side, the lack of an inflationary threat in the domestic economy could give U.S. stocks an edge over foreign stocks. The latter may be at risk from central banks that are compelled to fight rising prices with interest rate increases. As for bonds, U.S. taxables may not be such a bad place either. Despite the widespread perception that interest rates are moving up, the reality is that bond yields are anchored to the rate of inflation, and they usually settle about 2-4 percentage points higher. While long-term treasuries, which are tied in with the global markets, may be vulnerable to some upward pressure on yields, the pricing for investment-grade corporates is about right and high-yield bonds may actually have a little room to run.

I’m surprised you have a sell rating on most muni bond funds. With such attractive after-tax yields, I should think they would be a buy?

Yields are higher than normal mainly because of the heightened credit risk in this segment of the market. Many cities, states and other municipalities are still struggling with a big drop in tax revenue brought on by the financial crisis. Property tax bases have fallen with declining housing values, sales tax revenue has slipped because of restricted credit and high unemployment, and capital gains tax revenue has largely disappeared due to taxpayers’ large carryforward losses from the 2008 selloff. It all adds up to a big shortfall in tax revenue.

This means that municipalities must shore up their finances by raising taxes or by cutting costs. Because it’s not easy to find the political will to raise taxes in this environment, and because many cities and states were not exactly frugal with taxpayer money over the last decade, most are now looking at cost cutting as a solution. But it’s been a struggle. To make meaningful cuts often requires these entities to confront public employee labor unions, many of which have negotiated generous salaries, benefits and pensions. They won’t give them up easily.

As a result, many state and local entities have simply turned to borrowing to close their budget gaps, in hopes that things will eventually get back to normal. Even worse, they haven’t exactly been willing to disclose their true financial condition. Unlike taxable bonds, the disclosure requirements for municipal issuers are minimal, and penalties are rare. Many entities simply ignore the rules.

Borrowing might work for a typical recession, but this time is different. Tax revenue may not get back to “normal” for 10 or 20 years, if it happens at all. For many taxpayers, carryforward losses for capital gains will not be used up for at least a decade, and property values in some regions may not return to pre-crisis levels for 20 years. Increasingly, it appears that some borrowers will go broke before they can put their finances in order.

The recent expiration of the Build America Bond program is bringing the situation to a head. During 2010, easy money from the Feds kept marginal municipalities afloat, and also kept yields low for the more creditworthy entities. It’s estimated the Build America Bond program bankrolled some 25% of municipal financing needs in 2010. That window has now been slammed shut, and all municipalities are back to borrowing from the municipal markets. However, that pool of capital is shrinking, just as the pool of capital for high-yield borrowers shrinks during periods of rising default risk. In effect, a credit crunch is taking hold.

While this credit crunch may be mild in comparison to those that have occurred in the corporate world, it could still shatter some long-held perceptions about the municipal bond market and its low default risk. Most municipal borrowers are not nearly as business-savvy as corporations, so few are prepared for even a mild credit crunch. Those with shaky finances that have been rolling over their debt each year are likely to find themselves cut off within 12 months. The percentage of borrowers in this situation is very small, but it’s still large enough to create headlines and municipal bond outflows (the latter has already begun to occur in anticipation).

We have a sell rating on most municipal bond funds because this slow-moving credit crunch is still in its early stages. At some point, when most of the marginal issuers have defaulted, and the stronger borrowers have become more serious about getting their house in order, the yield premium in the municipal arena could then be worth its added risk. We’re not there yet. A good guess is that it will take another 6-12 months.

Why don’t you recommend Select Gold? For many time periods, it’s the best performing sector.

There is growing evidence that the price of gold (the metal) may have peaked after a long run-up that was fueled by Chinese buyers and ETF investors:

• Short-term interest rates are rising for many of the world’s currencies, and the odds are increasing that the Fed will end QE2 in June, and perhaps even make a tightening move in 2012. Gold does not pay interest - it actually has a small negative yield due to its storage costs. It is backed only by jewelry demand, which in itself has fallen off in recent years.

• Gold and other precious metals surged partly on fears that excessive sovereign debt levels would eventually doom paper currencies. But increasingly, it appears that the U.S., Japan, and Europe will have the ability to put their financial house in order (see the next question).

• More investors are being lured by stocks. World class companies with attractive growth rates are selling for relatively cheap multiples. Gold and gold stocks look expensive in comparison.

• A lot of smart money from hedge funds and mutual funds has already checked out. Fidelity’s own Jurrien Timmer (Dynamic Strategies) recently said he had cut his stake in precious metals by more than half in December.

• Gold ETF inflows were a major reason that gold went up in 2009 and 2010, and now they’ve turned negative. Some two-thirds of gold ETF investors are novices who have never before owned gold. They have no clue how volatile it can become, and when the herd instinct kicks in, many will conclude they own too much of it.

Select Gold invests mostly in gold mining stocks, which are about twice as volatile as the precious metal (its risk rating is 1.97). We’ve downgraded the fund to a sell, with the recommendation that subscribers cut their overall precious metals position to 5% or less of their investment portfolio.

I’m worried that foreigners are going to stop buying U.S. treasuries, which will lead to a collapse in the dollar. Are we all going to wake up some day and find that all our investments are worthless?

In the highly unlikely event of a dollar collapse, most U.S. stocks would retain their value. Those with significant exports or foreign operations would actually increase in value. But we’re jumping ahead. Let’s step back, take a deep breath, put on our critical thinking caps, and add a little scrutiny to the media’s latest doom theory.

The dollar is the strongest currency around, backed by the largest and most resilient economy on the planet. The U.S. may be facing a significant economic challenge, but the survival of the economy is hardly the issue. It’s more a question of GDP growth and the length of time it will take to put the employable portion of the population back to work.

Currencies do not collapse from excessive debt levels alone – if they did, the yen would have been snuffed out over a decade ago. Rather, they collapse when their tax base has been destroyed. Once an economy is in shambles, it doesn’t matter how you tax it, because you won’t be able to service its national debt. Think Russian Rubles, 1998.

The U.S. economy is hardly in shambles. By most measures (GDP, corporate earnings, wages, productivity, exports) it is barely dented. Granted, our system of taxation is somewhat dysfunctional, and we have a big government spending problem. But those are solvable problems – all you need is political will. Just because it doesn’t exist today does not mean it won’t come about at some critical juncture a decade or two down the road.

For example, Congress could ultimately chop spending by a third, impose a value-added tax like Canada’s 5% GST, and make a substantial dent in the Federal debt over the next 30 years. Realistically, it doesn’t even need to get to that point - all we need to do is eliminate future deficits, because servicing the existing Federal debt is manageable given a modest amount of GDP growth. Congress is even working on a baby step in that direction.

The media gives the impression that without emerging countries buying our treasuries, we would be in serious trouble. But the reality is that emerging countries are more at risk than we are. China and other low-wage exporters are desperate to keep their currencies from appreciating against the dollar, and will settle for relatively low returns on their recycled trade surplus money. They end up with a large share of our treasury debt because domestic investors won’t usually settle for treasury-like returns. Another way of looking at it is that emerging countries need our import markets more than we need their capital.

Consider the consequences for both sides if this trade game were to end abruptly:

• U.S. inflation and treasury yields would climb by about two percentage points. The former would allow the Fed to begin reversing QE2, the latter would pull in enough domestic investment capital to fully cover Federal borrowing demands.

• Cheap imported goods from emerging countries would climb in price by about 50%, accelerating the return of made in the U.S.A. products and eliminating the trade deficit much sooner in the current decade.

• Emerging countries would enter a long, hard recession that solves their inflation problem but wipes out large segments of their manufacturing base.

The media seems to think we’re at the mercy of foreign investors. But if they stop buying our treasuries, the real question is, “Would they be doing us a favor?”

Those who claim that Federal debt will continue to mushroom until there’s a day of reckoning do not fully appreciate the powerful forces that are working against that kind of scenario. Throughout history Americans have rarely been stumped by tough economic problems. Moreover, today’s threat pales in comparison to the challenges of the Great Depression, World War II and the 1971 collapse of Bretton-Woods (which led to a Federal Funds rate of 20% in 1980). There was, of course, one big advantage in dealing with the problems of the past – there was no drumbeat of financial pundits telling us how hopeless things were.

Do you time the market by holding cash during bearish periods?

No. It's our belief that any form of market timing would only dilute our returns:

• The concept of timing the market seems simple when reflecting on history, but predicting the future is an entirely different game – and the statistics are formidable for anyone who bets against stocks. The market moves up about two-thirds of the time, so a cash position has only a 33% probability of being right for any given period. Anyone who regularly moves in and out of cash may cut their average risk level, but they have almost no chance of beating the S&P 500 over a long period of time.

• Those who get out at the right time rarely get back in at the right time. It takes a person who's on pins and needles to take profits just as stocks top out, and it takes a battle-hardened opportunist to jump in at the bottom of a bear market. It's rare the same person can flip between those two personalities. More common is the nervous investor who gets out shortly after the market heads down, then remains in cash for the rest of the decline and the full recovery, returning only when the market hits new highs.

• Seasonal strategies don't hold up over time. As soon as they become popular, they self-destruct because some of the participants shift their timing to try and come out better than the rest of the “herd.” Two strategies that are currently headed for oblivion include the four-year Presidential cycle and being out of stocks from May to November. The fundamental reasons for these trends disappeared long ago, so they persist only because investors still believe they work. Eventually, they'll join the things-that-used-to-work scrap heap, just like the January Effect did.

• It's not necessary to time the market, because the opportunity available with fund selection dwarfs any chance to get ahead with timing. A decade ago we did a quarterly study of perfect market timing versus perfect fund selection. It was no contest. Over a 14-year period, perfect market timing multiplied money by a factor of 25, whereas perfect mutual fund selection (in Fidelity's diversified growth lineup) grew it by a factor of 200! These results could never be achieved in the real world, of course. But they make a good case for ignoring the market's ups and downs.

By their very nature, financial markets move in directions that surprise and disappoint the maximum number of participants. If a majority wants to buy, prices move up. If there are more sellers than buyers, prices fall. The only way to win is to stay in the game and benefit from the long-term trend.