Now, as the administration’s primary proponents of free markets, they are again subverting efforts to tightly regulate trading activities and break up investment banks that are “too big to fail.”   

According to a report on “Frontline,” a program broadcast by the Public Broadcasting System on October 20, current Treasury Secretary Timothy Geithner and Lawrence Summers, the Director of the White House Economic Council, were part of a group of free-market advocates that led a charge against proposed regulations to limit trading in over-the-counter (OTC) derivatives during the Clinton administration.

Those laissez-faire policies later led to a twenty-fold increase in the OTC markets over a ten year span – a house of cards that collapsed and spun the global economy into what is now being called the Great Recession.

The Frontline story raises new questions about Geithner’s role in financial regulatory reform at a time when he is already being criticized his continued ties to Wall Street and his inability to effectively manage the bailout at American International Group, Inc. (NYSE: AIG).

The questions come as the administration continues to reject calls to break up the biggest banks and investment firms long before they fail, or impose strict limits on trading the high-risk OTC derivatives and other “dark market” securities that largely precipitated the economic collapse.

The Wizard of Wall Street and His Acolytes Invade Washington

As Frontline reported, Geithner and Summers were both principal advisors, along with Federal Reserve Chairman Alan Greenspan, to Robert Rubin, President Clinton’s Secretary of the Treasury during the late 1990’s. 

Greenspan, sometimes called the “Wizard of Wall Street,” is known as a financial libertarian vehemently opposed to government interference in markets.  He first rose to power when he was named Chairman of the Federal Reserve Board during the Ford administration.

He and Rubin, who once ran Goldman Sachs (NYSE: GS) – along with former Harvard University professor Summers – were largely responsible for populating the Clinton administration with other free market acolytes, including Geithner.

The Frontline report examines how they formed a tight-knit alliance to shut down efforts by Brooksley E. Born, the Chairwoman of the Commodity Futures Trading Commission (CFTC), to regulate the secretive derivatives markets.

Born, who graduated first in her class at Stanford Law School in the early 1960’s, and spent more than 20 years litigating the OTC markets, rose to chair the CFTC after failing to secure an appointment to be Attorney General under Clinton.

At the time, the markets were flying high on the Internet boom and hardly anyone knew, or cared, about what Wall Street had labeled “The Black Box” — a $27 trillion market where banks operated in secret with no exchanges, no record keeping, and no public reports. 

The lack of transparency led Born to wonder about the OTC markets.

“It puzzled me,” Born told Frontline. “What was it in this market that had to be hidden?  Why did it have to be a completely dark market?  So it made me very suspicious and troubled.”

But, according to the report, Greenspan warned Born against stepping up regulatory maneuvers. Incredibly, during an introductory lunch, Greenspan actually told Born that he didn't believe that fraud was something that needed to be enforced or was something that regulators should worry about – free markets could regulate themselves.

Later, Born had her staff issue a “Concept Release” publicly proposing a CFTC rule change to regulate the OTC markets. Rubin, Greenspan, and Arthur Leavitt, the Chairman of the Securities Exchange Commission (SEC), immediately launched a firestorm of criticism, issuing a statement condemning the release and lobbying Congress relentlessly to prevent her from initiating oversight.

“They were all part of a very concerted effort to shut her up and shut her down,” New York Times reporter Timothy O’Brien told Frontline.
 
Congress subsequently killed the initiative.  A frustrated Born resigned shortly thereafter.

The Fallen “Rock Stars” of Wall Street 

Meanwhile, a little known hedge fund had been attracting billions in investor money by using its own “Black Box” to quietly rake in fat returns. The creators of Long Term Capital Management (LCTM), known at the time as the “rock stars” of Wall Street, used proprietary formulas to rake in millions in trading fees.

With their sophisticated computerized trading algorithms, LTCM traders not only bagged huge profits, they bragged that their systems could strictly limit daily losses to a maximum of $30 million. But when the Russian currency crisis hit in 1998, LTCM suddenly began hemorrhaging money, losing $400-$500 million a day. 

When large banks asked to collect on their collateral, they discovered that same collateral had been promised to other banks as well.  Credit markets immediately locked up.

Facing a possible systemic meltdown, Rubin mobilized the Treasury department with emergency meetings to deal with a suddenly out-of-control “free” market.

Before the crisis was over, the government prevailed on 15 Wall Street banks to ante-up a total of $3.4 billion to bail out the hedge fund and settle accounts.

After the crisis was contained, an alarmed Congress once again held regulatory hearings, but Greenspan and his cronies again convinced them to drop the idea.

But Born, who had removed herself from the crossfire in Washington, clearly recognized the LTCM debacle as a familiar symptom of an unregulated market running amok.

“I thought that it was exactly what I had been worried about,” she said. “This was…gambling of a colossal nature. All these big banks had in essence … extended unlimited loans to LTCM, and they hadn't done their homework. They didn't even know the extent of LTCM's exposures in the market.”

Nevertheless, Congress failed to pass regulatory reform to address the problem.

A Ticking Time Bomb

Later, after Congress repealed the Depression-era Glass-Steagall Act, designed to keep investment activities segregated from typical banking functions like loaning money, the dark markets exploded.

Trillions of dollars of sub-prime mortgages, were sliced and diced together with investment-grade loans into murky collateralized debt obligations (CDO) that were insured by counterparties with credit default swaps (CDS) – something that the bankers and credit ratings agencies themselves didn’t fully understand.

The hands-off approach eventually inflated the OTC derivatives markets to $680 trillion worldwide in 2007 — 10 times the GDP of all the countries in the world.

As the economy collapsed, derivative products exploded all over the world, resulting in the seizure of credit markets and the bursting of the U.S. real estate bubble.

Reform Measures Still Lacking

As previously reported by Money Morning the regulatory overhaul that U.S. President Barack Obama proposed back in June has been derailed by lobbyists and cast aside by a Congress that is preoccupied with the heated debate over healthcare.

But while little progress has been made on regulatory reform, the banks keep rolling along, booking huge profits on the same risky wagers they were making before the financial crisis.

“We’re seeing the same kind of behavior from the banks, and that could lead to some huge and scary parallels,” Simon Johnson, former chief economist with the International Monetary Fund, told CNBC.

Geithner said Sunday he is planning to endorse a path before the House Financial Services Committee on Thursday that focuses on seizing control of troubled financial institutions and regulating them extensively before they can get themselves and the nation in trouble again.

The measure would make it easier for the government to seize control of troubled financial institutions, sack the management team, and wipe out shareholders. The administration still insists it will not separate commercial banking from investment operations.

But there is at least one top economist with Obama’s ear who says that is not enough.

Former Federal Reserve Chairman Paul A. Volcker has forwarded a proposal to roll back the nation’s commercial banks to the days of Glass-Steagal, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.

Volcker, arguing that regulation by itself will not work, says that the relentless pursuit of profits will eventually get the giant banks into trouble again.

Money Morning Contributing Editor Martin Hutchinson also thinks current reform efforts will prove futile.  He recommends breaking up the big banks or putting restrictions on leverage as the only ways to keep them from taking on too much risk.

“Some of these banks are leveraging $50 million in cash into $500 million in credit.  We’ve got to outlaw credit default swaps altogether or put limits on leveraging collateral.  That may take some of the liquidity out of the system and make loans harder to get but so be it, if it reins these guys in,” Hutchinson told Money Morning in an interview.

For her part, former CFTC Chair Born calls the 2008 implosion “my worst nightmare come true,” and has no doubt about the dangers of leaving the banks to their own trading devices in an unregulated market that is still worth about $582 trillion. 

“I think we will have continuing danger from these markets and that we will have repeats of the financial crisis, she said. “It may differ in details, but there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience.”

News & Related Story Links:

• Frontline: The Warning
• Money Morning:
  Is Timothy Geithner A Roadblock to Regulatory Reform?
• Money Morning:
  Obama’s Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street
• Money Morning:
  Wall Street Back to Business as Obama’s Regulatory Overhaul Loses Momentum
• CNBC:
  Wall Street Taking Same Risks That Caused Crisis: Analysts
• Money Morning:
  Here’s Why It’s Time to Ban Credit Default Swaps
• Investopedia:
  credit default swaps
• New York Times:
  U.S. eyes reining in ‘too big to fail’ institutions
• New York Times:
  Volcker Fails to Sell a Bank Strategy

Others have suggested reviving the Glass-Steagall Act – the 1933 legislation that forced financial institutions to separate their commercial and investment banking businesses. Glass-Steagall was repealed in 1999.

It’s enough to make your head spin. And don’t think that our elected “leaders” aren’t feeling just as overwhelmed. At the end of the day, however, there has to be a solution to the banking mess. Doesn’t there?

Leaving everything as it is isn’t an option, or at least it is a very bad option. In the short term, it may have been necessary to bail out all the major banks and investment banks – save for the unfortunate Lehman Brothers Holdings Inc. (OTC: LEHMQ).

In the long run, this has established a presumption that any financial institution that is too complicated for politicians to figure out – and that’s big enough to make them afraid of losing it – can pretty well do what it likes. And that includes paying its senior managers grossly excessive bonuses within a year of receiving a state bailout – can anyone say Goldman Sachs Group Inc. (NYSE: GS)?

This also gives these particular banks an unfair advantage in funding – and in accessing large pools of capital. The past year has demonstrated all too well that these particular institutions are only too happy to use this advantage to squeeze their smaller competitors out of the market.

On the other hand, I don’t think that bringing back Glass-Steagall – as it was – will do the job properly. Today’s investment banks just aren’t the same as they were in 1935. In fact, they're even more sophisticated today than they were as recently as 1985.

Trading dominates investment-banking activities more than ever before. And that’s resulted in a way it never used to, and they have an impossibly tangled network of obligations to counterparties on interest rate swaps, currency swaps and now the inevitable credit default swaps (CDS).

That last derivative security, in particular, makes it impossible to imagine an investment bank with a large portfolio surviving anything but the mildest downturn. The reason: In a real recession, an investment bank will have to post collateral on all of its credit-default-swap obligations, which increase in value once money gets tight. Thus, just when it is most difficult to attract funding, investment banks with large CDS portfolios are subject to a “giant sucking sound,” as all their funds are drained away to satisfy counterparty claims on CDS portfolios.

But there are three things we can do in response: Ban credit default swaps, initiate a transaction tax and boosting capital standards. Let’s consider all three.

Three Moves to Make

I’ve been warning investors about the dangers of credit default swaps since very early in 2008, months before the problems surfaced. There actually are several reasons to ban credit default swaps, except possibly for the rare cases in which the credit-default-swap seller actually owns enough of the credit in question to cover the CDS. Let’s consider the top three:

• First, they are destabilizing to the market, because they zoom up in value in tight markets, draining their sellers of funding.
• Second, they encourage speculation on bankruptcy – they are like short selling on steroids, because the potential profit from a CDS is a large multiple of its cost.
• And third, credit default swaps mess up bankruptcy negotiations; because some creditors will be a “phantom,” either covered by the swaps, or actually “short” the credit, meaning they have an incentive to push the firm into bankruptcy.

The fact that Congress – a year after the collapse of American International Group Inc. (NYSE: AIG) – still has not banned the use of credit default swaps is a tribute to the power of the investment-banking lobby.

(Note to U.S. Rep. Barney Frank, D-MA, House Banking Committee Chairman: Ban credit default swaps now! It’s’s the one thing you can do to make up for the damage you did in shielding Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) during the housing bubble.)

There is another thing that we can do as well as banning CDS, and that is to impose a Tobin tax on trading, of some small percentage of each transaction. Much trading – especially short-term trading – is more or less just rent-seeking, making money on insider knowledge of the fund flows in the market.

When you hear that the major investment houses have electronic-stock-trading computers set up inside the stock exchange building – ostensibly, to provide them with faster access to the trading feed – you know the playing field is tilted. High-speed trading appears to earn about $5 billion a year for Goldman Sachs, the largest operator, and that $5 billion is just scooped out of the U.S. economy – without providing any value in return. A Tobin tax, even at a low rate, would yield billions of dollars in revenue to set against the budget deficit. More importantly, it would loosen the grip of the traders over the marketplace we all share.

Having banned credit-default swaps and introduced a Tobin tax, you would have solved much of the problem. The truly dangerous and damaging businesses would be eliminated – or at least would have shrunk in size – because their net profitability would be limited. (You need to do a lot of trades, each one of which would be Tobin taxed, to benefit from high-speed trading.)

The rest of the problem could be solved simply by applying stricter capital standards to banks with more than $1 trillion in assets and off-balance-sheet commitments that include derivatives and securitization vehicles. That would currently catch the top four banks – plus Goldman Sachs and probably Morgan Stanley (NYSE: MS).

For this to work, these standards would need to be applied internationally on a consolidated basis, and would have to be loophole-free. Setting them up would take time, because the big banks would battle to insert loopholes, as they did in the decade-long process negotiating the Basel II capital standards, which came into effect in January 2008, just in time to fail disastrously.

With those three protections, you wouldn’t need to break up the “too big to fail” banks. Passing a bill through Congress to do so with say a two-year delay might be helpful, however, just to have a threat to hold over them during the inevitable haggling and lobbying process for these changes.

[Editor's Note: Throughout the global financial crisis, longtime market guru Martin Hutchinson has managed to call both sides of the market correctly. During the market rebound that started in early March, Hutchinson assembled high-yielding dividend stocks, profit plays on gold, and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for savvy investors.

But his market calls before the meltdown that started last year were just as important. His warnings about the dangers of credit-default swaps - issued half a year before those deadly derivatives ignited the worldwide financial firestorm - would have kept investors who heeded his caveats out of ruinous bank-stock investments. In fact, Hutchinson even issued a highly accurate prediction of when and where the U.S. stock market would bottom out (a feat that won him substantial public recognition).

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and his "Alpha-Bulldog" stocks into winning portfolios. And the strategy is designed to work in any kind of market- bull, bear or neutral.
To find out more about the Alpha-Bulldog strategy - or Hutchinson's new service, The Permanent Wealth Investor - please just click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should.
• Wikipedia:
  Credit Default Swaps.
• Money Morning Market Commentary:
  Credit Default Swaps: A $50 Trillion Problem.
• Wikipedia:
  Glass-Steagall Act.
• Wikipedia:
  Giant Sucking Sound.
• Money Morning Investigation of the Banking Bailout Deals:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  Basel II Capital Accord.
• Wikipedia:
  Tobin Tax.
• Money Morning Special Report:
  High Frequency Trading: Wall Street’s New Rent-Seeking Trick.

Dr. Kent Moors is one of the world's foremost experts on oil, energy policy, finance, risk management and new technologies. Moors advises the leaders of six oil-producing countries, including the United States, as well as global corporations and banks operating in 25 countries.

Moors is the founder and director of the Energy Policy Research Group, which conducts analyses and makes recommendations on a range of energy-related issues. He is also the president of ASIDA Inc., a worldwide advisor on the oil-and-natural-gas markets.

In an interview with Money Morning Executive Editor William Patalon III this week, Dr. Moors detailed the top current energy challenges in the global economy, and also provided investors with a look at some of the looming new technologies, as well as a future in which China is a dominant global energy player.

Some of these issues are already at work. Although oil prices remain well below the all-time record of $147 a barrel set in July 2008, crude prices have been on the march of late. Just yesterday (Wednesday), in fact, supply concerns pushed oil futures up above $81 a barrel, their highest level in more than a year.

"If you think the run up to July 2008 was a wild ride, you haven't seen anything yet," Dr. Moors told Money Morning. "In the next five years, investors who focus on medium- to small-sized producers and oil-field-service companies having a well-developed specialty niche will outperform the overall energy sector."

Money Morning (Q): In an earlier discussion, you said that the successful energy investor of the future wouldn't be a person who just goes out and invests in ExxonMobil Corp. (NYSE: XOM). Can you explain?

Dr. Kent Moors: We are entering a period of rising prices. There is still some play left in the large verticals (vertically integrated oil companies, or VIOCs) such as ExxonMobil, but the primary profits will be made with smaller, leaner exploration-and-production (E&P) outfits, field-service companies and specialized producers (unconventional gas producers – shale gas, coal bed methane, tight gas, hydrates – heavy oil and biodiesel).

(MM): How will investors have to play this future? What types of companies should they be looking for, and where should they look?

Moors: The market rapidly approaching will be more volatile with valuation often more difficult to determine than in the past, even with prices increasing. How much of the increases result from actual product margins and how much results from oil becoming a financial asset rather than just a commodity is a major concern. It requires some careful homework. The types of categories mentioned above – smaller producers, new developments in field services and technology (especially those providing ways to decrease wellhead and operational costs, increase productivity, use associated gas, treat and utilize produced water, increase efficiency per barrel … there is a long list here) as well as the specialized producers and providers of their technical needs are the main targets.

(MM): When we look at the U.S. economy, you said that investors would be stunned to discover how much of our oil is produced by small players. In that discussion, in fact, you even described the type of firm that could be the "savior" of the U.S. energy sector, and perhaps even the economy. Could you take a moment to describe that situation and explain what that means for the economy?

Moors: The United States remains one of the top five producers of crude and will shortly ramp up production of natural gas (once the current glut has moved through the system). Sixty percent of crude produced in the U.S. market is at stripper wells providing less than 10 barrels of crude a day, but more than 20 barrels of water, a major byproduct. As America enters an accelerating field maturity curve (and an intensifying decline in well debit – well production), the efficiency of production declines. Therein lies a significant area for innovation and leaner companies. And that spells greater profitability at lower entry prices. Some offshore and Alaskan National Wildlife Refuge (ANWR) production will be done at scale, but that is not where the future of U.S. production will be. It will be the result of greater profitability at existing depleting wells with the new technology rolled out (on the oil side) and unconventional gas production.

(MM): Let's take a look at the global markets, too. China's global shopping spree has been well chronicled. As China locks up suppliers and supplies of oil and natural gas, what are the chances there could end up being what's almost a two-tiered market, where China has access to oil and natural gas at lower prices levels, creating a shortage of non-captive supplies and leading to Western countries having to pay much higher prices?

Moors: Price rises for Westerners will occur anyway, and not just because of China (where a rising energy bubble resulting from the recent acquisitions is a concern). The competition for available energy sources will usually result in those regions prepared to pay more, increasing the overall aggregate price for most others. China, India, a resurgent East Asia, Japan and even regions such as West Africa will occupy important positions moving forward in this regard. Also, rising demand will center in places other than OECD countries. The new oil market emerging can hardly discount the developed countries, but the primary demand spikes are going to come from elsewhere.

(MM): After some significant turmoil in recent years, you said that Russia is finally opening up to foreign investment. Will that last, and what effect will that have on global energy prices?

Moors: To offset a more rapidly declining traditional production base (primarily Western Siberia), Russia must move north of the Arctic Circle, into Eastern Siberia and out on the continental shelf. These moves are technologically sensitive and very expensive. Moscow needs the outside investment and that will remain. However, projects must be carefully structured. Foreigners cannot own 50% of "strategic fields" under new laws or anything on the shelf. This means watch out for the smaller, focused operators and oilfield service companies. They will include companies currently trading on the Alternative Investment Market (AIM) in London: The AIM and London Stock Exchange (LSE) are the sources of the new external investment phase in Russia.

(MM): From a global perspective, which markets show promise? And which ones – either because of overly restrictive investment policies, or because of the risk of nationalization – are markets to be avoided?

Moors: Many markets show promise or telegraph restraint. Let's look at some of the more noticeably promising markets, organized by energy category:

• Conventional Oil: Sub-Saharan Africa, Brazil, Kazakhstan, Russian Eastern Siberian and Far East smaller fields.

• Conventional Natural Gas: Turkmenistan (if recent government overtures to outside investment remain genuine), Uzbekistan, Northwestern Australia (region of the Gorgon project) and New Guinea.

• Unconventional Oil: Tatarstan (Russia) for bitumen and heavy oil, Alberta for oil sands (assuming an average and multi-year sustainable crude price of $72 [USD] a barrel or above).

• Unconventional Gas: The United States for shale (especially Marcellus Shale) and coal bed methane (Powder River Basin, Wyoming, also basin into Montana – if that state reduces regulations), Poland, Turkey and Germany for shale, south central Russia and Ukraine for coal bed methane. If Baghdad and Erbil can finalize central Iraqi and regional Kurdish oil legislation – and if security is maintained – Iraq will become a major play in both oil and gas.

• TO BE AVOIDED: Iran (sanctions and buyback contract frustrations), Mexico (collapsing infrastructure and nationalization), Venezuela (significant technical shortcomings, concerns over productivity assessments, and absence of Western operators).

(MM): If an investor were to divide the energy market into short/intermediate/and long-term segments, what will be the dominant energy plays (oil, natural gas, solar, coal-bed methane, for example) in each of those three time segments? What time periods would you tack onto the short-term, intermediate-term, and long-term segments? And which energy plays will be the real winners?

Moors: To make this easier to see, let's divide this into short-term, intermediate and long-term segments and look at the key players, issues and technologies in each category.

• Short-Term (five years out): Here we'll see an increasing efficiency at existing oil wells; Marcellus Shale natural gas; an extension of large fields into known deeper production layers – for example, BP-led (NYSE ADR: BP) multinational plays such as the Azeri-Chyrag-Guneshli and Shah Deniz deposits offshore Azerbaijan. Other developments to watch are the huge Chevron-led (NYSE: CVX) Tengiz field in Western Kazakhstan, initiatives in the central Gulf of Mexico and all satellite fields operated by other companies.

• Intermediate-Term (five to 15 years out): All U.S. and Canadian shale plays, Wyoming, Montana, New Mexico and Russian coal bed methane, selected wind power Western U.S. and Baltic Sea region (Denmark, Germany, Poland).

• Long-Term (20 years or more): All alternative and renewable energy (by this point, crude oil will be too volatile with supply problems and natural gas from whatever source will be the main power source both for conventional applications and for new technologies – fuel cells will obtain most of their price-sensitive hydrogen from natural gas).

Moors: Here's the bottom line. Looking forward, successful energy investors will be those who: (1) weigh volatility as well as opportunities; (2) understand the rapidly changing supply/demand balance; (3) hedge within a focused time-frame; (4) watch the development of new technology to improve production, processing or transport; and (5) have a flexible approach to the market.

(MM): Spotlighting and providing detail and in-depth analysis of the specific winners would require a much-more-detailed category breakdown than we have here. But stay tuned: Dr. Moors will delve into these topics in future issues of Money Morning.

[Editor's Note: As today's investigative story demonstrates, successful investors have to know when to act, and when to hold back.

But they also have to know where to look.

Like under the Eiffel Tower.

The French Oil Ministry has confirmed there is a 40-billion-barrel reserve under that historic landmark - enough to fuel total U.S. oil demand for 5.2 years, according to the Energy Information Administration.

And a tiny U.S. company is poised to profit from this $2.8 trillion cache of crude. Opportunities such as this are the kind of potential profit plays that we focus on in our monthly affiliate newsletter, The Money Map Report. This publication tracks global money flows, and helps subscribers identify precisely where those capital flows intersect with some of the most powerful economic and financial trends at play today.

For more information on The Money Map Report, as well as on the oil cache beneath the Eiffel Tower, please click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Three Reasons China is Positioned to be the Oil Sector's Next Big Profit Play.
• Montana State University:
  Frequently Asked Questions About Coal Bed Methane.
• Biodiesel.org:
  Biodiesel 101.
• Money Morning Commentary:
  Venezuela Says "Adios" to Most Foreign Investment, Making it a Stay-Away Play for Investors.
• Wikipedia:
  Vertically Integrated Oil Company.
• Schlumberger:
  Shale Gas.
• Wikipedia:
  Stripper Well.
• Policy Almanac:
  Arctic National Wildlife Refuge Policy History.
• Organisation for Economic Co-operation and Development: Official Web Site.
• WiseGeek.com:
  What is a Continental Shelf?
• Wikipedia:
  Alternative Investment Market.
• Google.com:
  Russia's Medvedev Signs Law on Arctic Resources.
• Wikipedia:
  London Stock Exchange.
• Lloydminister OTS:
  What is Heavy Oil?
• Wikipedia:
  Powder River Basin.
• Energy Tomorrow:
  Canadian Oil Sands.
• About.com (Archaeology):
  Bitumen.
• Oil Shale Gas:
  Marcellus Shale.
• HowStuffWorks:
  How Fuel Cells Work.
• Tatarstan:
  Official Web Site.
• Forbes.com:
  Australia's $37 Billion Gorgon Project Gets the Go-Ahead.
• MarketWatch.com:
  Oil hits new one-year high above $80 after report

Of the 41,572 people polled, it now looks like those 31,179 bullish investors kept their word.

The Standard & Poor's 500 Index has zoomed 15% since those investors were polled (and 53% from its March 9 market bottom).

Let's face it. A 75% bullish inclination is a disproportionately high percentage. It's way out of the norm. 

What those 31,179 bulls are telling me is … well … we'd better watch out. Statistically, the individual investor excels at making the wrong decision at precisely the worst possible time. I view this survey as yet more evidence that the "herd" may once again be heading down the wrong path.

After the collapse of Lehman Brothers Holdings Inc. (NYSE: LEHMQ) investors yanked more than $120 billion out of equity mutual funds. That's more than the total amount of money investors poured into these funds during 2007 and 2008, a period when exuberance was at its height, according to Money magazine.

And after the S&P 500 hit its March low, most people missed the subsequent rally – 32% through June 23, when the CNNMoney poll was concluded – a run-up that could have mitigated their enormous losses.

The disturbing reality is that investors chase hot money and hang onto losers.  Most individuals have an awful sense of timing – as well as an unending tendency to act irrationally.

According to a recent Dalbar/IFA study, over-exuberant investors can lose a lot of money.  For example, the S&P 500 returned 11.81% a year on average between 1989 and 2008.  The "exuberant" gain-chaser scored 4.48% in the same time frame. Factor in inflation and the average investor gain disappears completely (See accompanying chart). You could have done better in a bank savings account!

Hope For the Best, Prepare For The Worst

That brings us back to the two most pressing questions of our time:

• What's going to happen next?
• And what should we do about it?

Although pundits are spewing forth about an "improved" outlook for the U.S. economy, history tells us that we're more likely to see a stock-market correction in the near term.

Over the last half a century, stock-market rallies that follow the horrific declines we've seen over the past 24 months are typically followed by a secondary decline of 14% to 50%.

What will happen after that is anybody's guess. According to a study by Ned Davis Research, any secular bull market that followed a recession in the last 100 years resulted in gains in excess of 60% during an 18-month stretch. In situations where that rally was actually the catalyst for a resurgent economy, stocks averaged 110% over the next 36 months.

But we also have to remember that the bear market that started all this grew out of the worst financial crisis since the Great Depression. According to longtime investor Jeremy Grantham, the record deficits, stimulus packages and bailout packages have "reduced to guesswork" any market forecasts (as reported in CNNMoney).  That's probably why Grantham recently warned clients: "If you feel overconfident about anything, take a cold shower and start [analyzing] again. Just be patient. In our strange markets, you usually don't have to wait too long for something really bizarre to show up."

Here at Money Morning, I've been counseling readers for more than a year to think long term. My advice is to preserve your wealth by navigating the near-term chaos. Stifle the knee-jerk urges to buy or sell.  If you succumb to the urge to follow the herd, the crowd will inevitably lead you down the wrong path. And probably at the worst possible moment.

Instead, follow these five strategies:

1. Position Your Portfolio: Develop a portfolio structure you can live with – such as the 50-40-10 allocation model we recommend in our monthly sister publication, The Money Map Report. That way you can take all sorts of economic contingencies into account, while still maintaining a steady course that emphasizes sound "safety-first" choices, portfolio stability and high income. How much stability should you be looking for? Our 50-40-10 model is typically 30% less volatile than the broader markets. But it can dramatically outperform the broader indices on the upside.

2. Limit Your Losses: Invest no more money than you can afford to lose. This sounds simple, but you'd be amazed at how many of the thousands of investors I've talked with through the years still don't get it. They view themselves as "investors," when they've actually become "speculators." One Texas man I know lost half his wealth during the past two years. When I asked why he'd put so much money at risk, he shrugged and replied: "Because I could."

Get your strategy in place then pick specific investments that keep you within the guidelines you established. Focus on global stocks with high dividend yields. And make sure you include a healthy dose of energy, technology and inflation-resistant holdings. Such stocks tend to blossom at the first signs of a real recovery – just like they have after every other documented economic downturn in history.

And finally, always make sure to manage your risk. Limit speculative positions to 2% to 5% of your overall portfolio value. That way even a total loss in one holding won't be enough to eviscerate your portfolio.

3. Avoid Surprises: In my talks with audiences all around the world, listeners are often the most surprised to learn that successful professionals  don't wake up with thoughts of how much money we can make each day. Instead, we think about two things from the time we get up until the time we go to bed:

• What's the most likely thing that could cause me to lose money today?
• And how can I avoid that?

In other words, concentrate on understanding what it is that you don't know. And then make sure to steer clear of that potential pitfall. It's an approach that helps you make better decisions. Don't swing for the fences and risk a strikeout each time you come to bat. Instead, make up your mind to go for much-higher-probability singles and doubles. Risk aversion should be your new mantra, especially now.

4. Risk Less – By Saving More: This is actually a neat little trick. Classic market theory holds that to generate bigger returns, you have to have to take on more risk. That's true – as far as it goes. But here's what that adage doesn't address: By taking some simple steps to save more, you can actually accumulate wealth more quickly than by the increased levels of risk most investors are relying upon at the moment.

5. Don't Let Yourself Get Whipsawed Out of the Market: Investors who prepare for only one kind of market are the most susceptible to panic selling. To them, investing is an all or nothing propostion. As we highlight in Money Morning, you've got to prepare for both "up" and "down" markets. And you do so with some simple hedging strategies. Hedging, after all, isn't just for hedge funds. In fact, everyday people just like us can use them very effectively, which is why we encourage our readers to do so. You see, if you've prepared for "up" and "down" markets, you no longer have to actually "predict" what the markets are going to do. Then you can focus on finding quality companies with real earnings, a healthy dose of overseas sales and high income.

Once these five strategies are in place, you can turn your money loose to do the work it wants do for you. And you can sit back and enjoy beating the so-called "smart" money – practically no matter what the stock market does next.

[Editor's Note: As Money Morning Investment Director Keith Fitz-Gerald's market analysis demonstrates, success as an investor requires knowing when to act.

But it also requires knowing where to look.

Like under the Eiffel Tower.

The French Oil Ministry has confirmed there is a 40-billion-barrel reserve under that historic landmark - enough to fuel total U.S. oil demand for 5.2 years, according to the Energy Information Administration.

For more information on The Money Map Report, as well as on the oil cache beneath the Eiffel Tower, please click here.]

News and Related Story Links:

• CNNMoney.com:
  Make fear and greed work for you.
• IFA Institutional Investors:
  The Average Investor's Return Compared to Indexes.
• GMO LLC:
  Waiting For Markets to be Silly Again (Jeremy Grantham).
• Ned Davis Research:
  Official Web Site.
• Money Morning Investment Research Report:
  Make Inefficient Markets Work For You.
• Money Morning New Market Rules Series:
  Five Wall Street Whoppers And Why You Need To Know Them.

With this recent rush of upbeat economic news, it's no wonder commentators are trumpeting the rebound of the U.S. economy.

But I think it's time to short U.S. stocks.

Shocked?

Don't be.

What most experts see as a strengthening U.S. rebound, I see as an increasingly dangerous "false dawn" – for these two key reasons:

• An overly expansive monetary policy that's almost certain to spawn inflation.
• And a record-level budget deficit that will cause interest rates to spike, crimping economic growth.

A Foundation for Trouble

U.S. policies that were intended to combat the financial crisis that broke last year – as well as the recession that's been plaguing us since December 2007 – have actually inflicted a lot of weakness upon our economic system.

For instance, the federal government has made $11.6 trillion in financing commitments, many of which will saddle us with debt for generations – some of it forever. Outlays of that magnitude in a $14 trillion economy are bound to have lasting implications: Think of the consumer who has a series of maxxed-out credit cards – he'll make the minimum payments, but the actual balance will never get paid down.

And the foundation for this financial fiasco was actually constructed several years ago.

After the bursting of the 1996-2000 "dot-com" bubble, the U.S. Federal Reserve re-inflated the money supply. That caused stocks to resume their upward march, and as we now know, also inflated a housing bubble of such enormous size that it caused a general financial-system crash when that real estate bubble burst in 2007-08.

This time around, the Fed has been even more expansive. The benchmark Federal Funds Rate was 1.0% in 2002-04. This time it is 0.25%. What's more, this time around we've had a $2 trillion expansion of the Fed balance sheet, a doubling of the monetary base and $300 billion worth of direct central bank purchases of government debt. Given this orgy of Fed expansionism, it's likely that the onset of inflation – whether it's in consumer prices or asset prices – will be correspondingly worse. In fact, we're already seeing that gold prices are once again making a run at their all-time high. And crude oil hovers at about $70 per barrel, a level that would have been unimaginable before 2004.

Now that he's been nominated for reappointment, U.S. Federal Reserve Chairman Ben S. Bernanke says he will tighten monetary policy in good time. But why should we believe him? If he tries to tighten significantly, he will incur the wrath of the Obama administration and the Democrats in Congress.

Even back during the 2001-04 time frame – when there was an administration in place that claimed to believe in monetary stringency – the Fed didn't tighten. Bernanke himself was among the most aggressive opponents of tightening. Back in 2002, in fact, when inflation was running at a perfectly respectable 2%, Bernanke actually spun myths about the imminent onset of "deflation."

Given what we know, it seems that if the current economic bounce shows even the slightest signs of faltering, Bernanke won't tighten – he'll pump even more money into the U.S. financial system. Rest assured that the administration, Congress, and much of the media will be cheering his move.

Borrow Now, Hurt Later

If an overly expansive monetary policy was the only problem we faced, it might not be so bad. Unfortunately, there's more.

Lots more.

Unlike in 2002 – in fact, unlike any other time in U.S. history – this country now has a budget deficit in excess of 10% of gross domestic product (GDP). For fiscal 2009, that was forgivable: We've had a major recession, and a shattering financial crisis, which the federal government has tried to battle with aggressive bailout programs.

Here's the problem, however: The projected deficit remains above 10% of GDP for fiscal 2010, even though no additional bailouts are contemplated and the Obama administration is projecting a modest-but-steady economic recovery.

The result is harder to predict – this country hasn't travelled down this particular path before. This strategy bears some resemblance to the position Japan found itself in during its so-called "Lost Decade" of the 1990s. But even Japan's deficit never reached this 10% threshold.

In Japan, the effect seems to have been the gradual abandonment of small business finance, and the resulting starvation of the most critical factor in economic growth – entrepreneurship.

The small-business sector creates most of the new jobs in the U.S. economy. But in a challenging environment, it's easy to see why this sector gets overlooked. Without political connections or large contracts to hand out, the small-business sector ends up being last in line in the financing queue when the economy faces strong headwinds. Why should banks or other people lend to small businesses when the U.S. government bond market stands as such as huge, safe parking place for their cash?

Interest rates will also become an issue. With the inflationary pressures we expect to see from the overly expansive monetary policy we've described, long-term interest rates are likely going to rise anyway. As was the case in Japan's decade-long malaise, these forces will combine to spark high default rates in the banking system, low or zero economic growth, and a general downward trend in the stock market.

All of this will make it tough for small businesses to obtain the cash they need to grow, meaning this key job-creation engine will have to sputter along.

It's still early in the game, and there are many factors to consider, so the future economic picture remains a bit murky right now. But my guess is that the bubble in asset prices will be largely confined to commodities, that economic growth after this current initial burst will relapse, and that U.S. stocks will prove to be the same generally unattractive investment that they were in 1970s – the era of the so-called "Nifty Fifty." If the stock market bubble gets even more exuberant from here, the relapse will be correspondingly more painful.

Profitable Pockets

Despite this dour backdrop, three things are worth remembering:

• First, all U.S. stocks are not created equal. Although I'm saying it's time to short U.S. stocks, and I see tough times ahead for the key indices, there will always be individual stocks worth consideration, such as the "Alpha Bulldog" stocks I highlight in the Permanent Wealth Investor service.
• Second, the best way to play this looming downdraft – either as a direct profit opportunity or as a way of hedging your current portfolio – is through the use of what I like to call "Stage 3" investments. An example of one such investment is long-dated "put" options on the Standard & Poor's 500 Index, which trade on the Chicago Board Options Exchange. If you buy these options when they are way "out of the money" with a strike price far below the current price, in a real bear market (like that of 2007-09), you will see them really zoom up in value as the S&P drops down closer to the strike price, or possibly even falls below it.
• And third, understand that my pessimism about the U.S. market doesn't apply to every other market around the world. While the monetary problems are more or less global, the budget-deficit problems are not. For instance, you might want to consider investments in Japan, where a recent election should spawn the kind of economic changes that will benefit savvy investors. Germany, too, looks to have avoided the contagion of "stimulitus," which is why its economy is now viewed as one of the healthiest in Europe. Consider the iShares exchange-traded fund (ETF) entry for each of those two markets: The iShares MSCI Japan Index Fund (NYSE: EWJ) and the iShares MSCI Germany Index Fund (NYSE: EWG). They each warrant a look.

News and Related Story Links:

• Money Morning Special Report:
  Goldilocks, Gloom or Doom? Three Views of a U.S. Recovery.
• The Conference Board:
  The Conference Board Leading Economic Index™ (LEI)
• Money Morning Investment News Briefs:
  U.S. Manufacturing Rebounds in August.
• Wikipedia:
  Dot-Com Bubble.
• Wikipedia:
  Federal Funds Rate.
• Money Morning Mid-Year Forecast:
  Oil Prices Due for a Short-Term Setback, Although Long-Term Outlook Remains Bullish.
• Money Morning Special Report:
  Commodities: The One Profit Play Investors Can't Afford to Ignore.
• Money Morning Mid-Year Forecast:
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• Money Morning News Analysis:
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• Money Morning News Analysis:
  With Reappointment in the Bag, Fed Chairman Ben Bernanke Turns to Face Troublesome New Challenges.
• Wikinvest:
  Nifty Fifty.
• Money Morning Special Report (Part I):
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan's Ten Years of Misery – And How to Play it.
• Money Morning Special Report (Part II):
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan's Ten Years of Misery – And How to Play it for Profit.
• Money Morning News Analysis:
  Landslide Election Victory in Japan Will Lead to an Avalanche of Future Profits For Global Investors.

Gold broke through the psychologically important $1,000-an-ounce level for the first time in 18 months yesterday (Tuesday) as the U.S. dollar slumped against key foreign currencies, exacerbating investor fears that loose fiscal and monetary policies will spur inflation as the U.S. economy recovers.

The thinly traded September futures contract for gold traded as $1,006.90 an ounce on the COMEX division of the New York Mercantile Exchange, or NYMEX (Nasdaq: CME), the highest level for a short-term futures contract since March 18, 2008, MarketWatch.com reported. The contract closed the day yesterday at $997.90, up $3, or 0.3% for the trading session.

The London gold fixing – a global benchmark – traded as high as $1,000.75 an ounce yesterday. Its previous high was also on March 18, 2008.

Now that gold has pierced that technical barrier, some analysts are looking for the yellow metal to return to its all-time-record high of $1,033.90 an ounce – a record set last March.

"The higher the price, the higher the volatility, but this market is so concerned with inflation possibilities and dollar weakness that momentum is bringing more investors to the 'Buy' side," George Gero, a precious-metals trader for RBC Capital Markets (NYSE: RY), told MarketWatch.com.

Gold struggled to breach the $1,000 price level last week. Yesterday's surge corresponded with a drop in the value of the U.S. dollar, which fell to its lowest point versus the euro this year.

"We had a good technical break higher last week and now the weaker dollar is helping gold progress higher," Saxo Bank senior manager Ole Hansen told Reuters. "We are finally taking out some levels we haven't seen for a while, especially in the currencies. On that basis, I would assume we will go up to test the highs from last year."

The dollar fell as low as $1.45 per euro in morning trading yesterday, its weakest level since Dec 18, 2008, according to Bloomberg News. The euro has risen by about 15% against the dollar in the past six months.

Analysts have warned for months that the combination of a soaring budget deficit and expansive monetary policy could weaken the dollar and spur inflation.

The federal budget deficit for 2009 will reach a record $1.6 trillion, more than three times 2008's record deficit of $455 billion, the White House's Office of Management and Budget (OMB) and the Congressional Budget Office (CBO) said last month.

From 2010 to 2019, the deficit will balloon to $7.14 trillion, the CBO says, while the White House paints an even uglier, $9 trillion picture for the same period.

Meanwhile, the U.S. Federal Reserve has injected more than $2 trillion into the U.S. financial system and its benchmark lending rate remains at a record low range of 0.00%- 0.25%.

U.S. Federal Reserve Chairman Ben S. Bernanke has provided few clues about exactly what his so-called "exit strategy" will involve, or when it will be implemented. However, the Fed chairman has said that the Federal Funds rate will remain "exceptionally low" for "an extended period" of time, as the U.S. economy trudges toward recovery.

Few analysts believe Bernanke will even start to rein in the Fed's fiscal stimulus before he's absolutely certain an economic recovery is underway. Now, with the belief that inflation is hiding around the corner, investors are piling back into gold to hedge against the dollar's decline.

"In the last year alone, the U.S. Federal Reserve has actually doubled the U.S. monetary base," said Peter Krauth, a Money Morning contributing editor who is also the editor of the Global Resource Alert trading service. "That can only lead to serious inflation, perhaps even hyperinflation. This will cause the value of the U.S. dollar – which has been eroding since 2001 – to decline at an even-more-frenetic pace."

Krauth expects that gold prices will shoot even higher in the months and years to come, not just because of the dollar's devaluation, but because demand is on the rise and global mining output is in decline. Global mine output has decreased at an annual compound rate of 0.8% from 1999 through 2008, according to GFMS Ltd.

In the meantime, demand for the yellow metal has skyrocketed. During the fourth quarter of 2008, for instance, North American and European purchases of gold coins and gold bars rose 811% over the same period the year before. And while demand for jewelry has flattened, new investment vehicles have made purchasing gold much easier for the average investor.

"Exchange-traded funds (ETFs) have been a tremendous catalyst for swelling gold demand," said Krauth, noting that the SPDR Gold Trust (NYSE: GLD) – the largest physically backed ETF on the planet – is now the sixth-biggest holder of gold bullion in the world.

The SPDR Gold Trust fund held 1,077.63 metric tons of gold totaling more than $34 billion in value as of yesterday, according to its Web site.

"Indeed, the fund's influence on the market is such that it actually seems as if every year or so it moves up past year another nation in the global rankings of gold-bullion holders," said Krauth.

Buying the SPDR Gold Shares is one way to get in on the gold rush. The fund's price fluctuates in concert with the price of gold and it's more convenient than buying gold bars directly.

For investors who are looking to hedge against the enormous inflationary pressures that are believed to be filtering through the U.S. economy, buying stakes in gold miners is another potential strategy to follow.

In this case, the Market Vectors Gold Miners ETF (NYSE: GDX) – composed chiefly of major gold miners – offers both company and geographic diversification, while including substantial leverage to the price of gold. Market Vectors is based on the AMEX Gold BUGS Index (HUI), which represents a portfolio of 15 major gold mining companies that do not hedge their gold production beyond a year and a half.

[Editor's Note: If you're new to the commodities-investing arena, and are uncertain about the landscape - or even if you're an "old hand" at natural-resource stocks, but want some insights into the new profit plays and new players - consider hiring a guide: Money Morning Contributing Editor Peter Krauth, a recognized expert in metals, mining and energy stocks, is also the editor of the Global Resource Alert trading service, which ferrets out companies poised to profit from the so-called "Secular Bull Market" in commodities. A former portfolio advisor, Krauth continues to work out of resource-rich Canada, which keeps him close to most of the companies he researches. Against the growing global financial malaise, Krauth says that commodities are among the most-profitable and least-risky investments available, and notes that this may well be the most powerful bull market for commodities we'll see in our lifetimes. He makes a strong case. To read more about his strategies, and the sector plays he likes the most, please click here.]

News and Related Story Links:

• Money Morning:
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• MarketWatch.com:
  Gold ends below $1,000; Futures hit 18-month high in session.

• Money Morning:
  With Inflation on the Horizon, Gold Prices are Ready to Rally

• Reuters:
  Gold eyes record as dollar and inflation stars align

• Money Morning:
  Slow Economic Recovery will Lead to Record Deficits

• Money Morning:
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• Money Morning:
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• Money Morning:
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In short, even though the economy has improved, the odds of a "jobless recovery" continue to grow.

Employers shed 216,000 jobs in August, an improvement over the 276,000 positions eliminated in July. However, the unemployment rate still swelled to 9.7% – its highest level since June 1983. The total number of jobs lost since the recession officially began in December 2007 now stands at about 6.9 million.

The overall employment picture is even bleaker when part-time employees that would rather have a full-time job and discouraged workers who are no longer looking for a job, but who would take one if it were available. The unemployment rate actually rises to 16.8% when those individuals are taken into account.

It is believed that the total number of people unemployed in the United States is about 15 million, and that number is expected to climb substantially for the remainder of the year and well into 2010.

The Congressional Budget Office (CBO) says unemployment will peak at 10.4% next year before receding to an average of 9.1% in 2011.

"High unemployment rates are going to be with us for quite a while," Michael Feroli, an economist at JPMorgan Chase & Co. (NYSE: JPM), told The New York Times. "It's going to be a long, long time before we see 6% or 7% unemployment."

Worse yet, a record number of workers have been unemployed for six months or more, and many others are starting to use up their unemployment benefits, their extended benefits, and even emergency payments from the government.

More than 500,000 unemployed Americans will run out of their 20 weeks to 53 weeks of benefits by the end of September, according to the National Employment Law Project. A further 1.0 million people will see their benefits expire by the end of the year.

With such a dour outlook for the future, the possibility that the U.S. economy is headed for a jobless recovery – where companies make up for lost profits by keeping their headcounts low – is becoming a reality. And that's if the economy actually recovers at all.

"There's no such thing as a jobless recovery – we need jobs to have a recovery," Kevin Mahn, a managing director of Hennion & Walsh told SmartMoney. "Until we start seeing positive signs in consumer spending and in the jobs market, we won't see a sustainable recovery. If, in fact, we don't see the consumer coming back to the table, we're going to see degradation in corporate earnings in the third and fourth quarter."

Consumer spending accounts for 70% of the economy by some estimates, and so far the little consumer activity the economy has seen in recent months has been the direct result of government stimulus programs.

Retail purchases rose 0.2% in July, but that increase was largely the result of the government's Car Allowance Rebate System (CARS), popularly known as "Cash for Clunkers," which drove a 1.8% increase in durable goods spending. Sales of cars and light trucks rose to an annual pace of 11.2 million units in July – the most since September 2008.

Analysts anticipate a significant drop in sales now that the Cash for Clunkers program has run out of gas.

"The reality is that clunker cash is ultimately an unsustainable fuel source for consumer spending," Richard Moody, chief economist with Forward Capital, wrote in a note to clients. "Restrained growth in consumer spending beyond [the third quarter] is one factor behind our forecast that what will be fairly rapid real GDP growth for [the third quarter] will not be sustained over subsequent quarters."

Incomes remained flat in July after dropping 1.1% in June. That led to a 0.3% drop in purchases of non-durable goods. Consumer spending fell 1% in the second quarter.

And just as the Cash for Clunkers program bolstered consumer spending, the housing market was buttressed this summer by an $8,000 tax credit for first-time homebuyers. Existing home sales rose 7.2% to a 5.24 million annual rate in July – the most since August 2007.

However, the supposed "bottom" of the housing market might not have come so soon without the government tax credit, which is set to expire in November.

"I'm not seeing a tremendous amount of good news on the job or economic front, so I do think it's important that the [tax] credit get extended," Richard Dugas, chief executive officer of Pulte Homes Inc. (NYSE: PHM), told The Associated Press.

To be sure, job losses are trending down, but the losses being sustained are still chipping away at the American consumer and the economy as a whole.

"The economy is no longer detonating, but we are still losing jobs," David Rosenberg, chief economist at Gluskin Sheff + Associates Inc., said in an interview with Bloomberg Radio. "It's going to be a very tough environment for the consumer."

News and Related Story Links:

• SmartMoney:
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• Bloomberg:
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• Money Morning:
  With U.S. Consumers Now Uncertain and Unemployed, is Hope for a Quick Rebound Fading Away?

• Money Morning:
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• Money Morning:
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• Money Morning:
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• Money Morning:
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• New York Times:
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• Money Morning:
  Economic Outlook Improves, But Unemployment and a Possible Jobless Recovery Remain Wild Cards, Bernanke Warns\

• Money Morning:
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However, recent evidence suggests that the financial services industry in Asia – particularly China, which was largely isolated from the toxic assets that caused the crisis – is starting to rebound.

Indeed, many global financial firms are picking up hiring in Asia even as broad unemployment continues to rise. The reason: These financial firms want to be most active in the region of the world that has the best potential for growth, as well as the best opportunities for profit.

“The death of the industry has been greatly exaggerated,” Matthew Hoyle, founder of Matthew Hoyle Financial Markets, a Hong Kong-based headhunter for the banking and hedge fund industries, told the New York Times. “I am actually quite excited about the prospects for the rest of the year,” adding that “Things have picked up here — unlike in Europe and the United States, where that’s absolutely not the case,” he added.

Financial firms slashed 19,000 jobs in August – the 21st consecutive monthly drop for the industry, according to payroll processing firm Automatic Data Processing (ADP). The finance and insurance sector has shed 332,000 jobs since the recession began in December 2007. And the losses will likely keep piling on.

Labor Department data set to be released today (Friday) is expected to show the U.S. unemployment rate surged to 9.6% in August after dipping to 9.4% in July. From December 2007 to July 2009, the economy as a whole shed 6.7 million jobs.

“There’s a gradual improvement in labor markets underway in the sense that the monthly losses are diminishing,” said Joel Prakken, chairman of Macroeconomic Advisors LLC and an ADP spokesman. “The disappointing news it that we have several more months to go of job losses.”

There’s a similar story unfolding in Europe, as well. The unemployment rate across the 27 European Union countries rose to 9% in July from 8.9% in June, while the unemployment rate for the 16 countries that use the euro jumped to 9.5%, according to Eurostat.

As in the United States, many of the job losses have been sustained in the financial services sector. European banks and financial firms have cut 140,000 jobs since the third quarter of 2007, according to data compiled by Bloomberg.

About 84,000 European finance jobs are expected to hit the chopping block this year, according to a recent report by City of London Corp. That’s nearly ten times the number of finance jobs the region lost in 2008.

As the Europe’s largest employer of financiers, the United Kingdom will be most affected. It is expected to lose up to 35,000 finance jobs this year.

Employment at British, French and German financial services firms won’t return to its early-2008 highs until at least 2013 the report said. Even then, the United Kingdom will have 10,000 fewer finance jobs than it did in 2008.

The EU financial services industry employed about 1.4 million people and was worth about $315 billion (219 billion euros) at its peak in 2008, according to City of London. However, the entire industry will shrink 6.2% in 2009 and not return to growth until 2011.

“I’m fairly optimistic on the financial sector returning to profitability, but that won’t necessarily feed through to dramatic employment growth,” Alistair Milne, a senior finance lecturer at London’s Cass Business School, told Bloomberg.

Financial firms will be focused on “growth efficiency” over the next four years and “earning money out of the staff they’ve got at traditional businesses” such as fixed income, equity trading and derivatives trading, Milne said.

Asian Growth a Beacon for Financial Firms

While the financial services sectors in the United States and Europe continue to shrink, finance firms operating in Asia are already rebuilding.

Standard Chartered Bank said last month that it would recruit 850 bankers in the next 12 to 18 months. The majority of those hires will take place in China, but significant numbers will also to be added in Singapore and Malaysia.

"We have aspirations to double the industry growth rate and double our customer numbers in three years,” Foo Mee Har, Standard Chartered's global head of premium banking, told the Telegraph.  

Household wealth in Asia, outside Japan, was expected to grow by 12% annually until 2012, she added.

Meanwhile, HSBC Holdings PLC (NYSE ADR: HBC) said last week that it is recruiting more than 100 staff members in Hong Kong, and it plans to add 1,000 employees in mainland China this year.

Vincent Cheng Hoi-chuen, chairman of HSBC's Asia-Pacific unit, even said that his company hopes Shanghai will grow into a financial center that rivals Hong Kong.

“I sincerely hope that Shanghai will become a financial center, as China is able to have two centers, given its size," he said. "There should be enough capacity for companies to list in both or either market at the same time, despite more and more companies planning to go public in the capital market."

And Australia and New Zealand Banking Group, which competes with Standard Chartered, expects to increase its staff in the retail banking business in China more than 10-fold to over 500 by 2012. The company is currently moving ahead with a plan to open more than 20 branches in the country by 2012, up from three currently.

In addition to these recently released plans:

• Bank of America Corp. (NYSE: BAC) added five senior staff to its Asia Pacific Commodities team and JP Morgan Chase & Co. (NYSE: JPM) added seven members to corresponding Asia commodities unit.
• Credit Suisse Group AG (NYSE: CS) added nine specialists to its Asia sales and trading business. (Credit Suisse’s Asia-Pacific operations are on track to contribute 25% of the firm’s total revenue in coming years.)

• And Citigroup Inc. (NYSE: C) said it plans to expand its commodity team in Asia at a “double-digit” pace in a bid to capitalize on rising demand for raw materials.

“Asia will be the biggest contributor to growth in commodity consumption,” Ananth Doraswamy, regional head of commodities, told Bloomberg in an interview from Singapore. “We will need more people in energy trading and metal sales, as well as agricultural products.”

A survey by Singapore-based recruiting firm Robert Walters showed that job advertisements in Hong Kong, Singapore, China and Japan jumped 6.4% in the April-June quarter from the three months prior, the New York Times reported.

That’s not surprising considering that unemployment in Hong Kong, Singapore, and Japan – at 5.4%, 3.3%, and 5.7% respectively – are still relatively low when compared to the United States and Europe. And while unemployment is still an issue in China, that country’s economy expanded by 7.9% in the second quarter, exceeding most analysts’ expectations, and lending credence to Beijing’s goal of 8% annual growth.

Indeed, the finance industry seems to have found greener pastures in Asia, where economic growth is still taking place.

“Asia is seen as a growth market,” Robert Walters’ Mark Ellwood told The Times. “Companies are not going out all guns blazing again, but there is once again an appetite to hire in certain areas.”

News and Related Story Links:

• New York Times:
  Finance Jobs Hint at Recovery in Asia
• Bloomberg:
  Finance Jobs Won’t Return Before 2013, Report Says
• City of London Corp:
  European financial services industry ‘will play crucial role in economic recovery across the EU’
• Telegraph:
  Standard Chartered to hire 850 bankers
• The Standard:
  HSBC bets on Shanghai as financial center
• Bloomberg:
  Citigroup Seeks ‘New Blood’ for Asian Commodity Team

But the reality is that this tectonic shift in global finance – and the economic shockwaves that will result – could provide investors with some of the greatest profit plays they’ll see in their lifetimes.

No matter which camp you’re in, the China-spawned changes are headed our way.

In 1990, the U.S. banking system was 2.3 to 2.7 times the size of its counterpart in China. Today, however, the situation has been reversed, and there is much more of an imbalance. In fact, China’s banking system has 25 times the reserves of the U.S. Federal Reserve.

At some point, the United States will no longer be able to dictate international monetary policy. Unfortunately, as our monetary policy aptly demonstrates, Washington seems to be the only player involved in this game of high-stakes global finance to not understand just how this is destined to play out.

U.S. leaders continue to employ monetary policy as a weapon – despite the fact that most of the rest of the world views the U.S. dollar as a liability.
At the end of World War II, virtually the entire world functioned on dollars. By some accounts, 100% of the world’s money supply was the dollar. Today that figure has dropped all the way down to 19%, says Rochdale Securities LLC analyst Richard Bove, a noted expert on the U.S. banking system and Federal Reserve.

Now that the federal government has deployed a few trillion dollars more as bailout bucks, it’s clear that the greenback has lost its mojo and the U.S. government has lost its international monetary leverage.

Why is this worrisome? History tells us that the countries with the strongest economies tend to also have the strongest currencies. It may take awhile for the latter to catch up with the former, but the relationship is highly correlated relationship – suggesting that China’s on the rise economically, while its currency is advancing with the unstoppability of a diesel locomotive operating at full throttle.

So if the U.S. dollar gets derailed as the world’s chief reserve currency – as we’ve repeatedly predicted is destined to take place – the world’s next reserve currency is likely to be China’s yuan, known officially as the renminbi.

Washington says that won’t happen, since Beijing takes steps to keep the yuan from being fully tradable. That’s true enough. But Beijing also understands that the dollar is a liability – which is why China’s leaders are going to great lengths to establish the yuan as a viable currency all its own, while simultaneously minimizing the Red Dragon’s dollar-based exposure.

In the last six months, for example, China has signed at least $95 billion in swap agreements, under which it can trade directly with countries for payment in yuan. The countries that sign these deals are getting huge discounts from China in exchange for their participation – and for buying goods from China. And the deals enable China to do an end run around the entire dollar-based currency trading system.

When it comes to this long-term plan to boost the yuan’s importance, China is waging a campaign on multiple fronts. This past spring, for instance, China organized a meeting in Moscow – attended by representatives from Brazil, India and Russia – where the main goal was to supplant the U.S. dollar as the world’s main reserve currency, replacing it with a yuan-led market basket of currencies, one that is simply backed by China’s renminbi, or perhaps even one based on the International Monetary Fund’s so-called Special Drawing Right (SDR).

Created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system, the SDR was redefined in 1973 as a basket of currencies. Today, the SDR consists of the euro, Japanese yen, pound sterling, and U.S. dollar.

My guess is that this gathering in Moscow was merely the first of many such meetings that we’ll see take place around the world in the years to come. Expect the list of attendees to grow, as well.

Given all that we now know, the real question becomes: What happens if China succeeds and the yuan displaces the greenback as the world’s top transactional currency?

The list of potential implications is very long, and includes several scenarios that are almost apocalyptic. But most of the outcomes raise as many questions as they answer.

Let’s consider the Top Five:

• Global Gloom Leads to U.S. Doom: The U.S. dollar goes into freefall for the simple reason that if no country has to hold dollars any longer, they won’t. Instead – thanks to the ragged state of the U.S. government’s finances – many countries will dump greenbacks fast as they can, which will only put additional pressure on an already-strained U.S. financial system, which in turn will further damage our economy.
• Inflation Inflates: Inflation will strike here with a vengeance, as anything bought, sold or priced in dollars will instantly rise in price to offset this fall.
• Repatriation Risk: With the dollar serving as the world’s de facto currency, U.S. companies bear very little exchange rate risk when the time comes to repatriate assets or make currency-related adjustments. That would change overnight and prices throughout the value chains would rise sharply to compensate.
• Money Costs More: The cost of money itself would rise. If the dollar falls, not only will there be massive selling pressure against it, but the cost of borrowing it will rise dramatically as lenders raise rates to cope with the increased risk of dollar-based transactions.
• Death By Debt: And finally, if there is another reserve currency, other countries will no longer have to buy our debt, and you can guess where that will leave us – especially given the fact that we’ve taken on trillions in new debt to help finance our way out of our current mess.

My best guess is that we won’t see any one of these things in isolation, but will instead experience a blending of several or all of them. To the extent that China continues to absorb our inflationary influences, buy our debt in measured doses and maintain its reserves, we’ll probably have a measured decline in the value of the dollar – but not the catastrophic fall many in the doom, gloom and boom crowd are predicting. At the same time, I also see the IMF change course in the next few years to reflect China’s increasingly substantial influence and monetary power.

On the individual investor level, this clearly provides a new set of influences that most investors have yet to grasp. Most will perceive what I have said as a threat, but I believe the correct way to view this is that there will be a whole new set of opportunities coming our way.

Some of those opportunities will be obvious – like the need to invest in currencies and commodities that are of interest to China. Others, like direct investments in China’s yuan, will require special insight, a good investment guide, or a leap of faith.

The bottom line – and the most important thing to remember – is this: No matter how this plays out, there will always be an upside for investors who are willing to seek it out.

News and Related Story Links:

• Money Morning News Analysis:
  Eight Ways to Profit if OPEC Dumps the Dollar.
• Money Morning News Analysis:
  China Continues to Push for Global Currency Overhaul.
• Money Morning News Analysis:

  Geithner Opens Up Debt Dialogue With China, but the Dollar Still May be Doomed.

• Wikipedia:
  Bretton Woods.
• Money Morning News Analysis:

  China Seeks to Dethrone the Dollar, Transforming the Yuan into the Dominant Global Currency.

• Wikipedia:
  Renminbi.
• Money Morning News Analysis:
  By Stepping Up to Sell China’s Bonds, Standard Chartered and HSBC May Accelerate the Yuan’s Acceptance as a Global Currency.
• Money Morning Market Commentary:
  How the New ‘Yuan Carry Trade’ Will Add to China’s Global Muscle, and Possibly Even Accelerate the U.S. Recovery.
• International Monetary Fund:
  Special Drawing Right.

In reality, however, this mega-deal is a harbinger of what's to come, and highlights the road that global investors must travel in their journey to maximize their own investment returns.

If you feel like you need a guide on that journey, just look to Australia. That country seems to be setting the pace when it comes to obtaining both a way out of the global financial crisis and an important new trading partner that could benefit their nation for years to come. What's happening there could be a model we'd best learn from.

As we have noted repeatedly here at Money Morning, when China buys, it buys big. Most recently, China's global resource acquisition spree has centered on Australia (after tours through Canada, Africa, the Middle East and South America).

By some accounts, the timing couldn't be better. Following the recent arrest of four Rio Tinto PLC (NYSE ADR: RTP) employees in China last month on corporate espionage charges, the two countries needed to do something mutually beneficial to smooth over relations. For China, the acquisition is viewed as a way to save face and further its strategic interests. For Australia, this deal is a source of cash that will flow right into the government coffers and help the country rebound from the global financial crisis.

The transaction involved a place most people here have never heard of – Barrow Island. Located about 30 miles off the northwest coast of Australia, and about 80 square miles in size, Barrow sits atop a supply of natural gas – a portion of which that will now be liquefied and sent to China.

According to the terms of the deal made public recently, Australia is going to process and ship some 15 million metric tons of the fuel each year – enough for this deal to be worth roughly $15 billion over the life of the contract.

Development of the project is expected to create 6,000 jobs initially, with another 3,000 to follow. It's also expected to yield some $6 billion for the Australian government, which – like most governments around the world – can really use the money, since it's still struggling to come to terms with the global financial crisis.

Not surprisingly, like most deals involving China these days, this one has sparked controversy on a number of different levels.

Naturally, there are the obvious environmental issues. According to conservationists, Barrow Island is home to a number of endangered animals, which is why environmentalists are pushing for the liquefied natural gas plant to be built on the mainland.

But Australian Environmental Minister Peter Garrett dismisses that notion. Speaking to various Australian media outlets, he's stated that he doesn't believe there will be "unacceptable impacts."

As you might expect, that's ignited a firestorm – akin to the environmental debates we're used to seeing in this country. Australian Sen. Bob Brown, leader of the "Greens" party, groused that Canberra has put economic interests ahead of those of wildlife and the environment.

What makes this transaction important – and worthy of study – is that the deal is a window into the future. In an increasingly global economy, as mega-dollar international deal proposals become more and more commonplace, the players will have to find a way of addressing the inevitable political battles.

And that's particularly true when one of the parties is China (as will also be the case on an increasing basis). With the LNG deal, the ink had barely tried before Australian Labor representatives were leveling charges that Canberra's conservatives had sold out. Many, who seem to feel that a pact reached with China is tantamount to making a deal with the devil, are saying that the diplomatic cost of doing business is steamrolling the concepts of human rights and democracy. But others view such a transaction in much more pragmatic terms.

After all, they say, $6 billion is still $6 billion.

This is not a simple issue and it's complicated by the fact that China sits on the world's largest pile of excess reserves – more than $2.3 trillion by some estimates. And the Asian dragon is going to spend or invest that capital as it sees fit, no matter what happens with the U.S. dollar, Western budget deficits, or the global economic recovery.

And it's not because China wants to spend this money … it's because China has to spend that money. It's a matter of the country's long-term survival.

As we have said a number of times here in Money Morning, China must engage in transactions beyond its borders to ensure that it continues to have borders. Deals like this are not about world dominance. They're aimed at avoiding "social unrest" – the two-word phrase that scares Beijing more than anything else.

This is why Chinese leaders have been so resolute in their drive to lock up supplies of raw materials and other key commodities.

For the most part, governments are caught between citizens who get uncomfortable at the thought of selling valuable national interests to a trading partner they don't really know or understand and their own corporations, which desperately need two things to maintain their own global competitiveness: access to China's low-cost manufacturing capacity, and market share (revenue) from what is the fastest-growing market on earth.

To be better able to deal with – and feel comfortable about – what's transpiring in an increasingly global marketplace, Westerners need to start understanding what's really at stake. And they need to also dispense with their own misperceptions.

Take the whole Unocal Corp. transaction of 2005. It failed because U.S. interests were appalled that a Chinese company could acquire "national interests." Yet few took the time to understand that most of Unocal's assets are actually located in Asia — which is why the Chinese tried to buy it.

For instance, not only did the United States slam the door in China's face when China tried to buy Unocal Corp. Chinese National Offshore Oil Corp., or CNOOC (NYSE ADR: CEO) tried to acquire Unocal for $16 billion to $18 billion. Following a vote in the U.S. House of Representatives, the bid was referred to U.S. President George W. Bush. The reason: The deal was said to have "national security" implications. CNOOC withdrew its bid and Unocal subsequently merged with Chevron Corp. (NYSE: CVX).

Then there's the whole human rights argument, which inevitably comes to the front of the line whenever China is involved in a deal. Detractors logically highlight the fact that China's record doesn't fit with our own. Yet, in doing so, they forget the West's history. The high and mighty, history reveals, weren't always so high and mighty. In short, we're not perfect, either.

On one hand we espouse free markets and the premium of economic choice. So why is it that we can't stand to have the tables turned when it comes to China's economic freedom? The West has engaged in direct economic investment abroad for years. Shouldn't China be allowed to do the same thing?

Then there are the concepts we've used to justify our own actions particularly when it comes to foreign direct investment. We've argued (and continue to argue) that our investments in distant locales will help spread democracy, improve human rights, nurture educational excellence and contribute to the free-market efficiencies that will allow the global economy to function much closer to peak efficiency. And we've used the increase in taxable revenue, local employment and even training as reasons to justify our actions and our interests.

If you adopt an objective, global perspective, and see things as China does (understanding its general objectives in the process), there is really only one conclusion a U.S.-based investor can reach: The changes under way are inevitable. Fight them, if you must, but realize it's at your own cost, and understand the once-in-a-lifetime investment opportunities you'll be missing.

Or embrace them and ride along – which is not only the path of least resistance: It's also the most profitable trail to take.

News and Related Story Links:

• About.com:
  Australia, China Ink $41 Billion Natural Gas Deal.
• Money Morning News Analysis:
  China Tightens Grip on Africa's Energy Resources with Stake in Offshore Field.
• Money Morning Analysis:
  China Continues its Commodities Binge with Brazilian Oil Deal.
• Wikipedia:
  Unocal Corp.
• Money Morning News Analysis:
  What Companies Are Profiting From China's Commodities Crusade?
• Wikipedia:
  Peter Garrett.
• The New York Times:
  China Says Australian Is Detained in Spy Case.
• CNNMoney.com:
  China arrests 4 Rio Tinto employees.
• Wikipedia:
  Barrow Island.
• WhiteHouse.gov:
  George W. Bush.
• Wikipedia:
  Liquefied Natural Gas.
• Money Morning News Analysis:
  The Three Reasons China Will Lead the Global Rebound.
• Money Morning:
  China Landing Natural Gas Deals as Prices Plummet

And as goes the semiconductor industry, so goes the U.S. economy.

These days, microchips are present in virtually every type of product – from coffee makers to cars: If it plugs into the wall or takes batteries, chances are good there's a semiconductor inside.

Given the microchip's ubiquitous nature, the companies that make them – as well as the companies that make the chipmaking equipment – can be viewed as a kind of leading economic indicator. Companies that intend to produce products down the road have to place orders for chips or for equipment now, meaning an uptick in semiconductor-sector business activity today and represent a jump in broader economic growth tomorrow.

"While most chip companies have as yet cited but modest improvement, and forecasts have been held in check, signs of a strong upturn are brewing that will significantly improve upon higher – but still modest – expectations," Rick Whittington, an analyst with JSA Research wrote in a Forbes column earlier this summer. "High proprietary chip content stocks are poised for breakout sales and earnings, probably quickly returning to levels before last summer's plunge."

While consumer spending remains the chief U.S. economic catalyst, accounting for more than two-thirds of gross domestic product (GDP), business spending remains a crucial contributor – especially at a juncture in which consumer confidence has been flayed. Indeed, business spending has stabilized and will return to growth in 2010, semiconductor and other electronics manufacturers believe. In the meantime, they are ramping up production to meet what they believe is a growing consumer demand.

Microchips are used in a broad scope of products: DVD players, automobiles, calculators, coffee makers and televisions, telephones – as well as such stalwarts as personal computers.

Like other economic indicators, electronic-order levels have yet to traverse the economic neutral zone to break into positive territory (marked by the "year-over-year growth" label) but at least the hemorrhaging is subsiding: Sales of semiconductors in North America in the month of July were $3.1 billion, an increase of 5.9% from June, when sales were $2.9 billion, according to the Semiconductor Industry Association (SIA). The continent's 8% year-over-year decline is significantly less than the rest of the world's 18.2%, and was the smallest decline of any major market in the world.

"Sales of consumer products such as netbook PCs and cell phones are supporting the modest recovery that is now under way," said SIA President George Scalise. "Purchases of information technology products by the enterprise sector continue to be tempered by caution and longer replacement cycles. There is evidence of a return to seasonal industry patterns."

That evidence was further backed up by trade organization Semiconductor Equipment and Materials International (SEMI), which said North America-based manufacturers posted a book-to-bill ratio of 1.06, meaning that $106 worth of orders were received for every $100 of product shipped.

Inventories for many chipmakers are at a lower level compared to their average level for the past three years, Purchasing.com reported, citing market research firm iSuppli Corp. But with the holiday season approaching and retail inventory levels already lowered by a weak consumer demand in the first half of 2009, chipmakers are once again ramping up production, according to iSuppli analyst Carlo Cireiello.

Semiconductor inventory levels are now at "appropriate levels, down from previously excessive positions," Ciriello told Purchasing.com. Ciriello forecasted in July that chipmakers would begin building inventories 5.5% in the third quarter and 1% in the fourth.

Semiconductors are used in a broad scope of products: DVD players, automobiles, calculators, coffee makers and televisions, telephones. Money Morning took a look at a few of the bigger players (and related companies) in the industry.

Chipmakers Fuel Business Spending

Intel Corp. (Nasdaq: INTC) reported its first quarterly loss in July, losing $398 million after setting aside $1.45 billion in funds to pay a fine from the European Union, which said Intel used illegal rebates to thwart competitors, Bloomberg News reported. Still, the world's largest chipmaker saw its sales beat analyst estimates and the company late last month boosted its third-quarter revenue forecast to at least $8.8 billion, from an earlier projection of $8.1 billion.

Before Intel raised its guidance, analysts polled by Bloomberg were expecting sales of $8.57 billion. A compilation of analysts' estimates by Thomson Financial Network now has the chipmaker's revenue at $8.93 billion. Intel's revenue in the third quarter of 2008 was $10.2 billion.

"Intel's second-quarter results reflect improving conditions in the PC market segment with our strongest first- to second-quarter growth since 1988 and a clear expectation for a seasonally stronger second half," Chief Executive Officer Paul Otellini said.

The increase in Intel's sales forecast could be attributed to a rebound in PC orders by consumers in Asia, and Edward Jones & Co. analyst William Kreher says the higher guidance bodes well for the technology industry because Intel is a barometer for spending.

"Consumers are driving the strength and the relative strength in PCs," Kreher told Bloomberg. "We do have an expectation that 2010 will bring renewed demand from the corporate sector as well."

Chipmaker Marvell Technology Group Ltd. (Nasdaq: MRVL) Chief Executive Officer Sehat Sutardja also sees initial growth by consumer products such as cell phones, e-books and mobile Internet devices. Marvell makes chips that are used in everything from computer hard drives to smartphones such as Research in Motion Ltd.'s (Nasdaq: RIMM) BlackBerry and Apple Inc.'s (Nasdaq: AAPL) iPhone.

"Demand for a lot of consumer devices seems to be picking up from six months ago, both in the U.S. and non-U.S., particularly non-U.S.," Marvell Chief Financial Officer Clyde Hosein said in an interview with Reuters. "That has picked up substantially since the April time frame and continues to improve or maybe accelerate."

Investing to Build a Better Chip

If the health of microchip firms is a leading indicator of the outlook for the overall economy, then the outlook for semiconductor-equipment manufacturers is a harbinger of what's to come for chipmaking sector.

The reason is simple: As chips become more powerful, they also become more complex – meaning the chipmaking process becomes increasingly demanding and deft. So before semiconductor firms can ramp up in a big way, they need to invest in the latest and greatest equipment.

That's where the equipment stocks come into play.

Capital expenditures – known as "capex" in Wall Street parlance – is a closely watched statistic. Chipmaking firms invest in new gear to expand capacity, to move to the newest technology, or both.

Because of the global financial crisis, so-called "capacity utilization" – the number of chips being turned out as a percentage of what those factories are capable of turning out – plunged to 55.6% in the first quarter of 2009 from 89.7% during the same period a year ago, the SIA reported.

And with more than 40% of the industry's "fab" capacity sitting fallow, new plants aren't being built – especially since they cost about $3 billion each, TheStreet.com reported. Several of the equipment players have filed for bankruptcy as a result.

Coming into this year, only three semiconductor firms planned to invest more than $1 billion in new equipment: Intel, Taiwan Semiconductor Manufacturing Co. Ltd. (NYSE ADR: TSM) and Samsung Electronics Co. Ltd.

That's down from eight companies in 2008 and 16 in 2007.

But the tide appears to be turning – and investments will ramp up as the worldwide economy improves. Already, United Microelectronics Corp. (NYSE ADR: UMC) announced it is boosting its outlays for new equipment to $500 million from the $400 million it planned earlier in the year. Chartered Semiconductor will increase capex to $500 million from the $400 million announced earlier this year. That will be an increase from the $349 million the company spent in 2008.

Chartered Semiconductor Manufacturing Co. Ltd. (Nasdaq ADR: CHRT) is boosting its outlay from the $375 million planned early in the year to $500 million now, according to TheStreet.com. And Toshiba Corp will spend $900 million – down from $3.2 billion last year, but still more than many analysts initially expected.

Additionally, U.S.-based equipment firms will benefit from a weaker U.S. dollar, which makes American products cheaper in foreign-currency terms.

One such U.S. firm is longtime industry leader Lam Research Inc. (Nasdaq: LRCX), which is experiencing an improvement in its business despite a loss in its recently reported fourth-quarter results. Those results included better-than-expected revenue.

During the fourth quarter, which ended June 30, the company said "business conditions improved … contributing to Lam's ability to show improved financial results for the quarter. Shipments and revenues increased as a result of customer investments to add [leading-edge capacity] in both foundry and memory."

And while business continues to improve, Lam said it hasn't lost sight of the need to carefully manage cash and to invest considerable care in choosing where to make next-generation strategic investments.

Lam's shares have surged nearly 42% so far this year, although they remain 21% below their 52-week high of $37.96. The shares closed yesterday at $30.16, up 5 cents each on a day the major U.S. stock indices were down for a fourth-straight day.

Older PCs Set Stage For Hardware Refresh

Dell Inc. (Nasdaq: DELL) Chairman and Chief Executive Officer Michael Dell is on a mission to save his company $4 billion a year.

The company outsourced 40% of its manufacturing as of its second quarter, helping it achieve an 18.7% gross margin that exceeded analysts' expectations. Dell's profit of 28 cents a share also beat Wall Street's estimate of 28 cents.

CEO Dell sees Microsoft Corp.'s (Nasdaq: MSFT) October 22 release of Windows 7, as well as faster processors from Intel, as the ignition for PC and server purchases next year.

"The size of the installed based of old hardware has never been greater," Dell said in a conference call with analysts. "I'm here to tell you there's going to be a refresh cycle next year. It's not going to come in the first month or the second month, but over the course of the year."

Dell remains confident that a majority of its business customers are deferring purchases and will accelerate IT spending to take advantage of technology improvements like Windows 7 and Microsoft's Office 2010, according to Chief Financial Officer Brian Gladden.

"This acceleration remains predicated on an improving economy and related improvements in customer profits and government tax receipts," Gladden said.

For Hewlett-Packard Co. (NYSE: HPQ), its earnings of 91 cents a share narrowly beat Wall Street estimates of 90 cents, and Chief Executive Officer Mark Hurd sees stabilization, but was reluctant to say the bottom has been reached.

"Business is stabilizing, and we are confident that HP will be an early beneficiary of an economic turnaround and will continue to outperform when conditions improve," Hurd said.

Both H-P and Dell have already credited consumers in Asia for a rebound in orders in PCs, Bloomberg reported.

News and Related Story Links:

• Semiconductor Industry Association:
  July 2009 Sales
• Semiconductor Equipment and Materials International:
  July 2009 Book-to-Bill Ratio of 1.06
• Purchasing.com:
  Semiconductor Suppliers Hold Low Chip Inventories
• Bloomberg News:
  Intel Posts Loss After Fine; Sales Exceed Estimates
• Yahoo Finance:
  Analyst Estimates for Intel
• Reuters:
  Marvell Shares Spike on Forecast
• Seeking Alpha:
  Dell Second Quarter Conference Call Transcript
• Bloomberg News:
  Manufacturing in U.S. Expands More Than Forecast
• Reuters:
  Market Report — In Play (LRCX).
• TheStreet.com:
  Watch the Chip Companies' Capex.

After 54 years of near-single-party rule – not to mention two decades of economic malaise – it's not surprising that voters eager for change delivered a landslide election victory to the opposition in that key Asian nation.

Last weekend's Japanese election represents a major milestone for Japan, and may well change the world's second-largest economy in unexpected ways. Many of things we think we know about Japan may simply have been policies of a Liberal Democratic Party (LDP), which has been in power for all but about 11 months over the past 54 years.

The "new Japan" may in certain respects be very different.

For example, we think of Japan as a country dedicated to exports. The big exporters are aided by cheap loans. Upon retirement, senior government bureaucrats get jobs with those exporters, a practice known as amakudari – descent from heaven. Not surprisingly, Japan runs a more or less permanent trade surplus.

Under the new Democratic Party of Japan government of Yukio Hatoyama, that may change. Hatoyama has pledged to end "amakudari" – even as he reorients the economy towards domestic spending. If he succeeds, the exporters may do less well, but the economy may be more balanced. As a result, Japan's economy may finally begin the economic recovery that Japanese consumers have been awaiting for 20 years.

Japan is also famous for its infrastructure spending – at its peak in 2001, state-funded infrastructure spending was equal to 6.5% of that country's gross domestic product (GDP) – a level that's twice that of Japan, the next-biggest spender.

While anyone who has dealt with Northern Virginia traffic knows that infrastructure spending can be a good thing, much of Japan's spending was wasted on remote rural areas, which happened to be homes to politically connected LDP barons.

Hatoyama has promised to redirect about 3% of GDP from infrastructure spending to payments to individuals. He will pay each family with children $3,000 per child per year. This should help Japan's demographic problem – its population is declining and is heavily weighted towards retirees. It will also boost consumer spending, especially among middle-income families.

Hatoyama's program offers no supply-side remedies for Japan's economic ailments. Those were the policy of Junichiro Koizumi (Japan's prime minister from 2001-2006), who seemed to be bringing Japan back from recession. Koizumi's faction lost out in the LDP power struggle, but may make a comeback. Big-spending Prime Minister Taro Aso has resigned from the party leadership, and his most likely successor, former Japanese Health Minister Yoichi Masuzoe, is a supporter of Koizumi's approach.

Nevertheless' Hatoyama's policies will reorient Japan's economy towards domestic spending. The danger is Japan's budget deficit (8.9% of GDP in 2009, according to estimates by The Economist) and its debt. With GDP down this year and spending up, the International Monetary Fund (IMF) has estimated Japan's debt at 217% of GDP by the end of 2009. Only one country has recovered from debt that high – Britain, whose debt hit about 250% of GDP in 1815, only to reach that level again in 1945, at the end of two huge wars.

Hatoyama must hope that Japan's recovery from this recession is a swift one. A sharp bounce in GDP, maybe 5%-6% growth in the first year, would make the debt level much less daunting, and allow good progress towards balancing the budget. After almost 20 years of near-recession, that's perhaps not too much to ask.

For investors, Japan looks attractive. The stock market is still trading at less than 30% of its 1990 high. However, the Japanese companies you have heard of are not the ones to buy. They are too large and too oriented towards exports. The construction companies should also be avoided – they have benefited from the fixation on infrastructure.

However, buying smaller Japanese companies is a problem, because they do not have actively traded American Depositary Receipts (ADRs) so you really have to buy them on the Tokyo Stock Exchange. The good news is that some brokers, notably E*TRADE Financial Corp. (Nasdaq: EFTC), will allow you to trade Japanese shares.

If you intend to trade on the Tokyo exchange, you might want to look at some of the Japanese retailers and consumer-goods companies. Even with these more-upbeat prospects, though, you should be careful not to overpay – a Price/Earnings (P/E) ratio of 20 should be your upper limit.

For those without access to the Tokyo market, there are two alternatives. One is the exchange-traded fund (ETF) covering the entire Japanese market, the iShares MSCI Japan Index (NYSE: EWJ). That has market capitalization of $5.26 billion, meaning it has adequate liquidity.

However, too much of it will also be invested in shares of the big exporters and construction companies.

The other alternative therefore is a mutual fund, the Fidelity Japan Smaller Companies Fund (Nasdaq: FJSCX). That has expenses of 1.1% and a total size of $394 million. It represents the most readily available way of investing in domestic Japan.

With the new government, Japan will look very different in a few years. Profit opportunities will arise.

As investors, we should look to capitalize on these changes – as well as the opportunities they create.

[Editor's Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best - because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world's financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

The Permanent Wealth Investorassembles high-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for subscribers. Hutchinson's strategy is tailor-made for periods of market uncertainty, during which investors all too often go completely to cash - only to miss some of the biggest market returns in history when market sentiment turns positive. But it can work in virtually every market environment.

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News and Related Story Links:

• Money Morning Special Report:
  Eight Ways to Profit From Japan's Game-Changing Election.
• Wikipedia:
  Amakudari.
• BusinessWeek.com:
  Historic victory for DPJ in Japan's election.
• Wikipedia:
  Yukio Hatoyama.
• Investopedia:
  American Depositary Receipts.
• Wikipedia:
  Junichiro Koizumi.
• International Monetary Fund:
  Official Web Site.
• Wikipedia:
  Yoichi Masuzoe.
• E*TRADE Financial Corp:
  Official Web Site.
• Tokyo Stock Exchange:
  Official Web Site.

Now, Chavez's aggressive economic policies are again being called into question, this time as the country slides into what could be a protracted period of stagflation, which is defined by the exasperating mixture of torpid economic growth and high inflation.

Before that, however, the period from 2004-2007 was marked by rapid economic growth – punctuated by a miraculous 19.42% burst in 2004. Since that time, unfortunately, Venezuelans have watched as their standard of living was slowly eroded by restrictive price controls, rapid inflation, unsustainable public spending, and widespread nationalizations that have put a stranglehold on industry.

Even as these problems festered, an unprecedented surge in oil prices allowed Chavez to maintain his questionable – and ultimately unsustainable – economic policies. When the bull market in commodities abruptly stalled last year, Venezuela's economy lumbered to a stop.

Venezuela's economy grew by 3.2% in the fourth quarter of 2008 and just 0.3% in the first quarter of 2009. Then – for the first time in more than five years – that country's economy contracted, shrinking 2.4% in the second quarter.

Unfortunately for Venezuela, the decline in gross domestic product (GDP) did little to quell surging inflation. The annual rate of inflation climbed to 26.2% in July, according to the Central Bank of Venezuela. Many foreign sources have it higher.

President Chavez insists his country is not in the midst of a financial crisis, but analysts believe this is just the beginning of a bad-news saga that will trip up a country whose heavy-handed economic policies have made it few friends.

"To sum up, we could say that such scenario of stagflation has two basic components," Orlando Ochoa, an economist and professor with Andrés Bello Catholic University (UCAB), told El Universal. "On the one hand, price control, exchange control, nationalizations and restricted distribution of foreign currency damage supply. On the other hand, lower oil prices curtail revenues and have an impact on demand."

Going forward, Venezuela's currency controls are perhaps the biggest hurdle for the economy to overcome. Chavez and his cabinet have said they are preparing to announce measures to stimulate the economy, but that may not be enough.

The problems that come with over-reliance on oil and a vast net of unwieldy social programs and the cost burden of nationalized industry aren't going anywhere. And the nation's other obstacle – the gap between its official and parallel exchange rates – won't be addressed until at least the end of September.

An Unparalleled Problem

Indeed, the problems facing Venezuela are many. But President Chavez and his cabinet believe they have the solution.

"There is a remedy," Venezuelan Finance Minister Ali Rodriguez said in an interview broadcast on state television. "The differential between the official dollar and the [so-called] 'parallel dollar' can be reduced."

Rodriguez was referring to the difference between the country's "official" exchange rate – which remains at 2.15 bolivars per U.S. dollar – and the so-called "parallel market," which suggests a rate of about 6.5 bolivars per U.S. dollar.

The official exchange rate of 2.15 bolivars per U.S. dollar was arrived at in 2003, when Chavez imposed currency controls that force Venezuelans who want to import goods to apply for a government permit. Importers that are unable to get permits to buy currency at the official exchange rate have been forced to turn to the parallel market, where they pay three times the official price.

The problem now is that a large drop in oil revenue has sharply reduced the amount of dollars the government has available to exchange. That has driven more importers to the pricier parallel market. Some have stopped importing entirely.

With limited access to imports, Venezuela's manufacturing sector contracted by 8.5% in the second quarter.

"The manufacturing sector is going to have a negative performance, mostly because of the restriction in imports and dollars, which has caused a drop in the supply of primary materials," Miguel Carpio, an economist at Banco Federal CA in Caracas, told Bloomberg News. "Add to that the drop in consumption, and this is going to be a very difficult year."

Now, with the threat of stagflation looming large, Chavez has no choice but to take action. But economists are unsure of what the government will do.

Few analysts expect the government to order an outright devaluation, because it would push inflation beyond the 28% annual rate. (Venezuela last devalued the official rate in 2005, weakening the currency by 11%.)

Instead, the government could try to lower the parallel rate by issuing dollar-denominated debt, by creating a second, separate exchange rate for "necessary" industries, or by doing both those things.

Traditionally, the government chooses to subsidize certain favorite industries – mainly heavy machinery, foodstuffs and medicines – by allowing them to trade bolivars at the official rate and driving other non-essential goods producers to the parallel market.

This could be taken a step further by imposing a tax on lower priority industries seeking dollars at the official exchange rate, Russ Dallen, head trader at Caracas Capital Markets, said in a research note. Or the government could simply create multiple "official" rates for different industries. Venezuela may create four different exchange rates to help the government deal with a drop in oil revenue.

"This complicated system, if implemented, would satisfy the requirements of the government of pretending not to have a formal devaluation of the exchange rate," Dallen said.

Credit Suisse Group AG (NYSE ADR: CS) said in an Aug. 28 report that it expects the government to avoid devaluating its currency by selling dollar-denominated debt to the parallel market. In 2008, after an aggressive sale of dollar-denominated bonds, the administration was able to bring down the parallel rate to around 3 bolivars.

Ultimately, it's Chavez – who opened the door to speculation in August by saying he would "restore balance" to the parallel rate – who will decide what to do about his country's quandary. But he won't be making a decision until later this month.

"Is there going to be an adjustment? I can't respond to that right now," Chavez said Sunday at the presidential palace in Caracas. "If any adjustment comes, it will be in September, towards the end of the month."

But whatever Chavez decides to do, his remedy is likely to fall short, analysts say. That's because the parallel rate is not the problem – it's actually a symptom of flawed economic principles. The restrictive price-and-exchange-rate controls, government expansion, and political obtuseness that Chavez has made the cornerstones of his economic policy will continue to conspire against Venezuela until there is reform.

"We always said the situation was only tenable for the government if oil prices not only remained high, but also rose constantly. But that has not happened, and the fall in oil income is now clearly in evidence," UCAB's Ochoa told Inter Press Service News Agency. "That's the first factor contributing to stagflation, to which are added price and exchange controls and restrictions on hard currency availability, which harm supply and investment, and thirdly, the policy of nationalization."

Venezuela's Crude Oil Slick

In the years leading up to the financial crisis, Chavez used PDVSA's growing revenue to finance large social programs, as well as the nationalization of other industries.

Spending on social programs soared 340% from 2000-2005, according to the Center for Economic and Policy Research. It rose even higher as oil prices soared into 2008, boosting purchase orders and fueling a spending spree among even the poorest Venezuelans.

But since the financial crisis eviscerated commodities prices, Venezuela's oil bounty has all but evaporated. Oil brought in $22.8 billion in the first six months of 2009. That's less than half of the $52 billion it brought in during the first half of last year. For 2008 as a whole, oil generated about $90 billion in revenue for Venezuela.

Meanwhile, FONDEN – Venezuela's development fund – has already committed all but $3 billion of the nearly $20 billion it had available at the end of January, as the government used most of the money in the first half of the year to sustain fiscal spending.

And while Venezuelan oil traded at an average of $53 a barrel in the second quarter, up from $40 a barrel in the first three months of 2009, that's still a far cry from last year's levels.

That means borrowing has had to rise to compensate for the decline in revenue. Venezuela's domestic debt jumped 44% during the first half of the year to $20.42 billion from $14 billion at the end of 2008.

"Public spending keeps rising and is financed by more public debt, which increases spending in a vicious circle, while the government defers or postpones workers' demands, which is itself another sign of the approaching recession, although the government seeks to deny it," economist Domingo Maza Zavala, a former head of the Central Bank told the IPS.

Calculations based on official figures suggest domestic and foreign debt repayments will total about $19.6 billion between the second half of this year and 2011, the Latin American Herald Tribune reported. Roughly $10 billion of that total will be due on foreign debt, with the remaining $9.6 billion destined for the domestic account. Total state debt is estimated at $50.3 billion.

What's the government figures don't include is the cost of compensating private companies that have been taken over or bought out under Chavez's nationalizations and expropriations.

Chavez's government earlier this year seized the assets of more than 70 foreign and domestic oil service companies after conflict erupted over nearly $14 billion in debt owed by PDVSA.

PDVSA demanded that service companies accept a 40% cut in their bills; when they refused, the Venezuelan government seized at least 12 drilling rigs, more than 30 oil terminals, and about 300 boats.

The demonstration was a pointed reminder of a 2007 incident, which is still playing out in the international courts. Two years ago, Venezuela forced six oil majors to hand over equity stakes of 60% or more to PDVSA. However, Exxon Mobil Corp. (NYSE: XOM) and Conoco Phillips (NYSE: COP) opted to walk away from their contracts rather than accept a minority role.

This conflict is still being disputed, and last year Exxon won a court order to freeze $12 billion in assets from PDVSA as compensation for its lost projects. Additionally, Chavez's heavy-handed policy has cost the country untold billions worth of oil-related investments, as many oil majors now refuse to operate there

"There is the uncertain outlook over how the extensive nationalization pursued over the past 12 years will pan out," Alvise Marino, an analyst at Ideaglobal, told The Wall Street Journal. "Based on the government's unimpressive track record on the economic management front, we tend to take a less-than-optimistic view."

The Colombia Conundrum

In addition to alienating foreign oil majors, Chavez has also sequestered Venezuela from many of its neighbors, especially Colombia. Chavez has ordered his country to prepare for an outright "rupture of relations" with Colombia after that country gave the United States permission to use its military bases.

The United States says access to the bases will help it fight drug trafficking, but Chavez has his own theory. He says American use of the bases could be used as a launch point for an invasion of his oil rich nation.

"Those seven military bases are a declaration of war," Chavez said last week. "We must prepare for the rupture in relations with Colombia. There is no possibility of a return [to normal relations] with Colombia, an embrace."

However, cutting off ties with Colombia poses yet another economic hurdle for the Venezuelan economy to overcome. Colombia provided about $6 billion in products to Venezuela in 2008, or about 15% of Venezuela's total imports, according to Venezuela's government statistics institute INE.

In fact, when Chavez closed the border for three days in 2006, there was shortage of food in Venezuela.

Chavez can turn to other South American countries, but his credit extends only so far.

"Nobody wants to sell to Venezuela if payment isn't made in advance," José Rozo, president of Fedecámaras Táchira, the region's main business association, told the Latin American Herald Tribune

About 70% of trade activity in Venezuela depends on imports from Colombia, Rozo said, adding that the only country that had been willing to export on credit had been Colombia.

Without Colombia, Venezuela will have to settle for trade terms that heavily favor its partners.

For instance, Argentine President Cristina Fernandez de Kirchner made a visit to Venezuela last month, and signed no less than 22 accords. Virtually all of the deals were in Argentine's favor, the Tribune reported.

"We're going to drive a horse and cart through all the regulations if they want to do business with us," an Argentine official told the paper prior to the signing of the deals. "Prompt payment. Simple procedures. Fewer controls. Less bureaucracy. No delays. Hard currency. I'll tell you the rest when I've thought of them."

That means if Venezuela wants to keep doing business with Argentina, it's going to have to pay more.

And that will fuel inflation.

"The cost of purchasing in Argentina is higher, and that means that prices will be higher in Venezuela," Abelardo Daza, an economics professor at Caracas-based IESA business school, told The Journal.

News and Related Story Links:

• El Universal:
  Venezuela falls into stagflation

• Money Morning Market Commentary:
  Venezuela Says "Adios" to Most Foreign Investment, Making it a Stay-Away Play for Investors.

• Bloomberg:
  Venezuela Economy Has First Contraction Since 2003

• The Wall Street Journal:
  Enduring Oil Dependence Seen Behind Venezuela Econ Decline

• Latin American Herald Tribune:
  Venezuela Business Fears Mount as Chávez Threatens Complete Break with Colombia

• IPS:
  VENEZUELA: Alarm over First Contraction of GDP in Five Years

• Money Morning:
  Venezuela's Oil Production Squeezed by Chavez's Heavy Hand.

• Andrés Bello Catholic University:
  Official Web Site.

• Banco Federal CA:
  Official Web Site.

• Latin American Herald Tribune:
  Venezuela Debt Repayments Loom Amid Economic Gloom

• The Wall Street Journal:
  Venezuela's Chavez Intent On Cutting Colombian Trade Ties

New home sales jumped almost 10% in July, while the Case-Shiller home price index rose for the second successive month. Yet luxury homebuilder Toll Brothers lost $493 million in the quarter ending July 31, considerably worse than analysts had expected.

Housing stocks are certainly acting as if a recovery must be on the way. Pulte Homes Inc. (NYSE: PHM) has more than doubled from its low. Toll Brothers Inc. (NYSE: TOL) is up around 70% from its bottom. D.R. Horton Enterprises (NYSE: DHI) is up almost four times from its bottom. Lennar Corp. (NYSE: LEN) is up about 4½ times from its low. Finally, Hovnanian Enterprises Inc. (NYSE: HOV) is up almost tenfold from its low after a flirtation with bankruptcy. Yet all of these companies are still racking up quarterly losses, according to their most recently released earnings reports.

In terms of house prices, it would seem unlikely that a bear market bottom has been reached. Yes, the average house price is now back down around its long-term average of about 3.2 times average earnings, or only a little above it. But history suggests that markets don't bottom at their average valuation: In fact, after such a huge excess to the upside, they overshoot on the downside.

The Case-Shiller 20-cities index is still 42% above its January 2000 level, having outpaced inflation during the last 9½ years. Yet January 2000 was not the bottom of a housing depression – far from it, in fact. That was actually close to the top of the dot-com bubble, when valuations of all assets were at all-time highs. So an average price over the whole country that – even now – remains 42% above the average price recorded at the very top of a huge economic boom does not seem like a market bottom to me.

You also have to remember that the U.S. federal government is hugely subsidizing the market. Interest rates are artificially low, and the U.S. Federal Reserve has bought more than $1 trillion worth of housing debt. Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) have been rescued by the government, and provided with more than $100 billion of taxpayer capital. And Ginnie Mae (the Government National Mortgage Association), directly a government agency, has provided almost $1 trillion of mortgages that require a 3% down payment.

And that's not all.

The government is spending additional billions helping homeowners avoid foreclosure. First-time buyers are given a tax credit of $8,000 towards the down payment on their house – this credit currently runs out on December 1. So the current overall market bottom is propped up artificially. Even if the proposed tax-credit extension is approved, at some point, those props will be removed.

In individual cities, the picture is somewhat brighter. Phoenix and Las Vegas prices are less than 10% above their 2000 levels, having been halved from their respective peaks. In those markets, house prices may truly be reaching a bottom, although the overhang of foreclosures after such a huge drop may make recovery slow. At the other extreme, Detroit housing is 30% cheaper than in 2000, a testimony to the awful economic environment there, with the bankruptcies of General Motors Corp. and Chrysler Group LLC.

Again, with the government bailouts of both companies, there may be something of a recovery in the local housing market.

Probably the best prospects, however, are in Denver and Dallas, where prices are about 20% above their 2000 level, roughly in line with the increase in consumer prices during that same period. However, the local economies are strongly based on natural resources, particularly oil, whose price is triple its 2000 level. With prices in Dallas and Denver down only about 10% from their 2000 peaks, a true recovery in those cities may be near.

At the opposite extreme are the metropolitan "Big Three" of Los Angeles, New York and Washington, where prices are 61%, 71% and 74% above their 2000 levels, respectively.

Washington will be fine, of course: The Obama administration's spending-and-legislation plans have attracted yet another huge influx of bureaucrats, lobbyists and lawyers, all of which will boost the housing market to new highs. With New York you have to worry about all the financial-services jobs being lost as a result of the worst financial crisis since the Great Depression.

From a nationwide standpoint, the most likely path for the housing market is for a modest recovery, with some later slippage as subsidies are removed. Housing is likely destined to once again become a highly regional market, as it always was prior to the 2001-2006 market boom, with the cycles in each market being very different.

As for homebuilding stocks, they appear to already be discounting a recovery in their businesses that may well be years away. Selling at well above net asset value (NAV), with Price/Earnings (P/E) ratios that are infinite because the companies continue to lose money, shares of homebuilders represent a very poor value, indeed.

News and Related Story Links:

• Money Morning News Analysis:
  "Hyper-local" Stats Show Housing Market Has Bottomed.
• Investopedia:
  Net Asset Value.
• Investopedia:
  Price/Earnings ratio.
• Money Morning News Analysis:
  Has the Housing Market Really Hit Bottom, or Is It Headed for Another Collapse?

Investors can be excused if the word "October" is one that strikes fear into their hearts.

The trouble is, it's actually September that deals investors the toughest monthly hands.

That's September – as in the month that starts today (Tuesday).

After a rally that's seen U.S. stocks surge 53% from their March lows (including 3.5% in August, alone), "investors are wondering if September will live up to its reputation as the month in which the S&P 500 posts its worst price performance and frequency of decline," Sam Stovall, chief investment strategist at Standard & Poor's Equity Research (NYSE: MHP), told MarketWatch.com yesterday (Monday).

Since 1929, September is actually the worst-performing months for stocks, with the S&P 500 suffering an average decline of 1.3% (compared to an average monthly advance of 0.5%), Stovall said.

The Dow Jones Industrial Average – the index that's more closely followed by retail investors – tells a similar story. In fact, if you look at the Dow over the last 100, 50 and 20 years, September is the only month in which the average monthly performance has been negative, the Bespoke Investment Group concluded in a recent research report.

Over the past 100 years, the Dow has suffered an average decline of 0.96% in September, with a positive month 42% of the time. The average loss widened to 1.23% for the last 50 years and to 1.49% for the past 20.

Fall, in general, hasn't been kind to investors: Of the 15 largest point declines in the Dow, six have come in October, four in September and two in November (See accompanying graphic).

Given that, investors "may have a reason to fear a setback in September," Stovall told the news service. "We don't know whether concerns over the upcoming [third-quarter] earnings reporting season will trigger this anticipated digestion of gains, or if further nervousness emanating from the Chinese stock market over the prospects of a slower-than-expected growth in GDP will cause U.S. equities to trim some of its recent advances, but September is as good a month as any in which to suffer a setback.

Stovall says that Standard & Poor's investment committee believes that stocks are "are due for a period of consolidation" – Wall Street parlance for a potentially painful drop – before resuming their advance.

Not all Septembers are the same, however, Bespoke Investment's recent shows. And this one could be particularly rocky.

When the Dow has a positive August, it does well in September more often than not. But when three specific market criteria are met, history shows that it's best for investors to fasten their seatbelts, since they're usually in for a rough September, Bespoke researchers found.

And – unfortunately – all three of those criteria have been met this year. Those three conditions are:

• The Dow is in positive territory year-to-date (+719.89 points, or 8.2%).
• The Dow is in positive territory during the past three months (+995.95 points, or 11.72%).
• The Dow is in positive territory in August (+324.67 points, or 3.54%).

Of the 17 times in the past when the Dow has boasted a positive return in all three of those time periods, the index has averaged a 1.73% decline for September, with positive returns for the month just three times. And those three months were each about 20 years apart.

Mark Arbeter, S&P's chief technical strategist, told MarketWatch that the S&P could fall all the way down to 940 – an 8% decline from the close yesterday (Monday) – before continuing its advance to a fresh recovery high.

Indeed, S&P's Stovall said that "while past performance is no guarantee of future results, history hints that September certainly has the reputation."

Not everyone is so bearish, however.

Michael Darda, MKM Partners' chief economist, this week told Barron's that the stock market's strong performance "perhaps [is] telling us that the idea of a painfully slow U.S. and global economic recovery is just plain wrong."

And even if there is a pullback, it could be both shallow and temporary – because of the huge cache of cash on the sidelines. While it's true that a record $327 billion in cash has flowed out of money-market mutual funds since March 11, that still leaves $3.58 trillion – down from the high of $3.92 trillion, but equal to 34% of the U.S. stock market's total capitalization, Mizuho Securities Co. Ltd. Chief Investment Strategist Carmine Grigoli told Barron's.

In 2002, when the last bull-market run began, money market cash equaled 29% of the stock market's total capitalization. And it's nearly double the 19% ratio that was present at the 2007 stock market peak, Grigoli told the closely watched Dow Jones (Nasdaq: NWSA) investment weekly.

And back then, the U.S. central bank wasn't holding the benchmark Fed Funds rate at a historic low of roughly 0%.

Because cash earns almost nothing today, "as financial conditions improve and fear subsides, sideline cash is drawn into higher-risk instruments such as bonds and stocks," Grigoli told Barron's. That's why we're in "the early stages of a liquidity-driven bull market that could take stock prices substantially higher."

After we navigate September, that is.

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And for that, you need a guide. As part of a new report, Money Morning Investment Director Keith Fitz-Gerald details "the $300 trillion global recovery that nobody's talking about" - as well as the six "lifetime" profit plays this powerful global money wave will open up to those who understand what's really playing out on the global investing stage right now. To read this report, please click here.]

News and Related Story Links:

• MarketWatch.com:
  Investors brace for a rough fall.
• Bespoke Investment Group:
  Official Web Site.
• Barron's:
  Not All September Songs Are Sad.

That could signal that a big rebound in bank-sector earnings is just around the corner. Or it could be merely a speculative “short squeeze” that all but confirms that these stocks are basically worthless.

Shares of busted insurer American International Group Inc. (NYSE: AIG) have soared from $13.14 to $50.23, as of Friday’s close, a gain of 282.3% so far this month. Shares of mortgage giants Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM) posted similar gains, MarketWatch.com reported. Fannie’s shares advanced from 58 cents to $2.04, an increase of 251.7%. Freddie’s shares zoomed from 62 cents to $2.40 each, a gain of 287.1%.

AIG actually gained for a ninth straight day Friday, reaching a 10-month high, as short-shelling speculators got squeezed and were forced to buy back the shares they’d sold short, traders told MarketWatch. AIG has 21% of its “float” – shares available to the public sold short, the sixth-highest proportion in the Standard & Poor’s 500 Index, according to Bloomberg News.

But the gains might also sign that the banking sector is poised for a major profit rebound, according to some new analyst research.

"Dating back to 1995, bank-sector outperformance has typically preceded [earnings-per-share] growth outperformance by one to two quarters," Stifel Nicolaus & Co. (NYSE: SN) analysts wrote in a market-research note last week. “With sector earnings growth expected to exceed that of the general market in mid-2010, we question whether we will see another leg down in this rally before year-end. On the other hand, perhaps we should question the current growth expectations for the sector?”

Trading in financial-services stocks has dominated the stock-market volume this month. So-called “day traders” have gravitated to once-questionable financial stocks and helped fuel those stunning gains – and huge volumes.

Citigroup Inc. (NYSE: C), for instance, has seen daily trading volume topping 1 billion shares this week. The stock closed above $5.05 on Thursday and $5.23 on Friday. That represents a 439% gain from its 52-week low of 97 cents a share.

Financial stocks have led the market's slingshot higher from the early March lows. Trading has been fierce in beaten-down shares of some companies that participated in the bailout, such as AIG, Citi and Bank of America Corp. (NYSE: BAC).

The New York-based AIG is trying to sell assets to repay government loans after accepting $182.5 billion in U.S. bailout money. AIG recently reported a profit for its second quarter – after having posted six straight quarters in the red. It engineered a so-called “reverse stock split,” in which AIG gave investors one new share for every 20 they turned in. The company did this to avoid a delisting action. That enhanced the short squeeze, since there were fewer shares available to for short-sellers to repurchase and “cover” their bets.

Despite the torrid run that AIG’s shares have been on, the insurance company’s bonds still trade at levels indicating the company’s shares may be worthless, Peter Boockvar, an equity strategist at Miller Tabak & Co., told Bloomberg.

“The value of the company is still the same,” Boockvar said. “AIG bonds tell you that the equity is possibly worth nothing and that they may not be able to pay back the government.”

AIG’s $3.24 billion of 8.25% bonds due in 2018 are quoted at 79 cents on the dollar, to yield 12.2%, Bloomberg reported. The insurer’s $4 billion of 8.175% percent bonds due in 2058 are quoted at 49.5 cents on the dollar to yield 16.7% Bloomberg said.

The Financial Select Sector SPDR Fund (NYSE: XLF), an ETF tracking the financial stocks in the Standard & Poor’s 500 Index, has rallied nearly 30% over the past three months and handily outpaced the market.

Market Matters

While the past few months have been anything but dull for the markets (euphoric may be more appropriate), investors enjoyed a few slow days of peace and quiet.

Another stimulus program came to a close as “Cash for Clunkers” ended with a last-minute flurry of activity.  Analysts claimed that more than 700,000 cars were bought over the past month and August auto sales should rise on a year-over-year basis for the first time since mid-2007.

While dealerships enjoyed a nice rebound in activity (even if just temporarily), banks continued to experience challenges as the Federal Deposit Insurance Corp. (FDIC) reported that 416 institutions were on its “problem” list at the end of the second quarter, up from 305 on March 31, and also conceded that its insurance-fund reserves were dwindling.

Goldman Sachs Group Inc. (NYSE: GS) was in the news again as controversy has continued to surround the investment giant since the AIG bailout and Lehman Brothers Holdings Inc. (OTC: LEHMQ) failures.  Regulators are investigating its weekly “trading huddles,” where its analysts allegedly gave short-term stock tips to select clients and traders, though most other customers were not privy to such insight.

Dell Corp. (Nasdaq: DELL) posted lower quarterly profits, though
the result still beat Street expectations and management projected stronger performance in 2010 when businesses get back in technology buying mode.  Intel Corp. (Nasdaq: INTC) boosted its revenue projections for the next few months, another sign that chip demand is increasing and the business climate continues to improve. 

The Dow Jones Industrial Average roared to eight straight days of higher closes, before hitting a stumbling block on Friday (though no one may have noticed as volume was so light) and the days of triple-digit moves ended (for a week at least).

The other indexes traded relatively flat during the week and even the positive news from Intel did little to generate any investor enthusiasm in the tech-heavy Nasdaq Composite Index. Fixed income fared better than most would have expected, considering another $109 billion in government debt hit the street.

Oil surged to a 10-month high before a larger-than-expected inventory report indicated that crude demand remained weak despite expectations of an economic recovery just around the corner.  In fact, natural gas plunged to a seven-year low.

Economically Speaking

In perhaps the biggest news of the week, U.S. Federal Reserve Chairman Ben S. Bernanke will manage to avoid becoming a part of the so-called “jobless recovery” when he was nominated for another term as central bank chair by U.S. President Barack Obama.

While Bernanke certainly has his critics among grandstanding politicos from both sides of the aisle, few Fed watchers expect Congress to hold up his confirmation.  For now, continuity seems to be the best thing. 

The economic data of the week was relatively favorable with signs of renewed strength in both housing and manufacturing.  New home sales jumped for the fourth consecutive month and the S&P Case-Shiller Index even depicted higher home prices last quarter for the first time since 2006.  Durable good orders surged in July on increased demand within the transportation sector as both General Motors Co. (OTC: MTLQQ) and Chrysler Group LLC put bankruptcy in their rearview mirrors and boosted production, while other companies also benefited from the “Cash for Clunkers” program.

When second-quarter gross domestic product (GDP) was announced as a decline of 1%, many analysts expected a downward revision (perhaps significant) in the months that followed.  Well, the initial revision again showed a 1% decline, a negative showing, but one that many economists believe will be the last contraction in overall activity for a while.

The U.S. consumer remains one big wildcard for the strength of the economy moving forward.  Though the Conference Board reported a better-than-expected increase in its August consumer confidence report, the Reuters/U of Michigan sentiment index offered a contrasting view as it fell to its lowest level in four months.  Personal spending in July got a nice boost from the increase auto sales (“Cash for Clunkers” strikes again), though the income component of the release was unchanged and concerns about the labor picture continued to hinder consumer activity. 

Weekly Economic Calendar

News and Related Story Links:

• MarketWatch.com:
  Speculation in financial stocks dominates trading.
• Bloomberg News:
  AIG Climbs for a Ninth Day, Burning Short Sellers.
• Money Morning:
  Government Incentives Boost July Durable Goods Orders
• Money Morning:
  “Cash For Clunkers” Gets a Reprieve
• Money Morning:
  With Reappointment in the Bag, Fed Chairman Ben Bernanke Turns to Face Troublesome New Challenges
• Money Morning:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout

The first was an unprecedented $41 billion liquefied natural gas (LNG) deal with Australia, which was announced last week. The deal calls for PetroChina Co. Ltd. (NYSE: PTR) – Asia's largest oil and gas company – to buy 2.25 million tons per year of liquefied natural gas (LNG) from the Gorgon field in Western Australia over a period of 20 years.

It is the largest deal ever brokered between the two nations.

The Gorgon field has yet to be developed but is considered to be a key global resource and an economic boon for Australia.

"The Gorgon Project is globally and nationally significant with a resource base of more than 40 trillion cubic feet of gas and an estimated economic life of at least 40 years from the time of start-up,” said Chevron Australia Managing Director, Roy Krzywosinski.

"Furthermore, the Gorgon Project is Australia's largest single resource project and is set to deliver significant economic benefits and create around 10,000 indirect and direct jobs during peak construction."

Chevron Corp. (NYSE: CVX) owns and operates 50% of the field.

Yet this is just one of the mega-deals signed between China and Australia. China was Australia's second largest merchandise trade partner in 2008 with two-way trade of $56.3 billion (A$67.74 billion). Australian exports to China grew 37% in 2008 from the previous year to $27 billion (A$32.48 billion) and comprised chiefly of raw and lightly processed farm, mineral and energy products.

"China needs us, we need China," said Australian Trade Minister Simon Crean.

Of course, China’s demand for natural gas and other resources is growing so fast that it needs more than Australia.  That’s why the Red Dragon recently signed a $5.6 billion deal with a consortium of energy companies operating off the coast of Myanmar.

The consortium, led by South Korea’s Daewoo International Corp., will supply China National United Oil Corp. (CNUOC) with 500 million cubic feet of natural gas a year from 2013 to 2043. The supply, which will come from Myanmar’s A-1 and A-3 offshore blocks, amounts to about 7% of China’s current gas consumption, Reuters reported.

The consortium – which also includes India’s Oil and Natural Gas Corp., Myanmar Oil & Gas Enterprise, India’s GAIL Ltd., and Korea Gas Corp. – will invest a total of $5.6 billion in the project and be responsible for production and offshore pipeline transportation.

Land transportation will be jointly managed with CNUOC. The two parties also plan to build oil and gas pipelines through Myanmar and into China’s southwestern Yunnan province, Reuters reported.

Few Western countries, or Western companies do business with Myanmar, which has been heavily criticized for its human rights violations. The military junta that controls the country is considered one of the most repressive and brutal regimes in the world today. Forced labor, child labor, human trafficking, and instances of sexual abuse are widespread.  

However, China, which has itself been a target among human rights watchdogs, chooses to overlook these discretions, preferring instead to focus on Myanmar’s resources. And in its defense, China is rightly concerned about securing enough raw materials to support its booming economy and a population of about 1.3 billion people.

Natural gas, for instance, accounts for just 3% of China’s total energy needs, but its use is expected to grow rapidly as energy demand increases. China currently consumes about 7.3 billion cubic feet per day, but that is expected to grow at a 10% compound annual rate to 18 billion cubic feet per day by 2020, according to Bernstein Research.

And China is doing the right thing by securing long-term supplies of natural gas now, while prices are low and supplies are high. It’s taken similar action with other commodities over the past year, stocking up on large amounts oil, copper, and iron ore as prices swooned.

China Gases Up While Prices Are Low

Natural gas prices yesterday (Thursday) fell to levels not seen since 2002 after the U.S. Energy Department said the amount of gas in storage hit a record high for this time of year.

Natural gas stockpiles rose by 52 billion cubic feet to about 3.2 trillion cubic feet in the week ended Aug. 21 –21% above year ago levels. Levels are now so high that some experts believe the United States will run out of storage capacity before winter begins.

“We have never been here before in terms of what to expect when storage gets this high,” Aubrey K. McClendon, Chief Executive Officer of Chesapeake Energy Corp. (NYSE: CHK), told the New York Times. “It’s like a balloon; there comes a point where you can’t blow any more air into it.”

Natural gas prices tumbled more than 6% to $2.725 per 1,000 cubic feet of gas on the New York Mercantile Exchange (NYMEX), a price not seen since Aug. 7 2002, The Associated Press reported.

However, now that gas prices have tumbled roughly 80% from last year’s high above $13, some investors believe the market is bottoming out – or at the very least, significantly below its fair value.

Chesapeake Energy stock has risen nearly 8% in the past month, despite plunging prices and mounting inventories. Devon Energy Corp. (NYSE: DVN) is up about a 5.5%.

“The perception is that gas has finally gotten to its lowest point, so people are buying exploration and production stocks," Marshall Adkins, energy analyst at Raymond James Financial Inc. (NYSE: RJF), told Reuters.

However, Adkins does not expect a rebound to come any time soon. His firm expects natural gas prices to fall below $2.50 per thousand cubic feet in the months ahead as an inventory overhang overshadows gas’ attractive price.

Still, there’s good reason to believe gas prices will have a strong rally in early 2010. To begin with, gas companies are slashing production exploration in dramatic fashion.

Newfield Exploration Company, for instance, has announced the plans to voluntarily curtail about 2.5 billion of cubic feet equivalent of gas of its third quarter of 2009 production in response to the recent lull in prices.

U.S. producers have cut the number of rigs drilling for new gas by more than half since Sept. 2008. Oil-services company Baker Hughes Inc. (NYSE: BHI) recently reported that 688 gas rigs were active in the United States, down about 56% from one year ago.

"We think the decline curve for production will be fairly steep because of the big drop in drilling," Rich Howard, manager of the Prospector Capital Appreciation fund, told CNNMoney.

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• Money Morning:
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• Money Morning:
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  China Imports Record Amounts of Copper and Iron Ore, but Exports Drop on Slack Global Demand
• CNNMoney:
  Natural gas stocks defy gravity
• Associated Press:
  Plunge in natural gas prices; new 7-year low
• NY Times:
  Natural Gas Prices Plummet to a Seven-Year Low
• Reuters:
  Investors buying gas stocks but more price pain seen
• Reuters:
  Daewoo in $5.6 bln Myanmar gas export deal to China

After spending three days visiting the restive eastern province of Zhejiang, Premier Wen Jiabao argued for maintaining the loose economic policies implemented under the stimulus program, saying it's too soon to be "blindly optimistic," according to a statement by the State Council.

His remarks are likely to fuel an ongoing debate between government officials over whether it's time to rein in bank lending.

After the government called on Chinese banks to provide increased liquidity to the economy, they lent about $1.08 trillion (7.37 trillion yuan) in the first half of the year – almost 50% over the government's target of $732 billion (5 trillion yuan), and nearly double the total loans extended throughout all of 2008.

Most analysts credit the stimulus program for China's economic rebound, as GDP expanded by 7.9% in the second quarter, up from 6.1% in the first quarter. But now some officials have voiced concerns that asset bubbles and non-performing loans could threaten a long-term economic recovery.

Last week, Chinese Legislator Yin Zhongqing called for limiting new loans to 10 trillion yuan for the full year, according to the Wall Street Journal.

The benchmark Shanghai Composite Index (SSE) is down 15% this month, amid fears that the government will move to tighten bank lending in the second half of the year to throw a wet blanket on the economy. The SSE, Chinas' benchmark index, zoomed 91% from Jan. 1 to Aug. 4, hitting a high of 3,478.01.

China's cabinet yesterday (Wednesday) said it's watching for signs of overcapacity in industries including steel and cement and will increase "guidance" in the coal, glass and power sectors. It will also place new restrictions on stocks and bonds sold by companies in those industries.

And continuing another trend, the People's Bank of China last week in an internal memorandum notified its branches to curtail lending for the remainder of the year. Other Chinese banks, including the Industrial & Commercial Bank of China (ICBC) and China Construction Bank (CBC), have also curbed lending in recent months, Reuters reported, citing anonymous sources.

The Chinese bi-monthly Caijing reported that with the new ceilings in place, ICBC has already lent 83% of its full-year new lending total, while CCB has lent 79%.

Other bankers reported that liquidity appears to be drying up and that loan approvals are taking longer than normal.

"It takes more time to process credit approval from Beijing headquarters now, and the pricing for onshore deals has been heading north in recent months, particularly for U.S. dollar deals,"a banker familiar with the process told Reuters.

And while the going rate for loans to top-tier multinational companies in the first half of the year were made at a margin of 150 basis points above the London Interbank Offered Rate (LIBOR), margins have now soared to over 200 basis points, according to the same banker.

Still, Beijing is unlikely to pull back from the massive stimulus program and the resulting liquidity that has bolstered the world's third-biggest economy. Even with the slowdown, analysts still expect total lending to exceed $1.5 trillion ($10 trillion yuan) this year.

And Premier Wen has called on policymakers to maintain "moderately loose" monetary policy and "active" fiscal policy.

That means the Chinese economy will remain flush with liquidity for the foreseeable future. And just to be on the safe side, the China's State Council has issued a directive to banks to provide more loans to smaller firms.

"We will give appropriate subsidies to financial institutions to support them in extending loans to small companies," the council said following a regular weekly meeting.

It also will extend measures to reduce the social security contributions paid by smaller firms that are facing difficulties and will increase tax support and direct government funding for them.

"This is tightening but it's not a total shutdown," Ken Peng, an economist with Citigroup Inc. (NYSE: C) in Beijing told Bloomberg News. "Policy hasn't reversed but they are contemplating moves that have a lesser impact on the broader economy."

News and Related Story Links:

• Wall Street Journal:
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• Bloomberg News:
  China to Study Curbs on Overcapacity in Steel, Cement
• Reuters:
  Chinese banks slow pace of lending
• Money Morning:
  Is It a Bear Market or Just a Breather For China's Smoldering Shanghai Index?
• Wall Street Journal:
  Beijing Is Chinese Stocks' Benefactor.

U.S. President Barack Obama yesterday (Tuesday) nominated Bernanke for a second four-year term as chairman of the U.S. Federal Reserve. The appointment was mildly controversial and must be approved by the Senate, but lawmakers and investors overwhelmingly approved of the decision to the central bank chief who has shepherded the U.S. economy though its worst financial crisis in more than 70 years.

Bernanke has been criticized for greatly expanding the powers of the U.S. central bank by bailing out large financial institutions like American International Group Inc. (NYSE: AIG) and The Bear Stearns Cos. – while letting Lehman Bros. Holdings Inc. (OTC: LEHMQ) collapse. At the same time, however, ambitious Fed programs designed to recapitalize banks and unfreeze credit markets have succeeded.

"Ben Bernanke, has led the Fed through the one of the worst financial crises that this nation and this world have ever faced," said President Obama. "As an expert on the causes of the Great Depression, I'm sure Ben never imagined that he would be part of a team responsible for preventing another. But because of his background, his temperament, his courage, and his creativity, that's exactly what he has helped to achieve."

Of course, that doesn't mean Bernanke's greatest challenges are already behind him. Over the next few years, the Fed chairman will have to unwind the programs he set in place to backstop the markets – such as the Commercial Paper Funding Facility – which holds $109.2 billion in short-term IOUs issued by corporations – and the Term Asset-Backed Securities Loan Facility (TALF) – which has lent $25 billion to investors to buy securities tied to auto and other consumer and business loans.

In all, Bernanke has injected more than $2 trillion into the U.S. financial system. He's also lowered the Federal Reserve's benchmark lending rate to a record low range of 0.00%- 0.25%.

As a result, the U.S. monetary base has about doubled during the past two years.

Earlier this month, Bernanke said that the central bank's program to buy U.S. Treasury securities would be shut down by the end of October. He's also pointed out that some of the Fed's emergency lending facilities automatically wind down as the economy recovers, because they have onerous pricing and terms.

The central bank could undertake two key steps to accelerate that whole process. It could:

• Increase the amount of interest paid on balances held at the Federal Reserve by depository institutions (banks).
• Sell securities from the Federal Reserve's portfolio with the agreement to buy them back at a later date.

However, Bernanke has provided very few clues about what his so-called "exit strategy" will involve, or how it will be implemented. That is, at what point will inflation become enough of a concern, and at what point does U.S. growth become sustainable enough, to warrant a change in Fed policy?

And that could easily prove to be Bernanke's next big challenge.

At some point, Bernanke will have to raise the Fed's benchmark rate from its current record low range. But it's almost a classic Catch 22: Doing so too soon could stall the fragile U.S. economic recovery; waiting too long to boost rates could allow ruinous inflation to take hold, resulting in a major spike in the cost of food, energy and other essentials.

In this sense, "policymakers are damned if they do and damned if they don't," said Nouriel Roubini, a professor at the Stern Business School at New York University who is often credited with predicting the financial meltdown.

"If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation)," Prof. Roubini said. "But if they maintain large budget deficits, bond-market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation."

Part of the reason Obama is seeking to reappoint Bernanke is that another Fed chairman could disrupt the markets if he or she were to deviate from the path Bernanke has set.

"Wall Street can breath a little easier," Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. (NYSE ADR: MTU), told Bloomberg News. "Having a new chairman come in at this late date would put the Fed-engineered solution to both the recovery and the exit strategy at risk."

Government officials told reporters that White House Chief of Staff Rahm Emanuel, U.S. Treasury Secretary Timothy F. Geithner, and National Economic Council Chairman Lawrence H. Summers all recommended that Obama reappoint Bernanke.

And Summers, the former president of Harvard University, had been the leading candidate to replace Bernanke as chairman of the Fed.

Bernanke's Political Challenges

Putting the economy back on the path to solid and sustainable growth won't be Bernanke's only task, either. In the years ahead, he will have a large role in the Obama administration's push to overhaul financial market regulation.

"Looking forward, we must urgently address structural weakness in the financial system, in particular in the regulatory framework, to ensure that the enormous costs of the past two years will not be borne again," Bernanke said earlier this week.

Obama's plan puts Bernanke and the Federal Reserve in an awkward position. The plan broadly expands the central bank's authority in dealing with systemic risks – such as the growth of reckless mortgage lending or the misuse of financial derivatives – by essentially giving the central bank the power to oversee from top to bottom almost any financial company in the country, including a firm's foreign affiliates.

However, that would make Bernanke an even bigger target for members of Congress who believe the Fed already has too much power, and was far too cozy with banks and Wall Street firms as the mortgage crisis was building.

"Why does the Fed deserve more authority when institutionally it seemed to have failed to prevent the current crisis?" U.S. Sen. Christopher J. Dodd, D-CT, asked last month.

It's possible that Bernanke will face similar questions at his upcoming confirmation hearing.

"I expect many serious questions will be raised about the role of the Federal Reserve moving forward and what authorities it should and should not have," Sen. Dodd told The Wall Street Journal yesterday.

Despite these concerns about the expanding authority of the Fed, Sen. Dodd did support Bernanke's reappointment.

"While I have had serious differences with the Federal Reserve over the past few years, I think reappointing chairman Bernanke is probably the right choice," Dodd said. "Chairman Bernanke was slow to act during the early stages of the foreclosure crisis, but he ultimately demonstrated effective leadership and his reappointment sends the right signal to the markets."

It was Bernanke's slowness to act early on that may actually cost the Fed some of its powers. While Obama's plan generally increases the role of the Fed, it also calls for the creation of a new, independent regulatory agency. That agency would write rules related to mortgages, credit cards and other consumer products, taking away powers previously held by the central bank.

Bernanke has acknowledged that the Fed underestimated the seriousness of the financial crisis at the outset – including the danger posed by subprime mortgage lending – but remains reluctant to relinquish the Fed's role as a consumer advocate.

"We think the Fed can play a constructive role in protecting consumers," Bernanke told members of the House Financial Services Committee last month.

Indeed, Bernanke's response to the financial crisis – and what he does to keep the U.S. economy from relapsing – will play two vital roles: It will shape Bernanke' s financial-crisis legacy; and it will help determine the future role of the Federal Reserve.

"This last couple of years has been clearly a move through uncharted territory, and as we've seen it's taken a lot of unconventional moves to try to deal with the situation," Robert Parry, former president of the San Francisco Fed, told Bloomberg. "There's been a lot of innovation that's gone on, and it seems to me that much of it has been successful."

[Please click here for a commentary analysis of Bernanke's reappointment by Money Morning Contributing Editor Martin Hutchinson.]

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• Money Morning:
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• Money Morning:
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• Bloomberg:
  Bernanke Is Nominated for Second Term as Fed Chief.

• Wikipedia:
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• Money Morning:
  Obama's Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street.

• Wall Street Journal:
  Politics of Bernanke Nod Could Affect Regulatory Overhaul Efforts.

• Wikipedia:
  Catch 22.

However, I have to admit that even I was surprised by last Friday's CBS Marketwatch headline: "We Saved the World From Disaster, Bernanke Says." Although that's an extraordinarily cheeky claim, it seems to have persuaded U.S. President Barack Obama, who yesterday (Tuesday) recommended reappointing the central bank chief to a second, four-year term.

From the investor's point of view, this is not good news.

Bernanke's claim that the world's central bankers rescued the global economy from collapse – even if true – fails to recognize the role they played in actually creating the disaster in the first place.

Excess money expansion throughout the world (a problem that dates all the way back to 1995 in the United States, although it really ramped up after the 2001 stock-market crash) – led to an asset bubble and a situation of over-leverage that left the global financial system in a highly vulnerable situation.

Yes, greedy bankers were part of the problem, but they got greedy because there was too much money sloshing around. History has shown time and again that excessive money always leads to a burst of bad banker behavior.

Bernanke didn't head the Fed until January 2006. For several years before that time, however, Bernanke had been an active voice encouraging his predecessor, former Fed Chairman Alan Greenspan, to keep printing money.

In a now-infamous speech in November 2002, Bernanke declared that the U.S. economy was in severe danger of deflation, and that the Fed should "drop money from helicopters" to avert the possibility. In reality, deflation was not close at that time and the low interest rates that Bernanke encouraged produced a housing bubble that became the center of collapse.

After 2006, Bernanke was fully responsible for any disasters. He continued Greenspan's policy of raising interest rates only very slowly, allowing asset prices to continue inflating.

In October 2007, when the first cracks began to appear in the financial sector – but before the economy itself began feeling the fallout – Bernanke began aggressively dropping interest rates. The result: Oil prices doubled in less than a year, which sent the U.S. and global economies into a tailspin, even as it further destabilized the financial system.

The September 2008 near-collapse of the U.S. financial system – which either badly wounded or took down such U.S. heavyweights as Lehman Brothers Holdings Inc. (OTC: LEHMQ), Merrill Lynch, American International Group Inc. (NYSE: AIG), and Citigroup Inc. (NYSE: C) – was more Bernanke's fault than anyone else's. The greedy bankers and hedge funds were just reacting to market signals, as they should do.

Since September 2008, the short-term economic pain has been somewhat lessened by Bernanke and his colleagues' aggressive monetary easing and massive bailouts of the financial sector. But it also created two problems.

The first one is that the economic bottom – if it's been reached – is being accompanied by unprecedented budget deficits, stretching several years into the future. This means that there will be a huge financing problem as the economy begins to recover.

Second, the huge monetary expansion will cause inflation. We can already see this effect in an oil price of $75 per barrel in the middle of a global recession. Those who tell you that you can't have inflation and recession simultaneously are wrong. It's called "stagflation," and we've seen its ugly effects before. To take just one example, think back to Britain circa 1975, a period that combined a nasty recession with 10% unemployment, and an inflation rate of better than 25%.

In an ideal world, the next Fed chairman would be Paul A. Volcker, to work his deflationary magic as he did in 1979-87. There is a strong case for re-writing the Fed statutes to ensure that Volcker-style monetary policies are mandatory and Greenspan/Bernanke sloppiness impossible. Given Volcker's age, a second choice could have been Lawrence H. "Larry" Summers, a person who is clearly tough enough to act quickly when inflationary problems appeared – as the most assuredly will.

Bernanke's reappointment means that the "Bernanke's Worldview" will remain dominant at the Fed. This is not good news for U.S. investors, savers, or anyone else whose assets will suffer badly when virulent inflation is at hand.

The last meeting of the policymaking Federal Open Market Committee (FOMC), held two weeks ago, promised to end Fed purchases of government bonds and mortgage-backed securities. At the time, I wrote that this seemed a bid by Bernanke to assist his reappointment by deflecting the wrath of the more moderate sound money types (Intransigent ones like me were little mollified by this belated action). With little opposition, Bernanke's reappointment would thus be assured by an administration that doesn't seem to care much about sound-money management, anyway.

Now Bernanke has been reappointed, the next FOMC meeting – set for Sept. 22-23 – will be very interesting. If the FOMC remains mildly restrictive, we will get inflation and higher interest rates, but the problem will remain containable, at the cost of some very unpleasant budget medicine by about 2011, probably in the form of higher taxes.

But if Bernanke's worst instincts are allowed to dominate, the next FOMC meeting will announce a renewed program of Fed purchases of U.S. Treasury bonds and mortgage-backed debt. That will mean that, over the long term, the Fed will print money to fund a large part of the budget deficit.

That was the policy of the German Weimar Republic in 1919-23, which led to 1 trillion percent inflation, at the end of which you needed a wheelbarrow full of money for daily food shopping. A full-fledged Bernanke policy – "dropping money from helicopters," primarily on Wall Street – would have the same effect.

Either way, Bernanke's reappointment means that we, as investors, should have some gold, to protect the purchasing power of our savings. If the FOMC meeting next month goes the wrong way, we should probably invest in a wheelbarrow, as well.

[Editor's Note: Money Morning Contributing Editor Martin Hutchinson - a veteran investment and merchant banker with nearly 30 years' experience in the world markets - is a firm believer in sound financial management.

But Hutchinson is also an opportunistic investor, who is better than almost anyone at ferreting out the high-return profit plays that market problems usually create. As the editor of the Permanent Wealth Investor trading service, Hutchinson says that gold and "Alpha Bulldog" stocks - those with high dividend yields and the likelihood of explosive capital returns - are the way to pounce on the profit opportunities current government policies are creating.

In a new video - which is available for viewing free of charge - Hutchinson details his strategy, and talks about three new Alpha Bulldog stocks that he's identified for his readers. To watch the video, please click here.]

News and Related Story Links:

• Money Morning Special Report:
  Why Dividends and Gold Are the Keys to Permanent Wealth.
• MarketWatch.com:
  We saved the world from disaster, Fed's Bernanke says.
• Federal Reserve Board:
  Remarks by Governor Ben S. Bernanke (Nov. 21, 2002).
• Money Morning Special Report:
  The Secret to Building a Portfolio that Pays – in Good Markets and in Bad.
• Wikipedia:
  Stagflation.
• Money Morning Market Commentary:
  With His Flawed 'Exit Strategy,' Bernanke Has Set the Stage for Stagflation

To be sure, stock prices in many of the markets around the world have come a long way since March. Investors who stood and watched as their portfolios were eviscerated last year have actually recovered at least part of their losses.

But now it's looking like stock prices in some markets have risen more than was warranted – some of the hottest Asian markets appear to be overvalued – which means that it's worth looking again at defensive investments that can protect investors from another stock market downturn.

There is no foolproof way of protecting your money against a market downturn. But a mixture of international investments, gold, put options and high-yielding dividend stocks will help you sleep better at night. Just as importantly, those investments will also behave decently even if the market doesn't crash.

Traditionally, the most frequently used defensive investment has been to keep cash in bank deposits or money market funds. However, with short-term interest rates at zero and inflation still between 2%-3%, keeping funds in cash is a recipe for a slow erosion of its value. What's more is that inflation is likely to creep up substantially before the U.S. Federal Reserve gets serious about raising interest rates, so that value erosion could become substantial.

Also, if short-term rates and inflation are both running around 5%, the saver still will lose, because he or she will have to pay taxes on the interest received and will get no tax reduction to compensate for the value lost to inflation.

The likelihood that inflation will resurface makes bonds an even worse defensive investment. The income is usually fully taxable and it probably won't cover the cost of inflation. (Municipal bonds are tax-free, but subject to the currently deep dangers of U.S. state and municipal finance.) Even the nominal principal value of those bonds will decline if interest rates rise.

There are a number of reasons why long-term interest rates may rise. In fact, I can think of three offhand:

• Inflation and a rise in short-term rates could push the whole yield curve upwards.
• Government deficits may become hard to finance, which will force up Treasury bond yields.
• The Chinese and Japanese central banks – and other big holders of Treasury and housing bonds – may get fed up with the low returns and uncertain currency outlook. They could sell their U.S. bonds and replace them with euro, yen or renminbi (yuan) bonds.

So, if the choice were between long-term bonds and cash, I would recommend cash.

The traditional investor remedy for inflation is gold and gold-linked investments. I would certainly recommend moderate holdings of these, but would avoid a complete devotion to them. For one thing, the gold price is already high by historical standards, and perhaps a little risky. There must be some chance that the global recession will be deeper and more prolonged and inflation more timid than I project. So, holdings of metallic gold, gold-mining shares and other precious metals such as silver, platinum and palladium should be no more than 20%-25% of your portfolio.

Another good way to hedge against risks in the U.S. stock market is to buy international stocks.

India's market, in particular, looks slightly overvalued at 20 times earnings. The lowest Price/Earnings (P/E) ratios are in Russia and Venezuela, but with the problems and issues they face, it would be silly to invest in either of those countries today.

Countries like Finland, South Korea and Germany are, perhaps, the most attractive. Their budget deficits are well under control and their economies are showing signs of renewed expansion. It's well worth thinking about a modest diversification into the markets of nations that have been notably distant from the toxic assets that led to last year's financial meltdown.

In recent years, inverse exchange-traded funds (ETFs) have become popular hedging mechanisms. These typically take a short position in stock index futures, so their share price rises when the index falls.

There are two problems, however. The obvious problem is that these ETFs are vulnerable to a rise in the index. The less obvious problem is that because the funds must rebalance daily – according to the amount of shares in the fund – they can accumulate "tracking errors," which means that they end up rising less than the index falls.

Even the Rydex Inverse Standard & Poor's 500 Strategy Fund (RYURX), which has been running since 1995, is currently only around 10% above its 2000 low, while the Standard & Poor's 500 Index is more than 30% below its 2000 high.

This problem is much worse for so-called "leveraged inverse funds," which are supposed to move two or three times as much as their index. These can accumulate tracking errors at an alarming rate – especially with highly volatile indexes in overseas markets. For less volatile indexes, such as the ProShares UltraShort 20+ Treasury Fund (NYSE: TBT), the tracking error is much less.

Nevertheless TBT is only a moderately good hedge against rising interest rates, unless that rise happens quickly.

The best way to hedge against a huge bear market, like that of 2007-2009, is to buy long-dated out-of-the-money put options on the Standard & Poor's 500 Index (SPX). These are traded on the Chicago Board Options Exchange (CBOE). You can buy these out to December 2011, and those with strike prices of 500 or 600 are currently reasonably priced, at $23 and $38, respectively. To get the value of the actual contract, you multiply by 100. So, for example, $3,800 will buy you an option to sell the SPX at 600 (so 100 units represents $60,000 of stock) in December 2011. Then, if at some point before December 2011, the SPX is trading at 450, you will sell your options, receiving something north of $15,000 for your $3,800 investment.

As with gold, your investment in these options should be limited – perhaps to no more than 5% of your stock portfolio. However, they can have the great advantage of providing investment cash and morale-boosting profits when the market gets hit and is truly depressed.

Finally, you can adjust your stock portfolio itself by buying stocks with strong dividend yields. These will fluctuate with the market, but the dividends they give off will provide you with an additional return, over and above the current measly 2.6% dividend yield of the S&P 500 Index. Moreover, that return will generally rise with inflation (as the company's sales and earnings rise in dollar terms) so your high income will be much better protected against inflation than you'd be if you were relying on income from bonds.

High dividend stocks, whose dividends are covered by earnings, are typically also low-P/E stocks. Thus, by buying them you are buying at the "value" end of the market where bubble-induced overvaluations are less of a risk. In my view, however, a low-P/E stock that pays a high dividend is greatly preferable to one that doesn't. That's because management is giving shareholders a chance to reinvest the money, rather than keeping it to spend on crazy expansion schemes or their own perquisites. There is also less of a chance for the company's earnings to be fudged through some funny and complicated accounting quirk.

[Editor's Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best - because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world's financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

The Permanent Wealth Investor assembles high-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for subscribers. Hutchinson's strategy is tailor-made for periods of market uncertainty, during which investors all too often go completely to cash - only to miss some of the biggest market returns in history when market sentiment turns positive. But it can work in virtually every market environment.

To find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor - please just click here.]

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  The Three Ways China May Deal With Growing U.S. Debt.

And with good reason.

Sugar prices have zoomed more than 80% since the start of the year – eclipsing the 21-cent-per-pound mark for the first time in 28 years. But Rogers says there's more room to run: Even after its scorching advance this year, sugar remains 70% below the record peak it hit in 1974.

Given that kind of profit potential, Rogers is much more bullish on sugar than he is on gold.

"Sugar is still very depressed on any kind of historic basis and I suspect it will go higher," he said recently. "I wouldn't sell sugar. I don't know if it is going to go up in the next week or the next month, but I am certainly expecting sugar to go much higher during the course of the bull market over the next several years."

Not that he's bearish on gold. It's just that his ardor for the yellow metal has clearly cooled: "If it goes down I'll buy some more, and if it goes up I'll buy some more," he said. "I periodically buy some gold. I don't have a method to it. I just buy it."

Rogers first made a name for himself with The Quantum Fund – a hedge fund that's often described as the first real global investment fund – which he and then-partner George Soros founded in 1970. Over the next decade, Quantum gained 4,200%, while the Standard & Poor's 500 Index climbed about 50%.

It was after Rogers "retired" in 1980 that the investing masses got to see him in action. Rogers traveled the world (several times), and penned such bestsellers as "Investment Biker" and the more-recently-released "Bull in China."

He's also made some historic market calls. Rogers predicted China's meteoric growth a good decade before it became apparent. And in early January 2008, he warned that the U.S. economy was headed for "one of the worst recessions" in decades, and counseled investors to shift into commodities since they were primed for a big upswing – two predictions that would have richly rewarded investors who took them to heart.
He reiterated those predictions – as well as several others – as part of two exclusive interviews that he granted to Money Morning Investment Director Keith Fitz-Gerald that April.

Rogers – the chairman of Rogers Holdings, and a man who shifted his home from New York to Singapore because of the global trends he follows – has now turned his attention to sugar. And he's not alone.

Commerzbank AG (OTC: CRZBY) analyst Eugen Weinberg told Commodity Online that net long positions on sugar contracts traded on the ICE Futures exchange (NYSE: ICE) (formerly the New York Board of Trade) are running at four to five times their normal levels, totaling more than 200,000 metric tons. His take: Cash-rich hedge funds have developed a sweet tooth for the crystalline commodity.

"This situation hasn't been observed in years," Weinberg said in an interview. "I think we are seeing a combination of very important fundamental factors and the price being driven by speculative interest."

And Michael Coleman, a Singapore-based manager of commodities hedge funds, told Bloomberg TV that sugar prices could soar an additional 80% – and could even eclipse the 40-cent-a-pound level.

After peaking at a recent high of 23.33 cents earlier this month, sugar closed yesterday at 21.79 cents a pound.

"Sugar is caught in a perfect storm," Coleman, managing director of Aisling Analytics, which runs a $1.4 billion fund invested in energy and agriculture, told Bloomberg. "From this point on, it depends on how price affects demand."

Both those factors – price and demand – are worth a closer look.

Tight Supply Will Send Sugar Prices Higher

Sugar enjoys a reputation as a volatile commodity during the past 50 years, with a price that's ranged from a low of three cents a pound to a high of about 60 cents.

From a price standpoint, sugar bulls say the natural sweetener is in a long-term uptrend.

If prices are to rise long-term, supplies will have to remain fairly tight as demand grows. The catalysts are in place for such a scenario to play out.

In the United States, the world's largest economy, sugar supplies are tight and should get tighter. The U.S. Department of Agriculture (USDA) estimates that in the months to come, the supply of sugar will fall 43% from current levels, The Wall Street Journal reported.

Demand will continue to outrun the supply of sugar for a couple of years, says International Sugar Organization (ISO) economist Leonardo Bichara Rocha.

"This year's deficit – the difference between supply and demand – is running at 7 to 8 million [metric] tons, and next year it will be between 4 and 5 million [metric] tons," Rocha said in an interview with Commodity Online.

Weather problems in the nations of the world's leading sugar producers – Brazil, India and China – are heavily to blame for the short supply. Heavy rains in Brazil have caused yields to drop, while in India a weak monsoon season has contributed to a production drop so massive that the country went from being a net exporter last year to a net importer this year, Reuters reported.

Nor are these easy problems to fix, experts say. Although Australia could boost production, China's growing demand has been accompanied by a lack of investment in new production. That's not surprising given that sugar requires a lot of land and water to grow – two things that are in short supply in China. Beside, entrepreneurs believe they can make much more by developing that land and putting a factory on it than they could by growing sugar cane.

The bottom line: It could take two years for sugar supplies to catch up to current levels of demand. And by that time, some powerful global forces could well be pushing sugar demand up to an entirely new level.

Global Trends Will Pump Up Worldwide Demand for Sugar

Although investors label sugar as a commodity, consumers view it as an "ingredient." It literally goes in everything – except, maybe, for diet soda.

Consumption of sugar ranges from around three kilograms per person per year in Ethiopia to roughly 40 kilograms a person a year in Belgium. The basic rule of consumption about sugar is that per-capita consumption rises in concert with per-capita income, until the annual ratio reaches about 35 kilograms per person in middle-income countries.

In that respect, sugar prices may well soon have a gale-force tailwind pushing them higher. And that tailwind has a name.

It's China.
China's emerging middle class is already a major economic force. Estimates of its current size vary widely – ranging from 100 million to 247 million – but again it's the long-term potential that's key, Money Morning's Fitz-Gerald said in a recent question-and-answer session with Executive Editor William Patalon III.
"One research paper predicts that China's middle class could reach 600 million by 2015. That's just five years from now," Fitz-Gerald said. "To put this into perspective, consider this: The entire U.S. population is about 300 million. So we're talking about a middle class alone that's potentially twice the size of the entire U.S. market."

The McKinsey Global Institute, the consulting firm's independent economic research arm, projects that China's middle class will increase from 43% of that country's population today to 76% by 2025. At that point, China will be the world's No. 3 consumer market.

China's a big story, but it isn't the only story – not even in Asia. India's middle class will grow from 50 million now to about 583 million people in the next 20 years, an escalation that will transform that country into the world's No. 5 consumer market, up from No. 12 today.

All told, the worldwide middle class will likely grow from 430 million in 2000 to 1.15 billion in 2030, the World Bank says.

Investors all too often focus on all the additional hamburgers, Cokes, baseball mitts or iPhones the world's corporate elite will be able to sell.

But the biggest winners could be the commodities producers – especially those whose products (like sugar) go into products of all kinds.

Right now, in a prospering Asia alone "there are 3 billion people trying to have a better life and most people when they get more prosperous, use more sweets," Rogers says.

On a global basis, the USDA estimates consumption will climb by 1.5 million tons in 2009-2010 from the previous year, BusinessWeek reported. And that's just a start.

Progress brings with it new technologies – and new products – which combine to form another powerful global force that will contribute to that long-term tail wind behind sugar prices.

One such new product: Ethanol fuel, much of which is made from sugar cane. Brazil, the world's largest producer of sugar, is diverting more than half of its sugar-cane crop to ethanol production. That compares to only one-third of the corn crop in the United States, where the ethanol market is still nascent, and where researchers are looking at "Cellulosic" alternatives for biofuel production.

So it's no surprise that when Rogers sat down with Money Morning's Fitz-Gerald last year, the iconic investor said he was bullish on two things: China and commodities. Late last year, Rogers and Australia's Macquarie Funds Group teamed up to create an agricultural-commodities index that will help investors profit from shifting patterns of food consumption in the burgeoning market of Mainland China.

"I bought more [commodities] recently. I know that one of the few bull markets that I can see going up in the next five to 10 years is in agriculture," Rogers told Money Morning earlier this year. "You may not have bull markets in cars or financial institutions or lots of other things, but I know the world is not going to stop eating."
The Macquarie and Rogers China Agriculture Index is an investable index that tracks price changes of the market "basket" of the agricultural commodities most commonly consumed in China. Macquarie Funds is the asset management arm of Australia's Macquarie Group.

Six Possible Profit Plays

There are several ways that investors may capitalize on this bullish long-term outlook for sugar? They're all worth a look.

• The "purest" sugar play – and also the shortest-term – is an investment in sugar futures, available on ICE in 112,000-pound contracts. The No. 11 contract trades global raw sugar, while the No. 16 contract trades the U.S. market, according to Commodity Online.
• Also futures Investors seeking an exchange-traded play on sugar can check out the futures-based iPath Dow Jones AIG Sugar Total Return Sub-Index (NYSE: SGG) Exchange-Traded Note (ETN). As of the close yesterday, this ETN had posted a year-to-date return of 62.1%.
• Although a bit more broadly based, the Deutsche Bank AG (DB) managed Power Shares DB Agricultural (NYSE: DBA) Exchange-Traded Fund (ETF) does include sugar as part (16%) of its holdings. Other holdings include soybeans (31%), wheat (28%) and corn (23%) – that last holding being a major near-term potential beneficiary if high sugar costs induce foodmakers to switch over to corn-based sweeteners. The fund is down about 3% so far this year.
• The ELEMENTS Rogers International Commodity Agriculture (NYSE: RJA) ETN, tracks 20 futures contracts worldwide. It's down about 6% this year.
• In terms of pure agriculture-related investment plays, there's the Van Eck Market Vectors Agribusiness ETF (MOO), a fund that really reflects the breadth of the agriculture sector, with holdings apportioned across such agricultural sub-sectors as chemicals, agri-product operations, equipment, livestock operations, and ethanol/bio-diesel. It's up 39.2% so far this year.
• Although not a sugar play, per se, iff you believe that sugar-cane-based ethanol – and other sources of alternative energy – will be an inevitable part of the global future, consider the following "green" ETF: The PowerShares WilderHill Clean Energy Fund (NYSE: PBW), one of the better-quality funds that focus on "clean" technology as determined by the WilderHill Clean Energy Index. It's up 17.2% this year.

News and Related Story Links:

• Money Morning Special Report:
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• Money Morning Special Report:
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• Money Morning Market Commentary:
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• Intercontinental Exchange:
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• CNBC-TV18:
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• The Wall Street Journal:
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• BusinessWeek:
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• Money Morning:
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• Macquarie Funds Group Hong Kong:
  Macquarie and Rogers China Agriculture Index
• InvestorDictionary.com:
  Market Basket
• Reuters:
  U.S. Food Companies Seek Easier Sugar Quotas
• The Wall Street Journal:
  Letter to Secretary Vilsack
• Investopedia:
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• CommodityOnline.com:
  Why Jim Rogers is bullish on sugar over gold.
• CommodityOnline.com:
  Bitter sugar prices and opportunities for investors.
• Dow Jones:
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• Money Morning News Analysis:
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• Bloomberg News:
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• Money Morning News Analysis:
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• Wharton Business School:
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Existing home sales rose 7.2% to a 5.24 million annual rate in July, the most since August 2007 and the fourth straight month the figure increased, the National Association of Realtors (NAR) said Friday. Year-over-year sales grew 5%, the increase since September 2007, just before the markets came crashing down the following month.

“The housing market has decisively turned for the better,” said NAR chief economist Lawrence Yun. “A combination of first-time buyers taking advantage of the housing stimulus tax credit and greatly improved affordability conditions are contributing to higher sales.”

Rising sales numbers in the past few months may have triggered previously discouraged sellers to re-list their homes, according to Yun.

Total housing inventory at the end of July grew 7.3% to 4.09 million existing homes available for sale, representing a 9.4-month supply at the current sales pace. However, the raw inventory totals are 10.6% lower than they were last year.

Sellers are responding to rising inventories accordingly: The national median existing home price was $178,400 in July, 15.1% lower than a year ago. But the fact that buyers are dipping their toes back into the murky depths of the housing market doesn’t necessarily mean the sector is trending toward a full-blown recovery.

Turn of the Year Makes for Uncertain Future

One in three homes sales last month came from first-time buyers who benefited from the Obama administration’s $8,000 tax credit, which ends after November. First-timers accounted for almost the same amount in June with 29%. That means there could be a significant drop in purchases when that program expires.

The real estate industry is lobbying Congress to extend the first-time buyer tax credit, and Nevada Democratic Senate Majority Leader Harry Reid told reporters earlier this month an extension is "something we can get done."

With or without a tax break, consumers in this economy are looking for a bargain much like they are with retail sales and auto sales. The bulk of the first-time tax credit sales have come from lower-priced homes, and NAR data supports that. Sales of homes that cost less than $250,000 were up almost 17.8% year-over-year through June. Meanwhile, sales decreased 13.3% in the $250,000-$500,000 bracket, 18.6% in the $500,000-$1 million range, and 32.7% in the $1 million – $4 million range.

Lost pricing power in the more expensive homes wasn’t lost on Pulte Homes Inc. (NYSE: PHM), which last Tuesday finished its acquisition of value-priced homebuilder Centex Corp.(NYSE: CTX), making Pulte the largest homebuilder in the United States.

"I'm not seeing a tremendous amount of good news on the job or economic front, so I do think it's important that the [tax] credit get extended," Pulte Chief Executive Officer Richard Dugas told The Associated Press.

The turn of the year isn’t likely to yield much good news on the job front. Most economists are expecting the unemployment rate to top out around 10%, and although July’s rate dipped one-tenth of a percentage point, the latest weekly initial unemployment insurance claims were discouraging, rising 15,000 to 576,000 for the week ended August 15.

“The improvement in the labor market has stalled,” Scotia Capital Inc. economist Derek Holt told Bloomberg News following the latest jobless claim figures. “Consumer spending will be pushed back on its heels for a longer time than markets are expecting.”

When the bleeding of jobs does peak, an upturn in employment could take some time as the United States experiences a jobless recovery. With an unemployment rate at or around 10%, home inventory levels could creep back in to 2008 territory. 

“[The unemployment rate projection] indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate,” Fed economists wrote.  “This suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing work forces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates.”

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In a report to be released this week, the Obama administration will boost its 10-year projection for the federal budget deficit to about $9 trillion – an increase of roughly $2 trillion, or 29%, from its prior projection, Fox News reported over the weekend, citing a source from the Office of Management and Budget (OMB).

The new cumulative deficit projection – for 2010-2019 – replaces the administration's previous estimate of $7.108 trillion. Changes in budget projections – whether they result in a surplus or a deficit – are often refined as economic conditions change. This new projection was necessary because the recession has gone on for so long, causing federal tax receipts to plunge – and because the economic rebound will be prolonged and weak, resulting in lower forecasts for future federal revenue.

Although most of the news media focuses on the Obama administration’s $787 billion stimulus measure, the fact is that the federal government was pushing forward with nearly $12 trillion in rebound-related financing commitments, Money Morning reported this spring.

The administration earlier this year predicted that unemployment would peak at about 9% without the financial-jump-starting initiatives and 8% with them. But U.S. joblessness zoomed skyward anyway, and stood at 9.4% last month, although many economists now say that a double-digit unemployment rate – one of 10% or more – is easily possible.

The nation's debt now stands at $11.7 trillion. In the scheme of things, that's more important than talking about the deficit, which only looks at a one-year slice of bookkeeping and ignores previous debt that is still outstanding.

Back in June, the non-partisan Congressional Budget Office (CBO) predicted that the federal deficit would reach $1.825 trillion this year. The CBO and the Obama administration will tomorrow (Tuesday) separately release new budget-deficit predictions. Last Wednesday, a senior White House official, speaking on the condition of anonymity, told The Associated Press that the administration estimate would reach $1.58 trillion – or triple last year’s deficit.

The report for the budget year that ends Sept. 30 also will predict Washington to spend $3.653 trillion this year, although revenue will reach only $2.074 trillion, the unnamed senior official told The AP.

"Whether it's $1.6 trillion or $1.8 trillion, it's pretty bad," said Robert Bixby, executive director of the bipartisan fiscal watchdog The Concord Coalition, told Fox News. "I hope no one tries to spin that as good news."

Total U.S. debt has soared to $11.7 trillion (the budget deficit is the “shortfall” in the annual deficit, while the debt is cumulative), having balloned to that level as a result of the multiple annual deficits that have become the norm, it seems.

Market Matters

Just who is the world’s great economic superpower these days?  At times, it seems, “as China goes, so go the world equity markets.”  Early in the week, the Shanghai Composite Index (SSE) suffered its largest percentage decline since late 2008, with the index plunging more than 20% for the month on concerns about the sustainability of China’s recovery.

The global markets watched as the Japan, Europe, and the U.S. indexes followed the SSE downward.  By mid-week, however, all eyes were back on the domestic market as another sell-off in China was overshadowed by signs of growing U.S. economic strength and reports of enhanced energy demand.

The global bailout plans moved into a new stage as the Swiss government relinquished its control over banking giant UBS AG (NYSE: UBS) by selling off its investment for a $1.13 billion profit, or a 30% annualized return.  While the U.S. government has yet to reap similar benefits, several major banks have paid off their Troubled Asset Relief Program (TARP) loans and the CEO for one of the poster children for financial distress, American International Group Inc. (NYSE: AIG), announced that his firm should be able to pay back the government and may even be able to “do something for shareholders as well.”

While many auto dealers complained about the rebate process on the “Cash for Clunkers” program, General Motors Corp. stepped forward and will begin providing advances to participants who continue to wait for the government to move through its traditional red-tape.

The healthcare debate (and political infighting) raged on (complete with widespread town hall civil disobedience).  Rumors that the government would remove its public-health-plan option sent related health-care stocks soaring early in the week, though the jury remains out as to how this will really play after U.S. President Barack Obama guaranteed approval of an overhaul and then bashed congressional Republicans for their efforts in blocking any plan whatsoever.

On the earnings front, the housing sector received mixed signals as Home Depot Inc. (NYSE: HD) bested expectations, while rival Lowe Companies Inc. (NYSE: LOW) fell short and reduced its outlook. Cost-cutting was widespread among retailers as The TJX Cos. Inc. (NYSE: TJX), The Gap Inc. (NYSE: GPS), and even Target Corp. (NYSE: TGT) benefited from increased margins, though sales remained lackluster at best.

Hewlett-Packard Co. (NYSE: HPQ) struggled in its PC and printer-business segments, though management expects a healthy rebound in its fiscal fourth quarter.

Fixed income benefited from some early “flight-to-quality” trades and a report that showed strong foreign demand for U.S. Treasuries in June (despite ongoing rumors to the contrary).  Stocks fell sharply in sympathy with the China sell-off, though buyers reemerged in a big way on positive signs from the earnings and economic reports.

Likewise, oil prices shook off some early week negativity and surged to 2009 highs, as a surprising plunge in inventory levels revealed growing demand – perhaps to coincide with the beginning of a global economic rebound?  On that note, U.S. Federal Reserve Chairman Ben S. Bernanke’s comments about the prospects for recovery (though slow at first) were extremely well-received as investors seemed to all but forget about following Shanghai and the U.S. markets assumed the leadership role once again.  The major domestic indexes shrugged off the weak start and pushed to new highs for the year.

Economically Speaking

In addition to the Home Depot and Lowe’s earnings reports, housing news was prevalent during the week and the results were somewhat confusing.  The National Association of Home Builders reported that its Housing Market Index climbed for the second month in a row and reached its highest level in over a year.  Likewise, applications for mortgages increased for the third straight month on declining interest rates.

However, foreclosure rates remain on the rise and, according to the Mortgage Bankers Association, 13.2% of mortgages are delinquent or worse (in foreclosure); in fact, subprime mortgages are no longer the only area of concern as the unsettled labor picture has prompted homeowners with strong credit to fall behind on their prime mortgages as well.

Though housing starts fell in July, the decline was entirely attributable to apartment activity and construction of single-family homes actually rose for the fifth straight month.  Additionally, existing home sales in July surged by more than 7% as buyers took advantage of the misfortunes of others (in foreclosure), though prices continue to fall because of transactions related to these distressed properties.

In non-housing news, separate regional reports from the New York and Philadelphia Feds boosted the outlook for the domestic manufacturing sector and the overall economy.  Wholesale inflation remained benign as the producer price index (PPI) fell by a wider-than-expected 0.9% in July and prices have plummeted over the past 12 months by the largest percentage (6.8%) since records have been kept, dating back to 1947.

Be forewarned: Oil just hit a 2009-high.

U.S. Federal Reserve policymakers met for their annual conference and Fed Chair Bernanke shared a favorable assessment about the recovery process from “the most severe financial crisis since the Great Depression.”  Of course, Bernanke tempered some of his remarks and reiterated that, while the recession seems to be coming to an end, the rebound would likely be slow, with unemployment remaining a concern.

Bernanke also spoke of the need for financial regulatory reform in order to ensure the current financial debacle isn’t repeated.  The Fed also extended its Term Asset-Backed Securities Loan Facility (TALF) lending program in order to help stem the potential “challenges” that remain among commercial mortgage-backed securities.

Weekly Economic Calendar

News and Related Story Links:

• FoxNews.com:
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• National Association of Home Builders:Official Web Site.
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• Mortgage Bankers Association:
  Official Web Site.
• Money Morning Special News Category:
  Jobless Recovery.
• Office of Management and Budget:
  Official Web Site.
• The Concord Coalition:Official Web Site.