Five Ways to Profit as the U.S. Dollar Turns Into the "Bernanke Peso"

By Martin Hutchinson
Director of Global Investing Research

As expected, U.S. Federal Reserve Chairman Ben S. Bernanke cut the Federal Funds Rate by another quarter point Wednesday, taking that benchmark lending rate down to 4.5%.

The European euro immediately soared towards $1.50, oil topped $96 a barrel, gold exceeded $800, and the once-proud U.S. dollar behaved more and more like the Argentine peso in one of that country's most-troubled periods. The financial markets seem to believe there's a severe danger of renewed inflation, and so do I. The question is: What's to be done about it?

There's no question that the U.S. housing market is in a real mess. House prices dropped by 5% in the year to August, housing starts are 40% below their peak, and unsold house inventory has reached a record 10 months of sales. The latter is the most dangerous statistic; most homeowners - those who aren't burdened with super-high mortgages - can well survive a decline in the value of their homes when they try to sell, particularly if the purpose of that sale is to buy another house, perhaps in a different area.

But if that house takes 10 months to sell, then the situation can be quite sticky, to say the least.

For one thing, if homeowners lived in the house for a long time, the plunge in value can mean that years and years of mortgage payments - and counted-upon home equity - have been vaporized. But if those homeowners are then forced to buy and move into another house before the first one sells, the financial squeeze can be deadly. For one thing, there's no longer that built-up equity, which can provide a down payment and even provide a cushion to borrow against, should the house take a long time to sell. Then there's the challenge of simultaneously juggling two mortgage payments, a near-impossible feat for someone actually burdened with the dreaded super-high mortgage I mentioned a moment ago.

When Time Doesn't Equal Money

It's not true that money is the most important thing in life; even ignoring any spiritual components, time is often much more critical, and wasting it much more damaging.

The same should be true in the financial system, but it isn't.

In a system that works properly, if some financial assets became damaged, dealers would just mark down their prices enough to sell, and move on. But in the system we have, dealers are reluctant to mark prices down, because their entire inventory would then have to be "marked to market," thereby reducing the current quarter's profits - and vaporizing everybody's bonuses.

Under such circumstances, it's much easier to let trading to dry up altogether, allowing traders to pretend all is well with the portfolio. That's essentially what happened with subprime mortgages and asset-backed commercial paper (ABCP) back in August, even though many of the securities were in theory only moderately value-impaired, meaning they still should have traded smoothly.

Fed Chairman Bernanke's rate cuts were intended to revive the market and relieve the blockage of paper that wouldn't trade, but they haven't succeeded. The stuff that wouldn't trade then still won't trade now, because it wasn't the previous higher interest rates that were preventing it from trading. Housing hasn't recovered, because there are still too many credit problems in that sector. These are credit problems that can't be solved without housing sales, and that can't take place until house prices have dropped to a level at which new buyers can afford them.

Meanwhile, share prices have resumed their climb, in spite of numerous earnings disasters in the financial sector. At the same time, international stock markets, fueled by liquidity from the United States and China, have gone on another roll, while oil has shot up another $20-plus per barrel.

Bernanke's medicine hasn't cured the patient's affliction; instead the meds have infected the given him a whole new set of diseases that will eventually make him worse. For one thing, you'd better believe that $96-plus oil, if it persists at these price levels for more than just a very few weeks, will cause all sorts of new and unanticipated stresses and strains in the U.S. economy - not the least of which is to finally make the inflation numbers tick up.

Higher inflation would, in turn, cause the dollar to sink further, which would cause oil and commodity prices to increase ... you get the idea. It's a vicious circle. Raising interest rates would halt the inflation of oil-and-commodity prices, while also stopping the dollar's downward spiral. But higher interest rates would speed the decline of the housing market, as well as making Wall Street squeal.

What a mess. The only consolation is that the havoc that's been caused is finally causing some of the Wall Streeters who helped cause all this to lose their jobs - though, if like E. Stanley O'Neal of Merrill Lynch & Co. Inc. (MER), they all get $161.5 million payoffs, Wall Street will be both broke and empty pretty soon, as all its practitioners exit stage right.

Profiting Against a Backdrop of Chaos

The question to ask, then, is how do we profit? There are several potential plays here. Let's review them carefully:

  • The currency that hasn't yet been affected by the declining dollar, and whose economy is big, highly liquid and immune to Wall Street, is Japan - hence the Russell/Nomura Japan small-cap (JSC) exchange-traded fund, or ETF, which invests in domestically-oriented Japanese stocks, seems a safe haven.
  • Gold may suffer the occasional hiccup, but overall it seems poised to soar, so the StreetTracks Gold ETF (GLD) seems a good place to have part of your money.
  • Overall, you might consider a large natural resources company like BHP Billiton Ltd. (BHP), especially since most of its operations are located in safe, resource-rich Australia.
  • For oil itself, you should remember that for every dollar that oil increases in price, there's also a gain in value in Canada's Athabasca tar sands, a politically reliable - if expensive - oil source. Accordingly, Suncor Energy Inc. (SU) should show some nice earnings momentum going forward.
  • Finally, if you still want a financial services exposure, you should consider Kookmin Bank (KB), a bank oriented towards the Korean economy, whose forecast growth rate for 2007 has been revised up to 4.6% recently. Korea has an election in December, and seems poised to become more business-friendly, which shouldn't hurt valuations in that market.

Interest-rate cuts make U.S. markets rise in value, and also bring happy smiles to the Wall Street crowd. But don't be fooled by their apparent happiness. Each time U.S. interest rates decline, foreign markets become all that much more alluring as places to put your money.

And remember this: Even the Argentines have always had the good sense to put their money abroad.

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