The worldwide credit crunch isn’t over after all.

Just days after U.S. stocks soared to record highs – and Wall Street upgraded the embattled homebuilding sector – worldwide groups are issuing warnings that there’s likely more pain to come. Investors even bid up the shares of Citigroup Inc. and UBS AG earlier this week – even though the two banking giants on Monday said they would write be writing down $9.3 billion in bad debts between them.

But we said that all this optimism – bordering on euphoria – was premature. And, unfortunately for key economies worldwide, we were correct. [For our free investment analysis, "Avoid the 'Resurgent' Homebuilding Sector and Go Global For Profits," please click here.]

Now the key is to find a way to profit, while also avoiding the growing risks complacent investors face from an insidiously expanding international credit crisis.

Let me explain.

Housing and Mortgage Crisis Not Over Yet

When the Dow Jones Industrial Average soared to its all-time record close of 14,087.55 on Monday, it was because investors thought the worst of the subprime mortgage mess and housing slump were behind us, and because the lousy earnings reports at Citigroup and UBS [Generally regarded as the most-conservatively run bank in Europe] allowed investors to define the scope of the credit problems financial institutions faced.

Unfortunately, investors were wrong on all counts.

Just since Monday, additional reports have pointed to a continued slide in the U.S. housing market, which will translate into still more defaults, and still more job losses in the "real" economy. That’s going to impact the ultimate key to U.S. economic growth – consumer spending. Depending on what other mini ‘boomlets’ are under way in the economy, at any given time, consumer spending provides 60% to 75% of the fuel for the economy.

Lately, housing has fueled some of that spending. Rising home prices that translated into growing "equity" enabled many consumers to treat their houses like an

ATM machine, extracting cash for big-ticket purposes, further fueling growth. Or, even worse, consumers have regarded their homes as their retirement "savings," meaning they could spend all of their paychecks today, thus also artificially boosting consumer spending.

That’s changing here in the U.S. market already. And it’s going to get worse.

Over the next few months, more than 2 million homeowners with subprime adjustable rate mortgages, or ARMs, are looking at resets – and at much-higher interest rates – a reality that’s likely to deepen and lengthen an already-dismal housing downturn.

More than $50 billion in ARM loans will reset this month alone, a record for a single month, says Economy.com, an econometric firm based in West Chester, Pa.

Even the near-term numbers don’t look that good: On Tuesday of this week, the National Association of Realtors reported that that the pending home sales index fell 6.5% in August after dropping a revised 10.7% in July. The index – a forward-looking gauge of home sales – is at its lowest point since it was created in 2001. [For our full report on this story, please click here].

And when it comes to housing and mortgages, the U.S market is not the only problem area. Mark our words – you heard it here, first – all this negative analysis will soon be true in the United Kingdom, too, where a white-hot housing market looks like an "I Love Lucy" rerun of what happened here in the U.S. market.

Just yesterday in the United Kingdom, in fact, a survey by that nation’s biggest lender said that prices fell 0.6% in September, dragging down the annual rate of price inflation from 11.4% in August, to 10.7% in September.

And that research by Halifax, the No. 1 U.K. mortgage lender, agrees with other market surveys, including reports from rival lender Nationwide, and one from the Royal Institution of Chartered Surveyors, BBC News reported yesterday.

Earlier in the month, the Bank of England said that the number of new mortgage approvals plunged 9% in August from the same month in 2006.

"Evidence is mounting that the housing market is now cooling markedly in the face of financial market turmoil, and the increasing affordability pressure on house buyers," said Howard Archer of Global Insight. "Mortgage rates are rising further as a consequence of the liquidity crunch pushing up money market rates, while the Northern Rock [British banking] crisis may hit confidence and increase consumers’ wariness about buying a house."

In late September, the Organization of Economic Cooperation Development (OECD) – which represents the world’s 33 most-advanced industrial nations – warned that the United Kingdom might need to cut interest rates to keep economic growth from declining sharply. The reason: The global credit crunch and that country’s domestic housing slump were the two key culprits cited.

Nor is Britain the only other problem area besides the United States.

In Australia, the credit crisis is affecting non-bank lenders so much that financial advisors and debt-recovery specialists are urging home borrowers to consider refinancing their mortgages with major banks. Non-banking financial-service firms have raised their rates to avoid the credit crisis fallout, the Australia Herald Sun reported in its edition today (Friday).

Other Problems Abound

Housing isn’t the only problem facing investors. Here in the United States, the dollar has weakened to near-historic lows against other major currencies, and the expectation of additional interest-rate reductions by central bank policymakers will likely lead to an even weaker dollar. That’s great for exporters – such as Boeing Co. (BA), the No. 1 U.S. exporter – but is highly inflationary for consumers, and for companies that depend on raw materials, sub-assemblies or ingredients sourced from, and purchased from abroad.

The U.S. jobs report due out today is expected to pave the way for another interest-rate reduction by U.S. Federal Reserve policymakers [For our report on the expectations for today's U.S. payroll report, please click here.]

All these issues rule out most banks and financial institutions in the United States and other key financial markets. Definitely avoid the homebuilding sector, even though Citigroup’s equity-research unit upgraded many of the shares earlier this week.

Then there’s China, perhaps the world’s most alluring profit opportunity for the long haul. But stock prices have been on a near-vertical ascent of late, meaning the chances of a near-term correction are fairly substantial. Look to buy in after a dip makes valuations more reasonable.

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The Plays to Make Now

There are four ways to beat the credit crunch and profit from the still-positive global growth trends that remain in place. Our strategy calls for you to:

1. Invest in agricultural commodities.
2. Invest in gold.
3. Invest in Japanese small-cap stocks, which are domestically focused and which therefore will benefit from that country’s highly liquid economy.
4. Benefit from Asian growth, and from the promising Korean economy, with a strong telecommunications play from that country.

No matter what the mortgage market looks like, how many cars General Motors Corp. (GM) sells or doesn’t sell, or what the price of a gallon of gasoline is at the pump, people will always need to eat. Indeed, as wages rise in such places as China, India, Latin America and emerging Eastern Europe, people will be able to afford more and better food. And that bodes well for agricultural commodities.

And a great way to play commodities is via an exchange traded fund, or ETF. One that we like is the Deutsche Bank’s PowerShares Agriculture Fund (DBA) is intended to reflect the performance of four commodities in the agriculture sector – soybeans (31.13%), wheat (28.87%), corn (23.43%) and sugar (16.58%). These include some of the key commodity plays that investment guru Jim Rogers advocates as great long-term investments. And we agree. [To see what famed author and investor Jim Rogers has to say about wheat - and other agricultural commodities - please click here.]

Commodities are also a good play when financial markets are unpredictable and when inflation is expected to remain in the picture. And the best of those commodities are precious metals, such as gold.

If you think the central banks will continue to print money to solve the credit crunch – they already are, and will continue to do so – you really need an inflation hedge, which means the StreetTracks Gold ETF (GLD). Gold is currently trading in the range of $740 an ounce, and some analysts, including our own Director of Global Investing Research, Martin Hutchinson, think that a price of $1,000 an ounce is indeed likely in the next 6 months

Despite our near-term concerns about China, Asia is still a highly promising market. [In fact, if you aren't yet a Money Morning subscriber, sign up now and receive - free of charge - our 6,000-word research report, "The Three Best Investments in Asia Today," by clicking here.]

Two of our four plays benefit from Asia’s rapid growth, but in very different ways.

First, invest in the streetTracks SmallCap Japan ETF (JSC). It focuses on smaller Japanese firms, which are more-domestically focused. That means the companies will benefit from Japan’s highly liquid economy, and are also somewhat insulated from the worldwide credit foolishness we’re trying to help you avoid.

Second, invest in SK Telecom (SKM), Korea’s largest cell-phone company, which has international operations in China, Vietnam and the United States, although the U.S. market is only a small part of its operations. With 18 million subscribers, this $15 billion growth company has a 52% share of the South Korean wireless phone market.

With these four picks, you’ll be able to boast how you beat the global credit crunch, and profited some hefty profits in the process. And these days, how many investors can truthfully say that?

Money Morning staffers Martin Hutchinson and Mike Caggeso contributed to this report.

Related News and Story Links:

• Money Morning Investment Analysis:
  Avoid the ‘Resurgent’ Homebuilding Sector and Go Global for Profits.

• Money Morning News Analysis:
  Citigroup and UBS Brace For Losses, but Dow Jones Sets Record Above 14,000.

• Australia Herald Sun Newspaper:
  Pressure building on non-bank lenders.

• The Economist:
  Bad News Bulls.

• Forbes.com:
  The Luck of the Buck.

• The Economist:
  To Infinity and Beyond: Contrary to Popular Belief, Stocks do not Always Go Up.

• The Economist:
  Rush Hour: In China, Share Prices Have Taken on a Life of Their Own.

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Invest in the homebuilding sector at your own risk.

U.S. homebuilders such as D.R. Horton Inc. (DRI), KB Homes (KB) and Pulte Homes Inc. (PHM) capped the sector’s biggest two-day advance since August yesterday (Tuesday), thanks to a growing investor belief that the worst of the subprime-mortgage crisis has passed. On Monday – a day in which banking giants Citigroup Inc. (C) and UBS AG (UBS) released horrid third-quarter results – the Dow Jones Industrial Average surged to an all-time record above the 14,000 mark, ostensibly because investors believed the subprime mess and the accompanying global credit crisis was at least now largely defined.

But don’t you believe it.

Peter Bookvar, equity strategist at Miller Tabak, is thinking along similar lines.

"You don’t have a multi-year credit bubble that is over in a couple of months," Bookvar told MarketWatch.com yesterday. "Why the market thinks that is beyond me."

Market trading in the housing-and-finance-related sectors will prove us correct in the days and weeks to come.

The Fed-Fueled Crisis

This whole subprime mortgage crisis – as well as the global credit crunch that grew out of it – is part of a financial bubble or speculative mania, not unlike the "dot-bomb" crisis that derailed high-tech stocks back in 2000. Both of these bubbles grew out of the overly open monetary policies of the U.S. Federal Reserve, the same Fed that just cut interest rates by a greater-than-expected half a percentage point back on Sept. 18.

Right up to the eve of that policymaking Federal Open Market Committee (FOMC) meeting last month, Contrarian investors such as Jim Rogers were arguing that the central bank shouldn’t be cutting interest rates, but should actually be raising the benchmark Federal Funds Rate. I wasn’t quite so contrary: However, I did argue that the Fed should hold the line on interest rates, and that it shouldn’t be looking to bail out the hedge-fund and investment-bank speculators who knew what the risks were. Nor should it be helping to bail out mid-level European lenders who had absolutely no business speculating in subprime mortgages. I mean, why a German or French bank would want to invest in the debt that consumers with lousy credit were using to buy homes in marginally justifiable transactions – and in the United States, no less – is beyond me. They deserve what they got, and don’t rate a bailout.

But they got one, and that’s only going to prolong the pain U.S. investors are going to experience.

If you don’t believe me, just look at some past bubbles.

Bubbles, Bubbles, Toil and Troubles

During the big Internet frenzy, telecom companies (as well as many wannabes from other sectors) searched for ways to capitalize on this new medium for the masses. Scores of companies built high-speed communications networks, burying fiber-optic cable faster than Johnny Appleseed planted Golden Delicious apple trees. But the analogy is perhaps fitting, since most of those greed-fueled companies ended up eating their fiber-optic networks. Indeed, when the dot-com bubble burst and the end came, Merrill Lynch estimated that of the millions of miles of fiber-optic networks that had been built, 97.5% was "dark," or superfluous.

Thankfully, in the seven years since, such innovations as video-on-demand, streaming media, Internet Telephony, videoconferencing, and countless other inventions have helped the new landlords of those networks recoup their "pennies-on-the-dollar" purchase prices.

But tech-stock investors – especially those who were late to the party in the latter half of 1999 and the first few months of 2000 – haven’t been so fortunate.

The bellwether index of that period was the Nasdaq Composite Index, which peaked in March 2000 at 5,048.62. It’s not been back since, and won’t reach that peak far above us for years – and maybe not for decades.

[At yesterday's close of 2,747.11, the Nasdaq is down about 2,300 points - or 46% - from its all-time high. For comparison, consider the Great Crash of 1929, and the Great Depression that followed. In researching our book, Contrarian Investing, my co-author and I found that the Dow fell from a high of 381 on Sept. 3, 1929 to a July 1932 trough of 41 - a sickening decline of 89%. The Dow didn't eclipse its 1929 high again for good until November 1954 - nearly a full 25 years later. The situation here isn't nearly so dire. But this example demonstrates just how deeply a financial crisis can wound an economy.]

I’ve done a lot of research on speculative bubbles and financial manias, and I’ve found one thing to be true time and again through history. Whenever there is a speculative mania, it’s never confined to one asset class. A bubble owes its very life to the fact that it’s being fueled by cheap money or easy credit. And, as the bubble inflates, it creates more of the same. Soon there’s all this easy money sloshing about in the economy. Basic physics holds that water will find the easiest route to travel, and as the level of easy money rises, it overflows the confining banks of the conventional economy, and starts fueling bubbles in other areas – just as the tech-stock bubble of 1999-2000 helped fire off the housing bubble we’re suffering through today.

And the fallout from that bubble won’t just go away because the Fed cut interest rates once, or even twice, or because the chief executive officer of Citigroup says the banks disappointing third quarter has allowed the company to better visualize the better days to come. Here’s why.

Citigroup and the Two Views of ‘Normal.’

This is actually a two-part problem, right now: The housing market is in deep trouble – still – and the financial markets still haven’t fully factored in the problems that are still to come.

The reason investors sent homebuilding stocks on their two-day jaunt was – at least initially – fueled by a ratings upgrade by an analyst at (of all places) Citigroup, the banking heavyweight that on Monday announced that big writedowns would cause the third-quarter profits at the No. 1 U.S. bank to plunge by 60%.

The banking giant attributed the $1.4 billion pretax writeoff to lousy mortgage investments, deteriorations in the consumer-credit markets, and debt it got stuck with because of some corporate buyout deals that went bad.

Some Wall Streeters were calling for the head of Citigroup Chairman and CEO
Charles Prince. But yesterday, Citi’s "other" prince – Saudi Prince Alwaleed bin Talal Alsaud, the bank’s single-biggest investor – said he was backing the current management team, even with the third-quarter "hiccup."

Even so, top Wall Street banking analyst Richard X. Bove said investors misunderstood what the Citigroup CEO meant with his reference to a "return to a normal earnings environment this quarter." If Bove is correct, the outlook is much more dour than investors currently believe.

Investors thought Prince meant that Citi would return to the level of profitability they were anticipating before the subprime mortgage problem surfaced, Punk Zeigel’s Bove wrote in a note to clients. But what Prince really meant was that Citigroup and its peers are merely on a track to normal profitability, Bove wrote.

Bove took the unusual step of cutting his rating on Citigroup to "Sell" from "Market Perform," and lowered his price target to $43 from the prior target of $53, The Associated Press reported.

Then there’s the housing market…

Housing Bubble is Double Trouble

When I heard that homebuilder stocks were rallying, I first thought back to the fiber-optic debacle of 1999-2000. This isn’t exactly the same situation, since it’s not so much an overbuilding boom that we’re looking at here. But it is an "over-selling" boom. Overly low interest rates created overly accessible credit.

With interest rates at abnormally low levels thanks to the rate-cutting campaign former Fed Chairman Alan Greenspan engineered to short-circuit the Asian contagion and the implosion of the Long-Term Capital Management hedge fund (see all the trouble those hedge-fund bailouts can cause?), consumers with solid credit were able to qualify for and then buy a much-larger and much-more-expensive house than they could have afforded during more normalized periods.

Then there were the consumers with poor, or undocumented, credit ratings, which fueled the subprime-mortgage market.

In short, while we didn’t build too many houses during this bubble, we probably sold too many. Many deals just shouldn’t have been made.

And while experts claim they suddenly have a handle on how much subprime debt is out in the market – a contention I have a tough time believing – that’s far from being the only problem. Consumers who "stretched" a bit to buy a house on credit, or to buy a bigger house than they could afford, often resorted to "adjustable-rate mortgages, or ARMs. But these ARMs have an added, troublesome feature, a trigger known as "resets." The premise of a reset is simple: As interest rates rise, high-credit-risk borrowers with adjustable-rate mortgages are going to get clobbered.

Over the next few months, more than 2 million homeowners with subprime ARMs are looking at resets – and at much-higher interest rates – a reality that’s likely to deepen and lengthen an already-dismal housing downturn.

More than $50 billion in ARM loans will reset this month alone, a record for a single month, says Economy.com, an econometric firm based in West Chester, Penna.

Even the near-term numbers don’t look that good: Just yesterday (Tuesday), the National Association of Realtors reported that that the pending home sales index fell 6.5% in August after dropping a revised 10.7% in July. The index – a forward-looking gauge of home sales – is at its lowest point since it was created in 2001.
[For our full report on this story, please click here].

Pending home sales are down 21.5% from a year ago and 22% from six months ago, according to MarketWatch.com. Even worse: Economists had been expecting the index to drop only 2.5%.

"This is absolutely awful, confirming that the existing-homes market is now in a freefall,” Ian Shepherdson, chief U.S. economist for High Frequency Economics, wrote in a research report.

Go Global and Profit

If the U.S. housing market is going to continue to erode, so is consumer spending, which accounts for as much as 70% of all U.S. economic activity. Over the past decade, U.S. consumers have repeatedly reduced their savings from their wages until that ratio has actually turned negative. But consumers could spend more than they earned because their savings was being done for them – first by the stock market, and then by the real estate market. Indeed, some economists charge that consumers were using their homes as "virtual ATM machines," extracting cash for cars, vacations, home improvements, and other non-necessities. That’s helped fuel the U.S. economic advance of the past decade or more.

But if housing prices are skidding backward, that’s going to put a crimp in consumer spending. And that’s going to cause new homebuilding – and the overall economy – to slow dramatically for at least the next couple of years.
Some perennially bearish investors are speaking of an even worse scenario. In a recent interview with Bloomberg TV, noted short-seller David W. Tice says that this financial mess could lead to a 40% drop in the value of the Standard & Poor’s 500 Index sometime in the next 12 months. We doubt it will be that bad, but would still preach caution.

One other troublesome point that no one here in the U.S. financial markets seems to be talking about: The real estate market in Great Britain has been white hot, and is eerily reminiscent of the path the U.S. real estate market took right up until the housing market here crashed. Some experts – at least, those overseas – wonder if Great Britain isn’t going to be another United States, perhaps delayed by six months, eight months, or even a year.

It makes me wonder what kind of "subprime surprise" we’ll find was fuel of Great Britain’s housing bubble, and subsequent collapse.

It’s worth watching.

Investors who turn their attentions toward profit opportunities in the right markets overseas, as we have been advocating for some time, won’t see a decline in their investment returns [If you aren't a Money Morning subscriber, please click here to receive our 6,000 word investment report: The Three Best Investments in Asia Today. It's free of charge.]

But those who continue to play "yesterday’s investments" in the U.S. market run the very real risk of being left behind financially.

And none of us wants that to happen.

News and Related Story Links:

• Contrarian Investing, by Anthony M. Gallea and William Patalon III.
• Bloomberg News:
  Alwaleed Backs Citigroup Chief After Profit ‘Hiccup.’

• Money Morning Investment Analysis:
  The Three Simple Secrets to Global Investing Profits.

• Bloomberg News:
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• Money Morning News:
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• BusinessWeek:
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• CNNMoney.com:
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• CNNMoney.com:
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• CNNMoney.com:
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• CNNMoney.com:
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• Money Morning News:
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• Money Morning News:
  Housing Sales and Prices Drop As Consumer Confidence Retreats.

• CNNMoney.com:
  Big Write-Downs to Slash Citi’s Quarterly Net 60%.

• Money Morning Investment Analysis:
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• Bloomberg News:
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• MarketWatch.com:
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• MarketWatch.com:
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• The Associated Press:
  Ahead of the Bell: Citigroup.

• Money Morning Investment Analysis:
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• Money Morning News Analysis:
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• Money Morning News Analysis:
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• Bloomberg News:
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• Wikipedia:
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• Wikipedia:
  Contrarian Investing.

• Finfacts Ireland: Fifth Anniversary:
  Nasdaq’s Record All-Time Closing High 5,048.62.

On a day that two huge banks took major profit hits because of the subprime market crisis, stocks soared to record highs yesterday (Monday) on the belief that the worst of the ensuing credit crisis had passed.

Citigroup (C) and UBS AG (UBS), the largest banks in the United States and Europe, said yesterday that their third quarter earnings would reflect the heavy toll taken by the collapse of the U.S. subprime market. Citigroup thinks its earnings will drop 60%, while UBS anticipates losing as much as $690 million in the third quarter.

Citi’s shares jumped $1.05 each, or 2.3%, to close at $47.72, while UBS, the largest Swiss Bank, soared $1.69 per share, or 3.2%, to close at $54.94, as investors put credit conditions behind them and sent the Dow rocketing to a new all-time record close.

The Dow rose 191.92, or 1.38%, to close at 14,087.55, surpassing its closing record of 14,000.41 set in mid-July. The blue-chip bellwether index rose as high as 14,115.51 to eclipse its previous intraday high of 14,021.95, set July 17.

It was the first day of trading in the new quarter. During the third quarter, a volatile Dow still managed to post a 3.6% gain.

Stocks advanced broadly yesterday. The Standard & Poor’s 500 Index rose 20.29 points, or 1.33%, to close at 1,547.04. That’s close to its all-time trading high of 1,555.90, which was established in the middle of July.

The tech-laden Nasdaq Composite Index jumped 39.49 points, or 1.46%, to close at 2,740.99.

The Nasdaq is nowhere near its all-time high of 5,048.62, reached in March 2000, in the middle of the dot-com bubble.

Citigroup said it would write down approximately $1.4 billion on loan commitments and record $1.3 billion in losses related to the subprime mortgage market. The company will release its third quarter results on Oct. 15.

UBS will write down $3.42 billion in mortgaged backed securities. The company will also cut 1,500 jobs, or about 2% of its workforce. The company’s management will see some changes as well. Chief Executive Marcel Rohner will take over as Investment Banking Chief, replacing Huw Jenkins, who will be relegated to an advisory position. Group Chief Financial Officer Clive Standish will retire. Rohner replaced Peter Wuffli as Chief Executive in July.

The subprime collapse and credit conditions have had an adverse effect on the buyout market as well. Because of the higher perceived risk, the debt required to finance acquisitions is now more expensive, meaning that deals struck at the height of the private equity boom have lost their original luster and are being abandoned.

Silver Lake and ValueAct Capital called off the $2.2 billion buyout of Acxiom (ACXM).

The $25 billion buyout of Sallie Mae and $8 billion deal for Harman International Industries are also in jeopardy. The current backlog of pending U.S. buyouts stands at approximately $400 billion. That means that more stalled buyouts may well loom.
However, further fueling the general feeling that the credit crunch is ending, Homebuilding stocks roared after several of the largest players were upgraded by Citicorp. A report by the bank’s brokerage arm said that large-cap builders with stronger balance sheets should benefit in the coming quarters.
Lennar Corp. (LEN) rose 62 cents, or 2.7%, to $23.27; D.R. Horton Inc. (DHI) added 65 cents, or 5.1%, to $13.46; and Pulte Homes Inc. (PHM) was up $1.18, or 8.7%, at $14.79.

News and Related Story Links:

• The Associated Press:
  Dow Jones Passes 14,000 for Record High.

Blue chip stocks had their best week since April last week, with the Dow Jones Industrial Average gaining 2.5% for the week. That 30-stock index is now up 7.9% for the year, according to The Wall Street Journal.

The Dow gained 17.64 points, or 0.1%, on Friday, ending the day and the week at 13,442.52.

Stocks posted the increase for the week in the face of a 3.1% jump in oil prices, which ended the week at $79.10 a barrel, up 2.40. Oil prices hit a record $80.09 a barrel on Thursday.

Rising prices – especially with such key elements as oil – can be bad for corporate profits because they increase company expenses. And that can translate into lower share prices. This will no doubt factor into the analysis of the U.S. Federal Reserve’s policymaking Federal Open Market Committee (FOMC), which meets tomorrow (Tuesday). Most analysts are expecting a quarter-point rate reduction, reasoning the central bank must increase liquidity to counteract a growing global credit crunch.

On other indices, the tech-laden Nasdaq composite index closed Friday at 2602.18, up 1.12 points. For the week, the Nasdaq rose 36.48 points, or 1.42%. The index is up 7.7% so far this year.

The broader Standard & Poor’s 500 Index rose 30.70 points, or 2.11%, for the week, closing at 1484.25. The S&P 500 is up 4.6% so far this year.

Gold finished the week at $709.60 per ounce, rising $8.80 an ounce, or 1.26%.