In a visit to Japan in the early 1990s, U.S. President George H.W. Bush threw up over the Japanese prime minister. When President Barack Obama visited Japan last weekend, he offered an effusive bow to the Emperor Akihito.

Politically, U.S.-Japanese relations have improved dramatically during that two-decade stretch.

Yet investor regard for Japan has gone the opposite way. Twenty years ago – in the midst of the Japanese stock-and-real-estate bubble – U.S. and other world investors were kowtowing to Japanese investments – and banging their heads on the floor in the process.

Today those same investors are much more likely to throw up in the direction of those Japanese investments.

The up-chuck response to Japanese investment is a reasonable one, given that country’s stock-market performance since 1990. After all, the Nikkei 225 share index is down more than 75% from its January 1990 peak. If my broker had locked me into Japanese stocks for the last 20 years I’d probably beat him about the head with the performance report, too.

As Japan fans have been saying for the last decade, the market is a much better buy with the Nikkei at 9,000 than it was when the index was at 39,000. Needless to say, that hasn’t enhanced Japan-backers’ credibility as the market has meandered around without a trend, performing similarly to Wall Street during the period overall, but without the excitement of hitting all-time highs even in 2007.

Japan’s stock market will only recover when Japan’s economy shows some signs of real growth. The good news, however, is that real growth may be resuming. Japan’s third-quarter gross domestic product (GDP) rose at a 4.8% annual rate, after revised growth of 2.7% in the second quarter. That puts it well ahead of the U.S. recovery, and means that Japan is outpacing the rebounds of most of the European Union, the other comparably rich bloc of countries.

Japan’s recession was very different than those suffered by the United States, Great Britain or most European countries. It had already suffered a banking meltdown during the 1990s, and had experienced no significant real estate bubble this decade. Thus, the only new bad debts in the Japanese banking system were the few it picked up from dabbling in the U.S. and British housing markets – investments that were foolish, but not significant in terms of the Japanese economy as a whole. Even Nomura Securities (NYSE ADR: NMR) – the most dedicated unprofitable dabbler in Western markets – scored a notable success in October 2007, when it wrote off its entire participation in the U.S. subprime-mortgage market. That write-off gave it one bad quarter, but left the remainder of its operations in good shape.

Even during its recession, Japan has had a better productivity performance than the United States or Germany, its principal rich-country rivals. From 1990 to 2008, Japan’s labor productivity increased by 39.7%, just fractionally better than the United States at 39.1% and significantly ahead of Germany’s 32.6%.

Thus, while the 1990s and 2000s were for most of the time an era of U.S. economic triumphalism and Japanese despair, neither was really warranted. During the 2008-2009 downturn, Japan’s principal problem was an export decline that reached 50% at its nadir – because of the yen’s strength against the dollar and most of the other major trading currencies.

In the period since March, Japanese exports have rebounded nicely. But unlike its U.S. counterpart, Japan continues to enjoy a balance-of-payments surplus and a strong yen.

The new Democratic Party of Japan government – led by Yukio Hatoyama and elected on Aug. 30 – is pledged to shift Japan’s priorities away from exports and infrastructure spending and towards the domestic economy. The government has already cancelled a substantial chunk of the previous government’s heavy infrastructure program and has pledged to introduce monthly allowances of about $300 per child to families with children. That will increase domestic spending, and should helpfully reorient the Japanese economy towards the small business sector.

Japan’s major problem is the government deficit and the debt that accompanies it. Its public debt is now 200% of GDP, although that ratio will come down if GDP improves strongly. The DPJ finance minister, Hirohisa Fujii, is pledged to substantial budget savings, and the rebound in GDP should reduce the pressure for more “stimulus.” Then you have to remember that with its high savings rate and payments surplus, Japan’s government debt is owned primarily by the Japanese people. So in this area, too, Japan is better-placed than many other countries.

With other East Asian countries – notably China, South Korea and Taiwan – rebounding nicely, Japan is poised to show good growth in 2010, far better than the Economist’s estimate of 1.5% GDP growth.  The wise investor will thus keep a portion of their money in Japan, concentrated in domestically oriented companies – it is, after all, still the world’s second-largest nominal economy.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the stock-market rebound that started in mid-March, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

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 specially designated "Alpha-Bulldog" stocks into winning portfolios.

To find out more about The Permanent Wealth Investor, please just click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Landslide Election Victory in Japan Will Lead to an Avalanche of Future Profits For Global Investors.
• Wikipedia:
  Emperor Akihito.
• WhiteHouse.gov:
  George H.W. Bush.
• Wikipedia:
  Hirohisa Fujii.
• WhiteHouse.gov:
  Barack Obama.
• Wikipedia:
  Yukio Hatoyama.
• The Los Angeles Times:
  How low will he go? Obama gives Japan’s Emperor Akihito a wow bow.
• Wikipedia:
  Democratic Party of Japan.
• Money Morning News Analysis:
  Japan’s Economic Growth Accelerates, but Deficit Raises Concerns.
• Library of Economics and Liberty:
  Balance of Payments.
• Money Morning Special Report:
  Eight Ways to Profit From Japan’s Game-Changing Election.
• Money Morning News Analysis:
  Land of Rising Debt: Falling Tax Revenue Forces Japan to Sell More Bonds.

I noticed you recently told the Japanese press that you intended to maintain a strong dollar, and that the Obama administration would bring the U.S. fiscal deficit back to a “sustainable balance.”

Tell me, don’t you feel your nose extending like Pinocchio’s when you tell these fibs to innocent Asians?

The dollar is not strong. In fact, it’s sinking to record levels of weakness, and it’s going to stay that way, for three reasons:

• First, the U.S. Federal Reserve is running a zero-interest-rate policy and has announced that it intends to continue doing so. While it does, there’s easy money to be made out of borrowing dollars and lending almost anything else – especially Russian rubles at the moment (maybe we lost the Cold War, after all!). That will actually make the dollar drop.

• Second, the Internet and all the cheap money sloshing around has made it attractive for U.S manufacturers to outsource production to emerging markets, more so than ever before. That leads to big U.S. balance-of-payments deficits. It also means emerging-market wage levels are rising fast against U.S. wage levels. Sadly, this is happening so fast that U.S. wage levels will probably have to drop – which is probably why unemployment has risen so much this time around. A weak dollar – perhaps with a little inflation – is the best way to make this adjustment without throwing everybody out of work as in the 1930s.

• Finally, the U.S. government is running huge deficits and pretty much everyone else in the United States has debt coming out the wazoo. A weak dollar – ideally mixed with a teensy, weensy bit of inflation – will make all those debts get smaller … like magic!

There are some very good reasons why the U.S. dollar is weak, and given the constraints on your policy, you’d probably like it weaker. It’s just that you can’t say so, because then foreign investors might stop buying U.S. Treasury Bonds.

Which brings me to the other point. We all know – don’t we? – that the budget deficit for the 12-month-period that ends next September will be even larger than the $1.4 trillion shortfall recorded for the 12 months that ended in September of this year.

Even though you’ve stopped bailing out banks – well, except for the odd $100 billion for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) – there are just too many other demands on the public purse. There’s the rest of February’s stimulus, most of which actually doesn’t get spent until the 2010 fiscal year. There are little details, like the extension of the $8,000 tax credit for first-time buyers – one that’s now extended by a $6,500 tax credit for non-first-time buyers.

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And still to come is the medical reform bill (which we know isn’t “deficit neutral” at all), the cost of which will kick in around 2013, just as the other budget pressures are abating. (Or not, since Congress will probably have found something else to spend money on by then).

It’s a mess, isn’t it? I mean, we’re actually talking about trillion-dollar deficits as far as the eye can see, aren’t we? Of course, Japan can’t really grumble about that, because it has public debt of almost 200% of its gross domestic product (GDP). On the other hand, Japan runs a balance-of-payments surplus and has lots of savings, so it actually owes that money to itself.

I’m not saying that it won’t be a challenge to restore American prosperity. Indeed, as the old saying goes: “If I wanted to get there, I wouldn’t start here.” At the same time, as a veteran banker who’s worked with troubled economies before, I do have a few tips to pass along:

• First and foremost, enough with the stimulus. You’re going to run into trouble soon in the bond markets, and that will prevent small business from getting the capital it needs. Cut at least $100 billion of the flaky projects out of the stimulus bill.

• If you want to encourage clean energy, put in a small-but-simple carbon tax and take away an equal amount of handouts to ethanol producers and clean-tech companies: You’ll get double the deficit cut – without having to boost your clean-energy incentive.

• Know who’s making money right now? Goldman Sachs Group Inc. (NYSE: GS) – that’s who. Unfortunately, those profits aren’t being delivered via sound capitalist practices. They instead stem from such contrivances as credit-default swaps and high-speed trading. And those are short-term rent-seeking activities – not long-term wealth-generating initiatives. Place a small Tobin tax on each trading transaction – the country needs the revenue much more than do the partners of Goldman Sachs.

• Get Fed Chairman Ben Bernanke to stop printing money. His zero-interest-rate policy is sending gold through the roof, and will cause huge trouble down the road. Interest rates need to be higher than inflation, so savers get rewarded for saving – which isn’t the case right now.

You may think those changes are “politically impossible.” We disagree. In fact, we believe there’s no time to lose. And we’d very much like to hear your reaction to our proposals. If you write to us here at Money Morning, we’ll gladly share your thoughts with our readers.

We’ll look forward to that time.

Sincerely,

Martin Hutchinson
Contributing Editor
Money Morning

105 West Monument Street
Baltimore, Maryland 21201

Notes and Related Story Links:

• Money Morning Market Commentary:
  Credit Default Swaps: A $50 Trillion Problem.
• Money Morning Investment Research Report:
  Five Ways to Profit From the New Waxman-Markey Clean Energy Bill.
• Money Morning Special Report:
  Is Mexico the “New” China?
• Wikipedia:
  Russian Ruble.
• WiseGeek.com:
  Outsource.
• Wikipedia:
  Cold War.
• Library of Economics and Liberty:
  Balance of Payments.
• Money Morning News Analysis:
  Unemployment Rate Cracks Double-Digit Barrier at 10.2%, Boosting the Odds of a “Jobless Recovery”.
• Wikipedia:
  Tobin Tax.
• Investopedia:
  Treasury Bond.
• Money Morning News Analysis:
  Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should.
• Wikipedia:
  Carbon Tax.
• Money Morning Special Report:
  High Frequency Trading: Wall Street’s New Rent-Seeking Trick.
• Money Morning Research Report:
  Three Ways to Avoid Another Credit-Default-Swap Crisis.
• Money Morning News Analysis:
  Hot Stocks: Goldman Sachs Expected to Post “Blowout” Quarter Amid Run of Lackluster Corporate Profit Reports.
• Money Morning News Analysis:
  Gold to Continue its Record Run as Central Banks Stock Up.

Massachusetts Land Court judge Keith C. Long recently ruled that foreclosure sales of two properties with securitized mortgages were invalid, a decision that ties up thousands of Massachusetts real-estate transactions.

If nothing else, this landmark court case should make one thing very clear: Securitization – the product of the finest brains of Wall Street for more than two decades – doesn’t work as advertised.

Historically, mortgage loans were made by small local institutions, which knew the borrowers personally and took the credit risk themselves.

You can see how it worked in the 1946 classic movie “It’s a Wonderful Life.”  Main character George Bailey (Jimmy Stewart), as heir to a local building-and-loan company, battles the evil capitalist Henry F. Potter (Lionel Barrymore) to change the character of his local town by offering affordable housing loans to the poor but upwardly mobile.

It is an appealing model, but has one real flaw: If a local savings and loan is in financial difficulty (as was Stewart’s “Bailey Bros. Building & Loan” in 1932), it will not be able to attract deposits, and no mortgage loans will be made in that locality. With the rise of interstate banking, that problem would have been soluble – mortgage loans would be more expensive in an area if a large national bank was their only potential source, but they would still be available.

Jimmy Stewart and his building-and-loan peers were forced out of business by the inflationary surge that we saw from 1974 to 1982. That surge caused short-term interest rates to rise sharply, while long-term returns on the lender’s mortgage loans remained fixed. By 1982, the great majority of U.S. mortgage lenders had lost their capital and were insolvent. It was almost another full decade for them finally to go out of business, but the damage had been done.

The initial securitizations were done by Ginnie Mae (the Government National Mortgage Association) in 1970; the government agency had guaranteed home mortgages, and wanted a way to finance the result.  Thus, when the U.S. savings-and-loan crisis began, and S&Ls actually began to fail, the securitization markets were available to pick up the slack.

It didn’t hurt that two government sponsored entities – Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) – were ready to guarantee everything in sight, and to prevent investors from worrying too hard about the underlying credit risk.

Under securitization, instead of making mortgage loans directly, mortgage bankers only “originated” them, doing whatever paperwork was thought necessary, then sold them on to a Wall Street broker, which packaged them into a shell company with other mortgages. The resultant mortgage-backed security and sold the resulting package to bond investors.

There are two major problems with securitization.

First, in modern securitization markets, nobody is really responsible for the credit risk. Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee for doing so. Wall Street, in turn, retains very little of the resultant mortgage packages: It sells them on to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

Thus, all the parties involved in originating the transaction became salesmen. Since it was no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did.

That’s how we ended up with so-called “Liar Loans.”

In newly unveiled draft legislation, the U.S. Treasury Department has proposed to reduce this problem by making securitization originators keep 5% of the resultant credit risk. This seems a sensible move, and should help matters considerably, even if it does reduce the attraction of the more-exotic securitizations.

A second problem with securitization, highlighted by the Massachusetts court decision, is that of documentation.  As I can testify from experience, securitizations are by far the most tiresome of all Street transactions to document, with a non-standard securitization creating incalculable costs while taking 18-24 months to complete.

You can see why the more complex transactions were complicated: Hundreds – or even thousands – of mortgages were being bundled and sold as a bundle to maybe tens of thousands of investors.

From the comments of Judge Long, corners were cut here as everywhere else during the housing bubble that subsequently precipitated the global financial crisis. If you take the documentation seriously, foreclosures are made very difficult by securitization, because each of those 10,000 investors owns a tiny piece of, say, a $300,000 foreclosed loan – while at the same time also owning pieces of loans not in foreclosure.

If you get to the point where loans that had already been packaged are repackaged and resold, the paper trail may become completely inscrutable, in the sense that it is no longer possible to figure out who owns what.

At that point, the owners can’t foreclose, because nobody can identify them. That’s true even if the documentation was done correctly. And we now know that during the bubble, it wasn’t – the lawyers had inexperienced interns working on this stuff. You can then either ignore the fine print, allowing securitizing banks to sweep the problems under the rug, or – as Judge Long has done – insist that the precise ownership position be known.

This may be a huge blow to the entire securitization industry. If given normal human fallibility, you can’t track down the true owners of a mortgage, then the ownership of thousands of houses in default, all over the country, comes into question. Whatever solution is found will inevitably involve increased costs.

And that means that the risks of securitization just got much greater.

Is this a pity? No. You see, the move to securitization actually cost home mortgage borrowers money. The average differential between Treasury bond yields and 30-year mortgage yields in 1971-76 (before securitization really got going) was slightly more than 1%. In 2000-06, before the housing finance crash made mortgages still more expensive, it was more than 1.5%.

In other words, securitization has added 0.5% to mortgage costs since moving away from the Jimmy Stewart mortgage-market model – something free-market theory says shouldn’t happen.

As you might expect, securitization was just a way for Wall Street bankers and lawyers (don’t forget the lawyers, who made out like bandits from all the documentation) to extract additional “rents” from the rest of us. In the long run, in a free market, this should not be able to happen.

In the ongoing battle between Wall Street, the Obama administration and the public interest, it will be interesting to discover whether the United States has a true free market.

If it does, securitization should die.

[Editor's Note: Throughout the global financial crisis, longtime market guru Martin Hutchinson has managed to call both sides of the market correctly. His warnings about the dangers of credit-default swaps - issued half a year before those deadly derivatives ignited the worldwide financial firestorm - would have steered investors clear of ugly bank-stock plays. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the subsequent rebound, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

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 specially designated "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 Investigation of U.S. Banking Bailiouts:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• The Boston Globe:
  Ruling upheld on sale of property:Ownership status of foreclosures clouded.
• FilmSite.org:
  It’s a Wonderful Life.
• IMDB:
  Villains We Love: Mr. Potter, ‘It’s a Wonderful Life.’
• Wikipedia:
  mortgage-backed security.
• IMDB:
  Lionel Barrymore.
• Slate:
  How the Mortgage Industry Nurtured Deceit.
• Wikipedia:
  Free Market.
• IMDB:
  Jimmy Stewart.
• Answers.com:
  Interstate Banking.
• Wikipedia:
  Law of Rents.
• Investopedia:
  Securitization.
• About.com:
  Savings-and-Loan Crisis.

Commodity prices have faltered in the last couple of weeks, and much of the “smart money” is saying the boom is over.

Don’t believe it.

As long as the world’s central banks keep interest rates at these very low levels, the speculative interest in commodities will be strong, and so will their prices. Since only minor central banks yet show signs of moving rates, the commodities bull market has further to run.

The commodities bull has already run a long way. Since Jan. 1, gold is up 20%, silver is up 50%, copper is up 100%, oil is up 110%, coal is up 90% and iron ore is up 60%. In a year of deep recession – with the exception of wimpy gold (which did not decline as much in 2008, because all the monetary “stimulus” made people fear inflation) – that’s a pretty good run.

The Key Catalysts

There are three reasons why commodity prices have been rising, and they’re all still true:

• China and India continue their torrid growth.
• Global stimulus plans are bullish for commodity prices
• And hedge funds and other speculative investors are big commodities players.

Let’s examine each of these in more detail.

1. The “China Syndrome:” While the rest of the world has been mired in recession, China has had a pretty good year, and so has India. China’s third-quarter gross domestic product (GDP) rose 9.5% from the same period last year, and India is expected to post an increase of at least 6%.

That has caused demand for raw materials to soar, because lifting the 2.5 billion inhabitants of those countries out of poverty generally requires lots of goods you can drop on your foot.

For instance, China leapfrogged the United States this year to become the world’s largest automobile market, with sales of 11 million cars and light trucks. China and India show no sign of dropping back into recession. If anything, demand growth in those two countries is likely to continue, which in turn will put additional pressure on global raw materials supplies.

Sign up below…and we’ll send you a new investment report for free: “Credit Crisis Report.”

In general, we have plenty of commodities, but opening up new production takes lots of time and money, so rapid demand growth pushes up prices.

2. Money Talks: Stimulative global monetary policies have tended to push up the prices of all assets – but most notably commodities – in the last year. Those monetary policies aren’t just a U.S. manifestation. Japan has interest rates close to zero and has engaged in lots of “quantitative easing.” Britain has had even laxer monetary policies than the United States, with the Bank of England buying more than $300 billion of British government “gilts.” And China’s M3 money supply grew 28% in the last twelve months.

Monetary policy would have to get quite a lot tighter – with interest rates higher than the inflation rate – before it started choking off commodity prices, and there’s not much evidence of that. Yes, Australia and Norway both raised their base rates by a quarter percentage point in the past two weeks, but both countries are special cases, being commodity producers themselves (Norway produces oil, while Australia produces pretty much everything).

Maybe China is beginning to tighten a little, too. However, the other big boys aren’t. U.S. Federal Reserve Chairman Ben S. Bernanke has said rate increases are a long way off. Britain’s GDP was still falling in the third quarter, so that country won’t be tightening soon. And most of the Eurozone (Spain, Ireland and Greece, in particular) is suffering from huge real estate meltdowns, while other exporting countries worry that the euro is becoming too strong against the dollar – so euro rates won’t rise fast, either.

The bottom line here: Without higher interest rates, the commodity boom will continue.

3. Investors “Get Physical:” Hedge funds and other speculative investors are piling into commodities. What’s more, as I mentioned a couple of weeks ago, they aren’t just buying commodities futures; in many cases, the hedge funds are buying the physical commodities. Since the supply of most commodities is a small fraction of the volume of hedge funds outstanding, prices could shift quite sharply as supply disruptions occur.

Until China and India stop growing or world monetary policy tightens a lot, any blips in the commodities market are just that – blips.

Ways to Play the “Bubble”

There are a number of ways to play a commodities bubble. It’s probably smart not to restrict your buying to gold and oil alone, but to spread yourself among a number of sectors. Let’s take a look at some of the better plays right now available. They include the:

• Powershares DB Base Metals ETF (NYSE: DBB): This exchange-traded fund tracks the Deutsche Bank AG (NYSE: DB) base metals index, thereby allowing you to invest directly in the price movements of non-precious metals. With a market capitalization of $387 million, this ETF is at least reasonably liquid and money has been flowing into it recently.
• Vale SA (NYSE ADR: VALE): Brazil’s largest iron ore producer, and a key supplier to China’s exuberant infrastructure growth, Vale is a true play on the global commodities market. With a historical Price/Earnings (P/E) ratio of about 15, Vale will benefit hugely from further run-ups in the price of steel.
• iShares Silver Trust (Amex: SLV): This fund invests directly in silver bullion, which has been left behind somewhat in its relationship to gold’s price rise – and which can be expected to move up as gold does, possibly by an even greater percentage.
• Market Vectors Gold Miners ETF (NYSE: GDX): Gold miners benefit disproportionately from a rise in the price of gold because their production costs are fixed. This means that miners are a more leveraged way to play gold than the metal itself, particularly as surging speculative demand can increase mining companies’ P/E ratios.
• Market Vectors Coal ETF (NYSE: KOL): China’s power supply is still coal-fired, and demand is soaring, hence global coal prices are likely to be pulled upwards by Chinese demand alone. KOL has a market capitalization of $283 million.

[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:

• Wikipedia:
  Quantitative Easing.
• Bank of England:
  Official Web Site.
• Investopedia:
  Gilts.
• Wikipedia:
  M3 money supply.
• Money Morning News Analysis:
  India Begins “Exit Strategy,” But Interest Rates Remain Unchanged – For Now.
• Money Morning Special Report:
  Hedge Funds Take Direct Stakes in Commodities … Should We Be Wary?
• Money Morning Special Investment Report:
  Silver’s Run Quietly Gains Momentum.

Crude oil is knocking on the door of $80 a barrel. That’s not what experts have been expecting. At the start of the year, when oil prices were below $40, these experts predicted prices would stay there, or even decline a bit.

But the truth is, an explosion in the world money supply, particularly in China, has fueled oil-intensive growth and caused crude prices to reverse their decline of late 2008. This trend is likely to last for at least the next several months. So how should investors play it?

The underlying cause of the continuing explosion in oil prices is the loose U.S. monetary policy that central banks around the world put in to counter the banking crisis and have kept there. In the United States, interest rates remain at zero – even though inflation is already creeping up towards 3%.

In Britain and Japan, interest rates are also close to zero. In the European Union, the “official” short-term rate is 1%. Chinese interest rates are higher, but China’s total money supply (M2) rose 27.9% in the 12 months through September. So there’s a lot of money sloshing around, and this time it’s not going into stocks or housing, but into commodities and energy.

Don’t forget the expansion in China and India’s automobile markets, either. China’s motor vehicle sales are expected to surpass U.S. sales this year, rising around 35% to 11 million vehicles, while India’s have also been rising rapidly, and this year are forecast to be up 25% to 2.5 million. All those new cars need fuel, and that’s why demand for oil hasn’t weakened as people expected, but has continued to advance.

Monetary policy in the United States won’t change for some time – the U.S. Federal Reserve recently said so. That’s also likely to be true around the globe, maybe with the exception of an occasional quarter-point increase like we saw in Australia, recently. So oil prices are likely to continue rising for months to come.

The New Rules for Oil Investors

Traditionally, we play increases in oil prices by buying stock in the major oil companies. That’s not the way to go today. The problem is that the majors don’t actually have all that much oil.

Furthermore, much of the oil they produce is in difficult countries, and when prices go up, those countries tear up contracts to make sure they get all but a thin sliver of the profits. The experience of Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) in Nigeria, where contracts were renegotiated in 2008 until only 2% of oil revenue flowed to the company, is typical and will recur in other countries if prices stay high.

A second possibility is to buy companies with access to high-cost reserves in stable regions. As the price of oil rises, those companies’ profits will increase exponentially. The obvious example here is Suncor Energy Inc. (NYSE: SU), which is the largest producer of oil from the Athabasca Oil Sands in Alberta, Canada. The Canadian oil sands, also known locally as the “tar sands,” contain more than 1.7 trillion barrels of reserves, as much as the entire Middle East.

However, Suncor is currently trading at 105 times the most recent four quarters of earnings, and is even trading at 20 times 2008 earnings – a year in which the average oil price for the whole year was considerably higher than it is now.

A third possibility is to buy an oil-related exchange-traded fund (ETF). These have the disadvantage that the storage cost of oil is very considerable. So they can’t just buy the physical commodity, as the SPDR Gold Trust ETF (NYSE: GLD) does with gold.

One reasonably “liquid” oil-focused ETF is United States Oil Fund LP (NYSE: USO), which seeks to track the price of West Texas Intermediate Light, one of the benchmark crudes. That ETF has a market capitalization of $2.24 billion, meaning it is reasonably liquid and has only moderate costs.

The Trouble With Trusts

A final possibility is to buy shares in either one of the Canadian royalty trusts or one of the U.S. trusts whose primary function is to exploit known reserves of crude oil. These have the advantage of paying substantial dividends as the crude is extracted and sold.

They do have two disadvantages:

• First, the tax regime for Canadian royalty trusts will change in 2011; at present, it’s not entirely clear what effect this have on the dividends and earnings, but it will certainly reduce them.
• Second, some of these companies are hugely overvalued, given the amount of oil they control. BP Prudhoe Bay Royalty Trust (NYSE: BPT), for example, has the right to a 16% royalty on the output of the BP PLC (NYSE ADR: BP) oil holdings in Prudhoe Bay, AK, which have 55 million barrels of proven reserves. Do the arithmetic, and you’ll find that at a price of $75 per barrel, BPT has an undiscounted value of $660 million. However, its market capitalization is currently $1.7 billion. There’s probably some upside potential I’ve missed somewhere, perhaps from secondary extraction or from some possible new discoveries in the holdings, but I doubt if there’s $1 billion worth.

I’ll leave you with two possibilities – of U.S. companies with oil-and-gas holdings that seem attractive. One is Linn Energy LLC (Nasdaq: LINE), which has oil holdings in the Mid-Continent and Western regions, and which uses some of its cash flow to buy new properties. That has a 10.12% dividend yield; its main problem as an oil play is that Chairman Michael C. Linn hedged its entire output for 2009, 2010 and 2011 at more than  $100 per barrel last year. That’s a great deal, but it also means that the company’s sales prices are fixed for the next 27 months!

Another possible oil play of the same type is MV Oil Trust (NYSE: MVO). This has net profits interest in oil and gas properties in Kansas and Colorado, with approximately 1,000 producing oil-and-gas wells. It pays out all its income in dividends, so shareholders directly benefit from rising oil prices, as it appears to be un-hedged. In the third quarter, it paid 59.5 cents per share – which on an annualized basis would give it a yield of 13.5%.

[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 Interview:
  The Future of Energy…
• About.com:
  What is M2?
• Europa.eu:
  European Union.
• PrudhoeBay.com:
  Official Web Site.
• Wikipedia:
  Athabasca Oil Sands.
• Reuters Executive Bio:
  Michael C. Linn.

It looks like the U.S. housing sector has bottomed. In fact, if you’ve been thinking about buying a house, this may be the time to make your move.

Let me tell you why.

Congress and the Obama administration are considering whether to extend the $8,000 first-time-buyer tax credit for another year from Nov. 30, when it expires. With cheap money, housing may show strength in the short term, just as we’ve seen with other assets. But there is the potential for a market hiccup next year or in 2011.

When the National Association of Homebuilders released its NAHB Index for October last week, it showed a drop of one point in homebuilders’ view of the market, from 19 to 18.

The good news: The index is at double its level from last spring – when it bottomed out at nine – meaning homebuilders see an improving market.

The bad news: The index is based so that a reading of 50 is the “neutral market” view. That means there’s a long way to go, yet.

But even if Congress doesn’t opt to extend the $8,000 tax credit, 30-year mortgage rates are still down around 5.1% – close to their all-time low. But rates probably won’t remain that low for long: Building inflationary pressures and the huge U.S. budget deficit will combine to push interest rates higher.

In other words, even if housing prices are destined to drop by another 10% (except in the very worst areas, I wouldn’t expect you’d see anymore than that), you still may end up saving so much on financing costs by borrowing now that you’d be mad to wait any longer.

Housing arithmetic is always complicated but one thing I do know: 7% of $90,000 is more than 5.1% of $100,000!

The S&P/Case-Shiller composite home price index bounced nicely in July, with the 20-city index rising 1.5%, after a 1.3% jump the previous month. That’s a pretty good indication that the markets have bottomed out.

Sign up below…and we’ll send you a new investment report for free: “Credit Crisis Report.”

What’s more, the $8,000 credit for first-time buyers was still in force for August and September transactions (you need to close to get the credit, so deals done before Sept. 30 should squeeze under the wire). Since interest rates remained low for those months, it’s likely we’ll see further price rises then, too.

That would mirror the market in Britain, where housing prices bottomed out last spring and have risen for the six months since. Indeed, the market in London for houses priced above 5 million pounds (about $7.5 million) is apparently exceptionally strong, because of the likely level of Goldman Sachs Group Inc. (NYSE: GS) bonuses!

For those of us who aren’t about to receive a Goldman Sachs bonus, or buy a house priced above $7.5 million, the short-term outlook is still pretty good. U.S. gross domestic product (GDP) almost certainly rose during the third quarter – probably by about 3% – and is expected to rise again in the fourth quarter.

That should translate into an abatement of the flood of job losses – perhaps from the 250,000-per-month rate of the last few months to around 100,000 per month. That’s still bad, but is indicative of a recovery ahead. At that point, the outlook for the housing market will depend on what region you live in.

In Florida, California and Nevada – where prices have dropped more than 40% – there may still be a large number of foreclosures and unoccupied new buildings left over from the bubble. In those markets, therefore, the excess supply may take time to absorb.

Similarly, even with the government bailout of the automobile industry, I probably wouldn’t invest heavily in Detroit, even though prices there are lower than they were in 1995. However, in such cities as Atlanta and Dallas, prices did not rise too much in the bubble – and haven’t dropped all that much since – so the market should rest on a firm foundation and we can expect it to advance.

Beyond 2009, the prognostication is still murky. On the one hand, even a slow economic recovery should induce consumers to more seriously consider home purchases. And with inflation apparently on the upswing, the prices of those houses can be expected to increase, as well.

On the other hand, if inflation really gets a grip, the U.S. Federal Reserve will have no alternative but to raise interest rates. Housing is the most-interest-rate sensitive sector of consumer spending. So if rates rise sharply, the housing market will inevitably suffer.

As for the $8,000 credit for first-time homebuyers, it doesn’t really matter. It’s like the “Cash-for-Clunkers” program. If Congress extends it, it will prop up the housing market a bit. But if Congress doesn’t, there will be no disaster – the market will simply fall back for a few months until demand catches up with supply.

It makes only a modest short-term difference in activity, and probably only a 1% to 2% difference in the level of housing prices.

If you’ve got the money, go buy a house. You won’t find a better time to strike.

[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:

• TheDeal.com:
  Homebuilders Still Struggling.
• Money Morning News Analysis:
  Existing Home Sales Pop on Rush to Beat Tax Credit Deadline.
• National Association of Homebuilders:
  Official Web Site.
• Money Morning News Analysis:
  With His Flawed ‘Exit Strategy,’ Bernanke Has Set the Stage for Stagflation.
• Money Morning News:
  “Cash For Clunkers” Gets a Reprieve.

Which global economy grew at an annual rate of 11% in the second quarter, and will report a second-consecutive double-digit advance when it reports on Monday?

Hint: It isn’t China.

But you are looking in the correct part of the world.

The economy in question is South Korea, which has enjoyed an astonishing rebound since it reached a recessionary bottom last winter. One factor in particular should nurture this rebound: The Korean economy wasn’t pulled down by the U.S.-led subprime mortgage crisis, which infected many foreign banks that invested in mortgage-backed securities – the Asian Tiger was pole-axed by a collapse in world trade in the first three months of this year.

At the nadir in March, South Korean exports were down 40% from the same point in 2008. The banking system also had a liquidity crisis that required a government bailout – not because of investments in toxic U.S. derivatives, but because of similarly lackluster credit card loans and dodgy mortgage rubbish of its own.

The South Korean won declined by 40% against the dollar during the 12-month-stretch that ended in February. It has since recovered about half that drop, so it remains undervalued.

But the overall outlook is highly upbeat. From its low point in December 2008, the Korea Composite Stock Price Index (KOSPI) is up 65%. Exports have recovered, particularly on the back of surging demand from China – a trading partner that is growing a bit more slowly than Korea, but that has considerably more muscle with 27 times the population.

Korea’s current account balance once again shows a healthy surplus. Credit-rater Fitch Ratings Inc.,  which had placed Korea on “credit watch” for a possible downgrade from it’s A+ rating, recently announced that the downgrade would be unnecessary, and said that Korea could expect to run a budget surplus in 2011.

That demonstrates Korea’s true investment allure: The country is well run. It elected a pro-business government led by President Lee Myung-bak in the beginning of 2008 (Lee’s term lasts until 2013), and that government has coped pretty well with the global financial crisis.

Since its trade agreement with the United States is on indefinite “hold” in the Congress of U.S. House Speaker Nancy Pelosi, D-CA., Korea recently signed a similar pact with the European Union, which may boost exports somewhat.

Like nearly everywhere else, Korea’s government spent on “stimulus” – but only moderately – so the budget deficit is only expected to reach 4.5% of gross domestic product (GDP) this year, according to The Economist magazine’s panel of forecasters.

In any case, Korea’s government spending as a percentage of GDP is one of the lowest of the world’s most-affluent developed economies. That means it will be much less of a burden than on the Korean economy than will similar outlays in the higher-spending Japan, United States and European Union.

The forecasters at The Economist expect Korea to advance at a 2.8% rate in 2010, but that forecast looks way too low. After all, remember that even in the difficult, post-Asian-contagion years of 1998-2008, Korea experienced average annual productivity gains of 4.3% – more than double the rate experienced by the U.S. economy during the same period.
  
At first glance, Korea’s stock market looks expensive, trading at 19 times earnings. However, the earnings concerned are from the bottom of the recession, when several of the big exporters were operating in the red. The market is still below its mid-2008 level, when the overall Price/Earnings (P/E) ratio was only 11.

One admittedly annoying reality is that most large Korean companies abolished their dividends during the credit crunch, and have yet to restore the payouts.

Even so, Korea’s economy is a big benefactor of the torrid growth being generated by its much-bigger neighbor – Mainland China – which is why some of Korean stocks are magnificent China plays.

There are several Korean stocks that trade as American Depository Receipts (ADRs) on the New York Stock Exchange, and in sufficient volume to make them suitable profit plays. My thoughts on each of these companies follow:

• KB Financial Group Inc. (NYSE ADR: KB):  A financial group that owns the largest bank in Korea, KB was hit badly by loan losses and problems in its Kazakhstan subsidiary, and by its badly timed (October 2008) conversion into a holding company.  It has rallied from its low, engineered a $900 million rights issue and currently trades at a P/E of only 8.8. In my view, however, it has a ham-fisted management team. HOLD.

• Korea Electric Power Corp. (NYSE ADR: KEP): Korea’s national electric power company recorded a loss in 2008 because of fixed tariffs. KEP’s steady growth should benefit from any acceleration in Korea’s economic growth rate, but it is forced to buy coal from overseas, which gives it a downside risk. Although it’s trading at only 54% of net asset value (NAV), but even so I think not. AVOID.

• KT Corp. (NYSE ADR: KTC): Formerly Korea Telecom, KT is Korea’s leading fixed-line telecom provider, which was privatized in 2002.  It carries a P/E of 18 on its trailing earnings, and it was one of the companies that last year cut its dividend. What’s more, I don’t like the sector. AVOID.

• Posco. (NYSE ADR: PKX): Korea’s largest steel company, with a P/E of 15 on the company’s trailing earnings, Posco has a large export operation to China, making it a direct participant in the Red Dragon’s explosive growth. Posco is the world’s No. 3 steelmaker, and is the most efficient in terms of output/man hour. Like KEP, Posco will suffer from rising raw-materials prices – in this case, iron ore. That key ingredient to the steelmaking process has been cheaper this year than it is now, and the price appears set to keep rising. The stock is right now trading at three times its 2009 low, and 1.9 times book value (BV). HOLD/BUY.

• Shinhan Financial Group Co. Ltd. (NYSE ADR: SHG): The third-largest financial group in Korea, Shinhan provides commercial and investment-banking services, but without KB’s large Kazakhstan exposure. The ADR right now is trading at 10.5 times earnings and 1.1 times net asset value. BUY.

• SK Telecom Co. Ltd. (NYSE ADR: SKM): Korea’s largest mobile phone company, with operations in Vietnam, SK Telecom is trading at 11.8 times earnings. It recently sold back its China investment for $1.3 billion, so it is no longer a significant China play. It is less attractive than it once was, and I don’t like the sector, but it’s still a better value than fixed-line player KT. HOLD.

• Finally, you could look at the Korean exchange-traded index fund, the iShares South Korea ETF (AMEX: EWY), which invests in the Morgan Stanley Capital International Korea Index. It has a P/E ratio of 13, but a yield after expenses of only 0.8%.

[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:

• Bloomberg News:
  
  South Korea Ratings Outlook Raised to Stable by Fitch.
• Wikipedia:
  South Korean Won (Currency).
• Central Intelligence Agency:
  European Union.
• Wikipedia:
  Korea Composite Stock Price Index.
• Ezinearticles.com:
  Net Asset Value.
• About.com:
  
  Current Account Balance.
• Investopedia:
  Credit Watch.
• Wikipedia:
  
  Lee Myung-bak.
• Center For Information Management:
  Just What Do We Mean By Productivity?
• About.com (Stocks):
  
  Price/Earnings Ratio.
• The Voice of Vietnam:
  
  Official Web Site.
• BNY Mellon Bank:
  The Ultimate DR Directory.
• Investopedia:
  
  Book Value.

ScotiaMocatta, the Canadian commodities trader and subsidiary of the Bank of Nova Scotia (NYSE: BNS), has asked regulators to approve plans for a fund that would take physical positions in copper.

Credit Suisse Group AG (NYSE ADR: CS) is working with Glencore International AG, the world’s largest trading house, on an exchange-traded fund (ETF) that will be backed by actual aluminum supplies.

And ETF Securities Ltd., a $15 billion U.K.-based firm that makes commodity-investment products available to retail investors, is offering U.S. investors gold-and-silver ETFs that are backed by the precious metals stored in vaults, instead of the more-conventional financial futures contracts.

ETF Securites is now also considering a U.S. oil fund that’s tied to swap contracts with a member of Big Oil. It already has such an arrangement with Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) in Great Britain.

Hedge funds and other institutional investors that invest in commodities are beginning to demand physical delivery – and not just futures contracts, the Financial Times reported last week.

Institutional investors are making these moves in order to sidestep expected regulatory changes. But with gold at near-record levels, and other commodity prices advancing, too, a major migration to the physical commodities market will translate into an actual jump in physical commodities demand.

Such a shift will push up commodity prices – and it has the potential to rev up inflation and cause major economic disruptions.

Regulatory Imbroglio

The world’s hedge funds all piling into commodities doesn’t matter much if the funds all stick to futures contracts. Dealers arrange the futures markets so that at expiration, the demand for physical pork bellies – or whatever – doesn’t outstrip the physical supply.

Even the major purchases of futures contracts we cite in our example would likely be enough to push up the price of pork bellies. But that increase would be limited in scope and consumers have learned to deal with such increases in living costs. What’s changing, however, is that the U.S. government is talking of introducing “position limits” to futures markets, and commodities speculators are worried that their hedging-and-speculating activities may be restricted.

Federal regulators are looking at these restrictions in part because of the way speculators allegedly whipsawed oil prices last year – causing them to zoom to more than $147 a barrel in mid-July 2008, only to drop to a four-year low at less than $40 a barrel by mid-December.

Sign up below…and we’ll send you a new investment report for free: “Credit Crisis Report.”

Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission (CFTC), which regulates the U.S. futures markets, has said that he wants position limits to be applied consistently across all commodity markets.

Here’s the problem. In an attempt to reduce risk, many institutional investors will seek to maintain certain investment levels in commodities. And if they can’t maintain those levels via financial futures markets, they may dump the futures and hoard the physical commodities.

That’s something that neither the CFTC – nor British counterpart, the U.K. Financial Services Authority – could do anything about, since neither one regulates the “spot” market for commodities.

In short, regulators could end up jump-starting the very problem that they are trying to avoid – for several reasons.

First of all, physical commodities investments are very different than their financial-futures counerparts – if only because physical supplies are limited. When a hedge fund buys a ship full of copper ore, that ore is no longer available to smelters, and the copper supply chain may get disrupted.

Similarly, investors buying iron ore, coal, aluminum or other commodities that are crucial to our industrial economy can potentially disrupt the economy itself. Supplies of most commodities are adequate, yet the supply/demand situation is in close balance in the short term. Since new mines or smelters cannot be opened quickly, even a moderate withdrawal of supply through investors buying up available inventories can wreak havoc on market prices.

Such pricing discordances can’t help but have a negative impact on the economy, too.

And the math is more than a little scary.

Scary Math

Hedge funds alone have about $1.9 trillion under management. Central banks in Japan and China have about $2 billion each at their disposal. And there are comparable amounts in the Middle East.

The grand total: Roughly $8 trillion.

Since all U.S. goods imports last year totaled only $2.1 trillion, you can see that there could easily be problems. If speculators tie up a big percentage of the physical global supply of a particular commodity, there will be a shortage for users. If that happens with a number of different commodities, that means that a swath of key industries could be plagued by super-steep prices – or even paralyzed outright.

Although it’s admittedly a worst-case situation, such a scenario could potentially spawn a deep recession. The reason: production patterns get disrupted and large numbers of people get thrown out of work.

This won’t be your typical recession, however, for it’s a downturn of a type that we haven’t seen globally.

In 1837-41, and again in 1929-33, the two worst downturns in U.S. history, severe shortages of liquidity caused disruptions, 25% price declines – and, finally, an economic collapse.

The problem we’re dealing with now is just the opposite: We have too much liquidity, so that money becomes worthless because it can’t physically buy the goods needed to carry on production.

These kinds of recessions have happened in single countries in wartime: Think of the worthless “continentals” in the U.S. War of Independence, or the “assignats” in the French Revolutionary War.

Single countries have had this problem. Argentina has from time to time had people starving – even though it is a major food producer – because its currency has collapsed. However, we haven’t seen it worldwide. If it happens, you can expect shortages and sharp output declines, but combined with rapid inflation, much more rapid than in the 1970s.

That’s the theoretical possibility. Will it happen? After all, except for gold, commodities prices are still lower than they were last year, and even gold is well below its 1980 high of $875, which would be about $2,400 in today’s money.

However, there are two factors that stand as the fundamental causes of the run-up in the prices of gold and other commodities. And they’re related. The first is the surge of liquidity that we’ve seen. And the second is the super-low interest rates that the central bank policies of the world have produced in the last year. If you have too much money sloshing around, you’ll get speculation. And this time around, that speculative money is going into commodities.

We need to stop the bubble before the trend of investing in physical commodities gets too strong. As I said, futures-markets investments don’t matter. Though they may lead to modest price increases, the fallout ends there. It’s the investments in physical commodities that have the potential to actually disrupt the world economy.

Keeping the Bubble at Bay

To stop the commodities bubble, interest rates have to rise. “Exit strategies” by central banks that involve taking away liquidity – using “reverse repos” or similar instruments – will be no help if interest rates don’t rise.

If rates stay low while commodity prices soar, commodities will look like a great investment. That will send the lower liquidity flow into commodity speculation and crowd out real investment. Only higher interest rates will make commodity speculation less profitable, and keep the bubble at bay.

Apart from watching the U.S. Federal Reserve directly, you can see how this bubble is progressing by watching the price of gold. If gold prices keep rising, interest rates are still too low and commodities speculation still too attractive. If gold dips in price, but then rebounds, the progress against the bubble may be only temporary. Only if the price of gold falls sharply – by 25% or more from its peak — will the bubble have been beaten and normal economic growth again be possible.

As investors, we should focus our attention on commodity plays. Cash is not king. If inflation gets going, cash will fall in value.

But companies supplying commodities will do well. You don’t have to buy a mining company directly. It’s not surprising that Alcoa Inc. (NYSE: AA) reported good third quarter earnings last week; it mostly controls its raw materials, and aluminum itself is a commodity, essential for the world economy.

Brazil’s Vale SA (NYSE ADR: VALE) – with its huge iron ore deposits is another good play. The Market Vectors Gold Miners ETF (NYSE: GDX) allows you to bet on inflation directly, without having to guess which gold mines will do best.

Commodity investments will remain a good play, better than cash, until the Fed and other central banks get serious about interest rates – say 2% above the prevailing rate of inflation. That means a Federal Funds Rate of 4%-5%. We’re a long way from that point, yet, so commodities are a good place to put your money.

[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:

• The Financial Times:
• Interest sparked in physical commodities.
• Money Morning:
  Exit Strategy Category.
• Wikipedia:
  ETF Securities Ltd.
• InvestorWords.com:
  Reverse Repos.
• Wikipedia:
  Futures Contracts.
• InvestorWords.com:
  Futures Markets.
• WiseGeek.com:
  What Are Pork Bellies?
• Wikipedia:
  Continentals.
• Hutchinson Encyclopedia:
  Assignats.
• Wikipedia:
  Gary Gensler.
• InvestorWords.com:
  Position Limits.
• Money Morning News Analysis:
  OPEC Production Cut Fails to Inspire Oil Market; Oil Drops to Four-Year Low.
• U.S. Commodity Futures Trading Commission:
  Official Web Site.
• History of War:
  U.S. Revolutionary War.

Quantum Fund co-founder George Soros had it right on Monday, when he said the U.S. recovery would be held back by “basically bankrupt” banks and companies.

I call them the “zombies,” the institutions being propped up by government bailouts. Companies like Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), General Motors Corp., Chrysler LLC, etc. On an operating level, these walking dead are sucking the life out of the recovery.

Unlike in previous downturns, huge resources have been devoted to propping up entities that should have been taken out of the picture.

Of course, it’s easy to avoid zombies directly. No one is going to force you to take a position in GM. But if you really want to know where to look for the bargains – for companies that have the greatest potential for serious growth in real numbers and real markets – you need to look for what I call “zombie-free zones.”

Unfortunately, the United States and the United Kingdom are not “zombie-free” zones – and thus offer the worst hunting ground available right now.

If you’re looking for something solid, there are only three places to aim your portfolio. In fact, my top three picks are Germany, Korea, and Canada. All have an abundance of companies you can invest in with at least a good chance of not being forced to compete with the undead.

The Problem with Zombies

You see, the problem with zombie banks and companies is that they soak up resources that should be devoted to living banks and companies, while providing unfair competition that makes their competitors unsound.

It’s difficult to see this effect at the moment, because the U.S. Federal Reserve is propping up the banking sector. It’s much clearer in the automobile sector, where the zombies GM and Chrysler make it more difficult for Ford Motor Co. (NYSE: F) to compete. There’s no question that the continued existence of Chrysler after its first non-bankruptcy in 1979 drastically weakened Ford in the 1980s and 1990s.

There’s the effect on wages too. The United Auto Workers (UAW) union is a huge supporter of the GM and Chrysler rescues, partly because they keep UAW members employed at above-market wage rates. One certainly can sympathize with the great many American autoworkers that have lost their jobs, but by keeping the sector over-employed, the government is driving up wages and hurting businesses – particularly Ford, the only member of Detroit’s “Big Three” to not ask for a bailout.

Sign up below…and we’ll send you a new investment report for free: “Credit Crisis Report.”

The same effect can be seen in the banking sector. The bonus pool at JPMorgan Chase & Co. (NYSE: JPM) is partly inflated by the continued employment of all the Citibankers who should have lost their jobs. Since banking pay scales got over-inflated during the bubble, it is reasonable now for them to come back down to earth, but that’s not going to happen while banks are in their current undead state.

Turning to the international market, it is immediately clear that Britain has the same problem as the United States, only on a larger scale. Royal Bank of Scotland Group PLC (NYSE ADR: RBS) and Lloyds Banking Group PLC (NYSE: LYG), two of Britain’s largest banks have been kept open by the government. (Though, to be fair, Lloyds only got in trouble because the government made it acquire another failing bank, HBOS.)

Financial services is a huge part of Britain’s economy, which needs to diversify, but it won’t be able to diversify if so much of its talent is locked up in banking, and its best graduates are sucked into the high-paying dealing rooms of the City of London.

Japan has the same problem. Here the zombies are really ancient, cobwebbed skeletons left over from the 1990 collapse of Japan’s bubble. Some of them were put out of their misery by Junichiro Koizumi, the reformist prime minister, in 2003. Yet just this week we learned that many Japanese retailers face losses because of competition from The Daiei Inc. and Ito-Yokado Co. Ltd., gigantic retailing companies that were effectively bankrupt in 1993 but have been propped up by Japan’s banks. If you’re afraid of zombies, Japan is really creepy!

Historically, Europe is the continent where investors have suffered most from zombies propped up by governments. Certainly some countries, notably Italy, are attractive only for investment necrophiliacs.

Where to Find “Zombie-Free Zones”

There are some exceptions. Germany has only a few relatively small zombies. Both Sachsen LB and IKB Deutsche Industriebank AG, the banks that got in trouble buying U.S. subprime mortgage-backed bonds, have been sold to other buyers – Sachsen to a larger Landesbank and IKB to the private equity group Lone Star Funds. Whatever their subsequent fate, those banks are currently being managed on a profit-maximizing basis.

There is a large older zombie, Hypo Real Estate Holding AG, the former Bayerische Hypothekenbank, which got in trouble in the late 1990s lending to real estate in the former East Germany, but that appears an isolated example. Industrially, Germany has been admirably rigorous in cleaning up its dead companies, and with its new pro-market government looks attractive for zombie-fearing money.

In Asia, South Korea is probably your best bet. The country had a big zombie problem ten years ago, but that problem has been cleared up with the bankruptcy and reorganization of several conglomerates and much of the banking system. This time around, there have been few major casualties and so the economy looks relatively zombie-free.

Finally, there is our northern neighbor, Canada. Canadian housing never became as over-extended as U.S. housing, and the Canadian bank bailout was correspondingly smaller, with none of the banks facing bankruptcy. Canada had a bad zombie problem fifteen years ago from decaying heavy industry, but today those zombies are long gone and the Canadian economy is resilient. The most recent bankruptcy, Nortel Networks Corp. (OTC: NRTLQ) in Jan. 2009, is being handled in a thoroughly market-oriented fashion, with its assets being sold off piecemeal. So your money is safe in Canada – lots of snow, but no zombies!

[Editor's Note: It's not always what you buy that determines whether you are a winner or loser as an investor.

Sometimes, it's what you don't buy.

Throughout the global financial crisis, longtime market guru Martin Hutchinson has managed to call both sides of the game correctly. Not only has he assembled high-yielding dividend stocks, profit plays on gold, and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for savvy investors. 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:
  Hidden Traps Make Bank Stocks a Bad Deal

• Money Morning:
  Bank Stock Outlook: Will First-Half Gains Give Way to Second-Half Pain?

• Money Morning:
  Why You Should Invest in the “New” Germany

• Money Morning:
  It’s the Best Investment in North America – and It Isn’t the United States

Billionaire investor George Soros said yesterday (Monday) that the U.S. recovery would be a slow one because of all the “basically bankrupt” financial companies impeding it.

U.S. Federal Reserve Chairman Ben S. Bernanke and Congress agreed Friday that the financial system – not the American taxpayer – should bear the costs of bank bailouts. Sheila Bair, head of the Federal Deposit Insurance Corp. (FDIC), wants the banks to ante up $45 billion – three years’ worth of deposit-insurance premiums – to bail out the fund that insures bank deposits.

When it comes to bank stocks, we all know that there were a number of Money Morning readers shrewd enough to buy Citigroup Inc. (NYSE: C) shares when the foundering giant’s stock price was below $1 a share.

If you’re one of those investors, good for you: With Citi’s shares now trading at nearly $4.70 a share, that shrewdness – or courage – has been amply rewarded.

But the question we have to ask at this point is: Why would anyone buy banks stocks right now?

Bailouts Revisited

When the Bush administration bailed out the banks last autumn, I opposed the bailout. But I understood the rationale for it. The Lehman Brothers Holdings Inc. (OTC: LEHMQ) bankruptcy had clearly done a lot of damage to market confidence. Thus, a series of high-profile failures – however well merited – could push the market into a behavioral funk that might take years to emerge from.

After all, as we were incessantly reminded, the banks were all intimately inter-connected – not in the least by the diabolical credit-default-swap market. So a big failure could trigger a mass-market meltdown.

That justified the immediate bailout back then. But it did not justify the continued existence of those banks and other financial institutions – especially Citi, Bank of America Corp. (NYSE: BAC) and insurance giant American International Group Inc. (NYSE: AIG) – a year after the bailout.

Even if there was an argument for preventing the immediate meltdown of those companies – to prevent panic – there was no good argument for allowing them to continue in business as zombies, distorting the market forever after. An orderly liquidation was what was really needed.

But if the plans called for these three bad actors to be liquidated, it should surely be happening by now. Two of the three have even kept their top management for the intervening year. The exception has been BofA, where Chief Executive Officer Ken Lewis is now being shoved – kicking and screaming – toward the exit. (However, I have no doubt he’ll end up being well rewarded for the indignity).

Japan’s ‘Lost Decade’

Economically, keeping banks and other companies alive after they should be dead is the mistake Japan made back in the 1990s. After Japan’s massive stock market meltdown, most of the banks were technically insolvent. A decline in the value of the stocks the banks held had gnawed away their capital, while their assets were shredded by the collapse in the value of their real-estate loans.

Despite this, Japan opted to prop up many insolvent companies, which kept the country’s entire banking system on life support until 1998 – hence the “Lost Decade” of financial legend. And a true resolution of the problem did not come until it was forced by Prime Minister Junichiro Koizumi in 2003. The result was more than a decade of economic stagnation and a mountain of public debt that actually exceeded 200% of gross domestic product (GDP).

For the banks themselves, the fallout can be even worse.

An ‘Artificial’ Market

At first blush, the profits of the last few months look pretty good. And the record bonuses being threatened on Wall Street suggest that all is fine. However, there are two problems. First, bank earnings have been propped up by an extraordinarily bank-friendly monetary policy, keeping short-term interest rates at close to zero and buying up more than $1.5 trillion of bad bank loans from the markets.

That simply can’t last. If it does, we’ll end up with a bad case of hyperinflation.

As for the bonuses, does anybody think that if Citi had gone bust, and ex-Citibankers were now selling apples on the street corners of New York, bonuses would be zooming so high?

If the market for overpaid bankers had been allowed to clear properly, they would no longer be overpaid.

If the Japan’s Nomura Securities (NYSE ADR: NMR) wanted to double its U.S. staff, as it announced Monday (an extraordinarily shareholder-hostile decision, given Nomura’s lousy U.S. track record), it could just lean out of its office and whistle, and a parade of ex-Citibankers, ex-AIG executives and ex-BofA execs would rush in, begging for scraps.

It appears that the concerns that Soros expressed are well justified.

A Grim Reaping For Bank Investors

Since there are more competitors in the market than there should be, once the Fed’s over-generous monetary policy is corrected, there will be too much competition, so bank profits will be squeezed. Conversely, there will be too many jobs in the industry, so banker pay scales will be artificially propped up.

If that’s a recipe for good shareholder returns, I’m a Dutchman.

There’s more. The populist fury against the banking system doesn’t look like it’s doing much about banker pay. However, it will almost certainly result in special extra taxes being levied on surviving banks, to pay for the bailouts.

The costs of those taxes will be passed through to shareholders, because competition from all the zombies that are still in business will prevent banker pay from being squeezed much. The extra levies that Bair, the FDIC chief, is employing to keep the deposit-insurance fund solvent also will fall on banks, although in this case it will be the small and medium-sized that will suffer the worst.

Squeezed profits, expensive staff, extra taxes and special FDIC levies – it doesn’t look to me as if there will be much left for bank shareholders.

Expect 2010 to be a grim year for them.

[Editor's Note: It's not always what you buy that determines whether you are a winner or loser as an investor.

Sometimes, it's what you don't buy.

Throughout the global financial crisis, longtime market guru Martin Hutchinson has managed to call both sides of the game correctly. Not only has he assembled high-yielding dividend stocks, profit plays on gold, and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for savvy investors. 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 Special Report:
  The Two Reasons it’s Time to Short U.S. Stocks.
• Money Morning Special Research Report:
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it.
• Bloomberg News:
  Soros Says ‘Basically Bankrupt’ Banks Restrain U.S.
• Federal Deposit Insurance Corp.:
  Official Web Site.
• Money Morning News Analysis:
  Banks Satisfied On FDIC Decision, but Will They Still Lend?
• Zombies:
  Definition.
• Wikipedia:
  Junichiro Koizumi.
• Money Morning News Analysis:
  Boom, Bust and Rebuild: Bank of America and the Kenneth Lewis Legacy.
• Money Morning News Analysis:
  Wall Street Back to Business as Obama’s Regulatory Overhaul Loses Momentum.
• The Financial Times:
  Nomura to double headcount in the U.S.
• Money Morning Special Report:
  Credit Default Swaps: A $50 Trillion Problem.