As the post-Memorial Day hangover lingers, and $4 per gallon gasoline becomes a national reality, expect more and more daily energy prognostications.

Goldman Sachs Group Inc. (GS) already is on record for $200-a-barrel oil. As you all know, our own Keith Fitz-Gerald – Money Morning’s investment director – has projected a crude-oil price of $225 a barrel. Do I hear $250?  What about $5 a gallon gasoline by July 4th?

Sometimes, these daily price gyrations take on lives of their own, but at the end of the day, the basic laws of supply and demand always work themselves out.

The upcoming week’s hectic economic calendar could go a long way to clarifying the "Are we in a recession, yet?" discussion.  Crucial news from manufacturing and labor highlight the week and any renewed strength in these sectors could put an end to the "R" talk for the time being (or until next week). In fact, the National Association of Business Economic forecast 0.4% economic growth for the 2nd quarter and a much stronger 2.2% gross domestic product (GDP) pickup in the 3rd quarter as the U.S. Federal Reserve and those tax rebates begin to work their ways through the system.  Suddenly, economists are projecting a rebound and cries of recession have become somewhat muted (and replaced by cries of inflation). 

Market Matters

Now that Memorial day has come and gone, investors seem to be monitoring the daily energy trades even more closely than usual (if that is possible) for signs that prices have peaked and Americans will be able to afford summer travel again.  Well, in the aftermath of the holiday, gas prices actually continued their trek toward that dreaded $4/gallon level and hit a new national average of $3.96 late in the week.  In fact, 11 states and the District of Columbia already are reporting average prices at the pump in excess of that psychological barrier. 

While crude prices fell from last week’s record highs of $135/barrel, the ongoing "supply/demand vs. speculation" debate rages on.  In one corner…The Department of Energy said that exports from the top oil producers dropped by 2.5% in 2007 and are on pace for a similar showing this year.  While much of the increased demand focus has been on China, oil consumption throughout the Middle East (and Saudi Arabia, in particular) has skyrocketed in recent years, thus, leaving less to export and meet the growing demand abroad.  On the flipside, conspiracy theorists cry wolf that prices have been running without any regard to true supply/demand issues.  They point to escalating trades in commodity (petro) futures indexes and make Internet bubble comparisons (remember those fun days?) as explanations for the wild price swings.  This week, the regulators got involved (typically a day late and a dollar short) as the Commodity Futures Trading Commission initiated a probe into potential market manipulations by energy insiders. 

And suddenly those increased water cooler discussions about the dreaded "I" word are starting to move from speculation to reality.  Dow Chemical announced a 20% across the board price increase to "mitigate the effects of raw material costs." German-based DHL soon will be "outsourcing" its North American delivery biz to competitor UPS as its seeks to reduce costs.  Discounter airline JetBlue will not be adding to its fleet as expected because it too suffered the ill-effects of rising fuel prices that have prompted major changes throughout its industry (can you say consolidation?).  Likewise, automakers continued to struggle from consumer activity (rather inactivity) as both Ford Motor Co. (F) and General Motors announced major reductions to their respective workforces.  Apparently, the "rich and famous" have been impacted far less than others as Polo Ralph Lauren and Tiffany both reported better than expected quarterly earnings.  Even Dell Inc. (DELL) surprised many analysts with a solid quarter on strong sales in Asia.  Turning to financials, shareholders finally approved the JP Morgan Chase & Co. (JPM) acquisition of The Bear Stearns Cos. (BSC) (like they had much of a choice), though $10 a share is a far cry from the $170 the stock traded at in early 2007. 

Investors took their clues from declining crude prices this week and again looked for value in the equity markets.  The major indexes traded higher (often at the expense of fixed income).   In fact, the yield of the benchmark 10-year drifted back above 4.0% for the first time in about five months as talks of inflation seemed to overshadow prior recessionary fears (see below).  Still investor sentiment can change on a dime these days and next week brings significant economic releases that are sure to be over-analyzed.  Until then, happy motoring (at $4/gallon). 

Economically Speaking

If the consumer truly accounts for 2/3 of the growth of the economy, the latest confidence readings cannot be good news.  The Conference Board reported that its confidence index fell for the 5th consecutive month to its lowest level in almost 16 years.  Meanwhile, the competing U. of Michigan sentiment survey plummeted to a 28-year low. (So, whatever your index of choice…the consumer appears to be in hibernation.)  Then again, what consumers SAY and what consumers DO are often two very different things.  Of note, orders for durable goods dropped by 0.5% in April; HOWEVER, once aircrafts and autos were factored out of the equation, sales of these high ticket items actually rose by 2.5% last month.  In fact, orders for appliances and electrical equipment surged by over 25%, the best reading ever reported.  Overall consumer spending also increased in April, though the naysayers quickly point out that much of the gains were reflective of higher prices as opposed to increased sales.  (Bear in mind, any over-analysis of the data can lead to a variety of diverse and confusing conclusions about consumer activity…so pick your poison, but don’t read too much into any one number). 

This past week also found the revision of the 1st quarter GDP which had initially been reported as growth of 0.6% during the January through March months.  Again, the pessimists in the bunch claimed that recession already was in our midst, and (by true definition) two consecutive quarters of negative activity were closing in.  Instead, the revised GDP reflected a 0.9% gain in the 1st quarter, a weak showing by any measure, but still positive and far from recessionary. 

News and Related Story Links:

• Money Morning Special Investment Research Report:
  Money Morning Boosts Oil Target Price to $225 a Barrel, Thanks to Continued Scarcity, Burgeoning Demand in China.

Since the start of the year, the debate over the state of the U.S. economy seems to escalate by the day. The ongoing subprime mortgage mess, the resultant credit crunch and daily stories about housing defaults, escalating oil prices and lousy corporate earnings only seem to further fuel the debate.

Of course, we all see the government reports and analyst research notes that seem to contradict one another from one day to the next – and sometimes from one hour to the next.

So here at Money Morning, we thought we’d take a bit of a different approach, and use some of the social indicators that we’ve come across to develop a "Top 10 List" of reasons the U.S. economy may have achieved a new market bottom – though perhaps it’s not yet the ultimate market bottom.

Admittedly, this list is absolutely tongue in cheek. But social indicators do play a huge role in successful investing, even though the scholarly types often consider them little more than slightly disguised voodoo.

Nevertheless, here’s our Top 10 List:

10. Although its company stock is down 14% year-to-date, there are still 172 Starbucks Corp. (SBUX) employees for every citizen of Vatican City.

9.   The world’s three richest men – Warren Buffett ($62 billion), Carlos Slim Helu’ ($60 billion) and Bill Gates ($58 billion) – are worth as much as the combined gross domestic product (GDP) of the world’s 40 poorest countries.

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8.   Chairman and Chief Executive Officer Angelo Mozilo of Countrywide Financial Corp. (CFC), and former executives Charles O. "Chuck" Prince III who was ousted from Citigroup Inc. (C) and E. Stanley "Stan" O’Neal of Merrill Lynch & Co. Inc. (MER), can still make house payments.

7.   Upscale hedge fund managers still prefer Mercedes SUVs for their nannies.

6. Weathermen have a better predictive record than economists.

5.   History shows that recessions wipe out between 20% and 25% of financial assets. Even with the almost $300 billion in financial write-downs we’ve seen so far, we’re still at a mere 5% of the total (depending on which numbers you believe).

4.   Alan Greenspan reportedly makes more money per speech now than he did annually as chairman of the U.S. Federal Reserve.

3.   U.S. Federal Reserve Chairman Ben S. Bernanke still has a job.
                                                          
2.   As of the close yesterday (Wednesday), the Standard & Poor’s 500 Index has only fallen 13% from its intraday peak on Oct. 11, 2007. Like a barber-school trainee, recessions typically clip 25%-30% off the top.

And the number-one reason we haven’t reached the bottom yet:

1.   BusinessWeek has yet to publish a successor issue to their infamous Aug. 13, 1979 cover story that predicted "The Death of Equities." That story preceded one of the greatest bull market runs in history.

News and Related Story Links:

• Money Morning:
  Dear Ben: To Save the U.S. Economy, Here Are the Moves You Need to Make Now

• Money Morning:
  Have We Hit The Bottom?

• Money Morning:
  One Sure-Fire Sign That Gas Prices are Heading Higher

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

Now, at the age of 77 Soros is making the rounds to promote his new book, "The New Paradigm for Financial Markets," which goes on sale next month. And while he travels the media circuit he’s taking the opportunity to speak his mind on the country’s current financial crisis, which Soros considers the "biggest financial crisis" of his lifetime.
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Last week, he echoed the International Monetary Fund’s estimate of more than $1 trillion in losses linked to the collapse of mortgage-backed securities. However, Soros pointed out that losses so far disclosed by financial institutions are related only to the decline in value of those financial instruments.

"I think it’s a pretty accurate estimate of the loan losses," Soros said during a conference call with reporters. "But we have not yet seen the full effect of possible recession. It only relates to the decline in the value of the various financial instruments which are held by the banks and other institutions."

They don’t "in any way reflect possible decline in the quality of loans that they hold. These are the eventual losses yet to be seen," he added.

Almost 50 of the world’s biggest banks have recorded a combined $232 billion in asset write-downs and credit losses since the beginning of 2007, according to Bloomberg data.

Soros described the $45 trillion market in credit swaps – which gives investors the opportunity to place bets on the likelihood that companies will default on bond payments – as the "Sword of Damocles."

"This $45 trillion market is unregulated," he said. "That’s more than five times the entire government bond market of the United States. It’s almost equal to the entire household wealth of the United States."

As far as accountability is concerned, Soros blames regulators and the current U.S. administration, which he says "failed to perform their job."

"This is a man-made crisis and it’s made by this false belief that markets correct their own excesses," he said. "It will take much longer for the full effect of the decline in the housing market to be felt."

He continued: "I think the situation is more serious than the authorities admit or recognize. They claim that there will be a pickup in the second half of the year. I cannot believe that."

News and Related Story Links:

• Bloomberg:
  Soros Says Credit Crisis Will Worsen Before Improving

• IHT.com:
  Soros urges officials to move faster in credit crisis

• IHT.com:
  Soros sounds the alarm again on world economy

• Money Morning:
  Jim Rogers: More Pain for the Greenback, and the Failure of the Federal Reserve

• Money Morning:
  IMF Warns of Global Economic Slowdown

With the recent market collapse, the subsequent U.S. Federal Reserve-negotiated sale of The Bear Stearns Cos. Inc. (BSC), and a central bank that’s socializing trillions of dollars in debt in a misguided attempt to "fix" the credit crisis, many investors are very astutely asking: How much worse could this get?

My answer: A lot.

Right now the big concern is whether a potential new financial crisis in Great Britain – spawned by the "St. Patrick’s Day Massacre" – will make the jump across the ocean and infect the U.S. financial markets. Fortunately for us, there are steps investors can take right now to position themselves for profit – and protect themselves from infection should this U.K.-generated contagion reach our shores.

But you have to know where to look and what to buy. And you also have to understand just what’s happening right now. So let me take a moment to tell you just what’s happening.

The "St. Patty’s Day Massacre"

Late Wednesday night, my good friend Jon Markman, a noted financial writer and commentator, pointed out a breaking news story out of London that has yet to really hit on this side of "the pond."

According to a story that appeared overnight in London’s Daily Telegraph, leading broker MF Global Ltd. (MF) informed clients that they’ll need to put up "significantly" more cash to cover derivative positions.

How much more?

Try 260%.

MF Global has had a rough week already, Futures & Options Week reported. It started with the so-called "St. Patrick’s Day Massacre" on Monday, when MF Global shares lost 65% of their value because of "a storm of negative news and inaccurate rumors about credit lines and investors," the F&O financial news service reported.

After starting the week at $16.11, MF Global shares traded as low as $3.64. They’ve subsequently rebounded a bit to close at $9.25, although they’re still well off their 12-month high of $32.20.

Now here’s the rest of the story. MF Global unilaterally increased margins on certain stocks [British small cap and U.S. shares] from 25% to 90% and clients were given until yesterday (Thursday) to either put up the cash or close out their positions.

Here’s why this matters.

Many of the stocks at the top of the list are those preferred by smaller investors. If the institutions and individuals that trade them cannot meet the margin calls, we could see another round of "forced liquidations." In a market environment where the U.S. indices alone are up 400 points one day and down 300 the next, this added downward pressure can’t be good.

If this happens, investors will rush to meet margin calls, and millions of shares could be "dumped" in any way possible. Add that into the ongoing market decline and you’ll understand it if traders are feeling a bit like long-tailed cats in a room full of actively used rocking chairs.

Against such a backdrop, the potential buyers simply turn their heads and the "bid walks away" which is an expression meaning that buyers simply don’t bid. Why should they? They know that they’ll get a better – even lower – price in the future.

So traders have to settle for less.

A lot less.

Unfortunately, this only steepens and accelerates the stock market’s already-existing downward spiral. Once that happens, all bets are off.

Now, bear in mind that what I am describing is the worst of all possible scenarios… a market with millions of shares for sale at a time when there is no liquidity to buy, meaning there are no buyers.

There are no guarantees that this will happen and I, for one, sure as heck hope it doesn’t.

We’ve already seen our fair share of forced liquidations as hedge funds have unloaded for similar reasons here in the United States. But we’ve at least got to consider the possibility in light of what MF Global has told its clients.

All three of Europe’s key indices – the London FTSE 100, Germany’s DAX and France’s CAC 40 – posted only moderate declines yesterday. So it appears that European investors have for now escaped the worst of what I’ve described. Indeed, it’s possible that some of the dumping has probably already taken place. And many European markets are closed tomorrow (Friday) and Monday for a national holiday.

But New York is "taking the book" now and, after the Easter weekend, anything could happen. But there are two key things U.S. investors should keep in mind and watch for:

• First, it remains unclear just how many U.S. stocks MF Global’s clients still hold, or if there still could end up being a spillover into the U.S. markets.
• And second, and perhaps the real question here: Given the fragile state of the U.S. financial markets, as well as many of the U.S. financial firms, how many U.S. firms – if any – will take similar steps with their clients in the coming weeks, drastically shifting margin requirements, forcing stateside investors to pony up big blocks of cash? If that happens, the impact could be quite remarkable, though not fun to watch.

So now the question is this: What’s a U.S. investor to do?

I’ve got a four-point strategy that will keep you out of trouble should either, or both, of these scenarios become reality.

And here’s the bonus: Even if they don’t happen, these strategies are highly effective strategies in the kind of "whipsaw" markets that we’ve been facing of late.

There’s No Such Thing as "Too Careful"

Rule #1: Your Best Offense is a Good Defense: This is the most important rule of all and can prevent a ton of trouble when it comes to growing your assets. After all, if you can’t keep it now, you can’t grow it later. Part of your defensive alignment includes the use of trailing stops. Even though you are convinced that your favorite stocks are the ones that will survive a downturn, there are no guarantees.

Rule #2: Stay "Balanced:" Globally diversified stocks and balanced funds may get hit if the selling starts in earnest, but history has shown that they’re far more stable than those limited to any single market – which is why we’ve been telling readers since last fall to park the bulk of their money in funds of this type.

Rule #3: Seek Help From Hedges: Protect yourself with such investment choices as the Rydex "URSA" [Latin for "bear," as in "bear market"] Inverse S&P 500 Strategy Investment Fund (RYURX), which grows as the Standard & Poor’s 500 Index falls. If you’re more aggressive, there are also some of the so-called "2x" funds, which do the same thing but at twice the rate (and volatility). One example is the ProShares UltraShort Financials (SKF). Funds like this have done well as the financial sector has cratered in recent months.

One caveat: Inverse funds are specialized choices, and while the potential for upside in a down market is tempting, nothing is for certain right now.

And that brings us to the final rule.

Rule #4: Don’t Try to Time the Markets: Especially now. Instead, think "safety and balance" and limit your positions – including the inverse funds – accordingly.

If you follow these rules, you’ll be poised to profit in the long run. And in the short run, no single mistake will wipe you out – even if the lousy markets get the best of those around you.

News and Related Story Notes:

• Futures and Options Week:
  MF Global gets pounded by rumour and conjecture.

• The Daily Telegraph (London):
  MF Global warning adds to market worries.

• Bloomberg News:
  European Stocks Fall; Credit Suisse, BHP, Nokia Lead Declines.

A drop in gasoline prices coupled with more troubling economic indicators sent stocks down yesterday (Thursday), erasing gains made in early morning trading.

At the New York close, the three major U.S. stock indices were in the red. The blue-chip Dow Jones Industrial Average Index dropped 147.60 points (-1.19%), to trade at 12,279.66. The tech-laden Nasdaq Composite Index shed 27.67 points (-1.19%), to reach 2,299.43. And the broader Standard & Poor’s 500 Index lost 17.82 points (-1.31%), to settle at 1,342.21.

All sectors were down with energy, conglomerates and transportation posting the largest declines. Shares of Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) declined.

Gas prices fell due to a surprise 1 million barrel increase in inventory. According to a Bloomberg survey, only a 500,000-barrel increase was expected.

"There comes a point where fundamentals can no longer be ignored," Michael Fitzpatrick, vice president for energy risk management at MF Global Ltd. (MF) in New York, told Bloomberg News. "You can’t justify $100 oil when inventories are up six weeks, demand is weak and the economy is slowing."

The Conference Board reported yesterday that its index of leading U.S. economic indicators slipped 0.1% in January. The index looks at several forward-looking indicators to try to determine future economic growth. The January decline follows a similar 0.1% drop in December.

Over the past six months, the leading economic indicator index has dropped 2%, which the Conference Board says can be one of the "reasonable criteria for a recession warning."

"The survey is gloomy indeed and suggests that if recession is avoided, it will be close," Ian Shepherdson of High Frequency Economics told MarketWatch.

The Federal Reserve Bank of Philadelphia also had troubling news for the U.S. economy yesterday. Its general economic index fell more than expected to settle at -24, with more manufacturing firms reporting a decrease in activity, rather than an increase.

"The economy is shrinking and business sentiment is as bad as it can be," Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York, told Bloomberg News. "We’re very close to a recession."

News and Related Story Links:

• Bloomberg:
  U.S. Economy: Philadelphia Factory Index Declines

• Bloomberg:
  Crude Oil Declines More Than $1 After U.S. Supplies Increase

• MarketWatch:
  U.S. economic indicators off 0.1% in January

With the Dow Jones Industrial Average having dropped more than 370 points over recessionary fears on Tuesday, and the much-broader Standard & Poor’s 500 Index having dropped by an equal 3%, it is clear that many investors have stopped thinking about stock-market profits.

But profits are exactly what they should be focusing on – especially now.

Here’s a simple five part recession-investing strategy you can employ to make sure you get your fair share. Think of it as an "Investor Recession Survival Kit."

Let’s take a look at the five key strategies you need to employ.

Recession Survival Rule #1: Sit in an Exit Row. One reason so many investors are getting clobbered is that they’re holding on too long. If you’re sitting in a movie theater and folks start yelling "Fire," you don’t just sit there and watch the action unfold around you. Do that, and you’ll get burned. It’s no different with investing. That’s why trailing stops are always a good idea: They can help you protect your principal and your profits during good markets; and they’re absolute life savers when the going gets really rough – as it’s been lately.

Recession Survival Rule #2: Bet on Income. When the markets lose their mojo, you don’t want to lose yours. Dividends are indisputably the perfect talisman. As interest rates decline, there will be an upward pressure on dividend-paying stocks because investors start reaching for yields. And if all the recession fears turn out to be much ado about nothing, the stocks will rally when the market does anyway. And if inflation continues to escalate – as we’ve been saying that it will – many of the dividend-payers will be able to raise prices for their products and services, which will boost revenue and profits, and also enable them to boost their dividends. In short, this is one of those rare situations where you win under almost every scenario.

Recession Survival Rule #3: Build in Safety. Make built in safety-brakes a permanent part of your portfolio. You can do that with bonds, of course. But a far-easier strategy – and one that packs a potential for profits, to boot – is one in which you allocate up to 50% of your assets in our favorite balanced fund, the Vanguard Wellington (VWELX). Because this fund offers both safety and balance, we include this in the "Base Builder" portion of the portfolios we assemble for our trading-service subscribers. Since 1929, the Vanguard fund has captured 80% or more of the market’s upward moves [including many of the years where there were market gains of 20% or better], even with a "safety-first" balanced blend that’s about 60% stocks and 40% bonds. This asset mix maintains your ability to gain in bull markets, while minimizing your risk during more-bearish trading sessions.

Recession Survival Rule #4: Think booze, bombs, and butts. A beaten-down greenback means that U.S. companies – particularly those with strong export businesses – are trading for bargain prices. And so-called "sin stocks" are at the very top of that list. These include the traditional "snacks-and-smokes" stocks, including tobacco, snack foods, alcohol, and gaming shares. These firms often pay a nice dividend, and are positioned to expand their sales more rapidly than most companies in the current environment – which, of course, will boost the bottom line. We’re also including defense-related issues in this venue, given the current focus on home security, the war in Iraq, and the concerns that additional problems could arise in other parts of the Middle East, with North Korea, or in other portions of Asia. The Bush Administration’s proposed $588 billion defense budget for 2009 includes money for weapons systems being sold by Boeing Co. (BA), Lockheed Martin Corp. (LMT), Northrop Grumman Corp. (NOC) and other manufacturers. Even if the Bush budget plan is modified by Congress as expected, it still shows that U.S. defense spending continues to grow and that the market outlook for defense contractors remains strong. With any of these companies – be it sin stocks, gaming firms, or defense contractors – stick with firms that have lower debt, steady sales growth, and that are posting strong earnings. The best plays will be firms with global operations.

Recession Survival Rule #5: Hedge Your Bets. Professional investors hedge with options, futures and other types of derivatives, but you can achieve this far more easily with such specialized exchange-traded funds (ETFs) as the Rydex Inverse S&P 500 Strategy Inverse Fund (RYURX), which is designed to rise in value by 1% for every 1% the S&P 500 falls. You could also pick up shares in a commodity related ETF or two, and not just the soft stuff, either.

Agricultural funds are appealing, too, because of the emergence of such markets as China, India and South America. The StreetTracks Gold ETF (GLD) offers bullion-based pricing, but without the storage problems and liability of delivery The Deutsche Bank’s Power Shares Agricultural Fund (DBA) is intended to reflect the performance of commodities in the agricultural sector – soybeans (31%), wheat (28%), corn (23%), and sugar (16%). The Van Eck Market Vectors Agribusiness ETF (MOO) reflects the infrastructure of the agriculture industry, focusing on chemicals (34%), agri-product operations (33%), equipment (24%), livestock operations (6%), and ethanol/biodiesel (2%).

When it comes to recession-survival strategies, here’s a final – but important – thought to consider.

When the markets get rough, the temptation is to run for the hills. We undertand. We’ve felt that way, too, at times.

But whatever you do, resist the urge to run.

Studies show that investors who stay in the game and pursue profits using strategies like the one we’ve just outlined tend to capture the biggest returns over time.

Studies also show it’s best to buy when there’s blood in the streets – even if it’s your own.

[Editor's Note: In addition to serving as the Investment Director for both Money Morning and The Money Map Report, Keith Fitz-Gerald is also the editor of the New China Trader service. A professional trader who splits his time between the United States and Japan, Fitz-Gerald's returns for subscribers have run as high as 1,804% in the past three months. For additional info, please click here].

News and Related Story Links:

• Seeking Alpha:
  Safety in Sin Stocks: Good Bets for a Slowing Economy.

• TradingMarkets.com:
  Budget Plan Boosts Defense Companies.

• Money Morning:
  Gold Glimmers As Inflation Hedge.

• Money Morning Investment Research Report:
  Outlook 2008: Five Ways to Profit From Soaring Agricultural Prices.

U.S. stocks plunged yesterday (Tuesday) after a report said that January was the worst month for the American service sector in nearly five years and Federal Reserve Bank of Richmond President Jeffrey Lacker said the chances of a U.S. recession had risen.

All three of the key U.S. indices dropped about 3% yesterday.

The Institute for Supply Management announced that its non-manufacturing index, which reflects almost 90% of the economy, fell to 41.9 in January, down from 54.4 in December. A reading under 50 indicates an economic contraction.

"This is a stunning fall," Michael Moran, chief economist at Daiwa Securities America Inc., told Bloomberg News. "If accurate, it’s dire news for the economy."

The decline was the largest in the survey’s 10-year history and the first time since March 2003 it signaled a decline in service sector activity.

The ISM’s index of new orders for non-manufacturing industries fell to 43.5, down from 53.9 in December. Its index of employment dropped to 43.9 from 51.8.

The Dow Jones Industrial Average plunged 370.03 points, or 2.93%, to close at 12,265.13. The broader Standard & Poor’s 500 Index skidded 3.2%, dropping 44.18 points to close at 1,336.64. And the tech-laden Nasdaq Composite Index shed 73.28 points, or 3.08%, to finish the day at 2,309.57.

Lacker the Tracker

 During some prepared remarks made to banking leaders in Charleston, W.V., yesterday, Lacker, the Richmond Fed chief, said he sees "the possibility of a mild recession," and noted that additional interest-rate reductions may well be necessary.

"A slowing economy requires a lower inflation-adjusted interest rate," Lacker told his audience. The prominence of downside risks means that further easing may be warranted."

The comments represent quite a turnabout for Lacker, who has been one of the U.S. central bank’s most vocal proponents of keeping inflation at bay. Indeed, in the last four U.S. Federal Reserve meetings of last year, Lacker dissented in favor of raising interest rates, according to a report by Bloomberg News.

 Butthe fact that he’s so closely tracking downside risks to growth underscores that Fed officials believe that the odds of a sharp slowdown – if not an outright recession – are on the rise.

Contradictory Data

However, a report released by the ISM last Friday indicated that the U.S. manufacturing sector actually expanded in January. The group’s manufacturing index rebounded to 50.7% for January, up from 48.4% in December.

"Startling, amazing, breathtaking. I cannot describe how unbelievable this report is," said Joel Naroff, president and chief economist of Naroff Economic Advisors in Holland, Penna. "It is hard to understand how the manufacturing sector could improve while services are collapsing."

But yesterday’s disappointing report on the services sector seems to justify the recent spate of short-term-interest-rate reductions directed by Fed Chairman Ben S. Bernanke.

During the past two weeks, the policymaking Federal Open Market Committee (FOMC) has reduced rates by 125 basis points [or 1.25 percentage points] in a desperate attempt to keep the U.S. economy and securities markets afloat.

"If we take the report at face value, it would be hard to dispute that a recession, if not already here, is coming," Naroff said. "This report will likely spook investors, who could move further to the sidelines. And it could put additional pressure to get a fiscal package out and it might be even bigger than the House plan."

If the ISM data is supported by other figures, Naroff thinks another 50 basis point cut could be in the works. 

Economic growth slowed to an annual rate of 0.6% from October to December. Employers in January reduced payrolls for the first time in more than four years, the U.S. Labor Department reported last week. And consumers increased their spending at the weakest pace in six months in December, the year’s peak shopping season.

Related News and Links:

• Bloomberg News:
  U.S. Economy: Service Industries Unexpectedly Shrank in January

• USA Today:
  Shocker: Services sector contracted in January

• Money Morning:
  Decline in U.S. Jobs, Recession to Follow?

• Bloomberg News:
  Lacker Sees Recession Risk, More Cuts May Be Needed.

A narrowing trade surplus and declining money-supply growth in China has some analysts worried about the prospects of global growth, particularly as the U.S. economy flirts with the possibility of recession. But the red-hot Asian markets may prove more resilient than many think.

China raised its interest rates six times in the past year in an effort to tame the worst inflation the country has seen in a decade. The government in Beijing has also restricted credit, and frozen the price of some products such as gasoline. And after months of reform, China is finally starting to see some results.

December’s trade surplus shrank to $22.7 billion from $26.3 billion in November, and the broadest measure of money supply rose by the least amount in seven months. That raised the eyebrows of analysts who think an economic slowdown, or worse, a recession in the United States could significantly damage Chinese exports and further hinder the global economy.

"As foreign demand deteriorates, China may overdo its tightening of policy and cause a sharp economic slowdown," Frank Gong, chief China economist at JP Morgan Chase & Co. (JPM), told Bloomberg News.  "If the central bank raised interest rates too much, it would damp domestic demand and increase the danger of economic downturn."

Yesterday [Monday], Goldman Sachs Inc. (GS) lowered its Asian growth forecast to 8.3% from the previously projected 8.6%.

There is no doubt that a U.S. recession would have a negative impact on Chinese exports and thereby the Chinese economy as a whole. But the United State’s role in the global economy, while still substantial, is shrinking.

America accounts for about 19% of emerging market exports, but its topped by Europe, which takes in 28% of the goods being shipped out of those countries. In 2007, the 27-nation European Union, not the United States, was China’s No. 1 trade partner.

Trade with the EU rose 27% year-over-year to $356.15 billion. The United States came in second with bilateral trade volume standing at $302.08 billion, up 15% compared with 2006, according to the customs administration.

And while the U.S. dollar remains weak, making it harder for the United States to import goods, the euro is hitting all-time highs.

China’s trade surplus for the first 10 months of the year expanded by 59% to $212.4 billion, easily eclipsing the full-year record of $177.5 billion set in 2006.  For all of 2007, however, China’s total exports rose 25.7% to $1.218 trillion.

Even as demand slackens in the United States, domestic demand in emerging markets, particularly China, continues to boom. In fact, many fund managers see weakness in the U.S. economy as yet another reason to invest in sectors that benefit from Asia’s dynamic domestic growth.

"The one pocket of growth for now at least is Asian consumers, particularly in China and India," Anthony Muh, head of Asia Pacific for AT Asset Management told the China Post.

"We’ve been pulling back on cyclicals, on the export sector, and adding more to domestic consumption and raising a little bit of cash to keep our powder dry to take advantage of some of the pullbacks," he said.

That’s not such a bad idea, either. The Shanghai Composite Index climbed 96.7% on the year, making it the world’s best performing major bourse for 2007. A pullback induced by a recession in the United States and tighter economic restrictions could take some of the heat out of overpriced stocks and open the door for bargain hunting.

Sectors such as retail, telecommunications, real estate, construction and infrastructure could present significant opportunities as domestic demand for their services remain high, declining in exports. Even if China’s rate of growth drops significantly from last year’s 11.5%, a growth rate higher than 8% is still exceptional.

George Hoguet, strategist at State Street Global Advisors doesn’t even see growth dropping that dramatically.

"[China's economy] will slow down less than half a percentage point for every point of growth the U.S. loses," Hoguet recently told CNNMoney. 

"Emerging markets account for 30% of the world’s economy," Hoguet added. "As the U.S. slows, investors will be looking for earnings growth in other parts of the world. Emerging markets will be increasingly driven by earnings growth over the next 12 months."

News and Related Story Links:

• CNNMoney:
  Emerging Markets Will Remain Strong, But U.S. Is A Worry

• Bloomberg:
  China Growth May Slow at Worst Time for World Economy

• China Post:
  U.S. economy woes push Asia funds to domestic plays

• Money Morning:
  Why the Chinese Trade Boom Could Cause the Country to Go Bust

• Money Morning:
  China Triples Investment Quota

It seems every analyst has chimed in on the possibility of a U.S. recession, but few have talked about the economic woes of the world’s second-largest economy – Japan.

Until now, that is.

Goldman Sachs Group Inc. (GS) has cut it economic growth estimate for Japan’s gross domestic product (GDP) from 1.2% to 1%, citing slowing growth in emerging markets and the country’s lax economy. Odds that the country will enter a recession now stand at 50%.

"The probability of a recession in Japan has risen to the danger level," Tetsufumi Yamakawa, chief Japan economist at Goldman, said in a report to clients today. "We project weaker-than-expected growth in Japan."

And that’s not surprising considering Japan’s leading index, the Nikkei 225, has fallen in the past two years. In fact, the country is battling a host of challenges – falling economic sentiment, tepid wage growth and rising consumer prices.

The current U.S. slowdown has already weakened the economies of countries that export a significant share of goods here. And Japan is one of the biggest.

Japan’s trade surplus with the United States shrank by 8.5% from last year to $6.53 billion (717.3 billion yen), as exports to the United States decreased 1.5% to $13.64 billion (1.5 trillion yen). Less construction machinery and fewer cars were shipped to the United States, an indication that the U.S. housing slump is spilling over into other economies.

"A U.S. slowdown affects Asia, beginning with China, and via that route it affects Japan," Japan’s Economic and Fiscal Policy Minister Hiroko Ota, told Bloomberg. "The extent to which Japan is hurt depends on the severity of the U.S. slowdown."

Dual recessions in the world’s two largest economies would sting every country in some way or another.

The Bank of Japan doesn’t have much leeway to loosen money flow by cutting interest rates, as they are currently at a very low 0.5%. But Japan wasn’t leaning in that direction anyway; previously, it contemplated raising rates last year, and Goldman believes the Bank of Japan will raise rates in the second quarter of 2009, Reuters reported.

"The greatest challenge for the Japanese economy, needless to say, is a recovery in personal consumption, which has remained in an extended slump," Goldman’s Yamakawa said. "Innumerable obstacles stand in the way."

News and Related Story Links:

• Reuters: 
  Goldman says Japan in danger of recession

• Bloomberg:
  Goldman Says Japan Recession Risk at `Danger Level’

• Money Morning:
  Bank of Japan Holds Its Lending Rate Steady

• Money Morning:
  Global Growth Fuels Japanese Exports Despite a U.S. Pullback

The U.S. unemployment rate for November rose 0.3% to reach 5% – the highest rate since 2003 – and non-farm payrolls gained slightly to 18,000, according to a statement from the Bureau of Labor Statistics (BLS). 

On Wednesday, the Institute for Supply Management (ISM) released the Purchasing Managers’ Index (PMI) for December 2007. PMI fell to 47.7 in December, after 10 months of consecutive growth, signaling a slow down in manufacturing. PMI consists of five underlying indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment.

These indicators are just the latest signs of an economic slowdown. A slumping housing market, rising energy costs, and the subprime-fueled credit crunch are all taking a toll.

"It’s not a done deal, but if we’re going to have a recession, it’s too late to do anything about it,"’ Stuart Schweitzer, global markets strategist at JPMorgan Chase & Co.’s (JPM)  Wealth & Asset Management unit in New York, told Bloomberg. "The Fed can’t prevent a recession if one’s in the making, and we’re pretty close."

Due to the delay in release of economic data, it can be hard to pinpoint the beginning of a recession until months after its start. Some are certain the U.S. economy is already experiencing recession. 

"If I had to be bold, I’d say we began a recession in December," Bill Gross, manager of the PIMCO Total Return Fund (PTTAX), told the Financial Times in a recent interview.

Others seem inclined to wait for more data to be released before making a call. While it’s clear the economy is slowing, it won’t officially be in recession until it experiences two consecutive quarters of negative GDP growth. 

"Let’s wait to see what January and February have in store, especially since BLS is notorious for revising the data. Anyone remember the negative August jobs report?" Joel Naroff, president and chief economist of Naroff Economic Advisors, included in a note to clients.

The August 2007 jobs report initially showed a loss of 4,000 jobs leading many to exclaim a recession was here. That number was later revised upward to a healthy gain of 89,000 by early October and the third quarter went on to post the highest GDP gain, 4.9%, in four years.

The Standard & Poor’s 500 Index closed Friday at 1,411.63 – down 10% from its 52-week high of 1,576.09. And that could spell trouble, says Money Morning Investment Director Keith Fitz-Gerald.

"Should we fail to hold this level in the days ahead, the next stop down is 1329.26 which will be psychologically devastating to investors who are not using trailing stops or ‘inverse funds’ to profit from a decline," which Money Morning readers have been advised to do in a series of news stories and investment-research reports.

Statistically speaking, the markets have fallen both far enough and fast enough that they are pushing new downside limits, Fitz-Gerald says. And, strangely enough, that points to upside potential, since markets have posted a decline like the current one only about 10% of the time. Therefore, it’s entirely logical to continue to plan for the upside, Fitz-Gerald says.

Potential upside triggers include a decline in oil prices, an interest-rate reduction by the U.S. central bank, or a federal fiscal stimulus package, Fitz-Gerald says.

How to Profit, Even During a Recession

Regardless of what happens here at home, Money Morning’s Fitz-Gerald cautions investors to remember that even if the U.S. economy contracts [though it's more likely U.S. gross domestic product (GDP) will advance at a modest pace of 1% to 2% during 2008], the rest of the global economy will be doing quite well – with economic growth rates as high as 8% to 9%. With foreign economies growing that briskly, there will be plenty of profitable investment opportunities available.

Investors should turn their attention to U.S.-based multinationals with a substantial portion of sales coming from overseas as McDonald’s Corp. (MCD) and Yum! Brands Inc. (YUM). And while they offer significant foreign-market exposure, being U.S. companies, corporations such as McDonald’s, Yum! Brands and such others like The Coca-Cola Co. (KO) and PepsiCo Inc. (PEP) at the same time offer investors the transparency of U.S. financial reporting requirements and the relative protection of the U.S. investment-regulatory system.

If you prefer to invest more directly in foreign growth, Money Morning Contributing Editor Martin Hutchinson says to try South Korea’s largest wireless service provider, SK Telecom Co. Ltd. (SKM). SK is well positioned to capitalize on the growing Asian markets. Likewise, the Hsinchu, Taiwan-based Taiwan Semiconductor Mfg. Co. Ltd. (TSM) [commonly referred to as TMSC], the world’s largest dedicated semiconductor foundry, is another Asian tech company that is not currently overvalued and should do well in the New Year, Hutchinson says.

Traditional inflation-sensitive investments such as currencies and commodities are also good plays during a recession.

The PowerShares Agriculture Fund (DBA), operated by German giant Deutsche Bank AG (DB), 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 agricultural commodity plays that Jim Rogers advocates.

Another is Van Eck’s recently launched Market Vectors Agribusiness Exchange-Traded Fund (MOO). Like the PowerShares Fund, this reflects the agriculture industry but in a different way. Instead, the ETF’s holdings reflect returns seen from agriculture chemicals (34%), agri-product operations (33.5%), agriculture equipment (24.3%), livestock operations (5.6%) and ethanol/biodiesel (2.3%).

For investors who have the constitution of a Contrarian investor – as well as some patience and a long time horizon – it may be well worth a look at some of the beaten-down financial-sector stocks that state-run sovereign wealth funds are buying into in a wholesale manner.

Although many U.S. investors are preaching caution – if not total avoidance – when it comes to companies involved with the American financial-services sector, these government-run investment pools clearly view such stalwarts as Citigroup, UBS, Merrill Lynch & Co. Inc. (MER), and Morgan Stanley (MS), as bargain-basement investment opportunities. Fitz-Gerald favors Citigroup.

News and Related Story Links:

• Bloomberg:
  U.S. Economy: Job Growth at Weakest Pace Since 2003

• MSNBC:
  Economists say odds of recession are rising

• Wikipedia:
  U.S. stocks pressured by jump in unemployment

• Money Morning:
  Outlook 2008: The U.S. Economy Is Down – But Not Out – in the New Year