Global investors seeking undervalued markets might want to look at Russia, China, India, Malaysia, South Korea or Brazil.

And if they want to avoid overvalued markets, they’d be best to eschew Italy, the United States, Japan, Canada, Switzerland, or Germany.

What’s tipping us off?

The so-called Price/Earnings-to- Growth ratio, better known to investors as the "PEG" ratio.

Let me explain …

One of the most popular stock valuations is the Price/Earnings (P/E) ratio. If you take that calculation one step further and include a stock’s expected growth rate you hit on the P/E-to-growth ratio, or PEG ratio.

Analysts have been using PEG ratios for years, now, to pick undervalued stocks, but now you also can use that same ratio to determine which countries are trading at good value.

A recent Bespoke Investment Group report used the popular PEG ratio to identify which country’s stocks are currently undervalued.

"Late last year, we began performing this analysis on countries to get a better comparison of the valuations of both developed and emerging markets," the B.I.G. Tips report read.  "To do this, we divide the country’s [gross domestic product] growth estimate into the estimated P/E ratio of its major stock market index."

Like an individual security’s PEG ratio, the lower the ratio, the more undervalued the stock.

The top-three spots on that list go to Russia (1.37), China (1.91) and India (2.06). Brazil clocks in at sixth with 2.80. Money Morning readers may recognize them as member of the "BRIC" nations – a term coined by Goldman Sachs Group Inc. (GS) in 2003 identifying rapidly growing emerging economies (Brazil, Russia, India, China). [For a complete listing of the PEG ratios of the respective countries, please see the chart below.]

Rounding out the top six are Malaysia (2.37) and South Korea (2.66), the latter of which is another investing favorite of both Money Morning and Warren Buffett, chairman of Berkshire Hathaway Inc. (BRK.A, BRK.B).

The United States, on the other hand, comes in near the bottom with an estimated PEG ratio for 2008 of 11.39.

When using the calculations to make investment picks, it’s important to remember that both the P/E ratio and the 2008 GDP growth are only estimates. Still, it’s easy to see how fast-growing economies have the leg up on more mature markets such as Japan and the United States.

How to Play the PEG for Profits

One of the easiest ways for U.S. investors to cash in on a foreign country’s expected stock market growth is with an American-listed exchange-traded fund (ETF) or exchange-traded note (ETN) that mirrors a foreign stock market index.

For the BRICs, you could try the iShares MSCI Brazil Index (EWZ), the Market Vector Russia ETF Trust (RSX), the Barclays IPath India Index ETN (INP), or the iShares FTSE/Xinhua China 25 Index (FXI).

If you prefer to stick to individual securities:

Russia: OAO Gazprom (OTC: OGZPY), the state-owned natural gas monopoly with ambitions to control Western Europe’s gas supplies.

Lukoil (OTC: LUKOY), the other obvious Russian heavyweight, is the largest state-controlled oil company.

China: A terrific way to play China is with the Region Opportunity Fund (USCOX), a mutual fund run by San Antonio-based U.S. Global Investors Inc. (GROW). Indeed, U.S. Global, itself, is a pretty good play on international growth. It manages some of the best emerging-market funds, and natural-resources funds, in the business. As global growth fuels global investments – and it will – U.S. global will see more money pour into its funds, boosting the management fees it collects, as well as its profits and stock price.

India: One of India’s titans is Tata Motors Ltd. (TTM), which recently sealed both ends of the consumer automotive spectrum with its forthcoming $2,500 Nano and its recent $2.3 billion acquisition of the Jaguar and Land Rover brands.

Another is option could be the pharmaceutical company Dr. Reddy’s Laboratories Ltd. (RDY). As many U.S. pharmaceutical patents expire in the next five years, this major generic-drugs manufacturer can expect to benefit. 

South Korea: Back in October 2007, Buffett took a 4% stake in this country’s Number One steelmaker, POSCO Ltd. (PKX). Studies have shown that following Buffett’s investment moves, even months after the fact can be the pathway to profits.

Brazil: Companhia Vale do Rio Doce, now referred to only as Vale (RIO), is an iron-ore company with ancillary operations in gold, nickel, copper and other metals. It’s one of the true global blue chips, with a market capitalization of almost $200 billion.

Another Brazilian firm worth a look is Petrobras (PBR). It’s one of the few emerging market oil companies with access to modern technology – and the willingness to work with the oil majors.
   
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It was another troubling week for the U.S. market, as the latest round of economic indicators continued to paint a downbeat portrait of the outlook for the American economy.

Let’s take a look at the economic reports released last week:

• Existing Home Sales: The week got off to a bad start on Sunday, when The National Association of Realtors announced existing home sales for January [including single-family, town homes, condominiums and co-ops] declined to 4.89 million units from 4.91 million units in December, a seasonally adjusted decrease of 0.4%. Even more troubling: January’s sales represented a 23.4% decline from the 6.44 million units sold in January 2007. It appears as if housing sales are still locked in a downward trend. 

• Producer Price Index: On Tuesday, the Bureau of Labor Statistics announced the producer price index (PPI) for finished goods increased a seasonally adjusted 1.0% in January. The increase was due in large part to an increase in fuel-related prices, which isn’t surprising since oil briefly topped $102 a barrel this week.

• Consumer Confidence: The Conference Board announced the Consumer Confidence Index declined 12 points in February. The Index now stands at 75.0 [from it's 1985 base rate of 100], down from 87.3 in January. Lynn Franco, director of The Conference Board Consumer Research Center, summed it by observing that "with so few consumers expecting conditions to turn around in the months ahead, the outlook for the economy continues to worsen and the risk of a recession continues to increase."

• Durable Goods Orders: On Wednesday, the Census Bureau announced that new orders for manufactured durable goods totaled $212.8 billion, a decline of $12 billion, or 5.3%. That means consumers are holding off on big-ticket purchases – such as appliances and furniture – until they feel more confident about the economy.

• New Home Sales: Also on Wednesday, in a joint news release, the Census Bureau and Department of Housing and Urban Development announced new single-family home sales for January were a seasonally adjusted 588,000, a decline of 2.8% from the 605,000 recorded for December. While that was only a modest decline from the month before, January’s sales were down a hefty 33.9% from January 2007’s total of 890,000. Even worse, new home sales experienced an even bigger decline than sales of already existing homes.

• Initial Jobless Claims: For the week ending Feb. 23, the Department of Labor announced the advance figure for seasonally adjusted initial unemployment claims was 373,000, an increase of 19,000 from the previous week’s revised figure of 354,000. The 4-week moving average, which is a more stable measure of jobless claims, was 360,500, a decrease of 1,250 from the previous week’s revised average of 361,750. While that’s only a slight decrease in the four-week moving average, with such a broad array of negative economics, even marginally upbeat news has to be viewed as a positive.

• Preliminary Gross Domestic Product: On Thursday, the Commerce Board announced that the preliminary gross domestic product (GDP) figure for the 2007 fourth quarter was 0.6%, unchanged from the advance figure released last month. Analysts had expected a slight upward revision to 0.7%. When that didn’t happen, the U.S. stock market hit the skids in a sell-off that carried over into Friday, when the Dow Jones Industrial Average dove more than 315 points. [For an in-depth look at Friday's trading activity and stock-market performance in today's issue of Money Morning, please click here.]

• Personal Income/Outlays: To wrap up an already disappointing week, the Bureau of Economic Analysis announced Friday that personal income increased $32.2 billion, or 0.3%. Personal consumption expenditures (PCE) increased $39.9 billion, or 0.4%. But don’t be fooled by this seemingly good news. Higher prices due to inflation were responsible for the increase in consumer spending.

The outlook for the U.S. economy continues to be uncertain, but recessionary fears continue to escalate. While the market isn’t technically in a recession until the GDP registers a decline for two consecutive quarters, the odds of a significant slowdown continue to increase. There’s still one more fourth quarter GDP reading to come, the so-called "final" estimate. But without any change between the advance and preliminary estimates, don’t expect a surprise there. And analyst estimates are pointing to a 0.0% change in GDP for the first quarter of the New Year.

News and Related Story Links:

• Money Morning:
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• Money Morning:
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U.S. stocks experienced their biggest rally in five years yesterday (Wednesday), as browbeaten investors seized on Federal Reserve Vice Chairman David Kohn’s suggestion that another rate cut could be in the offing.

The Dow Jones Industrial Average soared 331 points, or 2.56%, to close at 13,289.45 yesterday. Combined with a 213-point rally Tuesday, the 30-stock Dow jumped 544 points, or more than 5%, over the two-day period.

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The Dow closed at 12,725.39 last Wednesday, and is up 4.43% since then.

The Standard and Poor’s 500 Index climbed 40 points yesterday, or 2.86%, to close at 1,462.09. It’s climbed 59.43 points from its Monday close. The Nasdaq Composite Index was up 82.11 points yesterday, or 3.18%, after a 23-point surge Tuesday. 

"The degree of deterioration that has happened over the last couple of weeks is not something that I personally anticipated," Kohn, the Fed vice chairman, told his audience at the  Council of Foreign Relations. 

Kohn, the Fed’s No. 2 official, said the central bank needs to be "nimble" and can’t risk threatening the economy just to teach speculators a lesson. The policymaking Federal Open Market Committee (FOMC) will have to take a good look at the current market conditions and future vulnerabilities at its next meeting, currently set for Dec. 11.

"Kohn’s comments just add to the perception that the Fed is embarking on a sustained path of easing," Michael Metz, chief investment strategist at Oppenheimer Holdings Inc., told Bloomberg News. "There’s also huge relief that the worse of the financial crisis may be behind us."

Chris Rupkey, Chief Financial Economist at Bank of Tokyo-Mitsubishi UFJ, said the Fed more or less gave the green light to a rate cut.

"Restrictive credit costs will very likely lead to a dramatic slowing of the economy if the Fed doesn’t take steps to forestall them," he told Bloomberg. 

News and Related Story Links:

• Bloomberg:
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• Bloomberg:
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• Money Morning:
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The markets are clearly counting on the "Bernanke Put," which is how market insiders refer to the Federal Funds rate cut nearly everyone is hoping for today (Wednesday).

I have to say that I’m dumbfounded.

I simply can’t understand why investors believe that another rate cut will somehow bail out the stock market and sweep away the nation’s housing and credit problems – as if Federal Reserve Chairman Ben S. Bernanke were the second coming of Harry Houdini.

Nor do I understand why millions of investors who have no rational belief in the tooth fairy, Santa Claus or any other creatures of myth and mirth, are willing to wager their hard earned money on nothing more than an assumption (with some folks, it’s more of a blind hope) that Team Bernanke will cut interest rates

What I think, though, really doesn’t matter leading up to the announcement that Federal Open Market Committee (FOMC) policymakers will make at around 2:15 this afternoon.

In reality, what does matter are the facts. And when you consider the subprime mortgage mess, the spillover effect that financial catastrophe has had on the global credit markets, and the sorry state of the U.S. housing market, well, those "facts" aren’t especially pretty.

The bottom line: No matter what the Fed actually does today, there are three key factors that underscore why it is crucial for you to "go global" – as always, the dominant theme here at Money Morning.  Let’s take a look at just why this is the case:

• First, the Fed usually bases its interest-rate decisions on inflation. Right now, inflation is running at an annualized rate of almost 2.5%, meaning it is well above the central bank’s well-established "comfort zone" of 1% to 2%. (If you really want a Halloween scare, check out http://www.shadowstats.com/cgi-bin/sgs which tracks unadulterated versions of the CPI that are tracking north of 6% at the moment).

• Second, the Bernanke-led Fed is right now engaged in the shell game of its monetary life. The central bank desperately wants to create the perception that inflation will take a breather. Not surprisingly, much of the commentary it has provided recently is oriented around the notion that oil prices will stop rising and that the credit crisis will ease. In other words, Bernanke & Co. are trying to get us to focus on an "inflation-free" future – ignoring what’s right in front of our noses. I find that worrisome at best, and troublesome at worst, for it leaves me wondering just what they really know. Hmmm….

• Third, Team Greenspan – and now Team Bernanke – has created and then perpetuated what is probably the most massive asset bubble of all time [and given the Godzilla-sized bubble Japan created back in the 1980s, we're really saying something here] by allowing real interest rates to slip to unprecedented lows. Greenspan dropped rates in the late 1990s to stave off an implosion of our financial system because of the Asian Contagion and the collapse of the Long-Term Capital Management hedge fund – only to inflate the money bubble that created the "dot-bomb" debacle. When Internet stocks imploded, we merely shifted what was left of our excess capital from stocks and into real estate – creating a housing bubble fueled largely by a barrage of hazy "liars’ loans." I mean, to borrow under some of those subprime- and "no-documentation" mortgage loan programs, prospective borrowers essentially only needed a heartbeat and they could obtain money to buy a house, or car, or some other hard asset. That ill-advised credit policy finally came home to roost this summer, as banks realized they couldn’t accurately value the asset-backed debt and the credit markets seized up. Now we’re left with a greenback so tattered that it looks like something a Depression-era hobo would wear while hopping a westbound freight train.

After reviewing all this "evidence," I reach two inescapable conclusions – both of which point to higher inflation:

• First, there’s still too much easy money available [in technical terms, the money supply is still way too high], an inflation-inducer if ever I’ve seen one.
• And, second, judging from the fact the global economy is still accelerating – even as the U.S. market slows – real interest rates are far too low to slow inflation down.

So when the Bernanke and the policymaking Federal Open Market Committee end their two-day meeting with a public pronouncement this afternoon, it will take one of the following three forms:

• First, the Fed could cut rates again. Given the way the markets reacted to the Sept. 18 "Bernanke Surprise," you can almost bet the ranch that a rate reduction of any magnitude would fuel an immediate rally in U.S. stock prices. However, it will simultaneously make the dollar weaker than it already is. And that’s going to mean more pain for American consumers because foreign made goods will be made more expensive. So will fuel. However, this will likely point to more big gains for investors holding shares of companies deriving a substantial portion of their sales and profits from outside U.S. borders.

• Second, Fed policymakers could actually raise interest rates – although that’s about as likely as the Air Force holding a press conference to say that a UFO really did crash at Roswell. This would make the U.S. dollar more valuable to overseas investors, but U.S. investors and consumers would suffer as U.S. stocks plunged. The only domestic beneficiaries might be the cardiologists called in to treat patients who’d suffered coronaries over the unexpected news. Globally, this might actually fuel growth, since investors worldwide would have more confidence that all markets would advance.

• Third, the Fed could stand pat, and do nothing. The decision alone would not affect the greenback’s value in either direction. However, global traders would likely take the dollar down anyway as companies begin raising prices to keep up with the inflationary pressures being felt around the world. And as you probably guessed, global growth – sans the U.S. market – would continue unabated.

No matter what the Fed decides to do, make sure to pay close attention to its commentary, and especially to its near- and long-term outlooks. Given that they’re being issued on Halloween, they could well be scary as anything for investors – especially if they’re expecting one scenario but end up getting another.

And no matter what the outcome is for the U.S. economy, nothing will change the green light for global growth. And that’s yet one more example of the American consumer, for so long the integral cog in global growth, becoming increasingly irrelevant on the world stage.

News and Related Story Links:

• Money Morning Investment Analysis:
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• Money Morning News Report:
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• MSNBC.com:
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• Money Morning Economic Analysis:
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• Money Morning Investment Analysis:
  How to Play Today’s FOMC Meeting.

• Wikipedia:
  Harry Houdini.

• The San Jose State University Department of Economics:
  The Bubble Economy of Japan.

• MSNMoney.com:
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• Investment U:
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• Money Morning Investment Analysis:
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• Money Morning Investment Analysis:
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• Money Morning Investment Analysis:
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• Money Morning Investment Report:
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• Money Morning Investment Report:
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• Money Morning Investment Report:
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• Money Morning Investment Report:
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• Money Morning News Analysis:
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• Money Morning News Analysis:
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• Money Morning News Analysis:
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• Money Morning News Report:
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Stocks tumbled yesterday (Monday) as oil prices soared and three major U.S. banks announced a plan to revive the asset-backed commercial paper market.

The Dow Jones Industrial Average fell 108.20 points, or 0.77%, to close at 13,984.80. The broader Standard & Poor’s 500 Index closed at 1,548.71, down 13.09 points, or 0.84%. The tech-laden Nasdaq Composite Index fell 25.63 points, or 0.91%, to close at 2,780.05.

The market sag came amid news that three major U.S. banks would combine forces in an effort to resurrect an asset-backed commercial paper market deeply wounded by the housing slump and subsequent credit crunch.

Also dragging on the market were concerns over rising energy costs as colder weather sets in.  Oil prices cracked $86 a barrel Monday, closing at $86.13, a jump of $2.44 a barrel, or nearly 3%.

Oil prices rose above an overnight record close in Asian trading today (Tuesday) to set a new high after the Turkish government yesterday (Monday) asked its parliament for permission to pursue Kurdish rebels into Iraq – stoking fears that oil supplies in the region will be disrupted.

Light, sweet crude for November delivery rose 51 cents a barrel to reach $86.64 in electronic trading on the New York Mercantile Exchange by mid-afternoon in Singapore. Indeed, prices rose by as much as 66 cents a barrel in the electronic session to a fresh trading high of $86.79 a barrel.

Oil prices of $86 a barrel or greater are at a "historically high level… Many people are looking at this level for the first time so it’s very difficult to say what will happen next," Tetsu Emori, a commodity markets fund manager at ASTMAX Futures Co., in Tokyo, told The Associated Press. "All the factors in the market are bullish, there are no bearish factors except maybe that the market looks like it’s been overbought, technically."
Despite the gains, oil is still below inflation-adjusted highs hit in early 1980. Depending on the adjustment, a $38 barrel of oil in 1980 would be worth $96 to $101 or more today.

Yesterday’s record oil-price surge stemmed from some troubling reports from both the International Energy Association (IEA) and the Organizations of Petroleum Exporting Countries (OPEC).

OPEC said in a report yesterday that it’s likely the rest of the world will produce 110,000 fewer barrels of oil per day in the fourth quarter than previously expected. It also said that at the same time, demand would grow by 100,000 barrels per day over last year. 

Last week, the Energy Department reported that domestic crude inventories fell during the week of October 5, when they were supposed to increase.  Also in a separate report, the IEA said that oil inventories held by the world’s largest industrialized is below its five-year average. 

Additionally, speculation that Turkey could enter Iraq in response to attacks by Kurdish rebels has given investors even more cause for concern. 

"Oil out of northern Iraq fields has been erratic for some time," Linda Rafield told CNN, "But complete disruption would definitely be bullish for this market."

Investors were troubled by a debt deal by three major banks. Citigroup Inc. (C), Bank of America Corp. (BAC), and J.P. Morgan Chase & Co. (JPM) said yesterday that they would buy assets from structured investment vehicles (SIVs) to prevent investors from dumping their holdings. SIVs are typically bank-run, programs de­signed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments such as bank bonds or subprime mortgage debt. 

The fund, known as the master liquidity enhancement conduit, or M-LEC, will finance the purchase of assets by selling medium-term notes and commercial paper to investors, the banks said in a joint statement.  Sources familiar with the agreement told Bloomberg News the fund would be worth approximately $80 billion.  The fund is expected to be fully established within the next 90 days.

The commercial paper market suffered mightily in July and August as the subprime meltdown forced investors to retreat. The amount of asset-backed commercial paper outstanding plummeted from a high of $1.14 trillion at the end of June, to $899 billion in the week ended October 10. 

Treasury Secretary Harry Paulson mediated the agreement after a commercial paper market shutdown forced the sale of about $75 billion in assets.  Alex Roever a debt strategist at JPMorgan told Bloomberg SIVs have at least $32 billion in assets.

News and Related Story Links:

• Money Morning Investment Analysis:
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• Money Morning Investment Analysis:
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• Bloomberg:
  Citigroup, Bank of America Plan $80 Billion SIV Fund.

• CNN:
  Oil smashes $86 for the first time.

• The Associated Press:
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The almighty consumer accounts for two-thirds of the economy’s growth (or, at least, that’s what the "experts" always claim). Well, last week, they received some pretty mixed signals about consumer activity: past, present, and future. While the world’s top retailer, Wal-Mart Stores Inc. (WMT), surprisingly increased its earnings forecast for the third quarter, few others had anything positive to report. Clothing stores ranging from Limited Brands Inc. (LTD) to The Gap Inc. (GPS) to J.C. Penney Co. Inc. (JCP) to Nordstrom Inc. (JWN) announced weaker sales in September and all reduced their outlooks for the rest of the year, a pretty concerning trend heading into the holiday season. Many of these retailers are already trimming prices in an attempt to get folks to catch the shopping bug a bit early this year. However, a recent survey by NPD Group showed that 40% of consumers will not even begin to focus on their gift buying until after Thanksgiving (better late than never, we always say…) While naysayers already started predicting plenty of coal for each stocking come December, the U.S. Commerce Department reported stronger-than-expected retail sales in September (see below). Mixed signals, indeed.

Alcoa Inc. (AA) kicked off another much-anticipated earnings season by announcing higher profits, largely due to the sale of its interest in a Chinese aluminum company. Management also increased its share buyback program, a move often perceived as positive for the future of the firm. PepsiCo Inc. (PEP) and General Electric Co. (GE) each reported double-digit earnings growth and attributed their gains to international/global sales. While consumers may be staying away from the malls, they haven’t lost their appetites for Big Macs as fast-food giant McDonalds Corp. (MCD) projected another strong quarter. And, as we demonstrated here with a Money Morning investment analysis, Yum! Brands Inc. (YUM) used yet another strong quarter to demonstrate that this appetite for fast food (KFC, Taco Bell and Pizza Hut) is becoming a global phenomenon – reporting strong results from China and the rest of Asia.

Heading into earnings season, many analysts raised concerns about the subprime mortgage mess (so what else is new?) and the impact it had on companies within the financial services and housing sectors. Microchip Technology Inc. (MCHP) tried to blame its quarterly woes on the subprime fiasco, but analysts generally weren’t buying. Only time will tell how many companies really are affected.

A few key mergers were proposed this week and corporate boardrooms seem to be buzzing again about the ‘art of the deal,’ and with promising transactions. Software leader Oracle Corp. (ORCL) took aim at rival SAP AG (SAP) by offering to buy BEA Systems Inc. (BEAS) in a $6.7 billion deal, but Oracle CEO Larry Ellison had the door slammed in his face. GE’s media division, NBC Universal (now known in some circles as "Nothing But Chicks"), will be acquiring Oxygen Media and its network that targets women viewers. Last year, the company bought web site iVillage, which caters to a similar audience. Male beer guzzlers took note of the proposed merger of the domestic operations of Molson Coors Brewing Co. (TAP) and SABMillerPLC to create the number two U.S. brewing company behind Anheuser-Busch Cos. Inc. (BUD). The deal will likely undergo a strict regulatory review for antitrust implications.

The bulls are celebrating a milestone five-year anniversary as the prior bear market (remember the dot.com bubble?) ended in October 2002. Stock-market investors reacted positively to Tuesday’s release of the minutes from the Sept. 18 meeting of Federal Open Market Committee (FOMC) policymakers (see below), and economists now believe more rate cuts are in the cards. While earnings season produced some decent early results, the jury is still waiting for the large investment houses to report.

Techs led the charge this week as news of the Oracle acquisition helped investors overlook a negative report on Chinese Internet firm, Baidu.com (BIDU). The Nasdaq climbed to its highest level in six and a half years. Bonds moved lower with the sudden renewed interest in stocks. (If only consumers could renew their interest in shopping…I’m just kidding, honey).

Economically Speaking: Fed Minutes, Inflation Worries…

"Given the unusual nature of the current financial shock, participants regarded the outlook for economic activity as characterized by particularly high uncertainty, with the risks to growth skewed to the downside…Although financial markets were expected to stabilize over time, participants judged that credit markets were likely to restrain economic growth in the period ahead." On those "concerning" notes, the Fed unanimously agreed to take "the most prudent course of action" and cut the Fed Funds Rate by 50 basis points (half a percentage point) last month.

The love-fest for Chairman Ben S. Bernanke began in earnest as a WSJ.com poll showed that 76% of economists surveyed believe that the aggressive move was appropriate, and 90% gave him favorable marks in his role as Fed Chief. (Somewhere out there, a man named Greenspan is both bitter and jealous.)

In addition to the minutes, some key economic reports were released last week. The significant recalls of Chinese products have started to impact the global trade picture as the U.S. deficit dropped to its lowest level in seven months.

Retail sales jumped by 0.6% in September as strong car sales helped overcome the weakness in apparel demand. The large increase was surprising given the poor sales results that had been reported by the nation’s retailers just a day earlier. Unseasonably warm weather and ongoing credit concerns have given many shoppers some good excuses to put off buying those winter wardrobes.

Energy prices soared by 4.1% and PPI jumped by 1.1% in September, though the more closely watched core number (ex-food and energy) rose by a mere 0.1%. Keep up the good work, Dr. B. Sorry about Talladega, Sterling (Keep your chin up!). Happy 70th, Dad. Good Investing…

As a professional trader, I’m never far from my trading screens. But I find that I’ve been watching them even more intently than usual over the past few days.

When I take a step back and attempt to assess just why I seem to be so concerned, I’m left with this answer: Were it not for the Fed, I believe this “record-setting rally” would have run out of gas some time ago.

Consider yesterday (Tuesday) as a case-in-point. Stocks were rather listless until the Fed’s minutes were released. That sent stocks up sharply, and both the Dow Jones Industrial and Standard & Poor’s 500 market averages closed at record highs. [For our news report on the Fed minutes report, and on the market’s reaction, please click here.]

Let’s rewind the tape back to Sept. 18, when a Federal Reserve interest rate cut played a similar role.  The belief the rate cut was coming kept a flagging rally alive. And when that bigger-than-expected rate cut became a reality, stocks were up and way and rallying again.

Against this setting, the general perception today is remarkably similar, and the fact that stocks hit all-time highs seems to imply that it’s clear sailing into the fall. But nothing is a given in this business. This market simply seems exhausted to me, and I can’t shake the feeling based on 20 years’ experience that the proverbial “other shoe” may be out there and getting ready to drop. We’ve already had a housing slump, a subprime mortgage crisis and even a global credit crunch. And still the market keeps climbing.

That worries me. And here’s why.

Trading over the last few weeks has been largely based on two assumptions:

• The U.S. dollar will continue to weaken, and the U.S. Federal Reserve will abandon all attempts at supporting or rescuing the greenback.
• And corporate earnings both here and abroad will be largely positive.

Neither is guaranteed.

Earnings so far seem to be under control: There haven’t been any of the ‘whisper numbers’ that so often lead to investor disappointment, and then to a steeply dropping share price. Nor have we seen any earnings warnings. But either situation could change at any time.

I do have a couple of earnings-related observations, however. The third quarter already seems to be emulating the second in that truly global companies are using better-than-expected earnings abroad to more than offset lackluster profits here at home. And all of us here have noticed that wage costs and raw materials costs are rising in China, a situation that could lead to badly crimped profit margins if costs keep rising, or revenue growth slows.

But overall, earnings have been so far, so good.

So that leaves us with the Fed.

Since late August, the dollar has enjoyed a comeback of sorts: Granted it’s not roaring out of the basement by any means, but it does appear to be building a strong base, particularly when measured against the latest trading data.

What’s more, the employment situation – which really had appeared to be weakening here in the United States – actually did turn out to be better than expected based on the most recent readings.
Admittedly one report doth not a trend make. But let’s face it, Friday’s reasonably strong jobs report served to substantially undermine the fervent believers in the “Fed is going to cut rates again” crowd. When the masses realize the Fed may not cut rates again soon, a market reversal could result.

Moreover, no less than three Fed governors seemingly spoke their minds about the dollar vis-à-vis exchange rates in recent days. This is highly unusual, because they almost never talk about exchange rates. And it suggests to me that there are some behind-the-scenes machinations taking place inside Team Bernanke, where one of two things is happening. Either:

• The Fed governors who spoke out really don’t agree with Bernanke’s strategies or decisions, and are trying to publicly distance themselves from him in the event the dollar flops.
• Or these Fed governors seemingly spoke out-of-school and out-of-turn as a kind of ‘trial balloon,’ to get an early reading on the impact of a potential exchange-rate-boosting, interest-rate hike.

Perhaps – for me – that’s where the market appears tired.

Without the repeated injections of Fed-brand jet fuel, this Bernanke-piloted market would have trouble staying airborne. And if there’s a jet-fuel boycott (in the form of an interest-rate increase), then Air Bernanke will be grounded on the runway.

If you’re concerned, as I am, here are a few potential action items to consider:

• First, set protective stops on any of the holdings you’re most concerned about, particularly holdings where you have large profits at risk.
• Second, rebalance your portfolio to include the diversified overseas companies I call the ‘global titans.’
• And, third, steer clear of mortgage-related holdings: The much-heralded “recovery” is, at best, premature, especially ahead of credit-crunch-related earnings reports.

The U.S. economy made a strong showing in the second quarter, with growth surging at an annual rate of 3.8% — a major improvement over the anemic 0.6% advance of the first quarter, according to The Associated Press. It was the strongest quarterly showing in more than a year, the U.S. Commerce Department reported yesterday (Thursday).

U.S. corporate profits helped fuel that economic improvement in the second quarter, with companies reporting that their bottom lines expanded at a 5.2% clip – more than three times the 1.5% rate of the first quarter. Third-quarter earnings season will be under way in the next several weeks.

The outlook ahead isn’t nearly so upbeat, however.

The National Association for Business Economics believes growth in the third quarter decelerated to a 2.4% pace in the third quarter and predicts that economic growth will remain relatively flat in the year’s final quarter, advancing at a 2.5% clip.

However, other analysts believe that the weight of the slumping U.S. housing market – and the accompanying credit crunch that has spread worldwide – will cause growth to slow much more significantly. Indeed, many economists anticipate that the housing downturn won’t reverse itself until well into 2008.

The Commerce Department said yesterday that new home sales fell 8.3% in August. The decline drove sales down to a seasonally adjusted annual rate of 795,000 units, the lowest rate in seven years. The median price of a home dropped 7.5% from a year ago. The number of homes for sale at the end of the month fell 1.5%, to 529,000. However, the inventory of unsold homes is up 8.2% at the current sales pace. The number of properties completed and waiting to be sold also rose by 2,000 to 180,000.

The worst housing slump since 1991 has taken a harsh toll on economic development. Higher interest rates have squeezed homeowners and defaults particularly in the subprime market have spiked dramatically.

Some good news breached the labor front as the Labor Department reported a drop in the number of new applicants for jobless benefits. The department said that new applications for jobless benefits dropped by 15,000 to 298,000 last week. Some analysts had predicted that the number of applicants would swing in the other direction, rising by as many as 7,000.

Indexes gained Friday amid encouraging earnings news from Oracle and a big buyback from Texas Instruments
U.S. stocks rose Friday, capping off a big week in which the U.S. Federal Reserve cut short-term interest rates to stave off a recession. Stronger-than-expected earnings from Oracle (ORCL) and a big share buyback from Texas Instruments (TXN) helped fuel the advance.

On Friday, the Dow Jones Industrial Average rose 53.49 points, or 0.39%, to close at 13,820.19. That’s only 180 points shy of its all-time high, reached in July. The Standard & Poor’s 500 Index rose 7 points, or 0.46%, to close at 1,525.75. The tech-laden Nasdaq Composite Index climbed 16.93 points, or 0.64%, to finish the week at 2,671.22.

Friday’s heavy trading volume came on a "quadruple witching" day for Wall Street – the day every three months on which futures, stock index options, stock options and single stock futures all expire.

Traders will be watching economic reports this week on the direction of both the U.S. and global economies as they decide which way to bet on stocks.

Releases scheduled for next week include includes some closely watched housing numbers, and new and existing home sales for August. Other reports will include income, consumption and durable goods.

U.S. Federal Reserve Chairman Ben S. Bernanke will give the opening remarks at a Fed conference in Chicago.

In the absence of new economic data Friday, comments from Fed officials garnered attention amid growing concerns about the central bank’s watch against inflation, Standard & Poor’s reported. Speaking at a Bundesbank conference in Frankfurt, Governor Frederick Mishkin said "the most severe business cycle downturns are always associated with financial instability," S&P reported.

Thanks to the uncertain economic outlook Lehman Brothers Economist Drew Matus to predict the Fed will add to last week’s surprise rate cut – with three more reductions of a quarter point each: One in December, the second in March and the third in June. That would bring the current 4.75% Fed Funds rate down to 4.0%.

After the October crude oil futures contact on Thursday set a new intraday record of $84.10 a barrel, the November contract fell 16 cents a barrel, closing at $81.62. Some analysts are looking at an ultimate record north of $85 a barrel.

Oracle shares rose 4.4% to a six-year high on Friday after the company said its first-quarter profit soared 25% to 16 cents a share. S&P raised its fiscal 2008 earnings estimate for Oracle to $1.21 per share, and boosted its 12-month target price to $26 a share – reiterating its "buy" rating.

Texas Instruments shares climbed 2.4% after it said it was boosting its dividend by 25% l – to 10 cents a share – and announced a $5 billion stock buyback. That equated to about 10 of its total shares outstanding.

News and Related Story Links:

• Bloomberg News:
  
  U.S. Stocks Rise on Earnings, M&A Speculation; Oracle Climbs.

• Standard & Poor’s Outlook.com:
  Stocks’ Post-Fed Advance Rolls On.

It’s Friday morning, and the $900 million ‘Mystery Trade’ that I’ve written to you about several times recently expires today.

This trade, which has been cause célèbre on the Internet, especially in chat rooms frequented by conspiracy theorists, will likely expire having served its purpose as a below-market-rate financing mechanism for some investor or institution. And that’s a good thing, because it proves that even unusual activity can have a perfectly rational explanation, even if the circumstances surrounding it remain an enigma.

For those of you who are reading about this admittedly fascinating situation for the first time, let me take a moment and give you a quick overview.

The Lowdown on the ‘Doomsday Trade’

On Sept. 5, anonymous parties agreed to buy and sell 120,000 September (SPY) call options using deep-in the-money strikes ranging from 60 to 95. Now, if you’re not options savvy, don’t worry. SPY, also referred to as a “Spider” in trader parlance, is an exchange-traded fund (ETF) that mimics the performance of the stock market’s closely watched Standard & Poor’s 500 Index (INX).

So, why all the fuss? Viewed at face value, this trade looked to many investors like someone was making a big bet that U.S. stocks were in for a huge tumble, almost as if whomever placed these trades “knew” something ominous was afoot. At the time, the S&P 500 was trading at roughly 1470. From this vantage point, these strike prices equated to the S&P dropping from that level all the way down to a range between 600 and 950 for a decline of between roughly 36% and 59%.

[From current levels of about 1518, we’d now be talking about a decline of between 40% and 63%.]

When these trades were viewed from that vantage point, they certainly were fear inducing.

But as a professional trader, I could see that it was very possible these were set up as a so-called “box-spread trade.” This is a highly specialized transaction that professional traders or sophisticated institutional investors use on occasion to “box” in the market and guarantee profits, risk or, as may be the case with this trade, financing.

Without boring you with the details, here’s what you need to know about how this type of trade works. Basically, the counterparties, in this case a buyer and a seller, agree to a trade at a price that essentially splits the difference between current interest rates or prices. The price the trade takes place at is really is a moot point.

What’s important to understand is that the seller benefits because they essentially get to borrow the money from the buyer at a slight discount to prevailing market rates, while the buyer is able to keep his money moving in what is essentially a cut-rate loan at a time when he probably can’t lend it to others at all and risks it standing still the kiss of death for a financial firm that depends on its liquidity for daily operations.

As it turns out, that is just what it apparently has turned out to be… a box-spread trade of some type.

As I’ve mentioned before, we were the first news service to report these trades; until we did so, news of the options deals had been confined to websites and chat rooms. But once we reported the story, scores of other media organizations began talking about the options deals, too. These media organizations seemed to fall primarily into one of two camps in terms of how they interpreted the trades:

• The first group, the majority of the media folks, agreed with my take that there had to be a logical explanation for the trades.
• The second group, the minority, couldn’t let go of the theory that there must be a more-sinister motivation.

Speaking of which, the odds are very high that we’ll never know who placed the trade, or exactly why they did it, but for the most part that’s irrelevant anyway.

But at the end of the day, the really vital thing to understand about this trade is that the capital markets worked the way they were supposed to and at a time when there was unprecedented potential stress, thanks to a worldwide liquidity shortage stemming from the subprime-mortgage mess.

That’s actually a very big deal. Personally, I find that reassuring, and I hope you do too.

A P.S. from the author: As of press time today (Friday), I’ve seen no evidence that this trade was rolled into subsequent months. But the day as they say in those great old cowboy Westerns “ain’t over, yet.” Rest assured that I will be watching vigilantly and that I’ll make sure to keep Money Morning subscribers informed.

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But it’s been a fascinating and rewarding experience. As a relatively new news organization, not to mention one with a highly specialized focus, it’s been very gratifying to actually experience a major news “scoop” so far ahead of our newsgathering rivals. When you look at the related links, you’ll see that our original report appeared first thing in the morning on Wed., Aug. 29. But as you’ll see from everything we’ve posted here, the other news organizations didn’t start running their stories until Wed., Aug. 30.

I mention that only to underscore that, as a Money Morning subscriber, you can be assured of getting news and investment ideas before everyone else.

One of the ways we do that is by tracking money flows, hence the name of our monthly sister publication, The Money Map Report. And I’m sure it’s no surprise to you that much of those money flows are flowing into – or out of – China.

If you’re just starting to add international investments to your holdings, or want to invest some money in China, consider either a very good Exchange Traded Fund (ETF) that’s investing in Asia, or even better directly into China.

That will provide you the long-term benefits of China’s continued explosive growth, while also giving you the diversification needed to rise out that economy’s inevitable swings. One top-performing mutual fund is the China Region Opportunity Fund (USCOX), which is managed by U.S. Global Investors Inc. (Nasdaq: GROW) – a great example, by the way, of a company that will be profiting indirectly from China.

I mention the China Region Opportunity Fund and U.S. Global Investors because the fund-management firm is well run, and its funds are well managed. The company is a favorite of several of our analysts – myself included – here at Money Morning.

But if you’ve already got a start on your Asia and China investments, and are looking for something more sophisticated, you’ll want to read our new investment-research report. Our team has several profit opportunities that are related to the growth in China, as well as the rest of Asia. These profit opportunities are poised to benefit from the growing global commodities boom, and to the capital that’s needed to finance the industrial development taking place on that side of the world.

In fact, our worldwide research team has identified $867 billion worth of industrial investments that will be flowing through the global financial markets, and that are aimed at development initiatives in such key sectors as agriculture and biotechnology, telecommunications, energy and finance. Our analysts have labeled this confluence of capital as “The Big Money Bang.”

That $867 billion is about to rock the markets, fueling bigger profits than gold, telecom, and the Internet combined. Investors who tap in now are about to pocket $1.54 million in the next 18 months.

The “Big Money Bang” will create countless investment opportunities. But we’ve singled out the best four, many of them keyed to some of the trends discussed below. They include:

• A financial institution so tied into Asia’s booming development that we’ve nicknamed it “The One Stock You Can Retire On.”
• A commodities-related company with ties to both agriculture and biotechnology whose product is provided by so few firms that it’s actually “more precious than oil.”
• A power-provider involved in a $40 billion energy venture that’s central to China’s continued ability to grow.
• And others.

[To get the details on the companies we’ve mentioned in this free report, click here.
You’ll be glad that you did.]

Related News and Story Links:

• Money Morning Investment Analysis: This $900 Million Bet Has Global Traders Talking.
• ‘Air America Radio.’
• Bizradio.com
• The Street.com TV Interview Video Clip:
  ‘Bin Laden’ Trades Stir Terrorism Fears.

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