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.
   
News and Related Story Links:

• Money Morning:
  Is Brazil "Investment Grade" for Investor’s Money, Too?

• Money Morning:
  Warren Buffett and Berkshire Hathaway Purchase Stakes in 20 South Korean Firms, Including POSCO

• Money Morning:
  Investors Leaving India’s Market Aren’t Thinking Long-Term

• Money Morning:
  With the New Russian President Vowing to Steer a Steady Ship, U.S. Investors Can Look to Profit

International sales drove fourth-quarter earnings for Coca-Cola Co. (KO), the world’s biggest soft-drink producer, which posted a 79% rise in net income to $1.21 billion, or 52 cents a share, and a 26% increase in net operating revenues for the quarter.

For the year, worldwide unit case volume was up 6%, or 1.2 billion additional cases. Full year earnings per share increased 19% to $2.57. And net operating revenues increased 20% on the year, 4% of which came from currency benefits.

"Importantly, this growth was balanced across our geographies and portfolio of brands," Neville Isdell, Coca-Cola’s chairman and chief executive officer, said in a statement.  

Indeed, the company posted net revenue growth in every geographic market:

• Africa: 25% in the quarter, 16% for the year.
• Eurasia: 34% in the quarter, 24% for the year.
• European Union: 15% in the quarter, 14% for the year.
• Latin America: 24% in the quarter, 24% for the year.
• North America: 13% in the quarter, 11% for the year.
• Pacific: 7% in the quarter, 7% for the year.

The company also announced that it plans to repurchase $1.5 billion to $2 billion of its stock in 2008. Last year, it bought $1.75 billion of its stock and paid $3.1 billion in dividends to shareholders.

And that’s not the only reason shareholders were happy in 2007. For as tumultuous as last year was for most investors, Coca-Cola shareholders were treated to a 26.3% gain, or $12.79 rise, in the company’s stock, far-and-away better than the 3.5% total annual gain of the S&P 500 Index.

Cola-Cola is one of the so-called "Global Titans," companies that combine the safety of the U.S. financial system [with its transparency, regulatory oversight and detailed financial reporting], with the long-term growth promise of emerging Asia and Europe. For that reason, Coca Cola and firms such as MGM Mirage (MGM), Yum! Brands, Inc. (YUM), General Electric Co. (GE), The Boeing Co. (BA) and rival beverage maker PepsiCo Inc. (PEP) are "best-of-both-worlds" investment.

With sales in North America markets slowing, Coca-Cola and PepsiCo have taken their rivalry to emerging markets, where the wallets and taste buds of new and growing middle classes are directly targeted. 

Specifically, the craze over the 2008 summer Olympics in Beijing has taken the rivalry to a new level.

For example, as part of its big Olympics marketing push, PepsiCo adopted the country’s national color in creating a red-themed can for sale exclusively in China.

News and Related Story Links:

• Coca-Cola Co.:
  Fourth-Quarter and Full-Year 2007 Results

• Reuters:
  Neville Isdell bio

• Money Morning:
  Pepsi ‘Goes Red’ in China

When stock market legends such as Warren Buffett, Jim Rogers or Sir John Templeton troll for investment plays, they hold out for bargains.

The investing masses would do well to follow suit: All too often, investors fail in the markets because they pay Neiman-Marcus prices for Wal-Mart stocks. If a stock is carrying a sky-high valuation – even if the company performs as it should – shareholders may end up sitting on losses that don’t go away for many years.

So-called "value" stocks, by contrast, have less downside risk, and often also carry a hefty dividend yield, which can go a long way toward assuaging the pain of a mediocre capital performance. Buffett, the chairman of Berkshire Hathaway Inc. (BRK.A, BRK.B), and Templeton have followed this formula through the years, with famous levels of success. So has Jim Rogers, perhaps the most successful Contrarian investor of our time. [To see how you can obtain a free copy of Jim Rogers' latest bestseller, "A Bull in China: Investing Profitably in the World's Greatest Market," please click here.]

However, as with any other area of investing, there are a few pitfalls that need to be avoided.

In this bargain-hunting stock primer, we’ll study some strategies that work, and will review some problems to sidestep.

When Low P/Es Translate Into High Profits

One of the best ways to determine whether a company is a bargain is to examine its Price/Earnings (P/E) ratio – which relates the current share price to one of several different measures of a company’s annual earnings per share. Conservative investors look at P/E ratios on a "historic," or "trailing" basis – examining the company’s earnings over the last 12 months – while more aggressive investors look at "leading" or "projected" P/Es – which are based on earnings forecast by analysts for the year in progress, or even for the fiscal year that has not yet started.

The advantage of forward or leading P/E ratios is that it generally gives you a lower number [if earnings are expected to increase], which is why many analysts, brokers and other slick salesmen prefer to use them. The advantage of historic P/E ratios is that the earnings are real, and in the books [or at least, they are if management isn't playing silly games with the accounting], which means that you are basing your analysis on a solid number.

In a deep bear market that hasn’t actually blossomed into a full-fledged recession, the average P/E ratio on the stocks in the Standard and Poor’s 500 Index can get down into the single digits. In 1949, for instance, the P/E on the S&P averaged a mere 7. Any time you see a P/E ratio that low for the market as a whole, it’s a pretty firm "Buy" signal.

At the upper end of the P/E spectrum, the highest non-recession range for P/E ratios for the market as a whole is around 20, reached in the late 1960s – and repeated in the late 1990s. However, if a severe recession hits, earnings plummet a lot more than stock prices, so you may even have a period in which the S&P 500 as a whole makes a loss, and its P/E ratio is correspondingly infinite. We had such a year in 1981. In 2002 P/E ratios got very high, but earnings didn’t fall enough to propel them to infinity.

Growth Stocks and the Not-so-Nifty 50

Proponents of so-called "growth" stocks believe that investors should invest in companies that are posting rapid earnings growth, with less of a focus on prices or valuations. The growth-stock school has been around for a long time, and growth-stock investors generally do well during economic upswings, and strong bull markets for stocks, since that’s when corporate earnings increase most rapidly.  This investing discipline is often given different labels. At the top of the 1972-73 bull market, for instance, advocates said you could get rich by investing in the so-called "Nifty Fifty" – such large-cap growth stocks as Avon Products Inc. (AVP), Eastman Kodak Co. (EK), McDonald’s Corp. (MCD), Polaroid, or Xerox Corp. (XRX), whose escalating P/E ratios reflected their high quality and perpetually excellent profit prospects.

Investment managers chose their stocks rather like they chose their dinner guests – only the truly superior were invited.

Well guess what? Like aristocratic dinner guests, some of those growth stocks tuned out to be ne’er-do-wells, and others turned out to be boringly plebian and stodgy. Only a few proved their elite status by continuing to provide the growth they appeared to promise. Thus, for every McDonald’s, which continued to grow at double-digit rates for the next 30 years, there was a Xerox, which was overtaken by newer technologies and fell back, or a Polaroid, which went bust altogether.

Investment guru Jeremy Siegel tried to revive the case for growth stocks at the top of the bull market in 2000, and proved that the average return on the "Nifty Fifty" stocks from 1972-2000 was less than 1% below that of the market as a whole, but guess what? That simply proved that 2000 was also the top of a bubble, and that some stocks that had been overpriced in 1972 were still overpriced in 2000. The real truth was that the "growth" stocks of 1972 proved exceptionally vulnerable to the next market downturn, falling 80% to 90% over the following years, and only then did some of them prove to have long-term operational resilience and begin to climb back. The fact that, if you had waited 28 years, you could have achieved a more or less market return on a holding of growth stocks is no reason to buy them.

After all, if you had needed the money at some intermediate point during the 28 years you’d have had to sell at a thumping loss.

Definitely Dig Those Dividends!

A recent study by Yale University’s Robert Shiller showed that in the 109-year stretch from 1889-1998 – including most of the biggest bull market in history there in the latter part of the 1990s – the average real return on common stocks was 7%, of which 4.7% was represented by dividends.

In addition, retained earnings form an important component of stock returns, so that around 97% of those profits can be accounted for by dividends and retained earnings – with only 3% being due to a change in their valuation.

Intuitively, this makes sense. Over a very long period of time, it is impossible for stock valuations to change sufficiently to generate an important part of the total return from holding them. Even if earnings increase rapidly for a few years, the stock can sell at an increasing multiple of its tangible book value for only a limited period of time; after that the higher earnings themselves must generate the bulk of its return.

Thus, if you buy a stock with either a low P/E ratio or a high earnings yield [which is the same thing], you may get a higher return from dividends. But even if you don’t, you will certainly get a higher amount of earnings retained each year, which will build the book value of the company more rapidly and enable its stock price to rise.

That’s why, in picking stocks for both Money Morning and The Money Map Report, I always pay close attention to the P/E ratio, seeking those stocks whose valuation is modest in terms of both the market they trade in and the business sector they compete in.

There’s one caveat to all this. Going into a recession, cyclical stocks may have a very low P/E ratio based on past earnings, but still be very poor investments. The reason: The earnings going forward can be expected to decline sharply or even disappear altogether.

Even more important, it is foolish to treat dividend yields as an equivalent to bond yields if there is a significant chance that poor operating results will cause management to cut the dividend going forward.

When it Pays to be Bored

Right now, in the financial-services sector, commercial banks and investment banks are both being forced to take massive write-offs as a result of their foolish forays into the subprime-mortgage market, investments in asset-backed commercial paper, and sundry other related sins. While a single such write-off may not affect the dividend, if additional write-downs are required, the odds become increasingly likely that investors, lenders and the credit-rating agencies will demand a drastic reduction in dividend payouts, if not an outright elimination of the quarterly payments. Moreover, if the top management team is ousted – as has happened at Merrill Lynch & Co. Inc. (MER), Citigroup Inc. (C), and others – the new management team may believe it’s best to eliminate the dividend as a means of conserving cash.

At present, for example, Merrill Lynch recently sported a P/E ratio of only 11.8, based on its 12 month trailing earnings, and a dividend yield of 3.0%.  If those trailing earnings could be dependably replicated going forward, we could project an annual investment return of about 8.5%, given the 3% dividend plus retained earnings of 5.5%  [its total earnings yield being 100/11.8 = 8.5%].

Unfortunately, Merrill has booked some huge write-offs on its subprime rubbish and given its chief executive officer the boot [with a $160 million "golden handshake!"]. It now seems likely that Merrill will need to take additional write-downs in the future. And there are widespread worries the investment banking and brokerage businesses are skidding into a cyclical downturn. For these reasons, Merrill’s attractive valuation could be a trap – if you buy the shares and there are more write-offs beyond those that are already projected and theoretically therefore already factored into the share price, you run the risk of taking a loss on your investment – particularly if the dividend is reduced, or eliminated altogether.

Clearly, there are two reasons why stocks might have an attractive valuation:

• One is that the stocks are risky, and that the market expects a downturn – in the stock itself, in the sector it plays in, or in the market as a whole. Those expectations don’t always come true, and that can make the shares a bargain play. But the risk is clearly high.

• The second is that they are boring, perhaps not followed closely by analysts, or aren’t in a fashionable country or sector.

For me, it’s always been true that boring is best.

[For a Money Morning Investment Research Report, "How Buying Like Warren Buffett Can Boost Your Portfolio Profits," please click here. The report is free of charge].

News and Related Story Links:

• Forbes.com:
  An Investment Legend’s Advice

• Money Morning Investing Strategies Report:
  How Buying Like Warren Buffett Can Boost Your Portfolio Profits

• Money Morning News Analysis:
  Renowned Investor Jim Rogers, "Extremely Worried."

• Wikipedia:
  The Nifty Fifty

Societe Generale SA (OTC: SCGLY), France’s second largest bank by market value, said yesterday (Thursday) that it incurred a $7.2 billion trade loss from an "exceptional fraud" perpetrated by a rogue trader.

It was the biggest trading loss ever incurred by a bank, Bloomberg News reported.

The trader, Jerome Kerviel, "had taken massive fraudulent directional positions in 2007 and 2008 far beyond his limited authority," the bank alleged. "Aided by his in-depth knowledge of the control procedures resulting from his former employment in the middle-office, he managed to conceal these positions through a scheme of elaborate fictitious transactions."

The fraud revelation deals still another blow to already-fragile investor confidence, as banks and brokerages have already endured a gauntlet of multi-billion-dollar write-downs brought on by the collapse of mortgage-backed assets.

"The news will cast a dark cloud over the already troubled European banking sector," an unnamed analyst told the Financial Times.

SocGen is one of many financial institutions already reeling from its exposure to risky credit markets. In its 2007 earnings report, it said it would take $1.6 billion [1.1 billion euros] in write-downs as a result of its exposure to the U.S. residential real estate market. It will also absorb $800 million in losses related to U.S. bond insurers, and a loss of $583 million on other unspecified credit market risks. The bank had previously reported $546 million in write-downs linked to credit-market turmoil in the third quarter. 

To cope with its losses, SocGen will attempt to raise $8 billion (5.5 billion euros) by selling shares in a rights offering. The offering – which will be jointly underwritten by JP Morgan Chase & Co. (JPM) and Morgan Stanley (MS) – diverges from the current strategy employed by U.S. banks, which are attempting to raise capital through sovereign wealth funds.

The bank expects 2007 profit to be between $875 million and $1.2 billion or (600 million to 800 million euros). SocGen earned $7.5 billion in 2006.

In a letter to clients, Daniel Bouton, 57, the company’s chief executive and chairman, described Kerviel as "an imprudent employee in the corporate and investment banking division" who possessed an "intimate and perverse" knowledge of the bank’s controls – which allowed him to avoid detection.

He also said the trader’s supervisors would be fired and that controls "have been revised and reinforced to avoid any reoccurrence of further similar risks." Bouton offered to resign, but the company’s board of directors rejected his offer.

Societe Generale has ranked first and second in client surveys of equity derivative firms over the past five years, according to Risk Magazine. In 2007, it received the award for "Equity Derivatives House of the Year" from The Banker, a monthly magazine based in London.

 News and Related Story Links:

• Associated Press:
  Societe Generale Uncovers Massive Fraud

• Bloomberg:
  Societe Generale Reports EU4.9 Billion Trading Loss

• Financial Times:
  SocGen’s €5bn rogue trader named

• International Herald Tribune:
  Société Générale loses $7 billion in trading fraud

• Money Morning:
  Citigroup Cuts Dividend, Receives Another Capital Infusion; Merrill Gets Cash Boost

Rogue Trader Hall of Shame

Jerome Kerviel isn’t alone in his alleged act of fraudulence. Here are a few more rogue traders infamous for losing sizable sums for their employers:  

• Nick Leeson: In 1995, Leeson was a trader in Singapore who lost $1.8 billion, bringing down venerable British bank, Barings PLC. He was sentenced to six and a half years in prison.

• Joseph Jett: In 1994, Kidder Peabody had to adjust its first-quarter earnings to reflect $210 million in false profit from bond trader Jett. Jett was forced to forfeit $8.2 million in bonuses, was fined $200,000, and barred from any future association with financial trading. General Electric Co. (GE) sold Kidder Peabody to Paine Webber the following year.

• Yasuo Hamanaka (a.k.a. Mr. Copper):  In 1998, Sumitomo Corp. revealed a $2.6 billion loss, which it blamed on Hamanaka, formerly the company’s chief copper trader. He was sentenced to eight years in prison.

• John Rusnak:  In 2002, Allied Irish Banks PLC (AIB) discovered that Rusnak at Allfirst Financial Inc. had hidden $691 million in losses for more than five years. Rusnak could have faced as many as 30 years in prison but was sentenced to seven and a half years. Allfirst was subsequently bought by M&T Bank Corp. (MTB).

Look, up in the sky…it’s a bird; it’s a plane; it’s SUPER PREZ!!!

Or is it?

With his second term nearing an end, U.S. President George W. Bush is searching for a lasting legacy [in case “peace in the Middle East” doesn’t work out] and has set his sights on the spiraling U.S. credit crisis. Of course, being the [compassionate] conservative, free-market, “less-government” capitalist that he is, Bush is quick to point out that his plan will not include any federal bailout and involves only private-sector assistance. With U.S. Treasury Secretary Henry M. “Hank” Paulson Jr., as his point person to iron out the more-technical financial details [although President Bush does have a Harvard MBA], the plan calls for a five-year rate freeze on certain subprime mortgage loans [The plan covers homeowners only: Real estate speculators, investors, and flippers need not apply]. 

Apparently the subprime debacle and ongoing housing “challenges” have prompted the need for a “Bat Signal” to summon in the big guns [no offense, Dr. Bernanke].

Make no mistake: This so-called “bailout” isn’t going to turn Super Prez into the certified Super Hero that his father was – although it is interesting that current President George W. Bush and his father, former President George H.W. Bush, were both immortalized as action figures.

The senior President Bush was the pilot of a Grumman Avenger torpedo bomber that was shot down on a dangerous mission and was fished out of the Pacific Ocean by a U.S. submarine. He was decorated for having flown 58 missions and was the youngest commissioned U.S. Navy pilot in World War II. His son, the current President Bush, was replicated as an action figure after he hitched a ride on a U.S. Navy S-3B “Viking” jet that landed on the deck of the U.S. aircraft carrier U.S.S. Abraham Lincoln (CVN-72) back in early May 2003. If it weren’t for those few exciting seconds, it’s doubtful there would be an action figure of the current president. One thing’s for certain, Mattel wouldn’t be rushing out to create a President Bush action figure based solely on this subprime bailout deal.

Although the president’s plan has yet to be fully defined, it’s clearly packed with problems. The key problems are simple to explain: By freezing rates, it keeps the “free market” from operating in an unfettered fashion, which can only delay the full resolution of the crisis. And by creating this artificial backdrop, it may allow financial institutions to delay the full recognition of their losses.

And that was an issue even before the Bush Administration plan was rolled out late last week. Deutsche Bank AG Chief Executive Officer Josef Ackermann said as much in a speech he gave at the University of Zurich last Wednesday. In a telling commentary, Ackermann said the credit crisis wasn’t over yet: Banks have yet to fully report their losses from risky credit investments, meaning additional write-downs can be expected as the already troubled credit markets turn even more illiquid as the year draws to a close, he said.

That can’t help but push the end of the crisis well out into the future.

With any kind of a speculative frenzy, or period of financial excess, the best and quickest way to return to normal is to allow market forces to “clean out” the system, and in a much-quicker fashion than any manufactured bailout.

If you want proof, consider Japan’s “Lost Decade,” the 10 years or so that followed that country’s speculative mania from stock and real estate. Japan “protected” its financial system, and didn’t force its financial institutions and keiretsu-linked corporations to recognize the massive devaluations in the assets (stock and real estate) they carried on their books. Couple that with key fiscal and monetary policy missteps the central government and central bank repeatedly made, and you can see why their malaise traversed the entire decade of the 1990s and lasted into the 2000s.
                                                                                                                                                                                                                                                
Contrast what happened in Japan with the quick resolution the United States engineered for the savings-and-loan crisis in the 1980s. The government created the Resolution Trust Corp. and forced insolvent banks to close. As a result, the S&L crisis cleanup was finished years ahead of schedule and for billions less than was originally projected.

The Bush Administration mortgage deal followed a few ratings cuts that were announced last week.  Moody’s Investors Services (MCO) reduced the credit ratings on more than $100 billion of structured debt securities [Many sponsored by Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM)], and downgraded virtually every financial firm [besides itself]: Goldman Sachs Group Inc. (GS), Lehman Brothers Holdings Inc. (LEH), Merrill Lynch & Co. Inc. (MER) and Morgan Stanley (MS).  Amid the high fives and back-slapping that seemed to follow the announcement of the Bush plan, the Mortgage Bankers Association announced that residential foreclosures soared to a record high in the third quarter [and the worst may be yet to come…then again, that was before the “non-bailout” bailout]. 

Believing – perhaps too optimistically – that the mortgage mess was now “clearly” on the road to recovery, investors next turned to the other high-profile issues du jour: holiday retail sales and energy prices.

Analysts were busy evaluating Black Friday, Cyber Monday and beyond to get a better feel for the potential success for the holiday season. Unfortunately, the same store-sales results for November were mixed, at best.  Discounters Wal-Mart Stores Inc. (WMT) and Costco Wholesale Corp. (COST) proved that their constant promotions seemed to be working, though many traditional mall retailers like Limited Brands Inc. (LTD) posted less-than-satisfactory sales numbers.  Department stores like Nordstrom Inc. (JWN) and Macy’s Inc. (M) benefited from the extra [post-Thanksgiving] week in November, though analysts fear that those decent results will be reversed this month. Only 18 more shopping days to analyze and over-analyze [But don’t forget that so many of those popular gift cards won’t be redeemed until January or February]. 

Oil took its cues this week from the decision by OPEC to not raise production levels at the present time, though it did agree to monitor the situation in the months to come.  Apparently, oil at $90 a barrel and more seems quite appropriate to the ministers, despite the fact that prices have surged more than $40 since the start of the year.  Investors reacted favorably to the Bush “bailout” plan and seem convinced that the central bank’s Federal Open Market Committee will do its part to help with another rate cut this week [It will probably be a quarter-point cut, but some observers still wonder whether 50 basis points remains possible].  The rally in stocks continued for a second straight week last week as investors reversed some previous “flight-to-quality” trades and moved out of safe-haven Treasuries.  The yield of the benchmark 10-year pushed back above 4%.  For the time being, confident investors clearly believe that “there is no need to fear…‘W’ is here.”

Unfortunately – at least from the standpoint of the subprime bailout plan – time could well prove those investors wrong.

Economically Speaking…    

*  Reflects changes in interest rates over various time frames. 

Weekly Economic Calendar

In the worldwide central banks club, the game of “follow the leader” continues. Last week, the central banks of Canada and England each lowered short-term rates in lockstep with the recent moves of the U.S. Federal Reserve. Now the question remains…will Federal Reserve Chairman Ben S. Bernanke do them one better with another rate cut?  Most economists believe that a 25 basis point move is in the cards, though investors are still holding out hope that the Fed will lower the funds rate by half a percentage point.

Does the recent economic data justify such a move? 

While both the manufacturing and services sectors continue to experience growth [as depicted by the ISM indexes], the paces have slowed over the past few months.  The Bush mortgage plan has offered renewed hope that housing will begin to rebound at some point in the future, though mid- to late-2008 seems the most optimistic time projection.  The same-store-sales results spawned more confusion about the holiday season and the buying activities of the almighty consumer.  The labor market continues to be the U.S. economy’s one saving grace.  With the solid addition of just under 100,000 new nonfarm-payroll jobs in November, the unemployment rate held steady at a near historic low of 4.7%.  Additionally, a separate ADP Employer Services survey (ADP) also revealed strong job growth last month.

Now it’s back to the U.S. Fed to “follow [be] the leader,” and slash rates once again. Ready to grab the limelight back from that Harvard MBA, Dr. B?

News and Related Story Links:

• OPEC.org:
  The Organization of the Petroleum Exporting Countries.
• Money Morning:
  Bush Announces Rate Freeze for Subprime Borrowers.
• Wikipedia:
  Henry M. Paulson Jr.
• Reuters:
  Deutsche Bank CEO Says Credit Crisis Not Over Yet.
• Amazon.com:
  Flight of the Avenger: George Bush at War.
• Amazon.com:
  Flyboys: A True Story of Courage.
• Official Site:
  U.S.S. Abraham Lincoln (CVN-72).
• International Monetary Fund:
  Japan’s Lost Decade.
• Minneapolis Fed:
  The 1990s in Japan: A Lost Decade.
• Wikipedia:
  Keiretsu.

Markets soared Wednesday, boosted by positive economic data that still left enough room for a Federal Reserve rate cut next Tuesday.

The Labor Department announced that productivity rose at an annual rate of 6.3% in the third quarter, up from 2.2% in the second, and the biggest increase in four years. Meanwhile, labor expenses dropped at a 2% pace, the most since 2003.

Combined, they ease the pressure on companies to raise prices, reducing the risk of inflation. That in turn, gives the Fed more leeway to cut its key interest rate.

Story Continues Below… Enter Your Email Address Below:

The Federal Open Market Committee is widely expected to reduce its benchmark rate at its next meeting Dec. 11. If they do, it would be the third consecutive rate cut in four months. Market futures are fully pricing in a rate reduction of 25 basis points, but indicate a 38% probability of the central bank reducing the rate by 50 basis points. Before the report, the market indicated a 54% chance of a 50 basis point reduction. 

Last week, Fed Chairman Ben Bernanke acknowledged "renewed turbulence" in the depleted housing sector. On Nov. 20, the Fed lowered its expectations for 2008 economic growth to 1.8 – 2.5%.

The market was also given a jolt by a report from a private employment service that increased optimism about Friday’s payroll report. In its November report, AMD said private employers added 189,000 jobs, the biggest monthly increase this year.

"While the market typically discounts the ADP report, a number this far out of the cloud could cause economists to revise their expectations for Friday," Brian Dolan, chief currency strategist at Forex.com, told Reuters. 

Wednesday’s news had very positive implications for the third quarter, which showed tremendous resilience in light of the subprime meltdown and subsequent credit crunch. Despite the good news however, lower expectations for inflation and a shaky credit market bode well for a Fed rate cut next week.

"No question that the third quarter went out with a big roar in terms of both growth and productivity," Brian Bethune, Director of Financial Economics at Global Insight Inc., told Bloomberg News. "Inflation is a diminished threat."

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Looks like Santa made an early appearance for investors last week.  While the continuous spirit of "gloom and doom" surrounded the markets for the past few weeks, a few elves (known as Donald Kohn, Ben Bernanke, and the Abu Dhabi Investment Authority) emerged with some much appreciated holiday cheer.  When the dust had settled, the Dow Jones experienced its best two-day performance since October 2002, and the biggest one-week gain in almost five years.  Throw in some lower oil prices, positive comments from our friends at OPEC, and a general bullish sentiment seemed to reemerge – at least, for the time being. 

Even the holiday shopping season got off to a solid start as ShopperTrak reported that sales activity climbed by 7.2% from last year’s levels on the Friday and Saturday after Thanksgiving.   The tracking company monitors sales at over 50,000 domestic retail outlets.  Not to be outdone, results from "Cyber Monday" also depicted strong sales activity as employees took time out of their "hectic" work schedules to click around a few web sites for some key gift purchases.

Internet researcher, ComScore Inc., announced that online sales increased on the Monday after Thanksgiving by 21% from 2006, and the number of online shoppers who actually purchased something grew by 38%.   Sears (Nasdaq: SHLD)  put a huge (but temporary) damper on the holiday spirit by announcing quarterly profits that declined by 99% on weaker sales. 

While "Dubya" was working hard to reshape the landscape in the Middle East this week, Citigroup (NYSE:C) was doing its part to energize the region’s financial markets (and help itself recover from the mortgage debacle) by accepting a capital infusion from the Abu Dhabi Investment Authority to the tune of $7.5 billion.  While the investment gives the state-owned pool a 4.9% stake in the nation’s largest bank, Citi assured concerned investors that it is entirely passive and the fund will not have any representatives on its Board. E*Trade (Nasdaq: ETFC) also received a bailout infusion as hedge fund giant, Citadel, invested $2.55 billion into the troubled financial services company.  (And, rest assured, theirs will probably not be passive.)  Euro-giant HSBC (NYSE: HBC) was forced to bail out two failing funds it oversees in a move much reminiscent of Bear Stearns a few months ago.

Inflation hawks got a nice reprieve from the oil patch this week as the price of crude plunged below $90/barrel, a level not seen since October.  Reports of an increase in oil supplies coincided with talk that OPEC may be increasing production (despite what Chavez and Ahmadinejad may be saying).  Investors welcomed such news as well as comments by Fed Vice Chair Donald Kohn who told the Council on Foreign Relations that "tight financial conditions may merit offsetting policy from the central bank." 

When Bernanke echoed his lieutenant’s sentiment a few days later, Fed watchers became virtually convinced that another rate cut was in the cards for the December 11 meeting.  Such a move would be a nice gift (though hardly a surprise) for investors, whatever holiday they’re celebrating.

Economically Speaking…

Weekly Economic Calendar

So suddenly the sky is falling and the economy is plummeting toward recession?  With the Fed’s top two honchos predicting sluggishness, the GDP release added a bit more confusion into the equation.  While the subprime fiasco was preventing any housing rebound and threatening other consumer-driven sectors over the past several months, the overall economy (as measured by GDP) experienced its best showing in four years by expanding 4.9% in the third quarter.

Most analysts believe that the fourth quarter will depict economic growth closer to 1.5% or lower.  Additionally, the Fed reported in its Beige Book that recent activity expanded at "a reduced pace compared with the previous survey period," and renewed calls for a rate cut have begun in earnest.  In fact, a Goldman Sachs analyst believes that the fed funds rate will fall to 3% in 2008. 

News from the housing sector did not reveal anything positive this week.  Existing home sales dropped for the eighth straight month. New home sales now have fallen over 20% during the past 12-months. And construction spending experienced its sharpest decline since July.  Can someone please recalculate that nonsensical GDP?    

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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. 

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Financial institutions dominated the headlines yesterday (Thursday), with yet another round of write-down worries – this time related to the banks’ fourth-quarter results.

• Investors and analysts believe Citigroup Inc. (C) may face $8 billion to $11 billion in fourth quarter write-downs, according to the Wall Street Journal – a huge leap from the $1.8 billion in third quarter write-downs.
• A planned $1.2 billion write-down at Bear Stearns Cos. Inc. (BSC) induced leading credit-rating agency Standard & Poor’s Inc. to lower its long-term credit rating on the company, from A+ to A. The write-down would give Bear Stearns its first quarterly loss, WSJ also reported.
• Shares of HSBC Holdings PLC (HBC) dipped after the global lender announced it would write down $3.4 billion because of its exposure to subprime loans, the Toronto Star reported. The number was well above the $1.9 billion and $2.2 billion the company wrote down in the first and second quarters, respectively
• And fellow London-based lender Barclays PLC (BCS) will follow suit, announcing it would write down $2.7 billion, Bloomberg reported. 

"If the housing market continues to weaken and if it has a broader impact on the underlying real economy, then charges will stay elevated and could increase," HSBC Finance Director Douglas Flint told the Toronto Star. [For a news report containing the industry wide write-down predictions of newly appointed Merrill Lynch & Co. (MER) Chief Executive Officer John Thain, please click here].

That sums up the mood for all lenders.

After news of the write-downs pelted the markets like hailstones, a hopeful day of trading turned negative by mid-afternoon as investors realized the subprime jitters are running deeper and spreading further than originally conceived. Indeed, the Dow Jones Industrial Average fell 120.96 points, or 0.91%, to close at 13,110.05. Its high for the year was 14,198.10. The Dow is down 8% from that record peak.

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Unlike the United States Federal Reserve, which seems to be content with a dollar policy of benign neglect, the Chinese central bank actually has real power and isn’t afraid to use it to protect and nurture the country’s economic health.

Most recently, China’s central bank – The People’s Bank of China – boosted the key reserve requirement for the nation’s commercial banks by half a percentage point to 13.5%. The central bank also raised deposit rates and key savings figures.

I realize that this may not strike readers as interesting at a time when the U.S. stock markets are struggling, but it provides an important confirmation of two things:

• First, it shows us just how strong China’s economy really is.
• And, second, it demonstrates exactly what the Chinese government is thinking when it comes to the next great step in that nation’s financial growth.

Let’s talk about the Chinese economy first.

Many investors are concerned that the bubble has burst, that all the profit opportunities are gone, and that somehow China is headed for a meltdown. Indeed, the real conspiracy theorists believe China has temporarily propped up the stock market in such a way that once the curtain comes down on the summer Olympics in Beijing next year, it’ll be "curtains" for Chinese shares, as stocks prices there implode.

They couldn’t be more wrong.

The interest rate hike is the ninth such increase this year alone. It’s an important step, a move intended to restrict the money flowing into the Chinese economy to curb what the People’s Bank of China refers to as "excessive credit growth."

Strip away the bureaucratic-speak that’s a common manifestation of central bankers the world over and what you’re left with is this: What China’s central bank is actually saying is that the nation’s economy is on fire.

According to the latest figures, in fact, China’s economy is surging at an annual rate of 11.9%, putting the country on track for a fifth-straight year of double-digit growth.

That’s impressive enough, but consider that this five-year surge follows 25 years of growth that averaged nearly 10% annually. The U.S., by comparison, advances at a 3% to 4% clip in a good year, and the average is probably half that, so we’re talking about growth rates in China that are four, five or even six times higher than our own.

If you consider that China is still primarily a cash-driven economy, and you compare what’s happening there to better-developed regional economies like Japan and Taiwan, the "official" growth rates are probably low … way low. In fact, it’s not crazy to believe that China’s real economy – the cash-based one that can’t be accurately measured on an official basis – is growing 15%-20% a year.

By increasing the reserve requirement, China’s central bank wants to encourage commercial banks to hold onto a greater percentage of their deposits, rather than recycling them as loans into the broader economy. Theoretically, this will curb the flood of capital that’s driving growth as everyone from normal China citizens to Western capitalists tries to profit from the "China Growth Miracle."

I’ll tell you right now that this rate increase by the central bank – like the increases that preceded it – will fail miserably.

Lending volumes have nearly doubled this year already and money-supply growth is actually accelerating. What’s more, the yuan is arguably undervalued by as much as 40%, and China’s stock markets are on a tear – even if you factor in the recent pullback.

And that brings me to what’s next in the Chinese financial markets.

With the way China’s markets have whipsawed investors in recent days, many people assume that the party’s over. [For an illustration, click here to track a month's worth of closing prices on the closely watched iShares FTSE/Xinhua China 25 Index (FXI) exchange-traded fund (ETF)].

Walking away now would be a mistake.

Indeed, when it comes to China, we’re still in the opening frames of what you can expect will be an exciting extra-inning ballgame. There will be many more volatile stretches like the current one. But each time – the present included – Chinese stocks will shrug off the fears and resume their march toward higher ground.

Here’s why:

• First, as we noted earlier, the economy is on fire. Hundreds of millions of people are trading stocks. It’s inevitable that most middle-class China consumers will want a piece of prosperity, meaning there’s still big blocks of cash that hasn’t yet entered the stock market.

• Second, you could argue the recent stock-price declines are, not surprisingly, being orchestrated by Beijing, although the country’s leaders would never admit it. Without boring you with the details, China’s getting ready to launch a stock-index futures market, so it’s entirely conceivable the government is making a concerted effort to knock share prices back to more-reasonable valuation levels before an even-bigger flood of capital hits the markets and pushes share prices far higher. Interest-rate increases are part of that effort to suppress stock prices. So are the instructions the central bank has issued to state-run pension funds, in which the fund managers are ordered to cut back on their holdings of China shares. That’s yet another source of potential downward pressure on stock prices.

• And third, this will result in an evening-out process that we here at Money Morning identified months ago when we suggested that investors avoid the China-based highfliers in favor of seemingly staid-and-boring companies that are actually superbly positioned to benefit "because of" the growth in China.

Case-in-point, consider some of China’s banks and insurance companies, which have been largely ignored in favor of sexier technology and industrial firms. These denizens of China’s financial-services sector have actually stabilized and even risen in value on several of the bigger down days recently. Part of that is associated with a record yuan parity rate of 7.4162 to the U.S. dollar.

That’s unlikely to change in the near future and the sector should see above-average returns in the next 12 to 24 months.

But investors will have to move with caution to make certain they don’t get burned in the interim. Beijing is notoriously secretive when it comes to many things, and protecting the yuan – as well as the future viability of the stock market – by pushing down near-term stock prices certainly qualifies.

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