Play Defense with ProShares UltraShort China, CurrencyShares Yen ETFs

Last Monday I told my Orbus Investor readers I had seen the future. With Monday's Asian trading day already closed and the European one halfway through, it looked bleak for Wall Street once traders came back from the MLK holiday. This Monday there was no holiday, and no respite either for war-torn bulls.

Out of the three primary regions of world stock market importance -- Asia, Europe, and North America -- the United States sub-prime storm that started this mess and last week's interest rate holds at the Bank of England and European Central Bank have set the tone, with Asia struggling to yank global investment averages out of the cellar.

Japan is still in bear territory, with the Nikkei 225 stock market benchmark down nearly 30% since June even as its currency has appreciated by more than 15% against the dollar. That appreciation has come due to the low-yielding yen's position as a safe-harbor currency, a rallying point for investors wary of higher yields and higher risk.

In the chart below we see the relationship between the Nikkei average, the Dow, and yen vs. dollar trading. Though the Tokyo market is down, the yen is up.

Asia itself is panicked by the prospect of a US slowdown, because the long-standing world order has held that advantageously-priced goods destined for the United States are the lifeline of Asian export centers. China's currency is carefully controlled by government-supported foreign exchange market manipulation, but Japan's free-floating yen can be a liability. But this week Bloomberg reports from Japan that exports from Japan's Tokai industrial heartland (where Toyota is based) to the rest of Asia rose by 4.5% from November 2006 to 2007, and shipments to the Middle East surged by 13.4%.

Will new internal and external Asian export outlets sop up the spill from a Yankee recession, especially as it is reflected in equity exchanges? Hope sinks easily in this market.

Last week's emergency rate cut by the Fed stoked mid-week excitement in Hong Kong and Tokyo, but London and Frankfurt (where the ECB is headquartered) held still as anti-inflation ogres, effectively putting the breaks on what fragile optimism Bernanke & Co. had jump-started.

What's more, inflation averages for many nations in the Organization of Economic Cooperation and Development (OECD, also known as the "rich countries' club") are at multi-year highs, distorting consumer prices and investment returns. There are exceptions. Stateside, on one hand, we are standing at a 17-year high for "core" inflation, which excludes food and fuel. In Canada, on the other hand, Toronto's Globe and Mail says that car prices have dropped the fastest in 43 years while core inflation (there, they exclude fuel and fruit, not all food) is at 1.5%, well below the OECD average of 3.3%.

This can be attributed to the Canadian dollar's dramatic rise past parity with the greenback in 2007, with the loonie holding more value than George Washington for most of autumn. Since it's easy for most Canadians who live near the border to dip south to take discounts, auto dealers from British Columbia to Nova Scotia have had to ratchet prices down.

From this witches' brew of interest rate policy motives, pricing pressure, and psychological barriers to investment, we get a key volatility measure, the Chicago Board of Options Exchange Volatility Index (VIX), pushing 2-year highs, but looking technically ready for a reversal. However, it took only four months for August's VIX high to be tested again, and since November's peak it was just two more months until last week the VIX pushed through resistance last week.

This coincided with the revelation that a rogue trader (financial speak for "egomaniacal jackass") at France's second-largest bank and purported risk managers par excellence, Societe Generale, had incurred over $7 billion in losses while betting that European stock markets would rise into 2008. Though his intentions are still unclear, Jerome Kerviel initiated another torrent of trepidation throughout the world's investment community at a time when all anyone wanted was a security blanket and a pacifier.

Global Investment Down, Your Portfolio Up

My top play for this week is a double-down bet against the Chinese market (which tanked by over 7% in Shanghai and 4.25% in Hong Kong Monday). The Chinese New Year holiday is coming up next week, which usually leads to lower trading in Singapore, Hong Kong, and of course the mainland exchanges.

What volume these trading floors do draw will likely be to the downside, as reports are surfacing that much of Chinese companies' earnings growth over the past 24 months has come from investments, not from product revenue streams. With market contraction will thus come earnings contraction, feeding a downward spiral that will probably take the better part of 2008 to sort out.

Even though bond futures are pricing in a Fed rate cut of at least 25 more basis points, forecasting a drop all the way to 2.32% for September, the best laid plans of investment houses and individuals around the world have been torn to shreds in the past few months, feeding more volatility and requiring more than easy money to revive widespread bullishness.

So use FXP, the ProShares UltraShort FTSE/Xinhua China 25, which will log double the opposite of 25 China-based stocks that trade in Hong Kong FXI. Therefore, every time the iShares FTSE/Xinhua 25 Index drops by 5%, you bank 10%. The CurrencyShares Japanese Yen Trust (FXY) can also be your retreat as the VIX volatility index rocks and rolls, though I recommend only a defensive allocation of 5-10% for this currency play.

It's a good way to benefit from a bad situation from east to west.