How the U.S. Financial Crisis Resembles Japan’s 'Lost Decade' - And How to Play It, Part II

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 |  Includes: ABB, ABX, BHP, GAF, GDX, GLD, GROW, KYO, MITSY, PBR, PKB, RIO, VALE
by: William Patalon III
A "Lost Decade" doesn’t have to translate into lost profit opportunities.
As the global financial crisis continues to escalate, the United States is increasingly facing the prospect of a long malaise that could easily eclipse Japan’s Lost Decade of the 1990s in both duration and depth.

And history shows that such periods can be the worst for investors to navigate - especially when they follow a record stock-market run, such as the all-time-highs that U.S. share prices reached last fall.

In the United States, for instance, the Dow Jones Industrial Average hit 381 on Sept. 3, 1929, a record pinnacle achieved in advance of both the Great Crash and the Great Depression that followed - and a level that wouldn’t be eclipsed again until November 1954 - more than 25 years later.

From the Great Crash, fast-forward 60 years, to 1989 Japan. On Dec. 29 of that year, the Nikkei 225 Index topped out at 38,957.44, before closing at 38,915.87. By the following September, stock prices had nearly been halved - and there was still much more bloodletting to go. (Despite several subsequent rallies up over the 20,000 threshold, the Nikkei ultimately bottomed at 7,830 in April 2003. It closed yesterday - Thursday - at 12,887.95, still down 67% from its trading high 19 years ago).

The fallout from Japan’s slow motion, stock-and-real-estate-market meltdowns was incredible. By early 2004, Japanese houses were selling at 1/10th their peak value, and commercial real estate was selling for less than 1/100th of its record highs. All told, an estimated $20 trillion in stock and real estate wealth was vaporized (although one could easily argue that the peak values weren’t real to start with).

That’s scary stuff, especially because many experts fear the U.S. version of the Lost Decade that’s to follow could be much worse. After all, the U.S. financial crisis is much, much bigger, and the resultant malaise is arguably going to take much longer to work through.

Let’s look at some of the some of the profit plays that will allow investors to sidestep a long U.S. slumber - and profit just the same.

1. Miss the Market Meltdown: The Dow closed at an all-time record high of 14,164.53 on Oct. 9 of last year. With yesterday’s 207-point rally, the Dow closed at 11,446.66 - leaving the 30-stock blue-chip index down 19% from the October record, leaving it right on the doorstep of a bear market.

But what if things were to get much worse? For the Dow to match the Nikkei’s wrenching decline of 67%, it would have to drop all the way down to 4,574.29 - an area it hasn’t seen since the first half of the 1990s.

Will the Dow drop that much? Probably not.

But it doesn’t hurt to hedge. That brings me to a key point: There’s a big difference between "diversification," which most individual investors equate with "protection," and actual "hedging," which is part of an investment-protection package that professional traders employ. If we believe a market poised for a real fall, we want to hedge and find an investment that’s going to go up in value while everything else is going down.

For us, that investment is the Rydex Inverse S&P 500 Strategy Fund [RYURX]. RYDEX URSA is a so-called "inverse fund" that’s designed to profit as the Standard & Poor’s 500 Index declines in value. In that way, it complements our other holdings by providing some portfolio stability.

As Money Morning Investment Director Keith Fitz-Gerald says, hedging is such a compelling strategy because financial studies demonstrate that "even though broad sections of the markets may decline over time and our portfolios with it, we need only have a small section permanently hedged at any given time. The reason is that, by having a small portion of our assets (5%-10% or less) earning above-average returns, our overall returns are far higher over time."

2. Gold Isn’t Just for Hedging Anymore: Mention the word "stagflation" to anyone who worked and invested during the 1970s, and I’ll bet you’ll actually see that person physically shudder at the memory. Stagflation - the double-whammy combination of stagnant economic growth and high inflation - was thought to be an impossibility, until it showed up during that decade, leaving ruin in its wake.

But for our purposes, no matter whether we’re looking at stagflation or inflation, one thing is clear - we’re looking at higher prices. And when prices are on the upswing, gold is the one investment you certainly want to own.

Then there’s also the whole "Lost Decade" outlook for the U.S. economy. In a misguided attempt to slowly deflate the asset bubbles it created with a years of overly expansive monetary policies, the U.S. Federal Reserve is now keeping interest rates at artificially low levels - gambling it will still be able to launch a successful counterattack on inflation later on. What’s more, the central bank also has made the ill-fated decision to diversify into the "bailout business" with its intervention in the Bear Stearns Cos. (NYSE:BSC) and Fannie Mae (FNM) and Freddie Mac (FRE) debacles.

The artificially low interest rates will continue to punish the U.S. greenback, sending it lower and causing inflation to accelerate. And the trillions in debt the U.S. government’s balance sheet will take on from the Fannie and Freddie bailouts certainly won’t help.

In addition to the bleak-sounding inflation-case for gold, there’s also what I like to call the "wealth case" for the "yellow metal." As the consumer classes in China, India, Latin America and Emerging Europe grow in both breadth and depth, their ability to buy luxury goods will finally intersect with their desire. And gold will be a major beneficiary.

But how best to play it? There are mining companies, bullion, coins and even jewelry. Everybody has his or her preferences for gold investments, including us. We prefer the SPDR Gold Trust Exchange Traded Fund (NYSEARCA:GLD). There’s no delivery risk, it’s liquid, and you can buy and sell easily through any online brokerage.

Oxford Club Investment Director Alexander Green prefers the Market Vectors Gold Miners (NYSEARCA:GDX) ETF. Market Vectors is linked to the AMEX Gold Miners Index and owns all of the world’s leading gold and silver mining companies. That means you can capture the performance of the entire sector in a single, well-diversified investment. 

Finally, there’s our favorite gold-mining stock: Barrick Gold Corp. (NYSE:ABX). Barrick is a Toronto-based company with mostly North American production, though it also has properties in South America and Africa, and some copper and zinc add-ons. It has a $41.4 billion market capitalization, so there’s plenty of liquidity. By gold-mining standards, this company has a substantial presence, is reasonably valued, and has little political risk. The company also recently sent some very bullish signals to the market and reasserted its confidence in meeting its 2008 output target of up to 8.1 million ounces of gold.

3. Profit From the New Trading Blocs: A decade ago, professional traders would tell you that "when Wall Street sneezes, the rest of the world catches a cold." There’s one major difference between the world today and the one that existed back in the early 1990s when Japan skidded into its Lost Decade: Globalization has today finally taken hold, and isn’t just some concept to be talked or hypothesized about, as it was back when Japan’s overheated economy threw a rod back in 1989.

That will make a huge difference, for it means that global growth can continue - even if the U.S. economy stalls and falls into decade-long slumber. One of the biggest developments is the emergence of new trading blocs - that don’t include the United States. At the center of most of them: China. The biggest of these new blocs is undoubtedly China and Japan, an immensely powerful alliance that might develop into the United States’ military equal, in addition to its economic superior. It’s ironic that Japan - which suffered through its own Lost Decade - would be one of the antidotes for investors seeking to escape a looming U.S. downturn that has the potential to be equally as devastating.

Investors will want to uncover profit plays from this deepening relationship, and would do well to look at major Japanese companies that already are shifting production from their high-cost home market into lower-cost China. One such company is Japanese heavyweight Toshiba Corp. (OTCPK:TOSBF).

This major manufacturer of computers, medical electronic equipment and telecommunications systems has developed a highly integrated manufacturing capability in China, enabling it to synergize its technical innovation with China’s highly skilled, low-cost workforce. Toshiba’s shares are trading at about 22 times earnings, reasonable for a high-tech company - especially one that’s poised to capitalize on such new-technology markets as flat-panel televisions and solar power.

For investors, one of the biggest profit opportunities will be with companies that are helping China build out its still-archaic infrastructure and build up its consumer sector, which is why such companies as solar-ceramics maker Kyocera Corp. (ADR: KYO), and trading giant and independent power plant developer Mitsui & Co. Ltd. (OTCPK:MITSY), are logical choices.

China also is establishing trading blocs with Africa and the Middle East.
For a broader exposure to the Chinese through a high-quality mutual fund, investors should carefully consider the China Region Opportunity Fund [USCOX], managed by the San Antonio, Tex.-based U.S. Global Investors (NASDAQ:GROW), itself not a bad stock to consider.

4. Invest in the Global Infrastructure Boom: Global consultant Booz Allen Hamilton recently estimated that the world’s water, power and transportation systems would require an outlay of $40 trillion to bring them up to modern standards - an amount equal to the value of all the world’s stock markets combined.

Some of our favorites plays in this area include raw-materials suppliers, such as miners Rio Tinto PLC (ADR: RTP), BHP Billiton Ltd. PLC (ADR: BHP) and Companhia Vale do Rio Doce, now referred to only as Vale (ADR: RIO).

One of the very best plays may be ABB Ltd. (ADR: ABB), the Zurich-based giant that’s a leading global provider of power-generation systems and components. With a market value of roughly $63 billion, ABB is one of the real heavyweights in a sector that includes such rivals as America’s General Electric Co. (NYSE:GE) and Germany’s Siemens AG (ADR: SI). Over the last several months, for example, ABB has announced deals of $233 million in Korea, $74 million in India, $170 million in the Sweden-Finland region, $53 million in Dubai, and $70 million in China, to name just a few.

Of course, you can also buy individual engineering and construction firms, or invest in the broad holdings of the PowerShares Dynamic Building & Construction ETF (NYSEARCA:PKB).

5. The Middle East Isn’t Just About Oil Anymore: Indeed, thanks to the petro-gusher dollars so many Middle Eastern countries were able to amass, and to the government-controlled sovereign wealth funds that now control that capital, these same nations have been able to transform themselves into major global financiers. There aren’t a plethora of plays here, yet, but there will be. For right now, consider the T. Rowe Price Africa & Middle East Fund [TRAMX], which carries a $2,500 minimum investment, and the SPDR Standard & Poor’s 500 Emerging Middle East and Africa (NYSEARCA:GAF) ETF, which tries to closely match the performance of the S&P®/Citigroup® BMI Middle East & Africa Index.

6. Head South of the Border When You Consider the BRICS: An acronym for Brazil, Russia, India and China, the BRICs are among the fastest-growing economies in the world. We’ve covered China, but Brazil bears more than a mere mention. The main play to look at here is Petroleo Brasilero SA (ADR: PBR). Latin America’s appetite for energy is nothing short of ravenous. As of now, three-fourths of the country’s electricity comes from hydroelectric power. That figure will be higher in 2012, when the region’s largest hydroelectric project, the Santo Antonio Dam, will begin producing electricity. Santo Antonio is the first of three Amazon River dams the government hopes will decrease Brazil’s need for fossil fuels. Until then, however, Brazil’s state-controlled oil-and-gas company, Petrobras, will continue to meet the demand.

Read Part I

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