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Japan-China Tensions, A Weak America, And Your Portfolio

It takes no genius to figure out that America's power is on the decline. A defiant Iran, uncontrolled riots in the Muslim world and a strong sense of distrust by old allies do not lie. Historically, when the US refrained or refused to carry the baton of civil and economical freedom the world found itself in chaos. So was the case in WWI and WWII, and the factors that culminated these tragic events are on the rise again.

With nearly 2 billion people, a thriving economy, and a strong national identity, China has emerged as a world power opposing the democratic West. Not only does it possess one of the largest and well equipped armies in the world, China has engaged in an arm race by supplying cutting edge weaponry to countries like Iran and North Korea. China owns a large portion of debt serviced by several world economies, while the Chinese themselves are savvy consumers with an unforgiving ability to save, making things even worse for those who hope to export Western goods to the developing country.

So what do we really know about China? Well not much. Most of the economic data that are available are screened and edited by the central totalitarian/communist regime, making any analysis questionable. From time to time the "People's Bank of China" will release information regarding inflation rate and economic growth, and will adjust its benchmark interest rate; however, no one, including the Chinese themselves, know how true or effective these measures really are. This approach of disinformation puts the already fragile global economic recovery at risk. The risk stems from our inability to correctly assess the vitality of the Chinese economy and to fully appreciate its impact on our own.

Is the Chinese economy on a rapid decline? Well, I think so. Indications are popping up all around us:

1) Recently, the Chinese central bank has decided to take several steps to stimulate China's economy. These include lowering of the current interest rate and the recent announcement of a "fiscal reform" which will include changes in currency devaluation, interest rate, etc.

2) Unrest in mainland China and Hong Kong suggests that the average person in China is hurting. Rising inflation and declining buying power will continue to threaten political stability in this huge country.

3) Recent analysis by FedEx CEO, Fred Smith, suggests that economists worldwide are completely underestimating the effect of the economic slowdown on China. His opinion mirrors that of Mr. Andrew Liveris, CEO of Dow Chemical Co., who cautioned against a wave bankruptcies of Chinese companies.

4) Finally, and in my opinion the most compelling evidence for the upcoming Chinese meltdown, is the recent headbutting between China and Japan over the disputed Diaoyu Islands. History tells us that totalitarian regimes have a tendency to ignite old disputes, many of which are territorial, to create a diversion from an imminent financial calamity. Adolph Hitler used Czechoslovakia, while Iran Uses Israel in their attempt to keep their subjects "at bay" with external threats. This is to me the clearest sign that China will do whatever it can to distract the Chinese (and us) from its current flimsy economic situation. This crisis will be kept alive as long as China is hurting.

So what does this mean to your portfolio? A lot! In fact, recent rallies were largely fueled by hopes that robust Chinese growth will continue to drive demand for Western goods, commodities, and such. A significant slowdown would mean that stock values would have to readjust to the real US GDP of ~2%, taking prices lower.

What can you do about? There are several approaches that I am taking to protect against a "black swan" event involving a Chinese meltdown. Shorting individual stocks is one option, but those will require capital and extensive analysis. Shorting Chinese stocks by using short ETFs, such as YXI and FXP, is a more viable approach which will protect against major downturns. Other steps may include accumulation of foreign currencies, such as the Swiss Franc and the Canadian Dollar, which should hold their value if the Yuan is in a freefall. Finally, companies involved in military defense missiles, such as Raytheon which has return 46% YTD and yields 3.4% in annual dividends, will benefit greatly due to public panic and outcry.

Disclosure: I am long FXP.