Let’s Make a Deal

Japan’s much-ballyhooded “Lost Decade” is actually now entering its third decade. Mainichi Tokubai, which means “every day best deal,” is a social networking site “staffed” by more than 70,000 Japanese housewives who, after nearly 30 years of flat wages and an increasingly dicey Japanese economy, simply want to stretch each yen in their quest to take care of their families.

From our home here in Kyoto, where my family and I live for part of each year, I’ve had a courtside seat to this economic drama. Even my wife Noriko uses the site: She estimates she can save at least 5,000 yen (roughly $50 a month) using the site. That’s a heck of a return on investment (ROI), given that a monthly subscription is about 105 yen (about $1.05).

Here’s how it works.

Each day, local housewives – called “regional correspondents” – upload the daily specials from their local newspapers to the site. Then, armed with their “keitai,” or smart phones, they go shopping for the best deals in neighborhood markets. If getting those “best deals” means buying a handful of items from three or four different markets, so be it.

It’s that resolve to find those “best deals” that’s threatening to further drive down prices – which could be deflationary.

It’s a great way to do things for a couple of reasons. First, we already receive the daily flyers from neighborhood merchants, so we’re able to instantly compare prices with other stores instead of having to plow through a half a dozen flyers a week. Second, we’re able to do it on our schedule and when we’re ready to go shopping. Third, we don’t really worry about getting the short end of the stick any longer from notoriously inflexible Japanese merchants who, for hundreds of years, have held the upper hand here.

The other day, for example, our family bought pork, eggs, pumpkin squash, ice cream and frozen foods – including peas, beans and blueberries – all on sale at our local stores and all at deep discounts that ranged from 10% to 50%.

Those bargains are akin to the “doorbusters” that U.S. retailers offer on weekends and holidays, and the strategy is the same: Japanese retailers offer those deeply discounted goods, figuring that, once in the door, the shoppers will then buy “iro iro,” or various things – and not merely the heavily advertised “loss-leaders” that got them into the store.

It doesn’t actually work out that way, however – thanks to Mainichi Tokubai. Take consumer Hiroe Ishimoto, who passed – as we did – on goods the Web site told her she could buy for less at other stores.

“I live with the comfort of knowing I never get a bad deal,” she told CNN.

At the other end of the spectrum are politicians and businessmen – like the chain store association’s Ogasawara – who worry that this small-but-determined army of consumers will tip Japan into a deflationary spiral.

Japan’s Lost Decade(s)

Unfortunately, Japanese retailers and politicians don’t seem to understand what the real problem is here. Consumers are feeling squeezed and have taken matters into their own hands, because Japan’s government won’t – or can’t – solve the problems they face.

And the pain has been intense.

For three decades – in what was known as the “Japanese post-war economic miracle” – Japan posted stellar growth. In fact, it averaged 10% growth during the 1960s, 5% in the 1970s and 4% in the 1980s – enough to vault right behind the United States and make it the world’s second-largest economy.

However, following the September 1985 Plaza Accord, a steep appreciation in the yen really torpedoed Japan’s export sector. Japan’s economic growth rate skidded from 4.4% in 1985 to 2.9% the next year. In an effort to offset the stronger yen, the Bank of Japan sought to ease monetary policy: Between January 1986 and February 1987, the BOJ slashed the discount rate from 5% to 2.5%. Asset prices – primarily stocks and real estate – skyrocketed, creating one of the biggest speculative bubbles in modern history, and setting Japan up for a classic crash.

The government tightened credit, raising rates five times in 1989 and 1990. By the time rates reached 6%, Japan’s stock was poised for a full-blown retreat. From an all-time high of almost 40,000 in 1989, the Nikkei 225 plunged more than 60% by 1992, dropping below the 15,000 level. The real-estate market was also crushed: Prices plunged 80% between 1991 and 1998.

It would have been bad enough had that been the extent of the damage, but it was actually just the start. Japan’s government rolled out 10 stimulus programs during the 1990s, and none did the trick. The Nikkei dropped below 12,000 by March 2001, and has continued to decline (it closed Tuesday at 9,338,04 – a full 77% below the all-time high reached in 1989).

Japan’s economy has been stagnant ever since: Real GDP rose just 1.5% per annum during the 1990s and 0.8% a year in the 2000s. The extremes experienced during the most-recent decade exacerbated the longstanding pain. After a major global slowdown in 2000-2001 hit Japan particularly hard, a resurgence of global trade and the policies of Prime Minister Junichiro Koizumi sparked a rebound that saw Japan’s economy advance at a 2.1% annual clip from 2003 to 2007.

But the global financial crisis brought about another reversal of fortune, causing the Japanese economy to shrink 1.2% in 2008 and a full 5.0% last year.

Fast-forward to 2010 and we find that the outlook hasn’t improved a bit. Unemployment is up once again and household spending is down, according to May data – most likely in response to lower Japanese factory production data and industrial output during the same month.

Note to Obama: Beware Mr. President

Japan’s got 30 years in this game and its leaders have tried everything from zero-interest-rate policies to cramming more capital into banks and other short-term lenders. The government has also purchased commercial debt and stock outright – all under the assumption that “lending” supports the very foundations of economic growth because it translates into “productive” investments.

Japanese companies are now so weakened by the multi-decade grind that there are literally not enough of them left to take on newly available capital even if they could.

If this all sounds vaguely familiar to you U.S. readers, your mind isn’t playing tricks: The Bush and Obama administrations have called some of the same plays – and we’ve already seen some similar results. Give it time and the parallels will become even more clear.

Washington would be wise to take heed: U.S. consumers aren’t going to put up with Washington’s malfeasance and mismanagement forever. Eventually, U.S. consumers, too, will take matters into their own hands, much like Japan’s housewives have done.

And when that happens in the United States, watch out.

Once consumers get that fed up – or that scared – they will take matters into their own hands … just to survive. Once that happens, consumer actions become the kind of hard-to-factor-in wildcard that transforms any new policymaking push into three parts guess/one part projection.

If you don’t believe me, just ask the housewives of Mainichi Tokubai – the “Real Housewives” of Japan.

News and Related Story Links:

• Wikipedia:
  Consumption.
• Bloomberg News:
  Bonds Gain in Best Year Since ‘05 as Rally May End
  
• Newsweek.com:
  Yes He Kan? Restoring confidence in Japan’s DPJ
  
• CNN.com:
  Japanese Housewives Driving Deflation.
• Money Morning News Archives:
  Japan News Stories
  
• Google.com:
  Japan’s Population
  
• Money Morning News Archive:
  Lost Decade News Stories
  
• InvestorWords.com:
  Return on Investment
  
• Wiktionary:
  Doorbusters
  
• Wikipedia:
  Junichiro Koizumi
  
• Von Mises Institute:
  Explaining Japan’s Recession
  
• Wikipedia:
  Plaza Accord
  
• Wikipedia:
  The Japanese Economy

To be sure, there are still world-class businesses here and many Japanese companies are in the best competitive positions they’ve been in for years. And yet, bluntly speaking, I’ve never seen a more-nightmarish situation. And here’s why:

• Japan’s domestic market is a demographic disaster that’s characterized by a rapidly aging population and an impossibly low birth rate – neither of which suggest that domestic consumption will improve anytime soon.
• Modern Japan is almost entirely reliant on exports. If exports can’t take up the slack caused by the domestic disintegration I’ve just mentioned, the Nikkei will fall further – as will corporate profits, lending and payrolls. To bridge the gap, Japanese corporations and Japanese companies will have to repatriate assets that are already under pressure abroad, further strengthening the yen at a time when the opposite is actually needed to spark growth. This repatriation is already happening to a small degree; but the real risk is that it becomes a self-perpetuating, self-defeating cycle – instead of the byproduct of the global financial crisis that it’s been up to now.
• Nominal gross domestic product (GDP) has not expanded meaningfully in 30 years, and the country’s debt as a percentage of GDP is nearly 200% – the highest on the planet. Even Greece – the poster-child for the ill effects of an over-reliance on government debt – has a debt-to-GDP ratio of “only” 115%. (For a look at the countries with the biggest debt-to-GDP ratios – and for some insight on the trouble all that debt can cause – check out the accompanying chart.)
• So far, Japan has been able to finance its debt internally, drawing its huge pool of domestic savings. By 2015, however, this Asian giant could be forced into the external financial markets (just like the United States) as a means of funding this domestic debt. That’s when Japan’s aging population is projected to begin consuming more assets for retirement than its work force is saving. This will likely double Japan’s long-term debt costs, and it will likely cause the stock markets to deflate further in response to interest rates that may actually triple to accommodate the increased risks of external financing. Japan’s largely internally financed 10-year note late last week touched 1.16%, the lowest level in 18 months. The comparable externally financed 10-year U.S. ended the week at 3.11%.
• Government reform here has bogged down, the victim of controversy and political mediocrity. Japanese Prime Minister Naoto Kan – elected in early June – is the fifth person to hold that post in the last four years. The story is even worse when it comes to cabinet-level posts: Kan’s choice as the new minister of finance – the conservative Yoshihiko Noda – became the ninth finance minister in the past four years. Many Japanese I know have simply turned apathetic, believing that nobody in the Japanese Diet is going to stick around long enough to make any meaningful changes.
• Even now, after 30 years of stagnation, Japanese firms still have some of the highest manufacturing costs on the planet, and remain generally inflexible when it comes to adaptation. Worse still, it’s my belief that Japan’s “old guard” still doesn’t fully understand the competitive threats their country faces from Korea and China – despite the fact that China, and not the United States, is now Japan’s single-largest trading partner.
• Prices at supermarket chains have fallen for 13 straight years, according to the Japan Chain Stores Association, and wages have been largely stagnant for decades. Neither is a harbinger of better times to come.

With such a negative outlook on Japan, you’d think that “shorting” Japan – or even abandoning it altogether – would be the investment strategy that I advocate. But that’s not the case. For me, in fact, this is quite problematic.

For one thing, years of living and working in Japan has demonstrated time and again that the Japanese have an admirable, intangible quality they refer to as kesshin – which loosely translates to “quiet resolve,” or “determination.” Americans might refer to it as “guts,” or “true grit,” but this quality or spirit actually runs much deeper than that and reflects a Japanese person’s innate refusal to give up or give in – no matter the odds.

There’s also some reason for hope in the corporate realm. Many Japanese companies – especially the bigger, more-established ventures – have cut their ties to the U.S. market, and have consciously focused their sales efforts on China, even if they don’t yet fully understand the nature of the competition they are unleashing in the process. In doing so, these Japanese companies hitched their horse, however hobbled it might be, to a stronger wagon.

Personally speaking, I’d rather invest in the stronger wagon (China) because the path to profits is more direct. But if you just can’t bring yourself to “give up” on Japan – for whatever reason – here’s where I suggest that you look for the best potential profit opportunities. Consider:

• Japanese companies that are selling into China’s infrastructure boom, which include players in the heavy-machinery, construction-equipment and green-energy. Companies such as Fujitsu Ltd. (OTC ADR: FJTSY), Mitsubishi Corp. (PINK ADR: MSBHY) and Komatsu Ltd. (OTC ADR: KMTUY) have all experienced solid gains thanks to China even though their stock prices do not yet reflect the growing trade there. Those are almost more a “China” story than a “Japan” story.
• Industrial materials suppliers that supply the bigger Japanese companies producing end-use products in the industries I’ve just mentioned to China. Pay special attention to such areas as industrial ceramics and solar manufacturing.
• And think about Japanese shipping companies. After all, the stuff China needs has to get from ‘Point A’ to ‘Point B.’ Most shippers – such as Mitsui O.S.K. Lines Ltd. – have suffered deep losses as a result of the global financial crisis and could logically benefit as the need to move goods north resurfaces. That means you may be able to snap them up at a bargain even if you are early to the party.

If you do decide to invest in Japan, do so with this Japanese proverb in mind: “Ishi no ue ni mo san nen” – which loosely warns us that you have to sit on a rock for three years in order to break it.

News and Related Story Links:

• Wikipedia:
  Consumption.
• Bloomberg News:
  Bonds Gain in Best Year Since ‘05 as Rally May End.
• Newsweek.com:
  Yes He Kan? Restoring confidence in Japan’s DPJ.
• CNN.com:
  Japanese Housewives Driving Deflation.

So, which is more important? Being there for the gains, or missing the worst the markets have to offer?

Picking stocks that skyrocket in good markets – but are vulnerable to wrenching plunges when markets roll over …

Or holding positions that generate profits in good markets and that protect you in bad ones?

I don’t know about you, but I’ll opt for the latter every time.

There’s a reality about investing and here it is: While the occasional quick hit long does pay off, investors are far better off building a well-balanced portfolio that protects them from sporadic stock market plunges than they are packing a portfolio with speculative stocks that have more downside than they do upside.

Think you already have a well-diversified portfolio? Think again.

Diversification, as promoted by Wall Street, is a perfect recipe for failure when everything goes wrong. Simply taking your assets and spreading them out among some stocks, a few bonds, a little real estate, a dollop of precious metals and a splash of cash isn’t enough. That’s like ordering a variety of meals at a fast-food chain – some parts may be better for you than others, but the whole is hardly healthy.

So what’s the solution?

The true answer lies not in how you spread your money around, but in how you concentrate it. You must first invest to ensure the security of your returns and second to maximize your profits relative to the risks you do decide to take.

That’s why I recommend – and personally use – what’s known as the “50-40-10 Pyramid” strategy. This is a portfolio structure I developed many years ago and have advocated ever since – and is one that ensures I always have both minimum risks and a “positive expectancy” in my investments wherever and whenever possible.

If you’re not familiar with the term “positive expectancy,” it simply means the investment offers a return greater than the amount of money that’s actually put at risk. Always remember: Successful investing isn’t about winning all the time…it’s about winning over time. picking more winning stocks than losing stocks; it’s about making more money than you lose over time.

That’s why To that end, I constantly harp on consistent risk management . is more important than profits over long periods of time. So, i I f you control the risks, the returns will come – and that’s what the 50-40-10 Pyramid does.

Here’s how it works:

• The “50″ refers to what I call “base-builder investments” and should generally account for 50% of your portfolio holdings. The base-builders make up the “safety-and-balance” portion of the portfolio. They consist of defensive positions that will hold their value better than other choices in nearly all market conditions, which will protect you from severe economic declines such as the ongoing European debt contagion. Of course, that doesn’t mean these investments are immune to loss. But they will generally take much less of a beating and be much less volatile than other investments when the going gets tough.

  This 50% of your portfolio should be generally focused on income and dividend-paying issues. Many people are dismissive of income investments, but in good times they can produce annual gains of 20% or more. Plus, the value of dividends can never be understated: Some studies show that Since 1871, dividend payments and reinvestments have been responsible for the dominant portion of total stock market returns – in some cases 90% or more.

• The “40″ is the percentage of the portfolio devoted to “global growth and income positions.” These holdings are the “Global Titans” – companies with dominant market positions around the world. They’re firms poised to benefit the most from rapidly emerging economies in Asia and elsewhere (with a focus on China). In that role, these holdings will derive their strength from riding one or more of the major developing global trends. The most dynamic growth will likely come in the energy, commodity, environmental and infrastructure sectors. Increasing dividend payouts are an added attraction, boosting returns and safety.
• The “10″ comprises accounts for what I call the “rocket riders.” These investments – which often involve initial public offerings (IPOs), takeover targets, aggressive stocks in special situations, or even the buying or selling of options and other more speculative vehicles – offer spectacular upside potential and can lift overall portfolio performance well above market averages during good times, even though they constitute, at most, 10% of your holdings.

A 10% return on your entire portfolio can be exactly matched by a 100% return on just 10% of your portfolio – and the consequences of being wrong are far less severe.

In fact, that’s the single most important benefit of adopting the 50-40-10 Pyramid structure for your portfolio – you preserve all the upside potential of your investments while still retaining the freedom to make an occasional misstep. With only 10% on the speculative line, a single miscalculation won’t devastate your entire portfolio. It frees you from the pressure of having to be perfect.

You have the freedom to screw up!

Adhering to the Pyramid also helps keep emotions out of your investing equation. If you structure your holdings according to the 50-40-10 formula – and adjust them regularly to reflect shorter-term gains and losses – you’ll be positioned for the optimum upside at all times, even as you protect yourself against major trouble when the markets decline.

News and Related Story Links:

• Wikipedia:
  Principles of Investment Diversification
• Investopedia:
  Dow Jones Global Titans 50 Index
• bnet:
  Historical perspective on global titans
  
• Money Morning:
  Dodge a Possible Debt Debacle With These Two Stimulus-Plan Safety Plays
• Money Morning:
  Dramatic Drops and Short-Covering Rallies Illustrate How Capital Waves Lead to Profits
• Money Morning:
  A V-Shaped Recovery? Don’t Bet On It
• Money Morning:
  “Capital Waves” Point to High-Tide Profits for Commodities, Tech and Emerging Markets
  
• Money Morning:
  The Four Tough Questions to Ask Yourself in a Tough Market

Wall Street Responds

To hear Wall Street’s reaction, you’d think that Germany was hiding something “that the market’s not aware of,” said Michael O’Rourke, managing director and chief market strategist at BTIG LLC, an institutional trade services provider, told Bloomberg News.

And Mark Grant, managing director of Southwest Securities, said Germany’s actions make it clear the European stalwart is engaged in an “obvious attempt to control financial market across the globe.”

Wall Street may not approve, but I certainly do.

I’m only sorry that our own feckless leaders didn’t make the tough decision to take the same actions several years ago when they had the chance to fix this mess – instead of taking the easy way out with trillions in bailouts that we can’t possibly pay back.

What the public doesn’t understand about naked credit default swaps is that they are not the effective insurance policies Wall Street has everybody believing them to be.

Simply put, buying a naked credit default swap is like taking out fire insurance on your neighbor’s house. Now you have an incentive to burn it down so that you can get paid off, which is precisely what global investment bankers have been doing – generating billions of dollars in profits and costing taxpayers similar amounts in the process.

The Self-Fulfilling Prophecy

The key to this whole mess lays in something called an “insurable interest.” In the old days, you had to actually own the underlying assets to obtain insurance, because having an ownership stake meant that you had property that required protection.
But the “naked” credit default swaps that are causing such big problems right now are an entirely different animal. They’re “insurance policies” written on assets where there is no ownership interest.

Thanks to this financial voodoo, financial firms all over the world are being allowed to bet on the probabilities of an event occurring – the failure of a financial institution or an entire country, for instance. The trouble is that by placing these bets, they have a vested interest in seeing that event come true.

They also have the financial firepower to accelerate the process, which is precisely what appears to have happened with insurance giant American International Group Inc. (NYSE: AIG), Lehman Brothers Holdings Inc. (OTC: LEHMQ), and a whole host of other institutions around the world.

That’s why Germany has taken these actions. Today’s naked credit-default-swaps market is played by relatively few participants, accounts for trillions of dollars and has the potential to nuke the global financial system – which is why investing icon Warren Buffett so astutely described derivatives such as credit-default swaps as “financial time bombs.”

While I believe there is a role for these and other types of derivatives, that role clearly isn’t being fulfilled as they are being used right now.

The Vested Interests

Needless to say, the financial heavyweights that have been profiting from this global gambit aren’t happy about Germany’s decision because they are like a bunch of party happy people who see a 24-karat punch bowl filled with their favorite libation being whisked away while the party’s still rocking.

But that’s not the worst part.

Financial giants like Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM) and dozens of the most powerful financial-trading firms in history aren’t above tanking the markets so long as they can rake in billions in profits from these financial instruments.

It doesn’t matter which direction the markets are headed (although, as we’ve seen, it’s even better when they can influence that direction): These firms profit as long as there’s “action” in the markets. And that “action” can be described with one word: Volatility.

Germany’s push to add some regulatory muscle is designed to calm the markets, and decrease that volatility. Based on the way the investment-banking brethren are already reacting, I think it’s pretty clear that Germany’s finally struck a nerve.

Personally, I think Germany should take things a step further and require that any foreign firm doing business in Germany, or with German institutions, should comply with German rules worldwide. New York State already does this with insurance companies, so this is not without precedent.

The way today’s global financial firms operate – and the financial instruments they employ – are so complex that there’s no single agency anywhere on earth that can police their actions. That’s why I’ve pushed for unified global action since the global financial crisis began.

And by “unified global action,” I’m not talking about bailouts, either.

Those have been a complete waste of time from Day One, and have done nothing to address the fundamental issue: Wall Street – and the financial instruments that it has engineered – is out of control and answerable to no one.

And Wall Street firms know this, which is why they are reacting so vehemently to Germany’s regulatory riposte. These rules could strip away a lucrative revenue stream, so you can rest assured they and their lobbyists will do everything they can to nip this in the bud.

So far it appears to be working if for no other reason than Germany stands alone. At least for now.

If you’re not of the same opinion, ask yourself why Wall Street lobbied so strongly leading up to the Commodity Modernization Act of 2000, in which derivatives and swaps like the ones in question were made exempt from official financial reporting. The latest estimates of the total value of credit default swaps written worldwide range from $30 trillion to $75 trillion – or more. In the world of estimates, that’s quite a disparity. And the reality is that nobody really knows, because the swaps market is completely unregulated and reporting requirements are largely voluntary.

Wall Street likes it that way: After all, you can’t regulate what you can’t see.

Then ask yourself why LIBOR (the London Interbank Offered Rate) and credit default prices have skyrocketed since Germany’s announcement. overnight. The LIBOR rate is supposed to represent the lowest possible interest rates banks charge to each other because, theoretically, they are each other’s best customers. If the banks were clean and not dealing in these things, rates should be falling, especially with the announcement of the $930 billion (nearly 1.0 trillion euros) European bailout package now on the table.

However, the reality that rates spiked signals that the banks increasingly don’t trust one another – perhaps because they all have financial skeletons in their closets.

It appears that Germany is the first to really see the light on this issue and that it’s going to take other key economies awhile to do so. Denial can be a powerful emotion, particularly when elections are just around the corner, as they are in the United States.

And that means we’re going to see credit default swaps shift to other markets in the days ahead because the political will to implement a concerted and coordinated global response simply doesn’t exist.

Moves to Make Now

The bottom line is that we need to do one of two things worldwide:

• Either outlaw these financial instruments entirely.
• Or require them to be brought into the light of day – and onto regulated exchanges – in a very short period of time.

Expect Wall Street to do what it has always done: Pull out all the stops – and pull in all the lawyers and lobbyists – to avoid a regulatory renewal that would take away the party punchbowl and the dry up their profits.

Granted, as individual investors, we have limited influence on that outcome (although I encourage you to write to your representatives, and let them know how you feel … print out this commentary and send it along with your letter or e-mail).

But we can absolutely take steps to protect ourselves – and even profit – from the situation at hand.

So no matter what your investing style or preference and whether you agree with me or not:

1. Cover your assets: Make sure that you have protective “stops” in place or have deployed options that help hedge your risk.
2. Take out insurance of your own: Purchase your own credit default swaps in the form of such “inverse” funds as the Rydex Inverse S&P 500 Strategy Fund (RYURX) or the Rydex Inverse Government Long Bond Strategy Fund (RYJUX), which profit when markets go haywire; these will provide important stabilizing influences on your portfolio that allow you to stay in the game even as others watch their financial futures get vaporized.
3. Create a shopping list: Get your “Buy list” ready; if we get even half the storm I think is possible based on how the markets reacted yesterday (Wednesday) to Germany’s CDS ban, the massive declines waiting in the wings could create some truly legendary buying opportunities.

News and Related Story Links:

• Money Morning Special Report:
  Credit Default Swaps: A $50 Trillion Problem
• Money Morning Special Report:
  When it Comes to Naming Wall Street’s Worst Invention Ever, Credit Default Swaps Continue to Fill the Bill
• Money Morning Credit Crisis Investigative Series:
  The Credit Crisis and the Real Story Behind the Collapse of AIG
• BTIG LLC:
  Official Website
• BTIG LLC:
  Michael O’Rourke Bio
• Reuters:
  Wall St slips as German move adds to jitters
• Bloomberg News:
  Germany Bans Naked Short-Selling, Swaps Speculation
• Wikipedia:
  Naked Short-Selling
• BusinessDictionary.com:
  Insurable Interest
• SkyscraperPage.com:
  The Square Mile Financial District in London
• Wikipedia:
  Ginza
• Wikipedia:
  London Interbank Offered Rate
• BaFin:
  German Regulatory Agency Official Website
• The New York Times:
  Germany’s Ban on Naked Shorts Adds Volatility
• Wikipedia:
  Commodity Modernization Act of 2000

The Mass Migration “Big Bang”

A population shift of this magnitude can’t help but be a major catalyst for increasing real estate values – especially in such top-tier cities as Beijing and Shanghai, where I am as I write this. This massive urbanization will also significantly shift the market dynamics of second-tier municipalities – such as Chongqing, where literally millions of people are pouring in from the countryside.

Some pundits, such as noted short-seller Jim Chanos, say this is already happening. Back in January, citing the vacancies that pepper the cities I’ve just named and the flood of speculative capital he says has washed through them, Chanos quipped that China is “Dubai times 1,000,” – a sound-bite that’s kept him in the media spotlight ever since.

Personally, I find that more than a little ironic considering he’s never even set foot in China and didn’t even begin studying China until last summer, critics say.

To hear Chanos and others talk about their concerns about a Chinese economic bubble, you’d think Chinese real estate developers and investors are essentially playing with M onopoly money.

My experience suggests otherwise. So does some of the latest market data that I’ve reviewed. One study, for instance, suggests that Chinese real estate has underperformed the benchmark MSCI China Index by nearly 30%.

The point is that Chinese real estate, on the whole, appears to be significantly undervalued – even at this stage of the game – when compared to regional alternatives in Hong Kong and Singapore, two other Asian markets that are a lot further along on the economic-development curve.

The bottom line – and the point that I keep coming back to – is this: If China’s real-estate market is as far out of whack as some people suggest based on vacancies, property-related prices should be falling – even cratering.

But they’re not.

In fact, they’re rising – and so is overall growth.

China: The White Hot Economy

Just yesterday (Thursday), in fact, China announced first-quarter gross-domestic-product (GDP) growth of 11.9%, the country’s fastest expansion in nearly three years and a rate that was faster than what analysts were expecting.

China’s economy had advanced at a 10.9% pace in the final quarter of last year.

Stephen Green, head of Greater China research for Standard Chartered PLC (PINK: SCBFF) here in Shanghai, told MarketWatch.com that central planners in Beijing could be faced with an asset-price bubble in the second half of the year that could trigger a sharp credit contraction in 2011 – unless they’re able to throttle growth back to a more sustainable pace.

“There are signs of overheating,” Green said in the interview.

Beijing is well aware of the stakes and is taking steps to manage China’s growth – with some signs of success.

As part of yesterday’s report on economic growth, Beijing said that March’s consumer price index (CPI) for China was 2.4% higher than a year earlier. That was down from the 2.7% increase in February, and is below the 2.6% increase that surveys by both Dow Jones Newswires and Reuters showed analysts were expecting.

In the real-estate realm, Beijing is raising reserve requirements for lenders, is tightening up on permits and construction licenses, and is even taking steps to halt illegal development. In some parts of China, local developers will often construct entire buildings and never pull a permit.

As incomes increase and China’s consumer class continues to emerge, such pastimes as golf become all the rage. One result: Even though golf courses aren’t exactly easy to hide, there may be hundreds of illegal links operating throughout China right now, the China Daily reported in a story that I read during my visit here.

If the markets were as overbuilt as some pundits allege, there wouldn’t be any competition for the best properties. Instead, that competition is as fierce as I’ve ever seen it – an observation that was seconded by many of the private-equity investors I talked with at the Halter Financial Summit that I attended in Shanghai. Like me, these folks have been actively investing in the Asian markets for decades.

There’s a very clear trend developing. As the property prices in Beijing and Shanghai increase in expense, many companies, investors and developers are shifting their focus to the second- and third-tier cities that have yet to experience the urbanization rush of their much-larger first-tier counterparts. That’s going to broaden the overall advance, creating a more-sustainable environment for real estate investing and development even if major pockets of urban overvaluation exist today. It’s precisely the pattern we described and told Money Morning readers to expect several years ago.

The speculative excesses that do exist appear to be limited to very-high-end residential real estate (read that to mean ultra-luxury real estate) in the primary cities. Over -speculation hasn’t meaningfully impacted the commercial-real-estate sector, or the more-mainstream housing sectors, although that could still happen . Residential projects aimed at the emerging consumer class, as well as the business-related real estate projects that are so important to a nation’s economic advance, both remain in the realm of “investments” – and not speculation – which is why they continue to have very clear government support as part of central planning objectives and China’s ongoing growth.

In other words, Beijing is willing to let the “Ferrari set” flame out, but clearly wants the middle class to succeed because that group’s emergence will create a foundation for both social and economic stability.

No wonder the enlightened institutional investors that I’ve talked with here in China continue to be optimistic. They understand that they could sit on the sidelines and wait for the corrections that periodically come along. But these investors also know that the “bottom” of the next correction could easily be represented by much higher than the prices we’re seeing today – and probably will be.

How to Profit From China’s Mass Migration

What does this mean for you?

If you’re actually “on the ground” here, and have enough money and the ability to do your own due diligence – or “DD” as the Chinese call it – you can begin hunting in the second- and third-tier cities, right alongside everybody else headed that direction. There’s certainly money to be made there in private equity.

For U.S.-based investors, however, there’s a much-easier way to participate. Consider investing in one of a handful of exchange-traded funds (ETFs) that offer exposure to China’s real-estate market – such as the Claymore/Alpha Shares China Real Estate ETF (NYSE: TAO) and the Claymore Alpha Shares China All-Cap Fund (NYSE: YAO). The first fund concentrates specifically on real estate, while the second fund is more broadly diversified and includes banking, construction companies and developers.

A more generalized alternative is the iShares FTSE NAREIT Asia ETF (NYSE: IFAS), which is a regional play that has approximately 8% to 10% of its holdings allocated to Chinese real estate. There are also several closed-end funds that offer a similar, generalized exposure, including the RMR Asia Pacific Real Estate Fund (AMEX: RAP).

As you incorporate this sector into your overall investment strategy, it’s important to keep in mind the general advice that I use as part of my own portfolio strategy for China. The Asian giant remains the biggest wealth-creation opportunity of our lifetime – in the long run. In the near term, you be certain there will be volatility, periodic pullbacks and even corrections.

And while the real-estate sector offers some of the best long-term appreciation of any China-oriented investment category, the investments I’ve just mentioned are all trading near to the tops of their 52-week ranges. And that means they could be poised for a short-term pull back just as easily as a long-term breakout. Position any investments accordingly.

News and Related Story Links:

• Money Morning View From China Report (2010):
  Washington – Not China – Is the Real Manipulator Here.
• About.com:
  What is the Current U.S. Population?
• Wikipedia:
  Chongqing.
• Wikipedia:
  Private Equity.
• China Daily:
  Illegal golf course threatens conservation area.
• The New York Times:
  Contrarian Investor Sees Economic Crash in China.
• MarketWatch.com:
  China’s quarterly GDP expands more-than-expected 11.9%.
• Halter Financial Summit (2010):
  Official Web Site.
• Money Morning News Analysis:
  The China Connection: Why Dubai is Really Interested In MGM,
• Investopedia:
  Due Diligence.
• InvestorWords.com:
  Closed-End Fund.

Every new dollar printed diminishes the value of every dollar that’s already in existence. This, in turn, effectively causes the prices of goods and services to rise. In this case, by keeping the yuan pegged within a narrow band to the dollar, China ensures that the bulk of our goods and services have not inflated, despite the Treasury Department’s turbocharged printing presses.

In essence, Beijing’s policies have acted like the relief valve on a pressure cooker: They’ve kept the U.S. pot from exploding.

Washington also frequently points to Beijing’s $2.4 trillion in foreign reserves as additional evidence that China is a manipulator. This, too, represents flawed logic. Trade reserves accumulate whenever a country sells more than it buys with its partners. Therefore, China’s huge reserves are not evidence of currency manipulation; instead it’s just proof that the rest of the world really wants to buy what China has to sell.

It’s easy to feel as if America is getting the shaft here – especially at a time when so many are out of work and with the country struggling to recover from its worst financial crisis since the Great Depression. Washington isn’t helping by nurturing this flawed view of reality.

It’s time for us to take a sobering look in the mirror.

China didn’t force America to buy anything, let alone run-up our huge-and-growing deficit. We did this all by ourselves – and with substantial gusto, I might add. Our companies sought out China’s inexpensive manufacturing because it helped them become more profitable and become more-globally competitive. Our consumers have been more than happy to go to Wal-Mart Stores (NYSE: WMT) and buy Chinese-made goods: They were inexpensive and the quality has reached a point where those products are as good – or better – than their U.S.-made counterparts.

If anything, we were perfectly content to benefit from this relationship right up to the point where it went against us – or at least, until we perceived that it went against us because we felt that the yuan is artificially undervalued in relation to the dollar.

Albert Keidel, a senior fellow at the Washington-based Atlantic Council and a noted expert on Chinese economic affairs, said that “China’s trade surpluses do not necessarily mean that the yuan is undervalued. In fact, economists [really] do not have an effective way of judging whether a currency is undervalued. China’s currency surpluses since 2005 have stemmed from the excessive consumption of the Americans, rather than problems with the yuan’s exchange rate.”

According to our own government, the yuan appreciated by 16.5% in real terms between June 2008 and the end of February 2009.

The yuan also performed like a thoroughbred during the global financial crisis.

According to the Bank for International Settlements (BIS), from February 2007 (when the U.S. subprime mortgage crisis really took hold) and January 2010, the yuan’s real exchange rate rose 10.7%, while the same rate for the dollar dropped 8.1%. These statistics are indicative of an appreciating yuan and a depreciating greenback, the BIS concluded.

In reality, even if China were to immediately revalue its currency overnight, that would not immediately restore the millions of lost American jobs. Nor would it magically restore our economy. In fact, we would likely see precisely the opposite outcome.

Let’s assume that China’s currency is 60% undervalued, as some believe. If Beijing were to immediately bring that to par, everything in this country that we import from China is going to see a price increase of at least that amount – and possibly even more. That would devastate our economy, wiping out the millions of American families that are struggling to make every dollar count right now. It would also seriously crimp – or more likely obliterate – U.S. corporate profits, igniting a new round of layoffs, plant closures and corporate bankruptcies.

The fallout wouldn’t be contained within U.S. borders. Our trading partners would immediately feel the pinch, too, as we bought less and as the price increases rippled their away around the world. It would be bad news for everyone.

And here’s the thing: A hard look behind the numbers demonstrates that this change isn’t necessary anyway.

According to China’s General Administration of Customs, exports increased 24.3% from a year ago to reach $112.1 billion, while imports jumped 66% to $119.3 billion. Furthermore, and despite what Washington wants us to believe, the bulk of China’s trade deficit came from trading activities with Taiwan, South Korea and Japan – not from the United States.

These facts and statistics make several important points. They demonstrate, first and foremost, that the global recovery continues, with worldwide demand on the upswing, But they also prove that China’s domestic demand is accelerating – a far more meaningful development, since it highlights the Asian giant’s emergence as a true economic marketplace.

We’re not the only ones to reach this second conclusion. Olivier Blanchard, ostensibly the chief economist for the financially conservative International Monetary Fund (IMF), said that it was important “that we do not criticize China for its currency policy. What China is now doing is to cut its savings rate to boost domestic demand while re-orienting production to meet increased needs at home. Only in this context can a stronger yuan help China better allocate its resources and prevent economic overheating, thus creating benefits for both the country and the rest of the world.”

This won’t be the last monthly trade deficit that we see Beijing post. Indeed, if you really break down these numbers, you’ll be able to see just why I’m predicting that there will be other deficits in the months to come: Higher domestic demand for crude oil and raw materials accounted for the dominant share of the March deficit, although sharp increases in the number of imported cars and manufacturing parts also contributed to the shortfall.

The best way to profit from these trends is to follow the advice that we’ve been providing in our investment reports here in Money Morning – as well as with the specific investment picks we continue to identify in The Money Map Report, our monthly advisory service. Going forward, the biggest profits will flow from companies operating in the sectors that provide the products, materials and services that China wants and needs. Now, more than ever, the best opportunities will be in the areas that Beijing has identified as being most relevant to China’s continued domestic growth.

The bottom line: This is yet another reason to double your exposure to Asia. Granted, there will be some wild swings … the kind of volatility that will cause some investors to reassess their commitment to their China-oriented investments. Don’t make that kind of mistake. When it comes to long-term growth and profit potential, this is truly the greatest game on the planet and will be for many years to come.

[Editor's Note: If you find this unique perspective and detailed analysis to be valuable, you might want to check out our monthly advisory service, The Money Map Report. Please click here for more information.]

News and Related Story Links:

• Reuters/Yahoo News:
  Yuan rise still on cards despite rare trade deficit.
• Bank for International Settlements:
  Official Web Site.
• China News and Reports:
  A Stable Yuan Contributes to Global Recovery.
• Atlantic Council:
  Official Web Site.
• General Administration of Customs:
  Official Web Site.
• International Monetary Fund:
  Official Web Site.
• Olivier Blanchard:
  Official IMF Bio.