There is no doubt that the global economic environment presents a very bleak outlook.  The National Bureau of Economic Research (NBER) last week announced that the U.S. economy has been in a recession since last December – a situation that appears to be getting worse, given that the economy lost half a million jobs lost half a million jobs in November. Interestingly, the market traded up both those announcements.
On Nov. 24, Hewlett-Packard Co. (NYSE: HPQ) reported a quarterly profit of $1.03 a share, exceeding analysts’ estimates of $1.01 a share.  Hewlett-Packard almost doubled its revenue from technology services from last year because of its acquisition of Electronic Data Systems Corp. earlier this year, and a 21% increase in quarterly sales of notebook computers and a 10% rise in personal computer sales.

You read that right: Hewlett-Packard recorded a big jump in three key business areas – during a recession.

These impressive results are due to Hewlett-Packard outperforming its peers with superior products and exemplary execution. What’s more, Hewlett-Packard has been an early adopter of some of the fastest chips for servers – the “Shanghai” chip by Advanced Micro Devices Inc. (AMD), which just leapfrogged the offerings of arch-rival Intel Corp. (INTC) in terms of both speed and market share.

In its core printer and server business units, Hewlett-Packard actually experienced a slight contraction in businesses.

The key to Hewlett-Packard’s better-than-expected results is the large proportion of recurring services and supplies, which are much less vulnerable to a contraction in economic activities.  You need to keep your systems running with the up-to-date software and maintenance services and you need to keep buying ink for your printers.  This recurrent income smoothes out earnings and is a blessing for companies like Hewlett-Packard, International Business Machines Corp. (IBM), Automatic Data Processing (ADP) and others, which benefit greatly from such sustainable income streams.

In this light, Hewlett-Packard’s management not only blew away its earnings estimates, but also came out with a much stronger-than-expected guidance.  Well, the market was overbought that day and the stock sold off the next day.  The word dropped by some was that the analyst community did not believe Hewlett-Packard’s rosy outlook.  But the reality is that the market had anticipated Hewlett-Packard’s strong results and bid up Hewlett-Packard’s stock ahead of the announcement.

So far so good, but what about the future?  Mark V. Hurd, Hewlett-Packard’s president, expects to be able to cut $1 billion in expenses in 2009 from redundancies from the EDS acquisition that he will be eliminating.  And Hurd has shown a strong track record in this sense since he took the helm in 2005. 

So the question is how much faster Hurd can cut costs to compensate for the reduction in economic activity, in case things keep getting worse as they very likely will in the first quarter of 2009.  But there is some hope that the incoming Barack Obama Administration will add to the aggressive monetary and fiscal stimulus already approved and only partially implemented by the current administration.  In any case its positive effects are only starting to be seen.

And the other question is how much downside has the market already discounted in Hewlett-Packard’s shares, which are down 38% from their 52-week high of $52.90. Well, with a trailing Price/Earnings (P/E) ratio of only 10.0 and a P/E to Growth Rate (PEG) ratio of 0.7 for this very resilient profit stream in a company characterized for flawless execution, Hewlett-Packard is a steal.  This can also be said for most of the market, which is in panic state, taking refuge in government bonds yielding almost zero. 

This last phenomenon has been referred to by Mohamed El Arian, co-Chief Executive Officer of PIMCO as a U.S. Treasury bubble. And in times of panic, it is a good idea to buy.  So I will unequivocally recommend buying HPQ in increments.  I would buy one-fifth of my position on weak days prior to year end – accumulating half our position – leaving the last half for purchase in the first quarter of 2009.

 ACTION TO TAKE: BUY Hewlett-Packard Co. (NYSE: HPQ), but do so with some care. Purchase two-thirds of your position between now and year-end, and the final third during the first quarter of the New Year. **

Editor’s Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises – cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]
** Special Note of Disclosure: Horacio Marquez holds no interest in Hewlett-Packard Co.

News and Related Story Links:

• Money Morning:
  Obama Unveils Economic Team, Plans 2009 Stimulus Package.

When – on August 22, 1851 – schooner-yacht America defeated 15 other yachts representing the Royal Yacht Squadron, racing around the Isle of Wight in England to win the renamed “America’s Cup,” Queen Victoria asked who was second.  The famous answer was: "Ah, Your Majesty, there is no second."

Similarly, in the search-engine category, Google Inc. (Nasdaq: GOOG), has run away with the trophy, leaving its competitors so far behind that they’re actually still over the horizon. Today, Google controls at least 60% of the search activity on the Internet, eclipsing all its rivals, most notably, Yahoo! Inc. (Nasdaq: YHOO), whose market share hovers around 20%.

And in an even more important landmark: Since the middle of the year, Google has finally been topping content-heavy Yahoo.

In fact, October traffic data released by comScore Inc. (Nasdaq: SCOR) showed Google growing to 147 million visitors, an advance of 12%, over the past year, versus only 6% growth for Yahoo. Google, with the increased ability to meet the new information needs of the public, is clearly gaining momentum.  Can you live through a single day without Googling? Probably not.

Also, this search engine dominance allowed Google to veer away from establishing an ad search partnership with Yahoo, which would have posed a significant regulatory problem, creating a controversial and administrative morass that would have diverted critical time and resources away from its mission.

Google’s success increasingly extends to new initiatives: Cloud computing, Internet telephony, search-sensitive ads just launched in the Google-owned You Tube LLC, and the recently-launched GPhone.  These are all extension strategies of its dominant presence in search on the Web, and Google is now pushing them aggressively to increase its ability to monetize them. For example, Google is now offering voice-recognition Web search in the IPhone.  And this soon will come to the GPhone.  So the Internet-search war has been quickly expanded.

Economic Backdrop

In the financial systems of the developed world, as well as in some unprepared emerging markets, valuations have collapsed.  What’s more, given the news, we expect no change anytime soon, for it will take months for the more than $3.5 trillion in global stimulus packages to take effect. In the meantime, job losses will keep escalating, especially in the United States, since unemployment typically peaks after a recession ends. It is a lagging indicator.  The financial markets typically discount the situation some six months ahead of an actual uptick in the economy.

And in this situation, where many leveraged institutional players were forced to dump the good with the bad, tons of apparently cheap stocks have hit the radar screens of value players have entered the radar screens of value players.  And Google is one of them.

Google, with a forward Price/Earnings (P/E) ratio of only 14.0 and a Price/Earnings to Growth Rate (PEG) ratio of less than one 1.0, is a one-time momentum play that is now a value play. And since it traded at $700 a share a year ago, it appears to be very cheap, and to have most of next year’s economic slowdown already built into its current price. Indeed, it’s quite possible that even if the economy does slow, some or all of Google’s new growth initiatives could generate a revenue or profit surprise.

The shares closed Friday at $262.43.

The company recently beat Wall Street expectations quite handily, with profits for the quarter ended in September rising to $1.35 billion, or $4.24 a share, from $1.07 billion, or $3.38 a share. 

Revenue rose 31% from last year, even though it was up only 3% sequentially.

Google is well-managed, is very resourceful and has plenty of maneuvering room. Its managers wisely started controlling costs by reining in expense growth, long the focus of criticism by Wall Street. And it has accelerated the monetization of some of the new initiatives. For instance, even though the economy’s slowdown has weakened consumer spending, competition by advertisers for performance-driven pricing is going to drive pricing-per-click up in the year-end shopping season.

In addition, Google’s vast dominance in its home U.S. market still leaves it room to grow in the rest of the world, including such promising markets as Japan and China, where it lags the market leaders. And the name of the game for global growth next year will be the emerging markets. These economies, even though they have been hit by the global financial crisis, have recently implemented strong stimulus plans, which will create growth opportunities as they take hold.

Google’s afore-mentioned “cloud computing” initiative, which involves having users utilize software and computing resources located in Google’s servers for a fee, as opposed as having to buy and manage their own software, is no longer laughed at: Google has recently achieved gains over Microsoft Corp. (Nasdaq: MSFT), with important enterprise clients adopting some of Google’s e-mail services, and dropping Microsoft Exchange and Outlook.

In an economy where cost-cutting is increasingly important, the opportunity to adopt Google’s lower-priced initiatives becomes increasingly attractive to an ever-growing population of small and medium-sized companies that are looking to control expenses.

Microsoft has responded by launching its own cloud computing initiative, Azure, in order to hedge its bets.  But the tide is turning away from boxed software towards cloud computing, meaning Google is clearly ahead once more.

Finally, Google’s GPhone is 10% cheaper than the rivaling Apple Inc.’s (Nasdaq: AAPL) iPhone, sports an “open architecture,” and emphasizes fast browsing, G-Mail and Google Calendar. This allows for third-party developers to create all sorts of software to run in it.  Web services and search are integrated across applications, allowing users to jump directly from applications into Web search or Google maps. Another advantage is the data plan, starting at only $25 a month.  The GPhone still has some kinks to work out, but in a few months it should be a serious play in the market. [For a view of the Apple iPhone, check out a recent “Buy, Sell or Hold” feature on Apple from Money Morning.]

The bottom line: The temporary slowdown in the rate of ad revenue growth gives us the perfect opportunity to establish a position in Google, at a very attractive valuation, and before the $3.5 trillion worth of global stimulus money starts to work its economic magic. Could Google’s shares tumble more? Sure. Some extreme bears consider $200 as a possibility.  I seriously doubt it could get there.  But we are not going to take the risk.  Determine how much of a position you want to establish. I would buy one-third of the position initially, and then add in on down days, until two-thirds of the position is established by the end of the year. Keep that remaining third ready, just in case we get the low-probability occurrence of seeing it down to $200.

Action to Take: Buy Google Inc. (Nasdaq: GOOG). Buy one third of your position initially, and then add to it on down days, until you complete two thirds of your position by year-end.  Keep the remaining third ready, just in case you get the admitted low-probability occurrence of seeing it down to, or below, the $200-a-share price level. **

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]

** Special Note of Disclosure: Horacio Marquez holds no interest in Google Inc.

News and Related Story Links:

• Money Morning Buy, Sell or Hold Feature:
  Buy, Sell or Hold: Apple Inc.

• Wikipedia:
  Cloud Computing.

• Wikipedia:
  Internet telephony.

• Wikipedia:
  G-Phone.

Apple Inc. (Nasdaq: AAPL) used to rule its niche world and will continue to do so, with lots of room to grow.

As Coldplay’s “I used to rule the world…” played softly on the outside stereo speakers of my sailboat “Southern Cross” as my family and I pleasantly glided by Execution Rock on a gorgeous Sunday afternoon in the Long Island Sound, I could not stop myself from thinking how the song got there.  It was coming out of my daughters’ Apple iPod, interfacing with the boat’s new iPod-ready stereo system.  And I was wondering whether it was time to get into Apple’s stock.  Yes … even on a weekend sail.

Apple in My Home

I have been patiently waiting to get into Apple for a long time. And now the market was tanking, sending good companies’ stock prices down with bad ones to ridiculously low levels, this could be the opportunity I’d been waiting for.

How things have changed. For starters, my three Generation “Y” daughters live connected to the Internet. On the way up to the club, we were listening to a mutually-agreed-to selection of their weeks of music stored in their iPods, which they downloaded from the Apple iTunes store onto their Apple laptop computers, before syncing them into their iPods.

And at home, I can’t move around the house without coming across an Apple laptop left hibernating in the kitchen or living room. They never turn them off and their battery life seems infinite! And they come to life so quickly from hibernation, that whenever I need to consult movie times, I inevitably search them in one of their machines rather than in my top-of-the-line gaming Windows-based one, which I bought precisely to put a premium on speed.

My daughters do their homework on them, consult their school e-mail, download music from iTunes, chat with their friends online and even engage in hour-long free videoconferences on iChat with friends both here and abroad.  And when they are not in their Apple computers or doing homework, they listen to music on their iPods while they clean up their rooms. 

They even burn CDs with their favorite songs for friends.  I thought that this might be a localized phenomenon, restricted to kids in affluent zip codes in the U.S. market. But I found out that my nieces in three other countries are in the Apple loop as well, and when we had my nephew from Germany spending a few weeks with us, he was keeping in touch with his friends in Frankfurt and Italy through the Macs as well.

Talk about a globalized world and a connected generation!

One night, while I diligently worked to keep my personal Windows-based laptop up to speed and secures with the latest anti-virus and software patches to plug the latest virus or exploit, my eldest daughter walked by and vehemently proclaimed, with an air of superiority: “Macs don’t get viruses!  I don’t even need an anti-virus program.”

With my daughter’s verbal gauntlet still hurting, I set to prove her wrong.  Human nature is such that I cannot believe that hackers would somehow not step up to the challenge of hacking into the Mac’s operating system – even just to get bragging rights under their screen name.

Precisely as I am researching this, my antivirus program in my PC is mysteriously disabled.  I would not dare to be connected to the ‘Net for a second without an anti-virus program.  I am really tired of seeing serious hack attempts being flagged by my firewall, coming from all regions of China, South Korea, Japan, Russia and other exotic countries and even from reserved Internet addresses.  I try to enable the program, but it requires a re-boot.  When I re-boot, I update my anti-virus on the background, while working on this article and my AV program tells me I need to re-boot once more. I save my work and re-boot right away. When I re-boot the second time, the anti-virus program launches a full scan and somehow my access to the Internet is slowed to nearly nothing.  I am forced to rest my modem.  It’s taken me a big chunk of time and much aggravation.

Back on the ‘Net, while I find few articles about Mac viruses, I also discover an article about an executive at one of the huge Windows-based anti-virus software leaders that runs his own computing on his Mac – without anti-virus software!  And I also find articles showing how few Macs have ever been compromised.  Apparently, hacking into Macs is high cost and the benefit of doing this is low, because of the low market share they have (around 9%), since most users tend to be individuals, with a preponderance of students and teachers.

That brings me back to my “Buy, Sell or Hold” investigation into Apple Inc.’s shares.

Strong Results

A few days after my family’s sailboat outing, I saw that Apple had posted its strongest results ever. The Cupertino, Calif.-based company said that it’s launching its next generation of Apple computers at higher prices – justified, as usual, by the uniqueness and hard-earned “coolness” factor that’s inherent in Apple machines.

Additionally, Apple just got Best Buy Co. Inc. (NYSE: BBY) to start selling its popular Apple iPhone in its chain of Best Buy electronics stores. And with Apple currently sitting on a $25 billion cash hoard, and having no debt, the speculation now is that Apple will launch a huge stock buyback.  After all, given Apple’s uniqueness and innovation excellence, there is little out there that could complement the company and it has a history of eschewing acquisitions.

At Friday’s closing price of $98.24, Apple shares are down about 52% from their 12-month high of $202.96. The stock is trading at 20 times earnings, but with its consistent high earnings growth, the company’s Price/Earnings/Growth Rate (PEG) ratio is less than 1.0, meaning the shares are right now priced at bargain levels.

If those consistent, predictable earnings continue, this stock is an absolute steal. But that raises the question: Will those predictable earnings continue?

For now, at least, the company seems to have all its “ducks in a row.”

While Dell Inc. (Nasdaq: DELL) and other PC makers are suffering, Apple is on a roll.  The iPod continues to rule the MP3 player market and has given birth to an entirely new, higher-end, higher-margin product, the iPhone.  The iPhone – and to a lesser, but still-important extent, Apple computers – have each been a tremendous success.

In the last quarter, Apple sold nearly 7 million units, more than five times the number of phones than in the same quarter last year.  This points to major market share gains from the estimates as recent as May. For a look at these market-share estimates, let’s take a look at Chart I:

Chart I: Wireless Phone Market Shares (By Brand)

56% Symbian (primarily Nokia)
13% Windows Mobile
12% RIMM Blackberry
9% LINUX
7% MAC (iPhone)
2% Palm
1% other
Source: Industry statistics, Money Morning Staff Research.

More importantly, Apple has recently been selling more units than the king of the enterprise-mobile phone segment, Research in Motion Ltd. (Nasdaq: RIMM) lately.  The mobile phone market is huge and has been almost doubling in size year after year.  And although growth is expected to slow a bit in the future, the profit possibilities remain huge.  Could these market growth numbers and Apple’s share gains be maintained?

To get a better idea, I started by studying the worldwide market-share sales projections for the “smartphone” market. Admittedly, these statistics harken back from before the current financial crisis really took hold in the past month or so. Still, it’s a good starting point. Let’s take a look at Chart II:

Chart II: Projected Global “Smartphone” Sales

The year-by-year and projected annual breakdown of global smartphone sales between both the high-end consumer and conventional corporate users (in millions of units).

Year          Corporate          High End Consumer         
2006 :                     12            +              39
2007                       21            +              77
2008                       40            +            134
2009                       74            +            219
2010                     111            +            300
Sources: Industry Statistics, Money Morning staff research.

The Competitive Landscape

To make some sense of the competitive landscape the Apple iPhone is facing, I called my friend Brenda Lewis, principal in Transactions Marketing, Inc., and a venture manager who has launched many mission-critical wireless businesses and who lives and breathes mobile phones.  I wanted to validate the industry forecasts for growth in “smartphones” – both for high-end consumers and for enterprise users.  I shared my forecasts and what I heard from Brenda was eye opening.

 “These forecasts for the high-end consumer are far too high now, especially given the lack of personal discretionary income in most markets,” she told me.

Of course, she is right.  Personal discretionary income has likely gone negative in the U.S. market because of high household debt and the need to replace lost retirement savings. But it’s also severely reduced in Europe and Japan, because of lower trade flows and job losses due to the global downturn.

Even so, there are roughly $5 trillion worth of stimulus packages that have been committed to the overall global economy by various governments around the world.  And we can expect to start seeing the benefits of those liquidity infusions very soon.

So the picture and slowdown we are feeling right now will “surprisingly” improve in about six months. In the meantime, economic numbers will be very tough, since the financial freeze brought the economy to an abrupt stop and unemployment is likely to spike – even from the already-increased levels we’re seeing right now.

Economic inertia is hard to shift quickly.

So until the economy turns around, it’s wise to consider other possible catalysts. For instance, what about the possibility that corporate users could adopt the Apple iPhone?  My hopes for being the discoverer of that as-yet-unknown-by-Wall Street catalyst were likely dimmed by Brenda, who said that corporate chief information officers (CIOs) “will likely use the downturn as a reason to reduce the number of devices permitted for enterprise use and to consolidate central CIO control of current business unit devices, a continuation of a trend of the past five years.”

Again, the enterprise-market segment, which she knows intimately, has two main concerns:

• Total cost of ownership, which includes the initial price for the phone, as well as the service and, very importantly the maintenance.

• Data security.

The latter one is a killer for the iPhone in the enterprise market, since corporate IT departments cannot remotely shut down iPhones that are lost or are stolen as they are able to do with Research in Motion-made Blackberries. In addition, the locked nature of the iPhone makes it very difficult for IT departments to customize solutions for company use.

So, while the iPhone is superb from the consumer standpoint for its “coolness” factor and functionality, and for the fashion statement they make for those who wear them in visible locations, Blackberries actually accomplishes many more business-critical functions for corporations, and at a lower cost. This means that Apple’s traditional consumer focus – a niche that it dominates – is shrewdly placed.

Competitive Threats for the iPhone

What about risks to the Apple iPhone’s success in its own turf – the high-end consumer?

Well, for starters, Apple faces many brewing challenges: For instance, Wal-Mart Stores Inc. (NYSE: WMT) is starting its own online music-download service, and will undercut the Apple iTunes prices by about 25%.

Wireless phone heavyweight Nokia Corp. (ADR: NOK) is operating a similar story overseas, and it is unclear how long it will take them to come to the U.S. market. More ominous is the ultra-secret plans of Internet-search behemoth Google Inc. (Nasdaq: GOOG), which has launched its own branded Google Phone, which will be sold by Walmart at a discounted price of  $148 (compared with a price of $199.99 for the Apple iPhone at Best Buy, for example).

The Google Phone is revolutionary and appeals to the spirit of the U.S. “techie” crowd: freedom.  It is designed with an operating system, called Android, that’s been tagged with the marketing slogan – “apps (applications) without walls.” The whole goal of the device is to speed up users’ ability to access and surf the Web via a mobile phone – all too often a very slow process, right now.

The Google phone also emphasizes the hottest trend in phones today, with the ability to provide “location services,” such as customized weather forecasts, directions and listings of nearby businesses and attractions.  Finally, the operating system is, unlike Apple’s, is “open source.” This means that it will be extremely easy for anyone to develop new applications for the phone and for corporate IT departments to create customized applications for their employees to use on the phones. There’s even an alliance of software developers – called the “Open Handset Alliance” – whose chief goal is to encourage such custom developments.

As if this new threat were not enough, Nokia, the king of the mobile consumer market, announced its Nokia Tube (5800). Research in Motion is adding to its Blackberry lineup with a newly launched iPhone competitor called Bold. And Samsung Electronics Ltd. is coming out with its entrant, Instinct, a touch-screen phone with some features that are not available in the iPhone, like streaming TV.

And even Garmin Ltd. (Nasdaq: GRMN), the ruler of the GPS device world – and the topic of a recent, well-read “Buy, Sell or Hold” feature here in Money Morning, has launched its nüvifone, that, unlike the iPhone, it gives you turn-by-turn directions.

My conclusion is that Apple’s iPhone business will continue its strong growth, but that the growth won’t be as strong as Wall Street recently projected. There will be market growth concerns in the near future, and with rivals ganging up on the successful iPhone, some of the market-share-gain momentum that we’ve recently seen will be blunted a bit in the future, although Apple will keep gaining absolute market share.

What about their computers?  Enjoying the synergistic “halo effect” from its iPod, iPhone and iTunes strategy, Apple keeps gaining market share in the computer market. Another Apple hit was its adoption of Intel chips that can run the Mac OS X, Leopard, and Windows Vista operating systems in the same machine, even simultaneously, with virtualization software.

I am encouraged by these machines, but not exuberantly so. Apple now faces very serious price competition from Windows-only systems.  But on the other hand, the segmentation of the market is critical and the ease of use, maintenance, fast recovery from hibernation, advantage in graphic-intensive tasks, intuitive use and virus-free environment make a Mac irresistible for its traditional constituents, provided they will keep paying the very steep Mac premium pricing.

The conclusion is that, moving forward, with 41% of sales coming from abroad and very small absolute market shares in its key iPhone and Mac businesses, Apple is very likely to be able to continue to gain market share, albeit at lesser pace. Also, given its consumer-centric focus, as the consumer gets hit in developed countries, sales growth will wither, while growth in emerging markets actually can accelerate.

Apple is not a pure computer company any longer, but is instead a consumer products company – and one that possesses a very cohesive strategy. That’s what will allow it to continue to survive and thrive.

The stock – with a PEG ratio of less than 1.0, is a bargain right here. But in the highly volatile environment, wait for weakness to start accumulating it, and take your time.  Apple’s results are much less dependent on the iPod today, and thus the soon-to-be revealed disappointing Christmas season is nowhere as important as it used to be.  So I would buy two-thirds of my position prior to year-end and the remaining third over the subsequent three months in the first quarter, as the bad news over the economy keep trickling in.

ACTION TO TAKE: BUY Apple Inc. (Nasdaq: AAPL), but do so with some care. Purchase two-thirds of your position between now and year-end, and the final third during the first quarter of the New Year.

News and Related Story Links:

• Wikipedia:
  Apple iPod.

• Web Site:
  Blackberry.

• Web Site:
  Open Handset Alliance.

• Web Site:
  Apple iPhone.

•  AT&T Wireless:
  Blackberry Bold.

• Money Morning Stock Analysis Feature:
  Buy, Sell or Hold: Garmin Ltd..

• Garmin.com:
  nüvifone.

Brazil’s economy has been given a second chance. And so have prospective investors.

Brazil will use that second chance well – shouldn’t we?

Although there are a number of ways to play this promising “BRIC” (Brazil, Russia, India and China) market, including some excellent companies, the best way to capitalize on Brazil’s terrific prospects is through the iShares MSCI Brazil Index (NYSE: EWZ).

In this special in-depth report – in which you will benefit from my special emerging markets expertise – I will demonstrate just why you will want to by this exchange-traded fund (ETF) in increasing increments between now and the end of the year. The report is longer – and more detailed – than the typical Money Morning “Buy, Sell or Hold” report. But this feature has proven so popular, and the following so enthusiastic, that in the midst of this volatile and very-trying market we thought we should go out of our way to offer our loyal following something very special. This report is the result of our wish to show you our gratitude.

My Brazil Story

It was February 1994, and I was discussing Brazil with the chief operating officer of a second-tier Wall Street investment house – one that specialized in high yield and emerging markets bonds. I remember looking directly at him and saying: “I believe Brazil will have no option other than to default or devalue its currency – possibly both.”

My words caught him by surprise and he called the head of the investment-banking firm into our meeting. At that moment, this firm happened to have more than 50% of its trading book playing the “carry trade” in Brazil.  That is, they were borrowing in Japanese Yen at very low rates and were investing the proceeds in Brazil – at the time, and consistently since then, one of the highest-yielding currencies in the world. The trade has been a winner for more than 15 years whenever the markets are relatively stable.  A sudden forced unwinding of that trade would have been extremely damaging for that bank.

I had just successfully predicted the blow-ups of both Argentina (August 1994) and Mexico (December 1994) and managed to minimize any damage from such financially horrific events, thanks to the superb team I was a member of at Merrill Lynch & Co. Inc.’s (MER) Asset Management unit. The accuracy of my predictions had been a real surprise – even to me, I’ll admit. My estimate was correct within three weeks of the actual blow-up. Now, I was very concerned about Brazil succumbing to the “contagion” effect.

In fact, I was so concerned that I had used my January vacation to travel down to my native Argentina – to visit relatives but also to check on the situation with the Ministry of Economics, the central bank and the heads of the top three Argentine banks to gauge the possible future ramifications of the Argentine fiscal crisis and the “Tequila Effect”.

I also stopped by Brazil on my way back to the United States and conducted my personal “due diligence” in that market, too. I met with the top three banks and the top local brokers, some government officials, a former head of Brazil’s central banks and a local hedge fund.  The Brazilians were all convinced that – even though the country was under extreme financial pressure from the markets – it would resist the economic and financial pressures then sweeping the region, and wouldn’t be force to devalue is currency, known as the “Real.”

At the time, derivatives contracts on the Brazilian Real had the largest open interest of all the derivatives contacts traded on the Chicago Mercantile Exchange, evidencing the incredible fight over the value of the currency that was playing out in the marketplace.  In Brazil, a similar fight was taking place, with a huge number of local players buying protection against devaluation in the forward markets.

I did not believe them.  I thought that surely the private sector would flinch, taking their currency in droves out of the country and forcing the government to devalue.

But Brazil was hanging on. Who was selling the protection?  I found out: It was the government banks, defending the currency with all their firepower, knowing that they had green light from the government, who would recapitalize them if needed.  The private sector did not panic.  Brazil held on.

Fortunately, on this part of the “Tequila Effect,” I was wrong and Brazil survived the contagion to actually thrive. I missed the first third of a zooming “gapping up” rally on the table (missing out on the profits that would have come with that near-vertical jump). But I learned a valuable lesson as I watched the first part of that rally.

I realized that Brazil had made the tough, gradual adjustments on the fiscal side and stuck to defending the stability of its financial system, evidencing a very strong resolve from the locals to stand behind their country. And I learned to recognize those patterns when they appeared again. As they have.

Suddenly, the motto on Brazil’s flag, “ordem e progresso” (order and progress) did not seem far-fetched, as it had been during the second half of the 20th century.

In fact, in Brazil, the phrase “O mais grande do mundo,” which means “the biggest in the world,” is considered locally as the national slogan and is used commonly with national pride.  Indeed, from the powerful Amazon River, to its iron ore reserves, to its incredible rain forest, Brazil has been richly endowed.  And although economic and political disorder has delayed its development for decades, Brazilian ambition has never died.  No wonder the national joke during the last couple of decades of the last century was that “Brazil is the country of the future…and it will always be.”

Even during this period, when there was no outward progress taking place, there were profound internal changes that were under way.

During the subsequent five years, many other crises reverberated around the world, and we watched as Russia and Asia – including South Korea – blew up. While it’s true that Brazil has sold off violently in response to external events or occasional internal problems, it’s important to note that Brazil has never defaulted on its debt nor resorted to a major devaluation as a policy response – unlike its nearby South American neighbor, Argentina. In Brazil, there was clearly a commitment to become a serious, orderly country. 

The only two pronounced incidents of weakness involving the Brazilian Real came as its  Mercosur partner Argentina defaulted and devalued its own currency by a three to one ratio at the end of 2001, and in a second episode toward the second half of 2002, in anticipation to the inauguration of current President Luiz Inácio Lula da Silva, known by his nickname “Lula,” since the markets believed he would lead Brazil deep into leftist policies.

In both those instances, the markets (and investors) were once again wrong to bet against Brazil. The Real came back every time, especially after President Lula launched one of the most responsible fiscal and monetary policies in the world, and also deepened structural reforms.

At the time, a friend of mine traveled to Brazil with the CEO of a major U.S. company that invests heavily in Brazil to find out what Lula would do.  Would he turn Brazil into an economic island or would he keep Brazil on track?  They came back from Brazil very pleased.  And we have all been pleased with Brazil’s order and progress since then.

Even during the “Goldilocks” stretch of the commodities boom, Brazil kept its interest rates high in real terms, avoiding any possibility of an overheated economy, bringing inflation and managing its economic house with an efficiency that some of the world’s most advanced economies could learn a thing or two from.

And Brazil achieved all of this while its major commodity and industrial exporters continued to invest heavily, expanding both their domestic sales and exports quite smartly.

Brazil’s Shrewd Game Plan for the Current Financial Crisis

Vale (ADR NYSE: RIO), formerly known as Companhia Vale Rio Doce, is the largest exporter of iron ore in the world. It has thrived and continued to expand production of this critical resource, supplying China, Japan, Europe and other major global steel-making operations.  The story behind Petroleo Brasileiro SA (ADR NYSE: PBR) is even more impressive: After decades of government initiatives focusing on oil self-sufficiency – which includes deep-sea drilling and the now-vaunted sugar-cane ethanol program – Brazil achieved that goal last year. Now, with the biggest oil discoveries in the world in decades, Brazil is well on its way to becoming an oil superpower. 

As President Lula said, “God has given Brazil one more chance.”

And us, as well.

Late last week, Brazil’s hopelessly mismanaged neighbor, Argentina, had to seize its privatized pension fund money in order to meet its fiscal obligations. We’re also watching as Hungary, Belarus and the Ukraine approach the International Monetary Fund (IMF) for help.  This directly contrasts with Brazil, which has amassed $200 billion in foreign reserves, having become a net creditor of the world.

 So, in this crisis, both the Central Bank of Brazil and the Brazilian government have acted very quickly to backstop the liquidity effects against their banks.  The Central Bank of Brazil has been continuously superbly managed, despite changing administrations: and is very experienced in crisis management. It is currently managed by Henrique Meirelles, a highly experienced and greatly respected international banker. Meirelles has operated in the tradition of Brazil’s inflation-fighting central-banking pioneer Gustavo Franco.  Franco was one of the economic advisers who put together the Plano Real, which brought Brazilian inflation down dramatically under former President Fernando Henrique Cardoso. Franco was followed at the Central Bank by Arminio Fraga, formerly associated with George Soros in the Quantum Fund, and finally by Meirelles, who was formerly with Fleet Bank.

It’s important to note that the Lula administration has many officials who have previously held senior positions with major international banks.  This is a clear indication of professionalism, transparency and commitment to serious macroeconomic and monetary policy management.  No more “brincadeira” – playing around.

President Lula went on to say that the government will buy bank stakes in order to shield its financial institutions from the global crisis.  This is happening today, as the government’s largest banks have been authorized to buy stakes in Brazilian banks.  Much like the U.S. Federal Reserve has done in here in the United States, the Brazilian Central Bank also has been authorized to enter into swap operations with other central banks in order to restore liquidity to the Real, which has been under pressure.

To add further liquidity, the Brazilian Central Bank has reduced minimum reserve requirements for the banks, extended an almost $2 billion line to the banking system to finance exporters and injected some $71 billion to ease liquidity.  The Central Bank explicitly requires the banks to lend the money and monitors closely their activities to prevent them from instead using the capital to buy – and sit on – government bonds.

The Brazilian Central Bank also has had to resort to selling only about $23 billion of its more than $200 billion in total reserves, in order to cushion the decline of the Brazilian Real. The upshot: Brazil today operates from a position of macroeconomic strength, like China, India and Russia.

And the Central Bank has stimulated housing by easing liquidity requirements and encouraging banks to lend more.  This policy will soon gather more strength.
Similarly, the government banks, rather than international investors, are the most likely to finance a huge electricity project coming for bid. And Brazil’s plans for a major infrastructure build-up should not have problems obtaining financing. 

For example, Petrobras should easily be able to finance the estimated $163 billion needed over five years to continue developing its ambitious mega-oil project out of its own cash flow, government and bank financing and profit-sharing arrangements where it chooses.   Vale and other major exporters should likewise have little difficulty in moving forward. These companies, like the government, are committed to continuing with their long-term investment plans, despite the current problems.

Nor have Brazil’s market-supporting measures stopped there. Brazil has required all companies to report their derivatives positions and even to estimate future potential losses under certain scenarios on a quarterly basis, starting immediately.  This will greatly increase transparency, dispel fears and increase confidence.  Some companies saw their currency derivatives positions get hit hard in the recent sell-off.  But these hits, which in some notable cases wiped out the quarter’s profits, are a one-time effect, so it represents a buying opportunity in those stocks.

Finally, the Brazilian banking system is sound, with strong capitalization and low delinquencies.  Credit expansion has been strong in the recent years, but not overdone.  And banks like Spain’s Banco Santander SA (ADR NYSE: STD), government banks and others are taking advantage of the crisis to buy loan portfolios from their weaker rivals, as has been the case in most liquidity crunches in emerging markets.

The critics will refer to this crisis as the first major test for Lula.  And many doubt whether he will resist the temptation to throw monetary and fiscal prudence out the window.  But Brazil, as has been seen for decades, is much more than just Lula.  Its technocratic administration and central bank have decades of experience in crisis management. Brazil’s strong local companies, which are world leaders in many industries, and committed investors, including major multinational companies, are heavily vested in the country’s success.

Going for Growth

As the Brazilian government has done in the past, I expect it to stay the course for the long term, to maintain its inflation-targeting discipline (as the Central Bank recently announced), and stimulate its economy as inflation drops markedly. That will keep Brazil in the running to be one the engines of growth in the world for the next couple of decades. 

As we’ve seen, the country’s prudent monetary and fiscal policies, coupled with its solid macroeconomic position, strong reserve position, and controlled inflation will lead to good growth. Gross domestic product  (GDP) is expected advance at a rate of between 4% and 5% next year. And since only 13% of GDP comes from exports, Brazil will have lots of room to maneuver.  The slowdown in the advanced economies will give Brazil – as well as India, Russia and other emerging economies – room to start cutting domestic rates as inflation abates, just as China is doing right now.

In China, savings are 10% of GDP more than investment, so a slowdown in foreign capital inflow to China is a blessing, since it will allow the Beijing government to deploy its own capital to work and increase China’s internally driven growth as opposed to export-driven growth.  The same phenomenon will be pervasive throughout the emerging markets that – like Brazil, India and China – have not squandered their newly found wealth.

Hence, at the current prices, Brazil is – if you’ll pardon the Wall Street slang – a “screaming buy.”  In fact, as we speak, foreign investors are flying in droves to Brazil to buy beachfront property at a discount.  Prices of financial and real assets have been hit by excessive fears of a Global Depression.  When you see that G7 nations have injected more than $3 trillion into their economies in order to backstop the credit crunch, and another economic stimulus plan in the United States is almost a given, you have to realize that this will have an enormous positive impact on the fragile global market situation we are seeing today.  As the credit markets thaw out, despite ongoing hedge-fund de-leveraging, we will see renewed waves of buying and Brazilian financial assets will be amongst the biggest winners.  Do not be left to watch from the sidelines as I once was.

Recommendation:  Buy iShares MSCI Brazil Index (NYSE: EWZ) in increasing increments over the next eight weeks.  This means that you will be increasing the amount of money deployed every week, until you’ve invested the total amount that you’ve set aside for this ETF purchase, between now and the end of the year.

News and Related Story Links:

• Money Morning Special BRIC Report (Part I):
  Special Report: Hit the BRICs for a Global-Investing Double Play.

• Money Morning Special BRIC Report (Part II):
  Special Report: Hit the BRICs for a Global-Investing Double Play.

• Investopedia:
  carry trade.

• Brazil.com:
  The Real Currency Unit.

• Wikipedia:

  Henrique Meirelles.

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as PepsiCo Inc. (NYSE: PEP), Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]

** Special Note of Disclosure: Horacio Marquez holds no interest in iShares MSCI Brazil Index.

PepsiCo Inc. (NYSE: PEP) shares plunged 12% in a single day last Tuesday – their worst one-day showing in 26 years – after the world’s largest snack maker and No. 2 soft-drink producer announced it would slash 3,300 jobs after its profits fell more than expected for the quarter and it lowered its forecast for the rest of the year.

The shares, which have traded as high as $79.79 during the past 12 months, closed Friday at $53.88. Pepsi’s 52-week low is $50.65.
Allow me to get right to the point. There’s been a lot of talk about this being the “opportunity of a generation” in the U.S. stock market. To make that comment about all U.S. stocks – across the board – is a major overstatement.

But there truly are some generational opportunities with certain specific stocks and entire sectors. And Pepsi – one of the world’s strongest consumer franchises, with a history that reaches back a century – clearly fits that bill.

To understand how we reached this point, some insight on the current mindset of the market is needed.

The U.S. stock market is in complete disarray right now.  Waves of selling are interrupted by strong short-covering rallies and pronounced lulls.  In this environment, with volatility at an all-time record, it’s difficult to talk about trading.  By the time I establish and explain one strategy, a new development in this rapidly moving environment has changed the rules, requiring traders to develop a new strategy.

But history tells us that the massive sell-off in stocks is similar in magnitude to the average sell-off since 1890.  And value indicators already have been screaming, “Buy” for months. The market is terribly oversold and offers tons of value as banks, hedge funds and other leveraged investors have been forced to sell – not because of fundamentals – but because of losses they’ve taken (and, in some cases, continue to take) in unrelated investments that force margin calls.

Here’s the problem. In a market such as this one, traditional measures – such as the afore-mentioned value indicators (such ratios as Price/Earnings, Price/Book Value, Price/Sales, and others) – often don’t work as they should. That makes bargain-hunting a much-more challenging – and potentially risky – exercise. As you’ll soon see, we’ve factored this lack of predictability into our strategy for this stock.

In a market such as this one, the problem is that emotions have taken over, and are now ruling the “thinking” that individual investors are using to guide their buying-and-selling decisions. When that happens, you can almost be sure that individual investors will invariably make their moves – and at precisely the wrong moments (selling when should be buying, and buying when they, in fact, should be selling). This is something you can count upon (for instance, nobody was selling their homes at the top, nor buying the market in the 2002 recession).

This time around, the cause of this systemic sell-off is the fragility of the over-leveraged financial system – and not the long-term viability of the U.S. economy as a whole.  When banks are not lending to one another – and are instead hoarding that potentially lendable cash, because they distrust the financial condition of their counterparty – the blood that feeds the U.S. economy (credit) ceases to flow, choking off economic growth.

And we have already seen increasingly aggressive policy responses by governments and central banks from all around the world.  These policies have enough firepower to blunt the sell-off, to reverse it, and to jump-start economic growth by the middle of next year.
Under such circumstances, good companies are being sold off along with bad ones for two reasons:

• Weak companies will founder in the crisis and “good” companies are sold to meet margin requirements of the few institutions that remain brave enough (or foolish enough) to remain leveraged in this environment, because they wish to maintain at least a portion of their positions.

• The same thing happens because of institutions that were trapped with high leverage, and are therefore now trying to hang onto their positions, praying for a quick turnaround.  Most leveraged players, however, are forced to raise liquidity to meet obligations or merely for panic.

It is precisely in these very volatile and difficult circumstances that investors seek to find the babies that have been thrown out with the bathwater. Enter the Purchase, N.Y.-based PepsiCo.

Founded in 1898, the company has navigated recessions, the Great Depression, two World Wars, and every crisis that’s touched the United States. And Pepsi came out stronger every time.  And with good reason: PepsiCo’s products are consumer non-cyclicals that suffer very little even in the worst economic times.

But the company just reported third-quarter profits that were down 9.6%, missing analysts’ estimates by 2 cents.  This compares to the 14% profit rise reported by archrival The Coca-Cola Co. (NYSE: KO), which beat earnings estimates by 6 cents in the same quarter.

Both companies are cutting costs, and Pepsi will be trimming some 3,300 jobs, or about 1.8% of its global work force, and will shutter as many as six plants.  This will cost between $550 million and $600 million in the fourth quarter, and will save the company $1.2 billion over three years.

Pepsi today has almost 50% of its sales coming from outside the U.S. market, including such economies as Japan, which has seen its currency strengthen substantially against the U.S. dollar over the past several years. What’s more, PepsiCo reported overall sales growth in both the second and third quarters – despite reduced volumes in the U.S. market. The company’s reduction in profit margin, which reversed gains made in the second quarter, has had more to do with the timing of its commodity hedges. Since the second quarter, the price of commodities (which Pepsi very prudently hedges), actually have dropped, which leads us to believe that margins will soon expand, creating a double-barrel benefit when viewed in tandem with the cost-savings being implemented.

While the company’s sales in the United States and in Europe will suffer some additional minor decline – as has been the case in every economic downturn – the benefit from expanding sales in emerging markets, widening margins and new-product introductions will restore Pepsi’s financial leadership position.

Emerging-market growth, even if slower than before, was still being estimated by the International Monetary Fund (IMF) this month at around 6% for next year.  The implementation of the policy responses by G7 countries around the world will be successful in re-liquefying the financial system, and emerging economies have plenty of room in their monetary, fiscal and foreign-trade policies to stimulate their economies.

As they do this, we will see these markets shift overwhelmingly to being driven by internal demand.  Incomes in these regions will continue to increase, and that obviously will translate almost immediately into higher purchases of such former “luxuries” as carbonated soft drinks and snacks such as Fritos Corn Chips.

And with harsh times ahead for the U.S. economy, “staying in” (which some theorists like to call “cocooning”) will trump dining out, which we believe also bodes well for Pepsi sodas and PepsiCo’s mega-brand snacks, produced by its Plano, Tex.-based Frito-Lay subsidiary, the largest snack food company in the world. As families weather the economic storm at home, watching sports events, movies and reality TV, what’s better to help pass the time but sodas and snacks?

That will translate into increased volumes and profits.

And some funds will start investing in the stock well ahead of the expiration of some anti-trust provisions, which will occur in a couple of years, which preclude the distribution of Gatorade by Pepsi bottlers.

Another strong positive of this type of company and specifically of PepsiCo is that in these times of banking illiquidity, cash is king.  And with cash and short-term investments of about $2 billion and a an annual operating cash flow of another $4 billion, Pepsi looks a lot like a money-printing operation, recognized by the strong investment grade ratings of its debt.  PepsiCo’s debt, even in these very distressed times, was trading at merely 200 basis points over U.S. Treasuries, or slightly more than 5%.  The dividend yield – as of Friday’s close – was 3.16%, a payout in line with U.S. Treasuries. But with Pepsi, investors also get all the capital-appreciation potential of a near-bullet-proof company (one that won’t succumb to such calamities as the one that befell American International Group Inc. (NYSE: AIG)), that can actually expand its margins and grow its profits while the United States stumbles through a financial-crisis-induced slowdown.

PepsiCo benefits from its long history of earnings consistency and growth, even in the worst of times.  With the just-announced cost-cutting plan, the company’s management team is working to return to that consistent performance. This long history, combined with the management’s current fix-it plan, will make Pepsi’s shares attractive to institutional buyers seeking stable growth with low risk, despite the recent earnings miss.  Confidence, however, might take some time to rebuild, as the company executes its cost-cutting strategy. 

Pepsi is trading at 13 times earnings and features a somewhat high Price/Earnings to Growth Rate (PEG) ratio of 1.43.  These high quality franchises, with their ability to deliver stable returns over the long haul, are typically terrific purchases in such unusual markets as this one.

Action to Take: Buy PepsiCo Inc. (NYSE: PEP). **

However, given the current market volatility, buy Pepsi’s shares in an increasing percentage as the market moves, by purchasing increasing amounts of the stock over the next 10 weeks, with the goal of holding this for the long-term – for a huge gain.

News and Related Story Links:

• Forbes.com:

  Pepsi Loses Fizz; Merrill Sees $1,500 Gold.

• Bloomberg News:
  U.S. Stocks Fall as Earnings Concern Overshadows Bank Plan.

• Money Morning Market Analysis:
  How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis.

• Money Morning Market Analysis:
  LIBOR Drops But Short-Term Credit Markets Remain Tight.

• Money Morning Market Analysis:
  Federal Reserve Joins Central Banks Around the World in Cutting Rates, but Is It Too Late?

• Money Morning:
  Hot Stocks: Coca-Cola’s Strong International Sales Serve Up Sparkling Third-Quarter Results

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]
** Special Note of Disclosure: Horacio Marquez holds no interest in PepsiCo Inc.

The U.S. financial-services sector is undergoing the broadest restructuring of a single industry in the history of Corporate America, and Bank of America Corp. (NYSE: BAC) has positioned itself to emerge as one of three clear frontrunners. Indeed, along with Citigroup Inc. (NYSE: C) and JPMorgan Chase & Co. (NYSE: JPM), Bank of America could well emerge from this financial maelstrom as one of the premier players on the global stage: All three will benefit from increasing market share and increased financial intermediation margins as their weaker rivals have failed and/or been taken over in part or in total by a stronger industry player.

During the many financial crises that I have analyzed around the world, the result has always been the same: The prudently managed, under-levered institutions that did not overstretch their capital bases and that were able to maintain strong funding not only survived – they ran away with the market.

As unsavory as it sounds, the moral hazard argument of too-big-to-fail also helped them, even in the cases where risk taking had been excessive, as was true with American International Group Inc. (NYSE: AIG).

The huge benefit of being conservative – even boringly so during normal economic times – is that when the economy inevitably turns down, or when the periodic financial crisis strikes (as it has right now), these firms are among the few that actually have the capital available to cherry-pick the “crown jewel” assets of their now-foundering rivals.

Indeed, in the very worst of circumstances – such as the one the U.S. financial-services sector currently faces – strong firms actually are begged to swoop in and use their capital to buy up troubled assets, divisions or whole companies.

It helps immensely to have one of the largest deposit bases in the world, which generates dependable income on a daily basis, even during the worst of times.  This is precisely the case of Bank of America.

On July 1, BofA snapped up the operations of dying mortgage leader Countrywide Financial Corp. Bank of America ended up paying only about $2.5 billion in Bank of America stock in a deal that had actually been announced back on Jan. 11. BofA had actually already invested $2 billion for a 16% stake in Countrywide.

Then came the weekend switcheroo. In a stunning turn of events back on Sept. 15, when investors were watching and waiting for Lehman Brothers Holdings Inc.’s (OTC: LEHMQ) possible acquisition by either Bank of America or Barclays PLC (ADR NYSE: BCS), BofA instead emerged from the weekend announcing that it had struck a deal with Merrill Lynch & Co. Inc.’s (NYSE: MER) President and CEO John A. Thain.  Realizing that the credit crisis had rendered moot the concept of the standalone investment bank, Thain avoided Lehman’s ultimate fate – bankruptcy – agreeing to be bought out by Bank of America. BofA’s Kenneth D. Lewis astutely took full advantage of the opportunity.

He got to acquire Merrill Lynch in an all-stock transaction for a 70% premium over a very depressed Merrill Lynch stock price at about 1.83 times tangible book value, or about $50 billion, less than a third of its own market capitalization.  What’s more, when the transaction closes (probably in the first quarter of 2009), Bank of America will jump from $1.7 trillion in assets to about $2.7 trillion in assets, retaining a strong capitalization ratio.

The transaction is only 3% dilutive for BofA shareholders, and will have some $7 billion in cost-reduction efficiencies: The company will achieve about 20% of those reductions next year, and will have them completed so that it can benefit from them by 2012. The deal also includes about $2.5 billion in amortization and restructuring charges.

With this second transformative purchase, Bank of America will jump from merely being one of the largest banks in the world to being a commercial-and-investment banking powerhouse, one of the first true heavyweights under this new industry model that’s emerged from the current credit crisis. It will have a dominant presence – shared by very few – in such businesses as commercial banking, asset management and investment banking.  In these very uncertain times, size and strength counts for a lot.

Just in retail-brokerage and wealth-and-investment management the figures are staggering. The combined entities will have:

• 20,000 financial advisors, most of which are from Merrill Lynch.
• $2.5 trillion in assets under management.
• 50% ownership in BlackRock Inc. (NYSE: BLK), which in turns manages assets worth $1.4 trillion.
• And the Columbia Management Group LLC fund family, with $425 billion in assets under management

In banking, Bank of America will have a dominant presence on both U.S. coasts, a leadership position in 15 of the 20 fastest-growing states, and relationships with virtually all the leading companies in the United States and most leading companies in the world.

All told, this combination will yield a company that has a very balanced business mix: Global-consumer and small-business banking will still be the dominant segment, despite decreasing to 48% of the total, while global-wealth management and global corporate and investment banking will increase to 32% and 20% of total revenue, respectively.

Very importantly, the failed trading mentality of Merrill Lynch, which under the since-ousted E. Stanley “Stan” O’Neal deviated from its traditionally successful client-brokerage emphasis, a misstep that nearly brought this otherwise successful giant to its knees, will no longer be a major hindrance under the new structure. Indeed, that’s why Thain is being kept on to remain as head of BofA’s Merrill unit.

Bank of America, strongly regulated as a bank, will necessarily continue with its tried-and-true risk-management discipline.

We’ve reviewed all the good news. What about the bad?

Investing in these markets has become extremely tricky.  The volatility that we experienced last week was almost unequalled for decades.  The cause for this volatility is the extreme uncertainties surrounding the hidden risks to the viability of many financial institutions which, in turn, have caused the credit markets to freeze up. This freeze, in turn, has affected both consumer spending and economic growth. This was evidenced in the 26% drop in car sales in September, the 4% drop in August factory orders and the larger-than-expected drop of 159,000 in non-farm payrolls. While the unemployment rate remained at 6.1% the drop was exaggerated by the impact of hurricanes Ike and Gustav in the South, which typically produce initial job losses, but then actually create jobs in subsequent months, due to the necessary reconstruction.

But it is clear that the U.S. Federal Reserve’s much-feared feedback loop from Wall Street to main street finally hit as the forced restructuring of the financial industry proceeded with minimalist government intervention, designed to avoid systemic risk only.  It becomes blatantly evident that the Fed, with the danger of imminent inflation behind, given the collapse of commodity prices and economic activity, needs to use some of the ammunition it kept in its arsenal by lowering rates further to deal with the liquidity shock.  At the same time, the European countries concluded just this past weekend that there needs to be a global response to the crisis that has affected not only the United States, but also markets across the globe, from Europe to Russia to Latin America.

And as the market got out of hand and ground to a halt, as it always goes to extremes, it forced the government to pass the $700 rescue bill.  The key to how fast and how high does the system begin to normalize itself depends upon the pace and details of implementation of this package – as well as how the Fed and other central banks around the world decide to act going forward.  And this is key to dictate the immediate direction of Bank of America’s stock.  I could write another paper on these issues, which are rife with uncertainties.  I am actually a lot more constructive about the beneficial effects in the market of “surprising” policy responses by governments and central banks around the world than what I hear around in the market.

But something we all seem to agree on is that BofA will undoubtedly be one of the winners in the long term.  The company, prior to the Merrill Lynch and Countrywide acquisitions, had already demonstrated signs of increased margins due to a de-leveraging of its balance sheet, moves that had resulted in surprising earnings gains well in excess of market expectations.  The economic backdrop will continue to pose challenges, but the strong ultimately become stronger in crises.  And individuals and institutions will find safe harbor and dependability for their deposits, investment business and loans, and at higher margins than we used to pay as other survivors get more conservative and as the weak perish.

Investing icon Warren Buffet has acquired stakes in three major companies in three weeks, with his characteristic very-long-term view, so I will strongly recommend you to buy Bank of America with the same very-long-term investment horizon.  In the short term, I would take advantage of market volatility to buy in increasing amounts of cash into any market sell-offs on a weekly basis, completing your stock purchases before year end.  The ride will no doubt be very bumpy, since market talk will continue to whipsaw – reflecting elation one minute and despair the next – but don’t let that deter you from your plan.

It’s possible that all of the downside is already factored into BofA’s shares. The July 15 lows haven’t been re-visited, for instance. Even so, pursue this plan shrewdly. In other words, go for it – but prudently.

Action to Take: Buy Bank of America Corp. (NYSE: BAC). **

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]

** Special Note of Disclosure: Horacio Marquez holds no interest in Bank of America Corp.

News and Related Story Links:

• Money Morning Special Investigative Report:
   The Inside Story of the Collapse of AIG .

• Money Morning News Analysis:
  Merrill Lynch’s Thain to Remain with Bank of America.