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How to Profit in Today's Economy: The Debt Paradox

Amid record federal deficits, there are opportunities for investors and consumers.

What it's all about. Faced with a mountain of debt of their own making, U.S. consumers have wasted no time in grabbing a shovel and getting their hands dirty. Frugality is in: The national savings rate has climbed to 6.4% from its low of less than 1.0% in 2005. Total household debt has fallen from its peak at the end of 2007, when it equaled 138% of disposable income.

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The U.S. government, however, continues to pile up IOUs. At the end of 2009, federal debt hit a level equal to 65% of gross domestic product. Stack state- and local-government debt on top of that figure, plus the unfunded promises of Social Security and Medicare, and the sum stretches to vertiginous heights.

Why it's different this time. The days of easy credit won't be back anytime soon, and consumers may never open their wallets as wide as they once did. "People's experiences with excessive debt are likely to stay with them for a long time," says Jeffrey Gundlach, chief executive of the DoubleLine Funds.

At the same time, says Rob Arnott, chairman of Research Affiliates, "the government's debt burden is so large we'll likely see a blend of belt-tightening, default and inflation" as a solution. By "default," he means that the government will likely revise its obligations under Social Security and Medicare by, say, cutting benefits for high-income households and perhaps raising the retirement age. Although a surge in inflation would hasten the process of paying off debt -- by pumping up incomes and tax receipts -- it would also erode savings and contribute to stock-market instability.

How you can profit. High-quality companies that generate a lot of free cash -- such as Microsoft (symbol MSFT) and Coca-Cola (KO) -- are good bets for coping with reduced consumer spending and subdued growth. If you can, boost contributions to your retirement plan, because you may receive lower Social Security benefits at retirement than current schedules suggest. With interest rates so low, this may be a good time to take out a loan, provided your balance sheet is in good shape and you meet the qualifications (see What It Takes to Get a Loan).

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