When I co-wrote The Silk Road to Riches: How You Can Profit by Investing in Asia’s Newfound Prosperity with my colleague Elliott Gue, along with Ivan Martchev, we noted:

Many skeptics will demand more concrete data in support of our conclusions and the underlying assumption upon which our assertions are based. We do not contest the rationality of this point of view, but the reality of structural change is that its evolution begins before hard data becomes available. Far-sighted investors must be ready to explore opportunities before indisputable proof emerges. When it does, everyone will jump at it-or will already have jumped-making it a more difficult, less profitable game. The old axiom that whatever everyone knows is not necessarily worth knowing is another underpinning of this book.

Two years later, the book’s themes are playing out in a big way. And this is only the beginning of the great shift of economic growth leadership from the West to the East. 

One of the arguments presented: the importance of geopolitical change in the investment process and how misreading the signs can cause investors to miss out on great profits.

Russia has proven this. In the past seven-plus years, it’s outperformed every major emerging market in the world by a wide margin. See Silk, 19 December 2007, Russia: Top 2008 Market.

The reason that the majority of investors failed to jump into this bull market early on was the misinterpretation of the structural changes that the country’s leadership was implementing, together with a gross miscalculation of the great bull market in energy and natural resources.

For the longer-term investor, it’s still time to enter Russia, which remains my favorite emerging market. Allocate funds using the Silk Fresh Money Buys below.

Another market/economy that we identified in the book as a potential big winner: Taiwan. Since then, I’ve written extensively on the subject. See Silk, 16 April 2006, A Bridge Across the Straits.

The reason I favor this market: Once normalization with the mainland gets underway (without US interference), China will make sure Taiwan is the recipient of big investments–just as it did with Hong Kong in the past.

The Taiwanese President’s inauguration speech yesterday touched on this argument. He devoted more than a quarter of his speech to the cross-straight relationship.

The president declared that he will respect the will of the people for “no unification and no military confrontation.” He also said that both sides should “face reality and suspend disputes in pursuit of mutual wins.”

It’s important to remember that observing and understating geopolitical change can help investors rake in profits.

Although trying to stay ahead of the markets is our main goal, the following section is an excerpt from The Silk Road to Riches that will help you make more profitable decisions in the future.

Paul Kennedy’s classic, The Rise and Fall of Great Powers, is said to have significantly influenced Chinese strategists. Kennedy’s thesis fits China extremely well: “…wealth and power, or economic strength and military strength, are always relative and should be seen as such. Since they are relative, and since all societies are subject to the inexorable tendency to change, then the international balances can never be still, and it is a folly of statesmanship to assume that they ever would be.” American leaders have not, one can safely assume, taken Kennedy’s book seriously.

The Sino-American relationship operates on two levels, economic and geopolitical. The former can be easily defined: China produces and the US consumes. The latter is more complicated. The two countries share many delicate and complex issues of mutual concern. And on several critical matters the US and China hold conflicting views, further complicating the relationship.

Major conflicts between the two countries stem more from commitments the US has in Asia than from any direct territorial or economic disagreement. US security commitments to Japan, South Korea, and Taiwan form the point from which problems develop.

The avenue for US-China cooperation would broaden if the US gradually disengaged itself from these commitments. This will happen in the next 10 years because the US is the “inheritor of a vast array of strategic commitments which had been made decades earlier, when the nation’s political, economic, and military capacity to influence world affairs seemed so much more assured. In consequence, the United States now runs the risk, so familiar to historians of the rise and fall of previous Great Powers, of what might roughly be called ‘imperial overstretch’: that is to say, decision makers in Washington must face the awkward and enduring fact that the sum total of the United States’ global interests and obligations is nowadays far larger than the country’s power to defend them all simultaneously.”

If the US and China can find common ground, or at least avoid unnecessary confrontation, Asia and the world will be better served. Vigorous and sustainable long-term economic growth will become more viable.

In order to expand its world presence, China has been changing its ways. Chinese international affairs experts and government officials reached the conclusion in 1999 that “China needed to stabilize and improve its relationship with the Unites States, as the single most important country for China’s national interests.”

China is also doing its best to become a more approachable regional player. As David Shambaugh noted, “ …Beijing’s diplomacy has been remarkably adept and nuanced, earning praise around the region…most nations in the region now see China as a good neighbor, a constructive partner, a careful listener, and a no threatening regional power…just a few years ago, many of China’s neighbors voiced growing concerns about the possibility of China becoming a domineering regional hegemon and powerful military threat.”  Changes in approach to the US and to its regional neighbors have allowed China to strike new economic deals all over the world.

This new profile has, however, inspired concern throughout the ranks of US policymakers, economic analysts, and foreign policy strategists. The dominant view predicts waning US influence and power in Asia, and even the world. Many political analysts and scholars have called for a containment strategy to prevent China from challenging the US position in the region.

The European Union (EU) has also cooperated with China via a vast array of economic and policy projects. The situation is easier for the EU since, unlike the US, it has no real military or strategic interest in East Asia. No European military forces are based in the region, and no security alliances or other commitments exist that would cause either side to view the other as a potential threat. 

The US is the only country whose interests span the globe, and it will have to be extremely agile when designing its foreign policy.  The US will be faced with the grand strategic dilemma of allocating resources in the regions most important to its interests.

If China establishes a firm foothold in Taiwan, it will control the South China Sea through the Taiwan and Luzon Straights. But this should increasingly become a Japanese and/or Korean problem. Japan (given its usually pragmatic view on geopolitical issues that has produced its strong alliance with the US) “may have to choose between ‘balancing’ against or ‘bandwagoning’ with China.” 

The US has been encouraging the Japanese to become more involved with issues of their own security. During the last 30 years Japan has consistently spent 1 percent of GDP on defense, making its military budget the fourth largest in the world in absolute terms. In late 2004, the Japan Defense Agency (JDA) issued the National Defense program guidelines, which stated: “…China, which has a strong influence on the security in this region, has been modernizing its nuclear and missile capabilities as well as naval and air forces, and expanding its area of operation at sea. We have to remain attentive to its future course.”  

This was the first mention of China as a potential threat. The document also addressed the North Korea and Taiwan Straits “situations.” A few months later, after a meeting in Washington, the US Department of State issued a joint statement of the US-Japan security consulting committee identifying a common Asia-Pacific strategic objective to “encourage the peaceful resolution of issues concerning the Taiwan Strait through dialogue.”   This was the first time in the last fifty years the two governments issued a joint statement concerning the Taiwan Straights.

Preventing Taiwan from declaring independence remains China’s most sensitive security concern. The US has “recognized that Taiwan is a Chinese province, not an independent state,”  and does not want a military conflict over the issue, but it is an issue the US could exploit to gain concessions on matters more crucial to its own interests. If the Chinese handle it elegantly, Taiwan will no longer be an obstacle to expansion of US-China relations.  

For investors who wish to allocate significant funds in Silk’s recommendations, follow the Fresh Money Buys below.

If you’d rather own only a few stocks at this time, please refer to last’s week’s issue in which I suggested five stocks to own now through the summer. See Silk, 14 May 2008, The Long and Short of It.

The recommendation are as follows (excluding Russian and Japanese stocks): China Mobile (NYSE: CHL, Hong Kong: 941), Cheung Kong (Hong Kong: 1, OTC: CHEUY), iShares MSCI Taiwan (NYSE: EWT), Singapore Telecom (OTC: SGAPY), Bank of China Hong Kong (Hong Kong: 2388, OTC: BHKLY).

Last week I recommend shorting HSBC Holdings (NYSE: HBC). I made this recommendation before, but it didn’t play out well for us. The argument is the same this time around: HSBC holds 63 percent of its loans in the US and UK, and its stock hasn’t suffered nearly as much as the rest of the global banks.

I still expect it to be hit in a downturn, and it’s a good hedge to our long positions. Short HSBC Holdings at current prices, and place your stop at USD100.

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio tables for details.

• Russia (energy, telecommunications)
• Hong Kong (banking, real estate, infrastructure)
• India (pharmaceuticals)
• Taiwan (ETF)
• Philippines (telecommunications, real estate)
• China (consumer, telecommunications, machinery, oil, e-commerce, coal)
• Singapore (banking, telecommunications, industrial)
• Japan (banking)
• South Korea (banking)
• Cambodia (casino/hotels)
• Macau (casino/hotels)